An examination of buying and shorting shares of stock.
In the last article we talked about Technical Analysis and that the main purpose of it is to develop expectations for what the price is likely to do. And to use these expectations to develop a trading plan.
Part of the process of developing a trading plan is to select the type of position that will be best suited to meet the expectations that were determined from the Technical Analysis. If the charts are showing a probability that the price is going to move higher, then you want a position that will increase in value as the price moves up.
Today we are going to begin by examining shares of stock.
I am not going to give a dissertation about the history of stock certificates and what they represent. What we are going to focus on is what they are used for, and that is to buy and sell to make money! Even if you follow the mantra issued by the brokers or “buy and hold” the object is to make money when you (or your heirs) do finally sell. You know that when you buy a share of stock you are “long” and looking for the price to move up. After the market declines since the end of the 90’s just about everyone has heard about “shorting” stock, where the shares are borrowed so they can be sold, with the expectations that the price will fall where the shares can be bought back at a cheaper price. When you purchase or short shares of stock, you have a constant profit/loss ratio. For each point the stock moves in your favor you earn a point of profit, and each point it moves against you is a point of loss. But with the higher cost of the stock, your return on investment is low. Such as if you buy a $50 stock and it moves $5, you have a 10% return.
One very important thing about buying or shorting stock sticks out at us. And that is the price MUST move in the direction you select for you to be able to make a profit. This brings about the first characteristic about buying or shorting stock, and that this type of position is best suited to a trend and a move with momentum.
We will begin by looking at different situation when you would want to purchase stock. The first is at a support level. Support is simply a level that prevents the price from falling any lower. And for the price to be at a support level it has either been falling down to the support, or is in a sideways move. The advantage of buying a support level is that you are getting the best possible price for that stock. And it would become evident very quickly if the price falls thru the support level that you are wrong about your expectations on the stock, and that you need to stop out of the position to prevent it from becoming a large loss. The disadvantage of buying a support level is that you do not have upwards momentum, and the price can remain in a sideways move as people have just lost interest in the stock, and sometimes it can take some time for an accumulation phase to build a base to launch the stock into an upwards move. While a sideways move is not decreasing the value of the position, you are losing the interest that those funds could be earning, and it is not very heartening to produce returns that are below what a savings account, bond or T-bills position would return.
The best times to take a long position in stock in when the price is in a trend, preferably when it is just beginning a new trend. A trend is simply a progression of moves that takes the price to new highs. In this progression you have 2 events that take place that you want to look for.
After making one of the upwards surges, the price will pull back. You are looking for it to form a higher low, to represent just a dip in the upwards action. As the price forms this higher low and begins to move up, you can buy the dip with the expectations that the price will move up to the highs it was just at.
And when it reaches those previous highs you have the second event that you are looking for, a breakout to new highs.
Both of these events show that the price is moving with momentum, and this is precisely what you need for your long position to create profits.
When the price stops setting new highs, then you have lost that momentum, and you are facing the prospects of a flat sideways move, or the start of a downtrend.
A short position uses the same principals, just in reverse. You want to take advantage of a downtrend. After the price falls, you look for a bounce up that forms lower high, and when it starts to turn down, that is the signal to sell that bounce with expectations to return to the recent lows. And when it gets back to the lows, you are looking for a breakdown that sets new lows. And when the price stops setting new lows you have an indication that a sideways move or uptrend could develop.
On the chart pictured above, we have the first event that took place, the price dipped down, and starting moving up towards the previous highs. Then it paused for 4 candles. When it paused it raised the question of whether the upwards move was coming to an end and creating a double top. You would want to examine the indicators of this single time frame chart to gauge the strength of the stock, and this is also where other time frames would come into play. You would want to look at a larger time frame to see if it is still showing strength and upwards potential. And you would also want to look at the smaller time frame to see if it is starting to create a downtrend, or if it is remaining in a sideways range and starting to breakout of that range.
Stock can be used for any time frame trade. We will look at these time frames and some interactions between them to help show what to look for to place a good entry.
For a day trade, the entire idea is to get in, capture a move and get out, and a day trade is one that will be closed by the end of the day, or in the after hours trading. It is not a position that is to be held overnight. The position can last for a few brief minutes up to a few hours. A common day trading set up would use a few intraday time frames for the entry and exits, along with a daily chart perspective to have an idea of which way the primary direction is headed. Some people prefer to use 2 intraday time frames, others choose 3.
A short term, or “swing trade” is one that last between hours up to a week or two. For a swing trade it is best to know what the weekly and daily chart perspectives, and to use an intraday chart for the signal to enter and exit.
A long term trade is one that will last between a week to a couple of months. And a very long term trade is for multiple months, into one lasting for years.
Each one of these has a range of time that the position is likely to be held for. That is because some moves are stronger than others, and with a position you do need to monitor it and adapt as conditions change. The phrase “let your winners run” is one that is very true, as you will capture the best profits with a longer term move. But, you also have to keep in mind the objectives of the time frame the trade is based on. The shorter the time frame of the trade, the more aggressively you have to take profits when a move does happen. And there is no rule that says once you take profits that if it sets up to continue the move that you can’t re-enter a new position for the continuation of the move.
The general idea is to use multiple time frames to help gauge strength and to signal when a move is starting, as most moves will cascade thru the different time frames as they develop. If the longer time frame is overbought, or is showing potential for a downwards move then the prospects for the shorter time frame breakout to new highs is decreased. And this would also show less potential of the price making a strong move up if it does breakout. If the longer term has successfully held a support level, or is successfully forming a higher low, and is showing potential that it is ready to turn up you have the best prospects for an upwards move. You then look to the shortest time frame to try to get the best possible entry, whether it is forming support or for a momentum signal on it, where it is either also forming a higher low, or starting a breakout. This gives you the indication that the price is starting a move, and the best prospects for placing a trade that will take advantage of that move.
The same philosophy applies to short positions. If the longer time frame is oversold or showing potential for an upwards move then the prospects of a successfully short position are diminished. The best prospects come when the longer time frame and shorter time frames are all showing downwards potential, and the shorter time frames are starting a momentum move.
|Directional. Price must move up to make a profit.
|Reward is equal to the move made in the stock Not constrained by time.
|Higher cost of entry. Low return on investment. Loss of interest income when the price is moving sideways, with prospect of paying interest on margin used. Risk of large loss from catastrophic event.
|Any time frame. Trend and momentum
|Directional. Price must move down to make a profit.
|Reward is equal to the move made in the stock. Not constrained by time.
|High margin requirements, with unlimited loss potential.
|Any time frame. Trend and momentum
This article did not look at how to protect a stock position. That will be explored in a future article, once we have covered the characteristics of some of the different options positions.