Placing a “Test Buy”

…Last night, I posted a watch list for the upcoming MSW portfolio which is eager to make its first purchase amid the negative market conditions. We recently screened a stock that we feel confident in placing a “test buy” to determine the direction within this lower priced stock (that is showing strength on big volume). The stock will remain unnamed as the watch list and portfolio is posted exclusively for community members. I never incorporated the strategy of making “test buys” into my philosophy until the bear market of 2001-2002. I would always place my entire stake in a position from the minute it crossed the pivot point, made a new 52-week high on above average volume or pulled back to a key trend-line. Things were great in the late 1990’s and “test buys” were not needed as 75% of the market was headed higher.

In today’s market, especially the start of 2005, we have not seen any leaders or solid industry groups produce multiple stocks that we can purchase. Aside from the few all-stars on our screens in 2005, the general market has been weak and has not presented excellent opportunities as it did in previous years. To determine the strength of the market, you can always initiate a position in a stock that you feel has potential by placing a “test buy” for approximately1/4 to 1/3 the typical amount of shares you would normally buy.

What is the reason for this test buy?

It allows you to measure the market with real money without hurting your portfolio too badly if the trade goes against you. If I want to buy XYZ at $10 but I don’t feel comfortable committing my usual stake or I am unsure if the stock can produce gains in the nasty environment, I can place a test buy. If I usually stake $10,000 for every position that I establish, I can place a test buy for $2,500 and see if I am right or wrong in my analysis. If the stock goes to $12 or $14, I am right and I can look for an additional entry point to place another 25% or $2,500.

If I am wrong, I can sell quickly for a 7% loss and wait until the stock and the general market presents me with another opportunity to re-enter. The loss of 7% on $2,500 is only $175, a very inexpensive insurance policy in the stock market. If I had placed my typical amount of $10,000, I would have lost $700 on the 7% stop. You can see the difference between the two losses and how I can continue to place “test buys” allowing me to determine where the market and individual stocks are headed. I can also get a feel for the market makers, the institutions and the general atmosphere by using real money without jeopardizing large amounts of cash.

If the stock does advance, you won’t make as much profit initially (if you used the entire $10,000) but you can add to the position on a pullback because you have already been confirmed correct with your analysis. When adding an additional position, I suggest that it should be equal to the original “test buy” so you don’t expose yourself to greater losses that could happen if the stock decides to breakdown. Once again, if you are proven right by making further profits, a third position may be established at yet a higher number as long as all indicators are positive (fundamental and technical). Always try to buy a stock on a healthy pullback instead of getting it at the peak of a short run above the pivot point.

Don’t get confused with this strategy:

• When a stock is approaching its pivot point, we try to buy at the precise peak where the line of resistance disappears.
• These additional purchases are happening well past the original pivot so they must be placed carefully and not at the new 52-week high. Another thing, if you like the stock, buy it “at the market” instead of penny pinching with limit buys and the like.

This idea of placing “test buy” usually comes into effect during sideways markets, corrections or bear markets. In a roaring bull market, test buys are usually not needed as most stocks will blow past the pivot point and never look back. Always know the general health of the market, also called the ‘M’ in CANSLIM.

We will all see how this “test buy” works out.

Piranha

Jesse Livermore Advice

...Times are tough in the market and we haven’t been in an up-trend since late last year. Many “talking-heads” on TV and radio are claiming they have get rich quick stock schemes, hot stock tips or systems that can be used in less than one hour per week. I laugh at these claims and feel pity for the novice that gets suckered into these money scams. Like any endeavor in life, success in the stock market takes time, lots of time to learn and develop a successful system. Over time, this system will be modified slightly to accommodate the changes in your life and the world around us. Without constant involvement and study, you will not be successful at managing your own portfolio over lengthy periods of time. If you do not have the time to manage your own money, please take the time to hire a qualified professional that has a lengthy track record with other clients in both bull and bear markets.

Many novice investors believe that fortunes will be yielded from the stock market with minimal amounts of work. I ask myself: How can anyone be so naïve? Nothing comes easy in life and the stock market is no different. I look to one of my mentors for advice, comfort and direction when things are not working as planned. His name is Jesse Livermore. He passed away in the 1940’s and is considered one of the greatest speculators (investors) that Wall Street has ever witnessed. The quote below by Livermore is arguably the best quote ever said pertaining to Wall Street:

“BEWARE of IGNORANCE – The market must be studied and learned, not in a casual way, but in a deep knowledgeable way. The stock market, with its allure of easy money and fast action, induces people into the foolish mis-handling of their money like no other entity.
THE REVERSE OF IGNORANCE IS KNOWLEDGE, AND KNOWLEDGE IS POWER!” - Jesse Livermore

Read this quote aloud several times and think about what it is saying. With our current market situation, now is the time to be reading and studying as much as you can while your cash is waiting on the sidelines patiently. The ‘M’ in CANSLIM is negative and we have not seen a group of quality leaders since 2005 has started. I highly recommend reading “How to Trade in Stocks” by Jesse Livermore. If you have already read this book, reread it; I have read this book in its entirety at least one dozen times and refer it numerous times every year. Another great book to read about the life of Jesse Livermore is “Reminiscences of a Stock Operator” by Edwin Lefevre (arguably the greatest book ever written about the stock market).

If you are not comfortable shorting stocks or playing our red flags, then cash is your best position in this current sideways market. As your cash earns minimal interest in a money market account, you should be studying your past trades, your past mistakes, your past successes and reading about the markets as much as possible. If you waste this precious time now, you will not have the luxury of additional time when the leaders do present themselves and your skills may lack when the time comes to make a profit. To start, read over our entire free Philosophy and Education section of the website and then study the common chart patterns on our Technical Analysis Guidelines page. Become familiar with everything on these two pages and try to locate similar patterns on current stocks making our screens. In sports, they always say that practice makes perfect and I believe this statement to be true with stocks. Note: No one will ever be perfect but you get the idea.

Piranha

Shorting Stocks – The Basics, Part II of II

...After the publication of the first part of this two part series, I had a few questions asking if shorting stocks is legal and I will quickly reply with a big YES. Some people believe that shorting shares of American companies is not patriotic or does not seem like the right thing to do. I respect the views and opinions of everyone in this community and understand that this strategy is not for all members. Shorting stocks is not my primary method of making profits in the market as many of you already know, but it is a valid strategy that must be covered especially since our screens have focused on red flag and shorting opportunities since December 2004. In the world of supply and demand, things go up and things go down, it’s human nature. Stocks have been shorted for over a century and have provided investors with an alternative strategy to making profits.

To initiate a short sale, you must place the order with your broker or online brokerage by determining the size and price at which the trade will occur. Your broker or brokerage company will check to see if shares are available in the specific stock selected or if they can borrow the shares. Once they are available or can be borrowed, they will be sold in the open market on the first plus tick or continuation of an up-tick also known as zero-plus tick (the stock must move up for the transaction to complete). To close the short position, the broker will purchase the shares using the original proceeds and return the shares to the third party.

As a short seller, you believe that the price of a particular stock will fall in value over time. For example: by establishing a short position for 100 shares in XYZ at $50, the broker will place $5,000 into your margin account. If the stocks falls over the next few weeks and you decide to cover the short at $40, you will initiate a buy for 100 shares in XYZ using the money placed in your account when you sold short. The cost to buy back the shares in this example will be $4,000 or $1,000 less than the original short sale amount. This difference in price will result in $1000 cash that will now become your profit.

On the flip side, if the stock was to jump to $60, you would most likely cover your short or have your stop loss triggered, buying back the shares at this price. The cost would be $6000 or $1000 more than the original short sale, resulting in a 20% loss. The broker would take the additional $1000 from your cash account to cover the loss in the short sale. This is how you can lose money when shorting stocks. The higher the stocks rises, the more money you can lose, theoretically resulting with an infinite loss (excluding stop losses and broker margin calls).

If the stock rises in price or if the value of the stocks you are using as collateral goes down in price, you may be forced to add cash to your margin account or cover the short sale prematurely. As I mentioned in the first article, you must pay any dividends issued while you are short a particular stock.

The two basic reasons for selling short would be to profit from a stock that you believe is grossly overvalued or to hedge your account with protection from a down-swing in prices due to anticipated or unexpected events. In the first case, you may have noticed a stock such as EBAY (red flag on our screens since December) topping on the charts and then slicing through all long term trend lines in above average volume. If the stock fails to recover these key trend lines, a further decline may be in the immediate future and you may want to profit from this action. In the second case, you may own several stocks and fear a market downturn is on the horizon but don’t want to sell for certain reasons. Instead, the investor can short specific stocks to hedge their account against possible down-turns. Some investors diversify their portfolio with several long positions and a few short positions. I don’t agree with this strategy but it is a common practice by some institutions and investors.

All short positions should be covered if earnings and sales surprise the street or are starting to become positive. A short should be covered when it breaks above the 200-d moving average and certainly covered when it breaks above the 50-d moving average. If the relative strength line starts to move up, gradually making its way to new territory, I would advise covering the short position before a big breakout occurs. If the ‘M’ in CANSLIM is starting to turn positive and the daily new highs list if growing with new leaders, this would be a clue that a new up-trend if on the way or currently forming, alerting you that it may be time to cover the short positions before they turn negative.

By utilizing our philosophy in up-trending markets, you will have consistent profits but you may become impatient during bear markets or sideways markets if you don’t learn how to short stocks. Shorting stocks will contribute to a more consistent strategy throughout good and bad times. As I have said in earlier posts, shorting is not for everyone and nothing is wrong with sitting in cash during bear markets, awaiting the next breakout and fresh batch of leaders.

Most important, always cut your losses quick! This rule applies to any strategy in the stock market.

Piranha

Shorting Stocks – The Basics, Part I of II

...What does it mean to short a stock?

This means that you borrow the stock from your broker to sell to a third party. The idea is to buy back the stock at a lower price, returning the shares to your broker while leaving the remaining cash in your account as a profit. Put another way, a short seller does not own the stock before they sell it. Instead, they borrow it from another investor who already owns it. At a later date, the short seller buys back the stock they shorted and returns the stock to close out the loan. If the stock has fallen in price since they sold short, they can buy the stock back for less than they received for selling it. The difference is your profit.

Short selling is a transaction made on margin. This means that you must open a margin account to sell short. Most online brokers allow you to open a margin account if you qualify according to their rules and regulations. Criteria related to minimum balances and cash reserves may apply. You will sign an agreement with your broker to open a margin account, this agreement says that you will maintain a cash margin or pledge your stocks as margin. (Note: Call your individual brokers for additional questions that you may have).

Shorting can be difficult even during a bear market. The conditions must be exactly right for a stock to be considered a short. Just because a stock looks overvalued or high doesn’t mean that it is time to sell this stock short. As I have said before, what looks high to one investor may still be low to another. Two things to take into consideration would be dividends and thinly traded stocks. A stock paying a dividend must be paid by you the short seller when this position is on. Low volume stocks can be very volatile and market makers and money managers can run up the price quickly crushing your short play and adding to your overall loss.

If the stock rises above your sell price, eventually you will have to cover your short for a loss. If you have not placed a stop loss, the stock can continue to go higher as your portfolio heads for disaster. Theoretically, a stock can rise infinitely, meaning your losses can rise infinitely. Imagine shorting NVR at $200 a share because you though it was overvalued, only to see it go to $700 per share. I am sure this type of trade would wipe out or leave a big dent in anyone’s portfolio.

Many great shorting opportunities come from the same small and mid cap stocks that were once high flyers in previous months or years. For example, TZOO was a high flyer in 2004 and a MSW All-Star before it became a red flag and shorting opportunity on our 2005 screens. Our screens rode TZOO up the charts and then back down the charts in recent months. Currently, DCAI has become a red flag on our screens, as recently as yesterday, after it had made gains of 300%+ and solidified itself as the #3 All-Star on our site.

Ideal shorting candidates will have built several bases over a long period of time resulting in faulty late stage bases as the stock starts to fall. We look towards stocks that have built four or more bases over a few years although this is not always necessary. Stocks such as the mortgage lenders (LEND & CFC) have built many bases since 2002 and have run up several hundred percent. Home builders also fall under this category but have not made our shorting lists as of yet. They have been showing some red flags but support has been noted at or slightly above the 50-d moving averages.

Additional criteria for shorting candidates will be decelerating earnings and sales and a relative strength line heading down. Basically take the characteristics that we use for long positions and reverse the criteria to develop a list of possible short candidates. Even familiar chart patterns can be used to spot shorts; the reverse cup shaped base, the head and shoulders pattern and/or the flat base with a stock breaking out to the downside on above average volume. Industry groups that are becoming weak or are showing multiple stocks falling and breaking through key trend lines should be noted on a watch list. If one stocks looks like a short candidate, look for additional sister stocks that may have the same set-up. Remember, stocks usually move in groups whether they go up or down.

As you may have noticed on our recent screens, I tend to look for stocks that are below both the 50-d and 200-d moving averages. Once they slice through both of these lines, I then look for a strong down-trend and a failure to break above the 200-d moving average. This is my ideal time to short a particular stock.

Always have a sound exit plan in place with a predetermined stop loss to protect your capital. We typically use a 7-10% stop loss for our long positions depending on the market strength but I would advise a larger buffer for short candidates. A stop loss placed 10-12% from your sell point would be ideal as most stocks have a natural tendency to go up or contain volatility near the shorting sell point.

Shorting stocks can be more difficult to learn than buying stocks because a whole new set of rules and bearish short patterns must be learned, on top of your buying rules and chart pattern skills. Shorting can take many more years to master and can provide a shorter window of opportunity as bear markets typically don’t last as long as bull markets do. No matter what strategy you develop with shorting or buying long, you must always stick to strict sell rules. Never argue with a position that goes against you, emotions and pride mean nothing in the market, especially in the short market. Sell all losers immediately before they devastate your portfolio and your confidence going forward.

The next article from this two part series will detail the strategies or reasons why you may want to short a stock and a few examples of how shorting stocks can benefit a portfolio during bear markets or sideway corrections, similar to our current situation.

Piranha

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