By Mark Phillips
Disciplined entry techniques are critical to trading success as we have seen recently in the LEAPS Portfolio. Good entries allow us the flexibility to exit on an adverse move without incurring huge losses. Sloppy entries in a choppy market virtually guarantee a losing trade, as the market seeks to humiliate the maximum number of traders. We've spent the past 2 weeks covering the fine points of how to line up those high-odds entries and then pull the trigger. But entering the play is only half the battle in our pursuit of profits.
Most traders have heard the advice, "Have your exit plan in place before you enter", but defining that exit plan requires the application of Technical Analysis combined with a plan for money management. While we don't have space to address money management here today, some of the questions that need to be addressed are:
What is my long-term trading goal?
And on each and every trade, we need to decide what we expect the stock to do and in what time frame. There are other issues involved in a complete money management plan, but I could write a series of articles on just the questions listed above. But that isn't the focus of our discussion here today. We want to talk about the details of setting up our exit strategy for a specific play and then watching how it is executed in the real world.
My preference in this column is to focus our discussions on stocks that are current (or recent) residents of the LEAPS Portfolio or possibly the Watch List, as I think it is more useful. Up until yesterday's close, I was having a hard time finding the right stock to focus on as the broad markets continued to meaner in their recent range. Although it is an unpleasant development in the LEAPS Portfolio, I was thankful to see Sun Microsystems (NASDAQ:SUNW) violate its $15.50 stop this morning. This play embodies most of the issues I want to cover on the topic of exit points, so let's get to the charts.
Remember when we took our LEAPS entry on SUNW as it bounced from $14.10 on July 24th? It was a near-perfect setup, as the stock was bouncing from major support and both the daily and weekly Stochastics were showing us bullish ascent patterns. We were able to set a fairly tight stop at $12.50, setting up a limited risk and attractive reward play. A quick look at the weekly chart makes it clear that the stock would have a hard time clearing and holding above $20 due to the resistance the stock encountered there during late April and early May. While SUNW did manage to trade as high as $23.50 in May, there was no follow through.
That seems to indicate that until Tech buyers start to return in droves, SUNW could be restricted to a $14-23 range. But a $9 potential range on a $14 stock should provide plenty of trading opportunities for disciplined traders. Prior to entering the play, we had to decide whether we would enter the play with a Buy-and-Hold strategy in mind, or whether we would target a short-term profit and then wait for another opportunity to repeat the process. As a further twist, we could have decided that we would buy a LEAP for the long term and reduce our cost basis by writing short-term calls against it. This last decision will affect the strike price selected, as Covered Calls writers would want to purchase an In-The-Money LEAP to provide greater flexibility in when and what strike to sell for the covered call. So you can already see why it is important to understand how we will manage the play before we even take our entry.
Pure LEAPS investors would have targeted the $15 Jan-03 (Jan-04) LEAP, symbol VZX-AC (LSU-AC), which traded between $4.20-4.80 ($5.50-5.70) on the day of entry. So now that you are in the play, are you going to take a short term profit when the daily Stochastics reaches overbought with price challenging the $20 level? Or are you going to hunker down for the long haul, simply relying on your stop loss to prevent a loss from getting out of control?
Investors choosing to implement a Buy-and-Hold strategy combined with selling short-term calls against the LEAP would have targeted the $12.50 Jan-03 ($10 Jan-04) LEAP, symbol VZX-AV (LSU-AB), as it traded for $5.50 ($7.70-8.00) on July 24th. Once the entry was taken, we just had to set our stop at $12.50 and wait for the stock to move up to resistance as the daily Stochastics ascended into overbought territory. We detailed the setup for selling the covered call in last week's column, so I won't rehash it here.
But the setup for selling the covered call forced our fictional Buy-and-Hold investor to make some important decisions. SUNW had run up north of $18 by August 2nd and there were some solid profits in both the '03 and '04 LEAPS. Short-term traders would have been looking to take profits as the second probe of the $18 resistance level appeared weak, complete with the daily Stochastics starting to fall out of overbought territory. Just in case the emerging profit-taking changed to all-out selling, we protected ourselves in the Portfolio by raising our stop to $15.50.
Sure enough, the sellers gained momentum the past couple days, with SUNW plunging through our stop today and we'll be writing a drop for the play in the weekend edition. Each individual trader would need to evaluate their own positions, based on their answers to the questions listed above. If they tightened up their stops as we did, then they are out of the play tonight, near break-even.
Traders that took profits on the initial weakness are looking pretty smart today, as they are in a position to consider playing the stock again as it bounces (hopefully) from the lower end of its range. The 2003 $15 LEAP traded as high as $6.70 before beginning its descent, offering a maximum profit of 40%. The 2004 $15 LEAP ran as high as $8.00, also offering a 40% short-term profit. That's not bad for a short-term play using LEAPS!
I'm out of time for today, but I want to cover the nuances of how the LEAPS Covered Call trader would have handled the recent drop in shares of SUNW. Tune in next week and we'll do just that - Same Bat Time, Same Bat Channel.
The important point to take from this discussion is to develop your plan and stick to it. If you can keep emotions out of the decision-making process, success will follow in the long run.
Questions are always welcome!