Anatomy of a Trade
By Quint Tatro Oct 04, 2007 1:30 pm
A step-by-step guide to making a trade that allows you to minimize risk and keep emotion from getting in the way.
Someone recently asked me a very broad question. "How do you trade?"
I wasn't quite sure how to answer that so I avoided it altogether and started talking about the UK Wildcats' phenomenal football season and their upcoming win against South Carolina tonight, but as I pondered the question further I thought it might be helpful to take someone through what I would deem the perfect trade.
As you may know, I like to buy in pieces, typically in thirds. I am not sure why, because rarely do I cut in thirds, but for the purpose of this example we'll keep it simple and work with the thirds theory.
Assuming I have identified my winner, which is an entire series of articles within itself, I would generally like to watch the stock a few days to make sure it continues to act appropriately. This is just a personal preference but it does tend to avoid the "You won't believe what happened immediately after I bought it" syndrome.
So, for the sake of my example, let's say that Andre Woodson, Quarterback for the UK Wildcats and stealth Heisman candidate is a publicly traded stock with the ticker symbol UKQB.
What originally catches my eye with the stock is that it has been lying dormant for years, trading within the $15 to $20 level, but a few weeks ago I noticed that volume started to pick up and it was slowly moving towards the previous high of $20.00. After a quick check of the fundamentals I find out that while this stock has been moving sideways for years, the underlying stats have been improving and this stock looks very cheap both on a future and trailing earnings basis. I start eyeing the stock a little closer and notice that over the last couple of days the stock has started to trade in a tighter range, no longer making wide swings within the $15.00 - $20.00 level but moving in .10 and .20 ranges around the $17.50 - $18.00 level. I see that volume taking the stock from $15 to $18 was quite large, but now is dropping off, which tells me that those same buyers are not selling and the stock may be resetting itself before making an attempt at a break.
I wait no longer, taking my first 1/3 position within the $17.75 area. It is merely dipping a toe in the water to make sure it is safe. I place a loose stop at the bottom of the longer term range, $15.00, to give the stock time to work. The recent consolidation range may be a sign it is getting ready to run but I am not quite sure and don't want to take my chances with too much capital. I don't get too anxious and I remain patient.
Over the next few days, I see the same thing. The stock continues to move sideways, with volume drying up, precisely within the current short term range of $17.50 - $18.00, almost looking as if it has stalled out. Most would view the trade as dead, but I know otherwise. I know that the chart is telling me it was accumulated by strong hands on the recent move and is now simply resetting itself before making another surge higher.
Because it continues to hold the short term resistance level of $17.50, a few days later I decide to wade in with my second 1/3 piece. This time, however as I am increasing my financial commitment, I raise my stop to the short term support area of $17.50. My thought is, that if this area does not hold, odds are it will retest the longer term support and I would rather not go through a draw like that with a 2/3 position.
Fortunately for me, I don't have to wait long as a few days later, I notice that the volume starts to pick up and slowly the stock starts to move again. I wait patiently with my 2/3 position as this is a very critical time that if rushed can often result in severe portfolio damage. With volume picking up and the stock starting to move towards its longer term trend line of $20.00 it will be sure to land on other traders' radar which is both good and bad. The stock starts to move towards the $20.00 level but doesn't quite push over the line and many who jumped in for a quick run decide to sell and flip shares. I continue to wait patiently.
A few days later, after the "flippers" are done, the stock continues its ascent and this time does not stop moving. Those that entered and exited for a short term gain are hesitant to remount because they fear a reversal but I have a much better basis and am not anxious at all. As soon as I see the stock clear the $20.00 level, which has served as resistance for years, I add my final 1/3 piece. I then go to lunch.
When I come back I see that the stock is up another $1.00 and is clearly on all traders' radars. The stock has no real resistance above and everyone wants in. Ironically, as is always the case, the fundos or story start to catch up with the move and word spreads that UKQB is a mover because Andre Woodson may have a shot at the Heisman and after South Carolina, UK is sure to beat LSU and then Florida. While it is nice to hear the hype, I remain patient with my stock and raise my stop to the break out level of $20.00. As is also the case with so many that start to break out, the run gets almost ridiculous and the stock quickly adds on another $1.00. I can't help but get a little anxious as I hold a full position of a stock up over 20% in just a few days. Later that day, as the stock is running on very high volume, I decide to peel back 1/3 of my shares booking a nice gain. I then wait patiently.
What I want to see now is how the stock "acts" after its break. If the stock gives back the entire break and closes back below $20.00, I know the stock is flawed and I must take my stop and move on. This would be classified as a failed break or a bull trap and happens frequently. The key here is to remain disciplined, taking your stop and not holding onto hope that the reversal is an anomaly and soon it will be back to highs. On the other hand, should the stock keep going, fade on light volume or start to base at highs, this would signal that the stock is acting well and is worth my patience. Furthermore, once I see the first healthy and normal retracement, I look to add back my 1/3 or even more if I feel confident enough in the trade.
What I am watching for to take off the entire position is an unhealthy retracement. This would be when a reversal sets in, followed by a failed rally attempt, or a series of lower highs. The biggest one I like to look for is a high volume; churn day at highs, like I recently saw in the FXI, to tell us a run may be over. Once I see this sign, I exit stage left and don't think twice about it.
Of course my UKQB stock is just a fantasy but recently I have done this same trade with Celgene (CELG), Hanses (HANS) China Finance (JRJC), Alkermes (ALKS), and many others. While I may not have exited as gracefully as I would have liked, they all followed the same pattern as was outlined above.
Positions in UKBQ and ALKS.
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