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Greetings, Pro-fundity team members -
08-29-03

At the bottom of the Guidepost, a full listing of this weeks picks are shown, in addition to the Charts via the Pick-link.

As a benefit of membership, you have access to all Guideposts (including Archived GP's) and Picks. If you miss a week or two for whatever reason, you will be able to go into the Historical Guidepost link to catch up with both the weekly guidepost and the 30 picks made for the week.

Greetings, fellow Pro-fundity team members.

1. In this lesson we will cover three points:
   1. Exit methods – conclude our discussion about ways to get out of long positions.
   2. Learn a simple technique to speed up the paper-trading process.
   3. Consider chart patterns, emphasizing the value of the price pattern as the most important technical indicator.

   Exits

2. Last week we introduced the Trailing Stop, which is moved up with price increases. We used the fixed-percent stop as a trigger, for instance the –8% default used by William J. O’Neal of IDB, in our example. However, an important point; stops as low as –2% and as high as –25% have been used successfully in certain circumstances. In each case, tighter stops give more small losses, wider stops provide fewer, but larger losses. We must each find the appropriate balance for our trading personality.

3. This time we will revisit the trailing stop but with a different trigger. Consider the principle of variation, with which we all live in all phases of our lives. Things vary. No two things are identically the same. If they appear to be, we are just not measuring closely enough. Let me illustrate with a simple example. If I take a deck of playing cards, draw a circle for a bulls-eye on the floor, then hold the cards at eye-level directly over the bulls-eye and drop them one-at-a-time, they will flutter to the floor and form a pattern around the bulls-eye. This pattern represents the inherent variation in this process. The pattern is random. As with any system or process, there will be random variation. This is one form of variation, random.

4. A second form of variation must be understood as well, called assignable or non-random variation. I can change the card-drop example by moving three feet to-the-right, then dropping another deck of cards, one-at-a-time in the same way. The combined pattern will be skewed to the right, no longer random. In fact, all processes are a mixture of random and assignable variation. The random portion is beyond our control, it can be called noise. Whereas, non-random or assignable variation has some discoverable cause.

5. Now, look at the chart of any price pattern. You see both elements of variation present, random being the small fluctuations day-to-day, with visible trends caused by business economics. For example, healthy earnings can cause a stock price to rise, bad management and/or economic downturns can cause a stock price to fall. Cause and effect! Yet, there will always be the random noise in price fluctuations whether a trend is present or not.

6. What is the purpose of a stop? To get us out of a bad position with minimum loss. But what is a bad position? One that has turned down, contrary to our expectations. We made a mistake and the quicker we admit it the less harm it will do. Now, that is rational thinking, however we don’t want the random variation that is always present to kick us out too soon. That is why a stop of –8% or –12% or –18% is chosen so a real assignable drop is required to trigger the stop. The next question, how large is the noise? We must set the stop beyond the noise! For a stock price the normal variation is the difference between the high and the low prices during a trading period. If we are looking at a daily chart, the bar represents the range the price varied during that day. Look at the next two price charts from this week’s main picks to compare the ranges.
   
   
   Fig. 1 Price variation (range) for CPHD.

7. In this first case, the average range for the last 5 price bars is $0.162. That value is 3.6% of the closing price on 8/29/03.
   
   
   Fig. 2 Price variation (range) for DOW.

8. In this second case, the average range for the last 5 price bars is $0.554 which is only 1.6% of its closing price on 8/29/03. Now, ask yourself, do these two examples justify the same percentage stop? Remember our purpose here, to keep the stop outside the noise level so it will be triggered only by a real assignable change. Clearly, CHPD is more volatile than DOW. We need a wider stop for the more volatile stock. It is not clear by simply looking at the chart because the price scales are different. However, the percentages make the difference obvious.

   Sidebar:

   We used the simple range (Hi – Low) for each bar to calculate the random variation. In 1978, J. Wells Wilder, Jr., in his classic “New Concepts in Technical Trading,” showed how the simple average range calculation misses changes in price from one day to the next, particularly with gaps, offering what he calls the true-range. True range for a days trading activity includes what happens the day before. True Range (TR) = The larger of the absolute values of (Hi - Low), (Hi - yesterday's close) and (Low - yesterday's close). The Average True Range (ATR) is a moving average of TR. This is easy to do on a spreadsheet (or find calculated in TC2000/TCNet with personal criteria formulas). For these two examples, a five-day ATR equals 0.162 for CPHD and 0.558 for DOW. That compares to the average range for the two at 0.162 and 0.554 on 8/29/03. Not much difference in this example. This becomes a variable to adjust as you settle on your own system. 2 to 5 times the random variation are common values to use to set the stop loss. For example, a 2x ATR stop for CPHD would be $0.33 below the closing price on 8/29/03, or $4.53 - .33 = $4.10. A 5x ATR stop for DOW would be $34.53 – 5x0.558 = $31.76.

9. Before we leave this discussion of the nature of variation, lets close on what it means to us as traders. We should be aware of how volatile a stock’s price pattern is. Often, lower priced stocks are more volatile and require more careful attention to where the stops are set. However, since we are truly guessing as we set our stops, guessing about where the price is going to go (it being impossible to know), we gain confidence with improved probabilities this understanding provides. For example, using “noise” in the price pattern as a guide to stop levels, we increase the chance of reaching our goals. Will the ATR give us better results than the TR? You be the judge. But this is one way to better understand the character of a particular stock and its price pattern.

10. We have all bought a promising stock, expecting it to rise skyward, but then watch it languish sideways. This is a not uncommon and requires a different strategy. This exit is called a Time Stop, providing a way out after a certain number of days have passed. It is rarely used by itself, but finds utility when a position is not moving, getting you out so you can used the money somewhere else. The time-trigger depends on your favored time-frame for trading. A day-trader expects to be out of all positions by the end of each day. On the other end of the scale are long-term investors who consider six-months to over two-years acceptable times to remain in a position. The purpose of a time-stop is much like a stop-loss, providing a safety net to keep opportunity alive. Another factor to discover in the trading system of your dreams.

    A short-cut for Paper Trading

11. In recent lessons you’ve been asked to paper-trade stocks using the Personal Investment Planner (PIP). Checking each day as the price pattern unfolds can be instructive, but unfortunately quite boring. Let’s look at another more productive way to learn from price patterns. Consider the following watchlist to illustrate the technique.
    
    
    Fig. 3 Watchlist for Quick Picks selected two weeks ago.

12. Selecting the best performer for this exercise, the price chart for IDTI is shown as it looked on the date of the pick. To paper-trade this pick the first step is to download historical data for a ticker. The pick was made on 8/15/03 and did very well, returning over 30% in two weeks. Our task is to learn what we can from the price pattern, as if we didn’t know where it was going on that date. Since we have the benefit of hindsight in this exercise, download data for three weeks, beginning one week prior to the pick, 8/8/03 to 8/29/03. Refer to the tutorial in Advanced Trading Tools on the main page for guidance in downloading historical data.
    
    
    Fig. 4 Price pattern for IDTI on 8/15/03.

13. Assume a buy is executed at the close on 8/15/03, then decide what stop to use at the same time the stock is purchased. The stop value can be determined with help from the five price bars shown the first week. Notice the range between high and low each day, for an estimate of the average range. That would be the difference between numbers in columns D (high) and E (low). In this case the average range for the five days is 0.31. A 3 times range stop would be $10.61 – 3x0.31 = $9.68. Now, lay a paper across the table showing only data prior to 8/15/03. As the paper is moved down, showing data on each succeeding day, watch for low prices that would kick you out of the position at the stop. In this example, there was no low price equal to or below the stop in the next 10 trading days. We can track the rise in price a day-at-a-time, watching as though we were doing it over the entire two weeks.
    
    
    Fig. 5 Historical data for IDTI from 8/11/03 to 8/29/03.

14. Look at the next watchlist for Quick Picks from last week. Lets examine the worst performer in the same way to see what lessons we can learn.
    
    
    Fig. 6 Watchlist for Quick Picks made on 8/15/03.

15. BELM was selected in part on the basis of its momentum gathered from high volume kicks. Assuming a buy at 8/22’s close of $7.59, select a stop-loss going forward.
    
    
    Fig. 7 Price pattern for BELM on 8/22/03.

16. On 8/22, the five day average range was 0.486. A 2 times Range stop would equal $7.59 – 2x 0.486 = $6.62. Moving down the table, again there was no low price to kick us out of the position. We should watch carefully going forward to test our stop if the stock continues to decline.
    
    
    Fig. 8 Historical data for BELM from 8/18/03 to 8/29/03.

    Price

17. This week we’ll begin a study of price charts as a critical feature in our trading tool box. Technical Analysis (TA) is a study to understand messages in the price chart itself. That is, what does the price chart suggest about future price patterns? Can the chart predict future moves? Wouldn’t that be a boon to our trading account! Rather, it is all about probabilities and likelihoods. As with all probabilities, they suggest, they infer, they imply what might happen. There are many in the business who view “chart reading” akin to ouiji boards and star gazing. That is another decision we must make individually about our own “system.” Do not dismiss TA out-of-hand but learn with us why it is important to keep all the probabilities on our side.

18. Last week we introduced the idea of using price charts, including both the price and volume levels, to improve our trading skills. Technical analysis (TA) is the study of price charts and price patterns to increase our trading skills. Before we begin the study of technical indicators and all they can do to facilitate this process, consider one more time the value of the most important indicator, the Price chart itself. What can we learn from the price chart? Most basically, we can ask ourselves before we enter any position, what is the most recent price activity? For example, if the stock has increased steadily, moving up seven days in a row, does that sound like a train leaving the station we just have to be on? There may be occasions like this, but in the world of probabilities, the chances of further increase are unlikely. That is not a good place to jump in. Look at BELM in Fig. 7 above. Then look where it is one week later in Figure 6.

19. Other questions we can ask as we view the price chart; Is the price at an all time high? Not a good place to enter. Has the price increased at an unsustainable pace during recent sessions? Has the volume level decreased as price increased? Volume frequently forecasts price moves. A condition known as “oversold” means too many people have bought into the company. Buyers have dried up in such a case leaving the price only one way to go, down. Although over-sold and over-bought conditions are fuzzy definitions, the price chart can tell us better than any other indicator where the strength lies, with buyers or sellers. It is critical we get on the right side of this equation to profit in our trades.

20. Next week we will continue our study of what makes prices move along with the first considerations technical indicators. Your task this week is to download historical data on at least four tickers from the Main picks list for 8/15/03. Find the random variation for five days prior to the pick and use it to find what you deem a reasonable stop loss, buying on the date of the pick.
    08-29-03 Pick Selection:

    Main Picks:
    CHKR,CPHD,DOW,DSPG,FLSH,JILL,NOK,PKTR,SRDX,STK
    Breakouts:
    ADIC,AFCO,ALTR,ASTSF,DIGE,MRGE,MTRX,PWER,RFMD,RIO
    QuickPicks:
    ADRX,AOC,AOL,BLTIE,CDX,CHKP,CRAY,CVC,HPQ,IOM

    For detail and followup on Pro-fundity Tradescape,
    find the link on "Advanced Trading Tools" on the home page.

    Be Diligent
    Take Action!

    

    
    
    
    
    

    
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