Stockscores.com Perspectives for the week ending June 30, 2006
Exit a trade when it does something that you would not expect it to do. A simple rule that is more difficult to follow because knowing what a stock should do requires a good deal of experience. Since crowds tend to be predictable, so too are markets. Here are my laws of market activity to help you see when to exit a trade.
Law 1 - Stocks shall not pull back more than 50% of their gain - an old Italian guy named Fibonacci recognized that many things in nature had the same proportions. He actually wanted to figure out how many rabbits would grow out of a pair of rabbits in one year. It was then discovered that proportions of the human body, how trees bud, rows on a pine cone, petals on many flowers, rows on a pineapple and many other things in nature all followed the same numerical sequence. The results are Fibonacci numbers which are the sum of the previous two numbers, starting at 1.
Human psychology relative to stocks often follows Fibonacci numbers as well, but using the quotient of the adjacent terms which is referred to as the Golden Rule. Stocks that go up in a quick trend tend to pull back to Fibonacci retracement levels which occur at 23.6%, 38.2%, 50%, 61.8% and 76.4% of the gains. If support at a level is broken, the stock often falls to the next level.
In my experience, an uptrend remains valid when the stock does not pull back more than 50% of the recent gain. We expect it to find support at that 50% level and if it instead penetrates that support price then the buyers have lost control of the stock and it is a good idea to exit. You can also plan to exit at the other levels since they too should provide support for the stock, but I find that 50% retracement levels are the strongest.
Law 2 - Breakouts are no longer valid when support before the breakout is broken - A stock that moves to a new, high price level for a certain time period are said to be making a breakout. All up trends must start with a breakout of some sort but not all breakouts lead to up trends.
Consider what often motivates a breakout. For investors to be willing to pay higher prices requires a changed perception of the fundamentals. The market has found agreement on fundamental value if a stock has been trading sideways at $10 a share. When the stock breaks out through $10 and up to $12 it implies that investors have found new fundamentals to warrant paying a higher price. The step up in price represents a perceived change in fundamentals.
I say perceived because markets can make mistakes. Emotion may cause investors to pay too much or speculation may cause investors to anticipate fundamental change that does not happen. So, when a stock pull back below the range it held before the breakout the implication is that the fundamental reason for the breakout is no longer valid. Thus, we should see stocks when they fail to hold the support established before a breakout.
Law 3 - Emotional buying always ends badly - most people are emotionally attached to their money. When stocks go up a normal person will feel emotions that make them want to buy that stock, even if it makes no rational sense. A speculative bubble is created when many people do this, sending the stock beyond its fundamental value.
If stock goes in to a parabolic up trend (one that has an ever increasing slope)with increasing volume, hits a new high but closes below its open for that time period, exit. This is a sign that the bubble is bursting.
Law 4 - Stocks that rally in to resistance will get stuck at resistance - investors have a memory, at least when it comes to previous price ceilings. Suppose you buy a stock at $10 and the chart shows you that the high for the last year was $15. After you buy it the stock starts to rally and move up toward those $15 highs. As it goes higher it is easy to believe that the stock is strong and will break through that old price ceiling but this is not usually what happens. If a stock rallies up toward resistance it is more likely to get stuck there, so plan to exit at resistance.
Consider what happened at resistance before. This was the price point where investors cast their opinion that the stock was not worth more than that. It is where the sellers took back control of the stock and sent it lower. The sellers will tend to offer stock at these same levels, creating a wall that the buyers have to work hard to break down.
Law 5 - Stocks that get no respect don't deserve yours - there are thousands of stocks for people to consider and many stocks are ignored because the companies are not good at getting their story to the investment community. A story can be very compelling to you but if no one notices the story the stock will go nowhere. When a stock trades with little volume and only goes sideways, exit the trade. Wait until some one cares or your money is just sitting in a parking lot.
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"...In my experience, an uptrend remains valid when the stock does not pull back more than 50% of the recent gain. We expect it to find support at that 50% level and if it instead penetrates that support price then the buyers have lost control of the stock and it is a good idea to exit. You can also plan to exit at the other levels since they too should provide support for the stock, but I find that 50% retracement levels are the strongest..."
Maybe this is why my MIDDLE TRADE indicator works!??!?!
Maybe this is why my MIDDLE TRADE indicator works!??!?!