Option Investor
Educational Article

Reevaluate The Risk

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By David Popper

If you jumped off of the Empire State Building, would you be injured? The answer is entirely dependent on whether you jumped from the threshold on the ground floor, or whether you chose to jump out of a window on the 100th floor. Gravity is a truth that we all recognize, except when it comes to the stock market. Isn't it amazing that the same people that clamor for a stock that is quickly advancing, treat that same stock like a leper when it tumbles. Indeed, every greedy fiber of my being wants to jump on a hot stock, whose major move may be behind it. Every fearful fiber of my being wants to dump that same stock if it falters. The funny thing is that often the stock's story has not changed. It is just that for some reason the emotional tide of the crowd has turned against that particular stock, sector, or perhaps the market as a whole for a short time. How many times has CSCO, SUNW, ORCL and others gone through a free fall only to come roaring back? On the other hand, when KTEL fell, who was there to catch it, certainly not the institutions. In a nutshell, that is why quality matters.

When you trade quality, corrections are buying opportunities. Corrections help you identify support and provide you with an entry point. The only real danger when you are buying quality is when you buy quality that is technically extended. You see, sometimes the enthusiasm for a stock develops into unrealistic short term price acceleration. Buying into that madness almost always guarantees you a short term loss because institutions will not pass up the opportunity to lock in a profit and buy the quality back cheaper. The money managers know that when a price becomes too extended, people get nervous, especially people on margin. (This is why I never use margin. I want my trades to be governed by logic, not emotion) The money managers know that when they sell, it will impact the price, because they sell a sizable amount. They also recognize that often when the price declines even slightly, nervous people pull the trigger and the momentum reverses. Just about the time that all the nervous traders sell, the price stabilizes, institutions buy, and the whole process begins again. You see, stock prices are very seldom based on true value. Remember the market is an auction, and often emotions effect prices at auctions. Institutions make a lot of money recognizing the value of a stock, and simply by trading against the emotions of the crowd. They have the advantage because their actions directly impact a stock's direction. This is precisely why it is critical to trade unemotionally, using at least basic technical analysis. This is also why you never put too much money in one play. This is also why you use proper money management. Failing to take these precautions exposes you to short term institution induced market fluctuations which can harm you.

How much technical analysis do you need? It depends on your time parameters. A daytrader may need every oscillator and short term signal available. Since I do not daytrade, and since oscillators often give contradictory signals, I prefer to keep it simple. And when I doubt, I get out. If I had more time, I would love to learn all of the fine nuances that undoubtedly have benefited so many. My schedule requires me to acquaint myself with a stripped down version. I typically like to buy a stock after a correction only when it begins to move up off its newly formed base. The base should develop for at least a couple of weeks. I take this precaution because often after a fall, there may be additional aftershocks. I may make an exception if the stock is compelling and I plan to use it to write a covered call. When I hold a stock, I typically use trend lines and moving averages as my guide. If the trend line becomes too steep, I will place stops because stocks that go up hard, will come down hard. Further, if a stock advances more than 20% over its 10 day moving average, I set stops because it is advancing too fast and profit taking will happen. (Again, these are my own rules, and I would gladly defer to those writers who are more experienced) Sometimes as a stock advances, I will take partial profits along the way, so that when the music ends I won't be hurt too badly.

Another safety feature that I find helpful when trading is to research the splits calendar and upcoming trade shows and analyst meetings. Often these provide a good emotional spike to a stock, though recent times have not necessarily backed up this proposition. Again, this is all relatively simple stuff. It does not always work, but more often than not, it keeps me out of too much trouble.

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