Trading Rules To Live By
By Tony Golan
Chief Technical Analyst
StockProfit.com™
Trade only in the direction of the long-term trend. The long-term trend is the most powerful force in the market. Once established, it is much more likely to continue than to reverse. So much more so, in fact, that trading against it is simply crazy. This means you only buy stocks that are in long-term up-trends and you will only sell short stocks that are in long-term down-trends. In technical terms, it means we only buy stocks that are making higher highs and higher lows and are above the 200-day moving average, and we only short-sell stocks that are making lower highs and lower lows below the 200-day moving average.
Chart 1 - An example of a long-term up-trend (BDX)
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In the above chart, you can see BDX is making higher highs and higher lows above the 200-day moving average. Every time the stock has pulled back, it made a low above the prior low and turned back up to resume the up-trend.
Chart 2 - An example of a long-term down-trend (OVTI)
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In chart 2 above, you can see OVTI was making higher highs and higher lows until it topped out last May just under 35. Then, it dropped and made a lower low, thereby breaking the progression of higher highs and higher lows. From there, OVTI rebounded but made a lower high (LH), then continued making lower lows and lower highs below the 200-day moving average and has not stopped yet. Note how far below the 200-day moving average it is.
Trade only in stocks whose Relative Strength Differential (RSD) is 25 or higher. Simply being above the 200-day moving average is not enough. Plenty of stocks that are in slow-moving long-term up-trends suffer surprise gap-downs and open down substantially one day, without giving you the opportunity to get out before the loss becomes huge. To further minimize the risk of a surprise gap-down, we only trade in stocks whose Relative Strength Differential (RSD) is greater than 25. These stocks are in up-trends so strong, compared to the performance of the S&P 500, that they are much less likely to suffer these big gap-down and will be much more likely to allow us to get out at the stop price. Since these stocks are in such strong up-trends, they tend to produce further price gains more often, which help result in profitable trades, which is an added benefit of concentrating on these stocks.
Chart 3 - An example of a stock making higher highs and higher lows whose RSD is 25 or higher (SYX)
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In chart 3 above, SYX took off initially, then corrected sharply back down, but was able to recover and rally far past the previous high made in September of last year, a characteristic common to stocks whose RSD is 25 or higher, but not to stocks with lower RSD.
Chart 4 - An example of a stock making higher highs and higher lows whose RSD is 25 or higher (TRA)
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In the chart above, TRA is making a powerful move away from the 200-day moving average, and is at just about double the value of the moving average. Note how big the percentage price move in TRA is when compared to the price gain in BDX in chart 1. This stock seems a bit overextended at the moment and therefore this would not be a good time to get in for anything longer than just the day.
Wait for a pullback before entering these stocks for any longer than just the day. For holding periods of more than just the day, and potentially even weeks or months, wait for the stock to pull back against the up-trend. If the stock pulls back mildly, compared to the steepness of the preceding up-trend, it is much more likely to resume the up-trend to new highs and beyond. If the stock corrects sharply against the preceding up-trend, it is not as likely to resume the up-trend and continue past the most recent high. A minimum pullback of 3 days after making a new high is required to be considered a correction of a pullback. A correction of less than three days is not really a correction and therefore not a good place to enter.
Chart 5 - HANS
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In the chart above, you can see an example of this at work. HANS started its up-trend at point '1', going from a low of 10 (adjusted for a 4:1 split) in October '05 to a high of just under 22 in December '05. Then, HANS pulled back for 3 days and hit a low of 19.07 at point '3', then rebounded with a long white candlestick and above-average, rising volume 3 days later. We entered HANS at 21.10 the next day when it went .02 above the high of the last day in the chart above (Dec. 21, 2005). We set the Good-'till-Cancelled sell-stop @19.02, .05 below the low at point 3. If HANS now comes back and makes a lower low, we need to get out right away. This brings us to the next trading rule:
Place a stop-loss order on every stock you buy immediately after you buy it. Trading without a stop makes it very difficult to take a loss, and almost impossible to take a small loss. Setting an appropriate stop removes the stress from the decision-making process and allows you to define how much you would risk before realizing you're wrong on a trade. Additionally, a stop-loss order removes the decision from your hands at the moment of truth, where so many people fail to exit a losing position. When you place a stop order as soon as you enter a trade, you act like a mature trader executing a well-defined gameplan. When you enter a trade and don't place a stop, you're an amateur and you will not last.
I cannot stress enough how important this is. It's like driving without brakes. When I ask people "Where is your stop ?" on a stock and instead of a definite, clear and concise answer I get something like "I'll just watch it" or "I have a mental stop" or anything like that, it is a clear sign that they will not last. I have far too much experience with this to know this is the difference between survival in the market and quick failure.
Chart 6 - HANS
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Chart 6 above shows what happened after we got into the HANS trade @21.10 (adjusted for split). HANS went down initially but did not violate the prior low and did not stop us out. It then rallied to a new high in the beginning of 2006, then corrected sharply into February, but again failed to make a lower low and the stop held. HANS then took off and rallied sharply for the next few months. We exited HANS in late May of 2006 at a split adjusted price of 47.42 for a 124% gain. Obviously, having the stop in the correct place was instrumental in helping us stay in this trade.
To be continued..
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