Trading The ultimate guide to trading shares - part 4 December 5, 2007 Adam Hamilton CPA, Zeal Research
Are you interested in trading in the stock markets? Do you have questions about getting started? You are certainly not alone. Almost weekly I hear from ordinary folks with basic questions about trading stocks. After addressing these on a consulting basis for years, I’ll outline some of the basics in this series.
Picking fundamentally-strong stocks in fundamentally-strong sectors is very important. You want to buy stocks that other traders will want to buy from you later at higher prices. But the real key to profitable trading is timing. In order to buy low and sell high, you have to have some idea of when these great stocks are relatively low or relatively high. Stock price behavior, or technicals, offers insights here.
Thankfully timing stocks is a lot less arduous than researching their fundamentals. Nevertheless, much of the art of speculation is dedicated to studying timing to make sound buying and selling decisions. Countless trading tools and indicators have sprung up to game timing, to try to gain an idea of when the probabilities for success for a given stock trade are high or low. Obviously you only want to buy or sell when your odds for success of executing an optimally profitable trade are high.
My favourite simple timing tool is based on a trading system I developed, Relativity. In bull markets when prices are trending higher, they don’t move up in a straight line. Instead they advance forward two steps in uplegs before retreating back one step in corrections. The best time to buy is late in these corrections. Interestingly these optimal buy times are fairly easy to discern on a chart because they often emerge at a common point. This point is the 200-day moving average of the stock price itself.
For any given stock, you can easily and quickly see where it is trading relative to its own 200dma by visiting StockCharts and entering its symbol. I love this website and use it many times a day, it is outstanding. The resulting chart will look something like this example of BHP Billiton, the world’s biggest mining company. The solid red line, labeled “MA(200)” in the chart legend, is its 200dma.
Note that BHP tended to retreat back down near or under its 200dma in corrections and then soar far above it in uplegs. When it was down near its 200dma, odds are its price would next head higher in the coming months. When it was stretched far over its 200dma, odds are its price would next head lower in the coming months. This simple general bull-market tendency forms an excellent basic guideline for buy and sell timing. So always check a stock’s price relative to its own 200dma before buying or selling.
If you want to buy a given stock low, you have a pretty good chance of achieving it when that stock is down near its 200dma. This is because in order to get to its 200dma, the stock had to just do one of two things. It either fell sharply back down to its 200dma in a short period of time (a correction) or it gradually ground sideways for a longer period of time (a consolidation) to give its 200dma time to catch up. Either way, it is likely trading at a relatively low level compared to where it will be in the coming months.
So if you want to buy a stock that is gradually climbing higher within a bull market, you should wait until it is near its 200dma before buying. Everything else being equal, odds are it is relatively low at that point compared to where it is going. Sometimes it is hard to wait for a hot stock to fall far enough or drift long enough to hits its 200dma, but patience before buying is essential to make sure you have a good shot at buying relatively low. Stalking trades well in advance, waiting for an optimal entry point, is a critical part of trading.
On the opposite end, your odds of selling high are greatest if you wait until a stock stretches far above its own 200dma. As this chart shows, after soaring well above its 200dma BHP tended to correct or consolidate. This is true of all stocks in long-term bull markets. You have an excellent probability of achieving a near-optimal sell point in a trade if you wait to sell until your stock is stretched way over its own 200dma.
Now I realize this rule sounds overly simple, and it is. And no it doesn’t always work 100% of the time, but no other trading system does either. The markets are full of exceptions to any rule-set that traders try to impose upon them. Nevertheless, I have personally earned a fortune trading stocks largely based on this simple principle. The key caveat is this strategy is only valid for stocks within long-term bull markets. This works best when a stock is likely to rise on balance for years to come for fundamental reasons.
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