Simple Trading Rule #4 — Become a Stalker

Patience is an important simple trading requirement

“The two most powerful warriors are patience and time.”

— Leo Tolstoy

Retail brokers, mutual fund salesmen, and Wall Street have a mantra (for the small investor anyway)… “you can’t time the market.” 

While I, of course, take issue with that thought given that I’m a short-term trader, I also object given that timing is the VERY thing that value investors do.

Don’t believe me?

Legal Stalking

How often have you heard a professional proclaim that a stock is cheap because it has a low P/E (price to earnings ratio)?  What’s that if not timing by some other means?  The implicit message is you can benefit by buying now in anticipation of multiple expansion (i.e., a rising P/E) in the future, which will, all things equal, drive the price higher.  In other words, good old timing.

The truth is timing your trades is a must if you want to be a consistently profitable trader.  As such, I  suggest traders become stalkers.  No, I don’t mean putting your freedom at risk by engaging in the unsolicited following of another person.  What I do mean is keeping a list of names in which you have a strong interest (based on fundamentals, momentum, celestial alignment or any other underlying driver you like) and waiting for the right moment to buy based on pre-determined criteria (also known as trading setups). 

Instead of adding a name to your portfolio the moment you “hear that it’s a great story,” you let price movement (the ultimate truth) confirm the correctness of your idea.  You then let it dictate your entrance into, management of and exit from the security.

This is the essence of Stalking.

Jack & The Beanstock

For example, in early January Jack reads a bullish story about LPX.  He pulls up fundamental data on the company and likes what he sees.  He checks recent analyst recommendations for the company and notices forecasts are starting to be revised higher.  Finally, he pulls up a chart.

He notices that the stock has had a nice run to the upside at the end of 2011, so he puts it on his Stalk List to watch for a good entry, and does what all good traders/investors do… he waits.

Sure enough, the stock rolls over and challenges the December low.  However, in early March the stock starts to push back toward the high.  Since Jack likes to Buy Breakouts, he sets a Buy Stop (an order that takes you into a trade long the moment price breaks up through the preset price) just above the January high.  If he gets taken into the trade, he will set his stop below the recent (late February) lows.  Jack also uses this information to determine his position size (or how many shares to buy).  Don’t worry… I’ll teach you more about that later.

Jack’s Buy Stop is elected in mid March.  His position looks like this.

Long 2 lots at $9.72; Hard Stop at $7.60.  This means he owns 2 shares at $9.72 and will cut his losses if price trades down to $7.60.  His risk on this trade is $2.12 per share… or $4.24 total.

Now there is nothing for Jack to do but wait.

In early April, it looks like Jack’s trade is all but done as LPX rolls over and heads lower.

Given he followed his process and, more importantly, only a small portion of his account is exposed to this name, Jack is fairly indifferent to LPX’s behavior.  So, parameters in place, he does what all good traders do in this situation…

Nothing.

LPX rebounds and heads back to Jack’s entry level. 

In his early trading days, Jack would have made the cardinal mistake of using that bounce as an opportunity to exit at breakeven and then he would have patted himself on the back for having avoided a loss.

The experienced Jack, however, does…

Nothing.

Though becoming a bit less patient with the name, Jack knows his best move is to let his process work for him.

By August, LPX is starting to move higher.

Jack is tempted to take his gains, but remembers all of the times that he has exited too soon and decides to stay the course for a bit longer.

In September, LPX pushes through $15, then begins to roll over.  Jack exits half of his position just above $14 and moves his Stop Loss on the balance to his initial entry. 

He suspects LPX has further to go, but he also knows that if he allows his winnings to vanish at this point he would be none too happy with himself.  His position now looks like this.

Long 1 Lot at $9.72; Hard Stop at $9.72

Exited 1 lot at $14.05; Profit of $4.33.

No remaining risk.  If price comes back to his raised stop, he will exit the back half of the trade flat.  As a trader, this is a great place to be.  If you don’t care much about small risk trades… You care even less about trades where your risk has been reduced to zero.

Jack settles in to watch and wait.

LPX resumes its upward trek.  As of Thanksgiving, Jack is nearing a double on half of his trade (having taken half off at just above $14).

He knows that he must continue to do what good traders spend most of their time doing…

Waiting.

The Point of It All

To be certain, there are a plethora of alternative ways Jack could have traded this stock…many of which would have yielded the same (or even better) results.  The point is Jack has a detailed process he follows to find trading candidates which he then Stalks for good entries.  Over time, this can’t help but provide Jack the steady growth he desires. 

By focusing your simple process on what you can see, measure and stalk, you can take your account growth to the next level.   

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