I've received a lot of great e-mail the last couple of day's regarding this week's "Ask the Analyst" column where we encouraged stock and option traders to set up a business plan for their trading accounts. Outlining certain rules that would guide them to a disciplined approach of identifying goals and measuring risk for their hard earned capital that traders look to risk in any trade.
So this morning I was going to use today's "play of the day" in AmerisourceBergen (NYSE:ABC) as our guinea pig for assessing risk reward and the subscribers would check that against their own trading/business plan to see if it fit their stringent criteria.
Gosh darnit! I didn't even look at today's action and got half- way through my point/figure chart analysis before I even realized what had taken place today as the stock plummets 7.2% after gapping lower at the open. Suffice it to say, this would have been a beauty put earlier last week, but currently analysis after this morning's gap may not fit most traders business plan after today's move.
However, it is still a good idea to look at the technicals, make some observations as other stocks with similar characteristics may also be ready to show some weakness like ABC did today.
As mentioned in this weekend's "Ask the Analyst" column, once a trader/investor has their business plan together, then it is time to begin looking at trades. The ONLY trades the business is allowed to initiate is those that meet the stringent rules of the trading plan. While some traders "don't like rules," it is those rules of discipline and stringent risk/reward tests that define the boundaries of a trader's future success.
In this weekend's column, we thought a trader should look for MINIMUM risk/reward of 1:2 with better risk/reward being 1:3 or greater. Let's put ABC to the test and see what a trader might have done should the stock of ABC opened flat this morning. Then deal with reality and see if a bearish trade in ABC still makes sense and if so, at what level.
I "know" from past commentary that the various market index Bullish % are all in a "bull" type of status. Therefore, a trader that does trade short/puts most likely checks the business plan that says "only 1/4 or 1/2 positions" when the MARKET INDEX bullish % are in a more bullish phase and internal strengthening is found.
The next thing I did is turn to Dorsey/Wright and Associates bullish % and find that ABC is a "drug" stock. According to Dorsey Wright, their drug sector bullish % is "bull confirmed" at 45.14% after being "bear confirmed" at 28% in early October (red A on a point/figure chart), then reversing up to "bull alert" at 34% not long after early October, and then just recently achieving "bull confirmed" status in early November (red B). These different time lines (A and B) give me a feel for the sector internals, and give me something to "measure" AmerisourceBergen against. Is it reflecting the sector bullishness or trading against it? Only if it is/was trading against it does a bear then become interested. This is the first steps of proper risk assessment. MARKET, SECTOR, then STOCK.
AmerisoureBergen (ABC) Chart - $1 box
Aha! The sector bullish % was improving (as was the various market bullish %, like the SPX, OEX which would be more appropriate of MARKET analysis with ABC), but note that ABC was actually giving sell signals during the latter part of October and early November. That's DIVERGENCE and I've said before, traders can make GOOD MONEY when they identify DIVERGENCE.
First question is what's a downside target? This is reward that is eventually plugged into the trader's business plan. The p/f chart gives us a bearish vertical count of $63. At last night's close of $63, there is then "no reward" to be calculated from the bearish count is there? Again... stocks can always exceed, or never meet a bearish vertical count, but the point and figure chart allows for such assessment of potential longer-term reward.
IF the drug sector had been in a BEARISH phase (as depicted by the drug sector bullish %) we could then have used Professor Davis' study to have identified the triple-bottom sell signal at $70, then used Professor Davis' study to think..."pattern is profitable 93.5% of the time for an average gain of 23% in 3.4 months. From $70, that would have been $53.90. We'll keep this in mind for a potential ABC bearish target, but would need the drug sector bullish % to show some type of reversal.
However, you can see how the stock was giving sell signals (70, 69, 66, 64) why the sector itself along with the market was showing other stocks generating "buy signals." There was something "wrong" with ABC wasn't there?
So that's our reward assessment, and it would have been "uncertain" at best with the stock already achieving a bearish vertical count price objective. The only downside target we really have is the old spread-double bottom support where the stock reversed sharply higher in the past at $57.
So, at best, from last night's close of $64.60, reward assessment to $57 gave reward = $7.60.
What about risk? Primary risk can be established to a level where the stock's point and figure chart would actually generate a "buy signal" (X columns EXCEEDES a previous column of X). That would have taken a trade at $69. Therefore, risk could be established from $64.60 to $69 as risk = $4.40. A quick check of MINIMUM 1:2 risk reward has trader moving on, not considering the trade.
Ooooo, but this stock's going down, down hard! thinks the trader by noted DIVERGENCE against the sector and the MARKET. The stock has had a tendency to rally back two-boxes above a past sell signal (see sell at 69, then eventual rally back to 71? Then sell at 66, then eventual rally back to 68?) OK... thinking short $53, but understand potential rally back to $66. Then risk to $67 ($1 above rally potential to $66) from $63 become risk = $4.
Hmmm... risking $4 to potentially get to $57 is 4:7, and still less than 1:2. No trade.
The only way a trader could have tried to trade ABC based on a stringent risk/reward and point/figure analysis was to have gotten some type of rally back near $65, where the STOCK could have reduced risk in the trade. Even then, it would have been tough to trade bearish as suspicious reversal was found near the bearish vertical count.
While it took me 50 minutes to write this, I actually timed myself and it took about 2-minutes to review the point/figure chart data.
Don't think it IMPERATIVE to know what the sector bullish % are, but it does help in assessing SECTOR risk.
I hope this "walk through" helps a bit as it relates to YOUR business plan. Try to use the OI play lists as an IDEA generator, but always test it against your business plan. Read the play descriptions and various news items in the play write up that might also be impacting the MARKET'S psychology and buy/sell decisions on the stock.
On the above chart, I showed a level, which now seems "obvious" to traders where a "best" short/put entry point was ($72) for a 1/4 or 1/2 position. Remember, even after the triple-bottom, the sector and the MARKET bullish % charts were reversing higher, showing internal strength. Therefore, when ABC was ABOVE trend, only 1/4 or 1/2 should have been initiated. But, the eventual multiple sell signals that too place BELOW trend gave traders ample opportunity to further leg to 1/2, 3/4 or full positions.
Now... pretend you initiated that "best" strategy of bearish trading. What would you have done this morning at $57? Based on that... what would you now be doing at $58.50 (where stock is trading as I write?) Shorting/putting? Probably not. Buying long? Are you kidding me? This stock has been going lower while the market moves against. What's a bearish trader's risk/reward from $58.50?
P/F charts combined with you business plan gives you the trader a rather "fun" way to look back perhaps see what "should have been done" for success. Then look for those technicals in other stocks that show what other "smart money" might actually be doing, that is a recreation of the past! Bulls and bears can be patterned. They usually go back to a similar food source at scheduled times. Once they find food based on certain technical is certain sectors in certain market conditions, they'll stick with it. The supply/demand charts along with your stated business plan will keep you on the right track.