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Thursday, March 31, 2005

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.



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