technical analysis

The Tale of Two Stock Trades

Sometimes you win, sometimes you lose. The most important part of stock trading is that you remember that your losers should be smaller than your winners. If you can learn to manage your trades like this, your win to loss ratio can be less than 1:1 (meaning you can have more losers than winners overall). Over the years I’ve learned a few different ways to manage trades in this manner.

Below you’ll find a breakdown of a pair of recent trades that illustrate my point. Within the past week or so, I opened two positions. Both Palo Alto Networks (PANW) and Starbucks (SBUX) had solid fundamentals and technicals at the time. Unless I am looking for an oversold contrarian trade (such as oil right now), I mainly have my eye on growth stocks. Both of the companies passed my fundamental tests, thus my next step is to look at the charts to determine a good entry point.

At the time PANW had pulled back roughly 15% from its all time high in July. I like stocks that are off their highs since this increases the probability of the price action going my way. Additionally the stock had formed a bullish pennant which gave me the “green light” to put some capital to work.

Over the next few days, PANW shot straight up (well, pretty much). So in order to ensure that this winning trade didn’t turn into a loser, I placed a stop order at the top of the gap to lock in my gains. At the time of this writing, the trade is up 18%. Keep in mind that most trades do not go in your favor this far and fast. An earnings release and reported projected growth rates had a lot to do with the price action shortly after I initiated the position. This one is still open.

The next trade didn’t go so well, it actually was a quick loser. I bought SBUX for most of the same reasons I bought PANW. The only difference being Starbucks growth potential isn’t as rapid as Palo Alto Networks. SBUX was off its highs and was consolidating in a ascending pennant. Additionally, SBUX had just bounced off the 50 day moving average twice before. Due to this price action and decent fundamentals, I expected price action similar to PANW.

Once the buy order was filled, I placed a stop order to sell the stock if the price sunk a dollar below the 50 day moving average. I figured that if price fell below that level, the chart and trade was broken and I didn't want to be in it. Well the very next day, SBUX sold off (with the rest of the market) and my stop order was triggered and filled. Over all I lost 2.3% on the trade; easily recoverable.

I hope this example illustrates the importance of trade and risk management. Before you get into a trade, know at what point the trade is broken and determine how much you are willing to lose if you’re wrong. Keeping your trade losses as small as possible will keep you in the market. If you spend more time trying not to lose money, the rest is will take care of itself.

MACD Bearish Divergence Signal

Recently I've been looking for a reason to reduce my exposure to securities and increase my cash reserves. I've been searching for a signal of a future stock market correction to confirm my suspicion that the U.S. stock market is overbought and frothy. It's commonplace for analysts (and other humans for that matter) to look for and find data that confirms their suspicions, this is known as confirmation bias. I try to remind myself of the potential of such a bias when I start to stretch an indication or signal that will confirm my forecast. The market has been consolidating in the past few months, with a breakout to all time highs in the last few weeks. The breakout proved that my gut instinct was wrong and further reinforced my understanding that it's difficult to time the stock market.

However, today I noticed a signal that could be used to support the hypothesis that the market will correct in the near future. This signal was the bearish divergence between the price of the S&P 500 (SPY) and it's momentum (which is measured by the Moving Average Convergence Divergence (MACD) indicator). The bearish divergence is illustrated by the orange lines in the image below. Notice how price is increasing while momentum is decreasing over time.

spy bearish divergence
spy bearish divergence

It's wise to be skeptical of this bearish divergence signal due to the fact that many strong market up-trends include long periods of bearish divergences. This is due to the market's tendency to move higher even as it's momentum slows. This common occurance is illustrated in the following chart. As you can see, the MACD is signaling that momentum is slowing; a change in trend could occur in the near future. However the market continues to move significantly higher for a year.

spy bearish divergence trend higher
spy bearish divergence trend higher

So that begs the question, "has my suspicion been confirmed"? Nope, not even close. In the short-run, prices could continue to slide until they (1) find support on prior price resistance or (2) fall through prior support and start a new trend lower. Only then would my suspicion be confirmed.

It should be noted that any reliance on this indicator over the long-term would prove less than optimal. As the case with any single indicator, using a bearish divergence signal should be utilized in combination with other indicators to help in the confirmation of a change in trend. The value that this indicator provides is that it can warn of a change in trend in the near future. At that time other technical analysis techniques such as breaks in prior support level should be used as a signal confirmation.

Timing Based Investment Decision Making

I consider timing, rather than a company's fundamentals (earnings, margins, debt, financial ratios, etc.), as the most important element in the investment decision making process. When investing in a great and fundamentally sound company, the wrong timing or entry point can still turn a good investment idea into a painful loss.

Many professional investors and traders will view the market and individual securities through three different time frames before deciding to put capital to work. Analyzing the market in these time frames can help avoid losses and maximize profits. The following methodology can be used to improve your investment decision making process, however it should be revised as need to reflect your personal investing and trading goals.

Start your market or security analysis by looking at price charts with a long-term time frame. Many investors and will use the monthly chart for this high level of analysis. The following long range view can help determine if the market as a whole is moving higher or is in correction (use an index for this type of review). It's best to invest when the market is moving higher in a solid trend. When the market is in correction it's wise to move to a cash heavy allocation until the positive trend continues. This is due to the fact that most stocks move in the same direction as the market, rearguards of individual fundamentals.

When viewing a broad market ETF in this time frame, I would consider the market in a major correction when price falls below the 20 period moving average.

monthly trend chart
monthly trend chart

After you have determined that the market as a whole is in an uptrend you can drill down into an intermediate time frame. I like to move from the monthly charts to a weekly chart for this level of trend analysis. In this view you will be able to determine if the stock is overbought, oversold or is close to it's mean based on technical indicators. This is also a good time frame for finding price levels that may serve as resistance or support. Regardless of the benefits of using a intermediate chart, I spend most of my time analyzing price action in short-term time frames.

weekly trend chart
weekly trend chart

The lowest level of time that I will analyze the price action of a security is at the daily level, this is my personal short-term time frame. More often that not, day and swing traders will start their long-term trend analysis at the daily charts or lower (hourly, etc.). However, like I said, we are looking for good entry points on our investments not trade set ups. I like to look at my daily charts with a 6 month time frame, as I've shown below.

daily trend chart
daily trend chart

The 6 month daily chart provides me with the last bit of information that I need to complete my personal investment decision making process. When analyzing the price action at this time frame, I look for positive price indicators such as price in relation to the 20 and 200 day moving averages. I also pay close attention to the Bollinger bands to gauge recent volatility and momentum.

Attempting to time the market perfectly is a fool's errand. Analyzing the market and individual securities in a variety of time frames can help you choose better entry points for your investments. Deciding to include time into your investment decision making process will dramatically improve your chances of making wise investments.

My Favorite Yahoo Finance Chart Setup

In the past 10 years I have used a variety of charting tools (TradeStation, NinjaTrader, etc.). I loved NinjaTrader; however I need to be able to access my charts from a web browser and not have to rely on a local program installed on a hard drive. NinjaTrader has tons of 3rd party indicators that notify you of trade opportunities, there are some really awesome ones.

The NinjaTrader platform also includes a bunch of trade management features, but I'm not a day trader and really don't need any of them. In the past year or so Yahoo Finance has spent some time upgrading their charting to a level that's, in my opinion, good enough for the average investor. Yahoo's finance charts don't offer a lot in terms of technical indicators, however I rather have a simple and easy to read chart over one that is filled with tons of difficult to read indicators.

My Yahoo Finance Chart Parameters

I make a conscious avoid analysis paralysis and set up my Yahoo charts with the following parameters:

Time Frames: 10yr (monthly), 1yr (daily), 6mo (daily), 3mo (daily)

Price Graph: Candlestick

Moving Averages (Simple): 20 and 200

Bollinger Bands: Period (20), Standard Deviation (2)

Moving Average Convergence Divergence: Slow (48), Fast (22), Smoothing (9)

My Favorite Yahoo Chart Setup
My Favorite Yahoo Chart Setup

As you can see the chart is rather simple, however it displays enough information to help determine wise buy and sell points for the average investor. The best traders will use hard rules to determine when to enter and exit a position, this helps remove the emotions of fear and greed from their decision making process.

Additionally, the best investors will use similar rules (not as hard) to help determine the right time to buy a security. This Yahoo finance chart setup helps me find the best time to enter a position. In my next post I will describe the rules I use when making decisions based on these chart parameters.