WIN TRADING STOCKS DURING A DOWNTURN

[Carlo Ferrari]

During the present downturn it is more important than ever to understand the use of Trailing Stops and especially the Short Trading of stocks and how to incorporate this in your overall strategy or portfolio management.
It is important to realise that picking winning trades is a
science not an art and certainly not guesswork or playing
hunches. Picking a winner though isn’t rocket science either, and can be quite easy to do if you follow some simple rules. This will not only improve your win/loss ratio but will greatly reduce your level of risk.
Many people spend too much time analysing stock sectors stock fundamentals, and pawing over recommended stock lists and their financial reports. Their time would be better spent looking at factors that seem to create short term winners rather than trying to predict which out of a huge number of stocks will turn out to be the next long term winners. Talking with traders shows that generally speaking they set their sights too high by expecting too much, often 30% or more return in the short term. Our experience shows that a 20% expectation is probably as much as “the crowd” following that particular stock will allow before profit taking begins. We find that by taking profits in two or more stages earlier than 30%, will likely keep the upward (or downward in the case of a short

trade) momentum in your favor. This is far better than allowing profit taking to set in, causing the stock to back track, and then risking having your trailing 5% stop loss triggered when the backward momentum will act against you, reducing the profit even further.
This leads us to another conclusion about trading stock picks, and that is the frequency of taking new positions. You see, if you set your sights too high you will probably experience one or more of these profit taking periods. These can last for some time while consolidation occurs before the stock resumes its onward progress. This will definitely extend the period of time required for a stock to reach its more optimistic target price levels of, as we said before, 30% or over. Looking at the return on investment from a time efficiency standpoint and not just the level of profit achieved, we find it better to trade a larger number of stock picks short term, setting no more than 20% target levels than spending too much time in a few stocks waiting for higher profits to occur.

There is another more technical mathematical reason why this is a good rule to apply. Using the analogy of wave forms caused by a disturbance or event. These waves will decay exponentially over time. Simply put, think of throwing a stone into the calm water at the edge of a pond. You will notice how the ripples formed by the disturbance caused by the stone move across the surface of the water gradually dying out the further away they get from the drop point.

Relating this back to your stock trading it means that the further away in time you go from the point or event that caused or triggered your decision to enter a position in that stock, the less likely will the movement continue due to that event. In other words, if some good news in a stock had caused a spike up in price on heavy volume and you decided to enter a long position due to these factors, you must be aware that the effect of this news may only be short-term. Many other factors such as approaching support/resistance lines or long-term average lines, or trend line envelopes, may well be more influential on the stock’s continued likely movement. So, better to take a 20% profit quickly while the short-term effect lasts than to stick out for a higher profit but taking far longer and having to weather several set backs caused by profit taking or testing of resistance lines etc., greatly delaying its progress.
Another reason why short-term stock plays are recommended relates to the mix of long or short positions chosen taking into account overall market conditions. Obviously, in a severe downturn or correction period for the overall market it would be wise to have more short positions than long stock pick positions. For example, if you had the majority of your stock picks as short positions during such a downtrend to gain re-inforcement from the overall market, the longer you remain in these positions the less responsive you could be if the overall market suddenly decides to change direction and rally. Quick In & Out positions gives you a big advantage over holding on!