Tactical Execution

Hello and welcome to Financial Audio, an information series providing listeners with detailed and tactical guidance on today’s complicated financial world. My name is Patrick and I’m your host. You can find written versions of these podcasts at FinancialAudio.com and I encourage your candid feedback at the same location. Today, we’re continuing our introduction of technical analysis and adding a few more variables so let’s get started.

In the last chapter, we looked at the psychology motivating buyers and sellers when the stock’s price is changing. We defined support and resistance as well as trend lines and moving averages. All of these “indicators” are built on the fact that a stock’s price generally TRENDS higher or lower over a period of time RATHER than jumping around arbitrarily from one day to the next. Combining that fact with buyer and seller motivations, you can gain valuable insight of a stock’s potential price movements by knowing where OTHER investors have their orders placed. You can then execute your OWN orders, silently aware of the playing field.

We also discussed the often-dramatic break-outs that occur when a stock is finally pushed out of a channel or beyond some support or resistance. With an accumulation of orders placed immediately outside the stock’s historic trading pattern, such break-outs often trigger heavy volume as these accumulated orders all get executed at once. This is a good time to point out that such break-outs are often followed by “pull-backs” because the sudden price adjustment outside the historical trading pattern motivates new trades. Let’s extend the example from last chapter to understand the psychology.

If you remember, the stock we discussed last chapter was trading between $20 and $25 for quite a while. Let’s assume that growing buying interest finally breaks through the $25 resistance and all of a sudden, a bunch of accumulated buy orders sitting at $26 and $27 get executed, driving the price up even further. Most of the sell orders were sitting at $25 so now, the stock faces little resistance and the price goes all the way up to $28. Well, now everyone who’s purchased the stock in the past has made a profit. Those who purchased at $25 are up $3 and those who purchased at $20 are up $8 and everyone else is somewhere in between. A number of those investors will jump on the opportunity to sell their shares at a profit and new sell pressure will come in as soon as the stock’s break-out slows down.

This new sell pressure will frequently pull the stock’s price back down but the old $25 resistance level that used to hold the stock price below $25 NOW becomes the new support, keeping the price above it. Again, it’s worth reminding ourselves that the stock traded between $20 and $25 for a while and the buy pressure was finally enough to push the stock above $25. You’re not the only one who saw that. Everyone else saw it too. And believe me; now that $25 has been crossed on heavy volume, a whole army of new buyers has jumped in and put their buy orders around $25 or $26. So as the sell pressure motivated by the newly higher stock price gently pushes the price down (usually on light volume), the price hits strong support at $25 or $26 and starts back up on heavier volume again.

So in summary, a break-out to the upside is frequently followed by a light volume pull-back that brings the price back to somewhere NEAR the break-out point. The price usually bounces off that new support level and the price starts back up again.

Let’s look at the opposite situation. Assume that building sell pressure finally breaks through support at $20 after trading between $20 and $25 for a long time. All of a sudden, a bunch of sell orders sitting at $19 and $18 get executed and the stock drops quickly to $17. Again, the stock’s been trading between $20 and $25 for a long time and NOW it’s down at $17, motivating new fundamental investors from taking advantage of the so-called “bargain”. Predictably, the price drifts back up but hits strong sell pressure at $19 or $20.

Everybody saw the stock break below $20 and the technical investors know that THAT spells trouble. They know it took a lot of sell pressure to break through the support at $20 and they know there will be LESS support below that line. So if they didn’t sell BEFORE the break-out, they put their sell orders near the break-out price and wait for the pull-back. Sure enough, the stupid bargain-hunters drive the price back up near $20, allowing the smart technical investors to get out at a better price. And of course, this added sell pressure makes the price bounce off $20 and the stock starts heading lower again.

High-volume break-outs are extremely common and low-volume pull-backs often follow close behind but it’s important to clarify that they don’t always materialize. If the break-out is strong and driven by real news items (either good OR bad), the pull-back may never materialize and the stock may continue its rise (or fall) into a whole new trading channel without coming up for air. The important thing is to understand the underlying psychology so you can evaluate each situation for yourself and make your decisions accordingly.

It’s also important to explain that high volume is always a necessary confirmation of an upward stock movement. If the price is going up without volume confirmation, I would be very suspicious about the opportunity and probably pass on it entirely. A rising stock needs to be accompanied by increasing volume, especially at the beginning. On the other hand, a stock’s price does NOT need increased volume to fall through the floor. In fact, stock prices can fall with little or no volume at all so be careful. And, if the price drop comes WITH high volume, watch out! That spells serious trouble.

Anyway, break-outs are exciting because they usually signal a shift to a higher or lower trading range, the beginning of a new trend or the end of an old trend. But these break-outs don’t happen every day either. Generally speaking, stocks spend a lot of time trading within a channel. And it would be nice if stocks just traded in a straight line in between break-outs but that never happens. Stocks usually trade upwards for a while and then come back down again. These patterns are motivated by many different factors, not the least of which is the overall market sentiment that shifts from positive to negative and back again on a regular basis. In our previous example, the stock traded upward all the way to its $25 resistance and then traded back down to its $20 support, and then did it all over again.

This is common and a variety of indicators try to quantify these patterns, yielding buy and sell signals within the channel. And incidentally, these same indicators will follow break-outs and trend reversals as well. They’re called oscillators and 3 of the most common are the MACD, the Stochastic and the RSI. All three attempt to distill price-volume action into a quantifiable pattern of “over-bought” and “over-sold” market conditions. In other words, when a stock trades upwards for a period of time, it is eventually referred to as over-bought and due for a correction to the downside. Likewise, when a stock drifts downwards for a while, it will eventually be considered over-sold and ready for an upturn.

These indicators can be extremely valuable in the right circumstances and we’ll discuss strategies for sharpening their buy and sell signals in a later chapter. For now, it’s important to understand that most technical indicators fall into one of two camps. On the one hand, you have indicators that are driven by support and resistance. These include trend lines, channels and a variety of consolidation patterns that we haven’t discussed yet. They also involve moving averages because heavily-watched averages often bring support and resistance with them. On the other hand, you have indicators that attempt to identify over-bought and over-sold conditions and those are almost all oscillators of one kind or another.

Okay. We’ve discussed the fact that stock prices generally TREND up or down. One of the most important rules in the stock market is to trade WITH the trend and NEVER against it. Believe me; the trend is your biggest friend when investing your money. Do yourself a favor and NEVER trade against the trend. The trend is your friend. Don’t bet against the trend. The odds are massively stacked against you. So how do you determine the trend? Well, that depends on your trading time horizon but I’d like to lay out some general guidelines for you to consider, and they’re all based on moving averages. Yes, there are other strategies but I believe moving averages are the easiest and fastest.

For starters, if the stock’s 50-day moving average is moving up, the stock is definitely trending upward. But keep in mind that with 5 trading days each week, the 50-day moving average is covering the past 10 weeks. Perhaps the stock rallied for 7 weeks, peaked out and then started drifting downwards again. In that scenario, the 50-day moving average is most certainly still rising even though the stock is now falling. For that reason, it makes sense to look at the 13-day moving average as well. With 5 trading days each week, the 13-day average covers less than 3 weeks and if it’s rising AND the 50-day is rising as well, it’s a pretty safe bet the stock is trending upwards.

Obviously, you can also look at the stock’s chart and get a good idea right away if the stock is trending upwards or not and it will take some practice to read those charts correctly and the moving averages are a good way to get started right away. And incidentally, if you’re looking for ONE single book that does a GREAT job introducing technical analysis and providing guidance on reading charts, I recommend Secrets for Profiting in Bull and Bear Markets by Stan Weinstein. I’ve read over 30 books on technical analysis and that’s the very best one.

Anyway, if you determine that a stock is indeed trending upwards and the other indicators you’re watching give a buy signal, go for it. You’ve probably got pretty good odds on that trade, at least in the short run. But what if the 50-day moving average was dropping and your indicator gives a buy signal? Well, some people would take the risk and some might even find a profit but truthfully, I’d stand clear. I’m not betting on the upside if the 50-day moving average is dropping. My biggest priority is protecting my cash. And if the 13-day moving average is ALSO falling, I wouldn’t touch it with a 10-foot pole.

It’s also worth looking at the market in general. Indeed, there are some stocks that rise even when the market is tanking but I personally don’t think it’s worth it. The overall investor sentiment ALWAYS affects all stocks. All ships rise in a rising tide. All ships fall in a falling tide. When the overall market is trending higher, all stocks benefit as a result. When the market is falling, all stocks are affected. Yes, some may still go up in value but their gains will be lessened by the market’s negative overall sentiment. Personally, I think there’s little reason to buy stocks when the market is falling. And how would you know? Well, check the 50-day and the 13-day moving average for the NASDAQ or the S&P500. Both are broad market indexes and will tell you if the market’s moving up or down.

We’ve talked about the stock’s trend and the market’s trend. Between those two, there’s another valuable category and that’s the industry. Let’s assume the stock market is moving up. Well, the market is a combination of multiple industries and some of those industries are leading the market higher while others are pulling it down. We’ll talk more about selecting stocks in a later chapter but it’s important to identify the leading industries and then select leading companies within those industries. That way, you’re betting on the best of the best, at least for that particular time.

After you’ve selected your best-of-the-best stock and bought some shares when your indicator indicated, do NOT fall in love with the stock. Things can change quickly and your best-of-the-best pick may fall from grace in short order. You need a formal plan for your trading. You need indicators telling you when to buy and other indicators telling you when to sell. And no matter how convinced you are the stock you just purchased is a winner, you have to be ready to get rid of it the second your indicator tells you.

As a general rule, your profits will increase the more you can control and eliminate your emotions from your trading activities. Stock market trading requires a computer-like approach and emotions almost always play a role in losing trades. Of course, the emotions I’m talking about are greed and fear. Those two emotions drive far too many investment decisions and a mechanism to eliminate them from your trading strategy will benefit you guaranteed.

It’s also important to note that even the most unemotional trading strategy can result in false signals. In fact, any trading strategy that is right even just half the time is considered a great strategy. Don’t expect every signal to yield big profits. The trick is to know when your trade is a winner and when it’s a loser. And when it’s a loser, you have to be willing to get out right away. If you can ditch your losers quickly and hold on to your winners, you’ll make plenty of money even if you’re only right 50% of the time. We’ll talk more about the science behind this in a later chapter.

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Again, you can find written versions of these podcasts at FinancialAudio.com and I do offer workshops, seminars and keynote speeches as well as a variety of more advanced information products so please email me at Patrick@FinancialAudio.com for more information. I’m also doing a series on innovative marketing and strategic business positioning. That series is called Tactical Execution and you can find it on iTunes.

Stay tuned. There’s a lot more to come. In the meantime, think big, take action and invest strategically. Bye for now.