Greetings, fellow Pro-fundity team members -
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Last week we covered in detail the several orders we can place with our broker. Specifically, we studied market, limit, and stop orders. The market order has the broker immediately buy or sell at the next available trade. This is both the simplest and fastest order type.

Stop and limit orders are conditional in nature, termed "alternative" orders. That is, their execution depends on the performance of the stock in the market. Let's repeat one graphic to review the stop and limit before we launch into their use. Stop or limit orders can be used to buy or to sell. The chart below shows how they work.

1. A buy-stop is always set above the market price. This becomes a market order and the stock is purchased at market price when the price reaches or exceeds the buy-stop set-price. [We buy when the price rises to our target]
2. A sell-stop is set below the market and triggers a market order to sell the stock when the sell-stop set price is reached. [We sell when the price falls to our target] This is the common "stop-loss" used to protect our downside.
3. Buy-limit becomes a limit order if the stock price falls to the limit set-price. [We buy when the price falls to our target] This order is placed below the market price.
4. The sell-limit is also a conditional limit order, triggering a sell if the price reaches or exceeds the set-price. [We sell when the price rises to our target] A sell-limit is placed above market.

Now, let's consider how they might be used on actual market transactions to help us settle on a successful strategy that will work most of the time. Remember, most on-line brokers will not allow us to place two orders on the same stock. That is, if we want to place a GTC sell-limit on the upside and a sell-stop (stop-loss) on the downside, we may have to limit our trades to a full service broker.

Paper Trades

All proponents of market activity suggest we spend a lot of time doing paper trades before we invest real money. That is to provide us with skills and understandings to limit our losses as we venture into the real market. But no one ever tells us how to do paper trades. It is assumed we will simulate trades and monitor the results, having the opportunity to make mistakes and corrections without dollar losses. I wish it were that easy. Particularly with the types of orders we have just reviewed from last weeks editorial. So, lets begin with some guidance on paper trading to take advantage of all we've learned about buying and selling stocks.

1. Paper trades: Let's begin with what looks like a rolling stock pattern and try, as though we didn't know what lay ahead, to buy and sell for maximum return. [Strategy: We only buy stocks to sell them!]
2. Definition: A rolling stock is one where the price pattern rises and falls at least 10% of its value, several times during a one-year period (several could be anything from 3 up).
3. Look at a good example on the price chart on (SUPX) below from November 97 to October 98.
   
   
   
   

1. In the first case, we use the increase to pay bills or go to a movie, investing only the initial amount on each subsequent roll. The second case, all of the return is reinvested in the next roll, letting the increase compound over the eleven months. The difference is dramatic and should encourage us to let our profits roll

2. Notice the cells in the top right corners of the tables, showing poor performance. It is much more difficult to make a profit while investing small amounts or paying high commissions.

We will use this stock to simulate a trading record, that is, execute a paper trade as though we didn't know what was going to happen the next day. This is called "back-trading" because we can use what has happened to develop trading skills going forward. Let's go back into the price chart and try our hand simulating a real set of trades with historical data. Before we do that, we need some tools. Look at the Paper Trade Worksheet below we use for this purpose:

The column headers, A through N, are included for reference in the explanation that follows. This worksheet can be used as is, entering the data and doing the calculations manually. However, it can be produced as a spreadsheet version where all the calculations are automatic.

Let's explain the columns and calculations in this worksheet:

Having found a roller we are ready to play: (SUPX), has shown some wild swings in the past and meets our selection criteria. It is November 13, 1997 and we have watched the price decline the past three weeks and are waiting to buy in.

To buy into a declining stock, we must be very careful. We should never put a GTC at some level on the downside. We shouldn't buy just because it reaches our selected "buy" point. Wait for the price to show some strength by at least two up-ticks in succession. Here is how we can exercise an alternative order to help reduce our risk as we buy in:

1. Watch for two successive up-ticks in the price, proof of strength.
2. Place a buy-stop order a few percentage points above the last price.
3. If the price increases further, the stop will trigger and we will take a position in the stock at or near our buy-stop price.
4. If the stock turns down, we don't fill and may want to watch for support at a lower (better) buy level.

We could do this without a buy-stop by carefully watching the price movement. However this is one way we reduce our risk. Is the magic number of up-ticks 2, or 1, or 3 or more? What is the best level above the last up-tick to set the buy-stop? These are questions we must all decide for ourselves after getting a feel for the "spirit" of the market, after paper-trading sufficiently to strengthen our trading skills and develop a sense, called market insight.

Back to our paper trade, let's watch the price movement for our next action. To get the maximum benefit out of this type exercise we must actually try to guess where the market is going and take action accordingly, on paper. It sounds stupid but believe me, the rewards are worthwhile. There is no substitute for taking the wrong action, revisiting the chosen strategy and learning alternatives. Here is what I like to do; get a full page printout of the price chart over the time frame to consider. Then lay another sheet of paper over it so I can only see the latest day's quotes. As I slide the cover to the right, showing new daily performance data, I take appropriate action based upon the strategy I am testing. And most importantly, I write down each step on the worksheet. There is a sense of permanency in this action, of capturing lessons learned for future reference. I can make profound comments with magic markers on the worksheets as I discover new and exciting aha's, then post them on the wall in my office as visual reminders!

So, lets watch the next developments with SUPX:

The actual data for the next three weeks is shown here to help make the important decisions:

We had a false up-tick on 11/17, but got two in a row on 12/1 with the price at $12.88. A buy-stop at 2% above this price equals $13.14. That is the order we place to continue our strategy. It fills the next day so we are in the market at something near $13.14. Remember, this is a market order so we are not sure of the execution price.

We put this value in column B, with the date 12/2/97 in column A. I use $2,000 for paper trades to keep commission a small percentage of the action. However, I always include the figure under heading N at the rate with my current broker. So, $2,000 goes in column C and I calculate the shares purchased for column D: [$2000 - $8]/$13.14 = 151 shares (with an $8 commission cost that is placed under heading N).

I next calculate what my break-even sell price must be as a reference to keep honest. The sell price must be high enough to cover two commission charges, one to buy and one to sell. Therefore, break-even = [2,000 + 8]/151 = $13.30.

I also like to have in mind what I expect to get out of this type trade. If my target is 10%, the price must reach [2000 x (1 + 0.1) + 8]/151 = $14.62. That does not mean I will sell when it reaches this level, it just provides a guide as we move forward.

Okay, we have a position in the stock, but our strategy is not complete without knowing where or how we will get out. We always define exit points on both the upside and the down side. First, we can protect ourselves with a safety net on the downside by placing a sell-stop order at some level below where we bought in. No matter how cleverly we choose the stock or how strong the fundamentals and technicals are, they can and do go south. This may occur on a fourth or more of the stocks we pick. The key, however, is not in always making correct picks, it is in cutting our losses quickly on those that do turn bad, to lose as little as possible when we are wrong. That is the role of the sell-stop order. The alternative is to hope, hope the stock will stop falling, hope it turns around before it falls any further, hope after hope.

There is another unique use of the sell-stop on the upside. In defining an exit strategy to get out of the stock we have two alternatives. First, we can specify what we expect to get and sell when that point is reached. We can do that with a sell limit, selling when the target is reached. It is not difficult to know what can be expected from a stock having looked at the historical record and use that as a basis for an exit. However, we have all had those experiences where we sold on our expected return only to have it move up another 5 or 10 points. Carefully watch the stock, as the price increases, for signs that is has reached resistance by looking for down-ticks, in the same way we bought in.

That is, if we wait for a couple of down-ticks, then place a sell-stop a few points below the last price, we have protected our position if the stock falls but we haven't given up on the upside.

Additionally, this order can serve as a "trailing loss" by increasing the sell price steadily as the stock price moves up. This will protect our profits whenever the price falls.

To execute these strategies, it is not necessary to watch the stock price continually. We can use the Good Til Canceled (GTC) order to let the computer do the walking. Particularly as the stock rises towards a sell target. This is the most favorable feature of using a buy-limit as an exit strategy. It takes more effort on our part to move the sell-stop higher as the price increases or to place a sell-stop after two (or 3?) down-ticks. This is another insight we can gain by continuous paper trades.

Take these ideas and continue with the paper trade on SUPX. See how close you can come to the ideal returns shown in the earlier tables. If we get 50% of those results we are in excellent shape.

As a help to picking entry and exit points, the Stochastics technical indicator is a good predictor for rolling stocks. (See the Technical Analysis tutorial) To see how this indicator might help, we have included it below with the chart repeated for SUPX. Include this as you continue your study of this ticker with your paper trades.

Observations:

1. Playing rolling stocks is a lot of work.
2. Rolling stocks do not roll within a given channel forever. Three to five times is the norm.
3. Rolling stocks are difficult to identify because by the time they expose themselves, they have stopped rolling (at least in the same channel).
4. To play rollers effectively, we must understand this is a trading strategy, not an investment strategy. Be buy to sell, not to hold.
5. Paper trading can help us develop both skills and market insight. There are no silver scientific bullets to do our thinking for us. This is both an art and a science.

Next week, we will continue with our paper trading strategies, but learn to use real-time quotes to make it even more interesting as we deal with the market going forward. Additionally, we will review the Stochastics and other technical indicators to help with our exit strategies. Stay tuned.