129
10
C H A P T E R
IMPLEMENTING
As you will recall, the MOM/MA method signals a buy when momentum crtosses above its MA and a sell when momentum crosses below its MA.
We begin our first example in late March 2001. During the last several trading days of the month, Chinadotcom Corp. (CHINA, Figure10-1) gave a buy signal. Momentum had risen above its moving average. Although we did not buy CHINA when it gave this signal, we still watched the stock closely. A sell signal came over a month later on May 29, when CHINA’s 28-day momentum fell below the moving average plotted on our MOM/MA chart. During the span of this move, CHINA had risen from about 2.00 to 3.40. Our MOM/MA indicator told us to buy around 2.25 and to sell at 3.25, making a 1.00 or 44 percent gain.
CHINA was a big winner by the end of May. But it was time for tech- nology stocks to take some heat. Between June and July, CHINA lost a majority of the gains made during April and May. We were done with our waiting on the sidelines. We decided to get in on the next buy signal. We bought on July 11, at 2.55. Momentum had once again crossed above its moving average, and CHINA was looking strong.
Only days later, on July 13, we took profit on our position, selling at 3.85. Our expectations for the trade had been met and far surpassed, even though MOM/MA had not given a sell signal. During the following days, we remained confident in our decision to sell, as the stock returned to where we had bought it.
Analysis
The CHINA trade discussed above was highly profitable. However, there are still those who would take issue with our decisions. As we’ve said before, we use technical indicators such as MOM/MA to determine when to buy and sell stocks. However, during the CHINA trade, we took some liberties in deciding how to interpret the MOM/MA signals.
If you take a close look at the chart provided (see Figure 10-2), you may notice that momentum crossed its moving average, not on July 11, but two days before on the 9th. Why did we decide to buy two days after the signal was given? Simply put, to be safe. There are strict technicians who would argue that one must buy when a signal is given, not before and not after. However, false signals do occur, and we like to weed out such signals by giving our indicator a couple of extra periods to confirm itself.
In this case, the strict technician would have bought on the 9th, between about 2.50 and 2.40. Our buy signal was not false, but the stock price did fall on the 10th. Some traders with large positions may have been stopped out of this trade, because risk had become too large as CHINA approached the low of the 10th at a price of approximately 2.30.
131
L = 262 = +3
02 08 16 22 29 01 12 20 2601 12 19 26 02 09 16 23 01 07 14 21 29 01 11 18 25 02 09 16 23 CQG © 1998
2001 Feb Mar Apr May Jun Jul
MA Mon
700
600
500
400
300
200 +250
–250 202
+10
Figure 10-1. CHINA with MOM/MA plotted below.
09 16 23 01 07 14 21 29 01 11 18 25 02 09 16 23
May Jun Jul
MA Mon
375
350 400
325
300
275
250
225
200
–200 262
+10 –35
Figure 10-2. Three-month daily chart of CHINA with MOM/MA plotted below, a closer look.
The other major (and probably more important) criticism that strict technicians might have with our trade is our decision to sell on the 13th.
There was no sell signal on our MOM/MA chart. Quite the contrary, momentum had continued to move further up and away from its moving average. In fact, most technical traders would have continued to hold CHINA for days after we sold. Such people would not criticize us for the success or failure of our trade. Rather, their quarrel would be with our tech- nique. For many technicians, there would have been absolutely no reason to sell when we did. Their trade ends only when momentum once again falls below its moving average.
We, on the other hand, did have a motive to sell: to make money.
Although it is highly important to remain objective while trading stocks, there is also a point at which personal judgments are appropriate. Let’s backtrack a little, so you can understand why our decision to take a profit was logical. Before making our trade, we had a conversation about our goals for the CHINA trade. We answered several key questions, to which one should always have answers before entering a trade. You should type the following questions into a document on your computer, write your answers to the questions before entering each trade, and store them to remind yourself of your goals:
1.How many shares do we want to trade?
2.With this number of shares, how far must the stock move to cover your trading costs (i.e., commission and fees)?
3.At what point will the trade become profitable?
4.How long are you willing to hold this stock?
5.Is the price at which you will make a profit a reasonable and realistic movement considering the amount of time you are willing to hold the one stock?
6.What is your profit target and is this target reasonable and realistic considering the amount of shares you own, the past price movements of the stock, and the amount of time you are willing to hold the stock?
7.What is the maximum loss you are willing to take on this trade?
With the above questions answered, our expectations for the CHINA trade were clear. Assuming we would buy at the market price of about 2.50, we felt that a profit target of 3.00 would be reasonable. We call this price “reasonable” for several reasons. First of all, we examined CHINA’s volatility for the previous year and decided that even at the low price of 2.50, the stock still had a large enough trading range to easily move $0.50.
Second, the number of shares we had decided to trade made a move of $.50 profitable. In fact, we decided that at $3.00 per share, we would be happy enough with our profits to take a profit. Finally, we agreed to hold the stock until one of three situations occurred:
1.We were satisfied with our profits.
2.We were unwilling to take more of a loss.
3.Our MOM/MA indicator gave us a sell signal.
Given these factors, the price of $3.00 per share seemed to be both a reasonable and realistic goal for our trade.
Now let’s return to our trade. On the day that our profit target was met, we sold. You may have noticed that we actually got out of this trade $.85 above our target. This was due to the intraday fluctuations. Once the price of $3.00 was hit, we began to watch the market closely. We decided that because the market still looked strong, we would hold our shares until later in the day. This decision paid off and we sold at $3.85. The market con- tinued to rise for the rest of the day and during the first few hours of the next trading day. But as the Nasdaq cooled off, so did CHINA. Over the next several days, CHINA’s stock price fell back to near where we initial- ly bought. Using a combination of a price target and a technical indicator served us well.
A good portion of the profits from our CHINA trade came from micro- management. Instead of placing a limit order at our target price and accept- ing our target price as the point of maximum potential profit, we began to watch the market as soon as the price of $3.00 was hit. This allowed us to assess market conditions on a short-term basis.
Summary
By now, you should be able to understand why we feel comfortable taking profits without MOM/MA indicating a sell. Our goal is not to teach you abstract theories about price fluctuations in the stock market. Nor is it to develop trading systems that will tell you the precise moment to buy and sell for maximum profit every time. Our goal is to teach you trading meth- ods that work. We want to help you make money. There is currently no sys- tem or strategy that will give you positive results 100 percent of the time.
As you have seen, systems like MOM/MA can be slow in giving buy and sell signals and can even give false signals. This is why we advocate the use of common sense and goal setting when trading. Trying to perfect a system is an admirable undertaking, but for the investor who wishes to make money, it is not always the most profitable one.
There are those who would argue that such a combination of methods causes us to lose our objectivity. When investors begin to think about price targets and profits, they also begin to feel emotional about their money and thus make irrational decisions. We feel that trading goals do not make traders lose their objectivity. Just as technical indicators are logical and mathematical, so are trading goals. They provide a supplementary logic to trading methods, which technical indicators tend to lack. Our CHINA trade is a shining example of how setting trading goals can provide this kind of logic to your trades. Now let’s change gears dramatically and look at a long-term strategy.