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Using Stop Loss Orders to
prevent an Investing Disaster
Many investors fail to use a Stop Loss Order to
protect themselves in case they end up buying a stock at the wrong
time. In his book "How to Make Money in Stocks" William O'Neil
states even the most successful investors maybe wrong about 50% of
the time when choosing stocks to invest in. The key is to cut
your losses early when a stock fails to follow through to the upside
and minimize your losses.However many investors fail to do so and
allow a small loss to turn into a much bigger one by not using a
proper Stop Loss Order.
A good rule of thumb is to never let a stock drop more
than 8% below the Pivot Point when it reverses to the downside
after initially trying to breakout. Thus this is where
a Stop Loss Order would come into play.
Let's look at a specific example. CLZR first
formed a Double Bottom pattern in 2002 and then traded sideways for
12 weeks while developing a Handle. While forming the Handle
CLZR traded roughly between $6 and $7 with its Pivot Point near
$7. CLZR then broke out strongly in February and above its
Pivot Point (point A) and rose to $10 very quickly. In this
case a proper Stop Loss Order should have been placed 8% or so below
the Pivot Point of $7 near $6.50.
After rising very quickly and stalling out near the
$10 level CLZR had then completed the right side of a 2 year
Cup. Over the next 10 weeks CLZR traded sideways again between
$7.50 and $9.25 while developing a Handle. Then in April CLZR
broke out again and rose to $12.50 rather quickly. In this
case if you had missed the original breakout in February you got a
second chance in April and should have placed a Stop Loss Order 8%
or so below CLZR Pivot Point of $9.25 near
$8.50.
Remember its always important to use a Stop Loss Order
just in case a stock doesn't perform the way you think it
will. Allowing a small 8% loss to turn into something
much bigger can be avoided by using a proper Stop Loss Order as the
example below shows.
Imagine if you would have bought AMZN right before it
peaked in the late part of 1999 (point A) near $120 and failed to
use a proper Stop Loss Order once it began to sell off. If you
had invested $5000 in it during the latter half of 1999 and used an
8% Stop Loss Order you would have lost only $400 as it sold
off. If you had held on to it and rode it down to the $10
level which occurred in the Fall of 2002 you would have lost over
$4000 instead.
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The Importance of
Identifying Favorable Chart Patterns
To be a successful investor it's important to look for
those stocks which are forming a favorable chart pattern such as a
"Cup and Handle", "Double Bottom" or "Flat Base". In
2002 some of the best performing stocks exhibited the above
mentioned chart patterns before breaking out and undergoing
significant price appreciation.
Here are a few stocks that exhibited a "Cup and
Handle" pattern before breaking above their Pivot Points on strong
volume. CBZ formed a 7 month Cup from July of 2001 until
February of 2002 and then developed 3 week Handle (H) before
breaking above its Pivot Point in early April on strong
volume. After breaking out of its Handle CBZ appreciated
nearly 155%.
FSTW formed a 1 year Cup from January of 2001 until
January of 2002 and then developed a 9 week Handle. FSTW then
broke out of its Handle and above its Pivot Point in April
accompanied by strong volume. After breaking out of its Handle
FSTW appreciated nearly 225% over the next few months.
HL formed a shallow 9 month Cup from May of 2001 until
February of 2002 and then developed a 4 week Handle (H). It
then broke out of its Handle and above its Pivot Point in late March
on good volume. After breaking out of its Handle HL gained
nearly 275% over the next few months.
MWRK or med a 5 month Cup from September of
2001 into the early part of 2002 and then formed a 4 week Handle
(H). MWRK then broke out of its Handle and above its Pivot
Point in early March. After breaking out of its Handle MWRK
gained nearly 200% over the next several months.
Another chart pattern to look for is the "Double
Bottom" which looks like the letter "W". Here is a stock (CFI)
that formed a Double Bottom pattern from May of 2000 into the early
part of 2002 and then developed a small 3 week Handle (H) before
breaking out in March accompanied by strong volume. After
breaking out in March CFI gained nearly 170% over the next four
months.
The third type of chart pattern to look for is called
a "Flat Base". Flat Bases form as a stock basically trades
sideways for several weeks or months. CVU formed a Flat Base
for nearly 6 months before breaking out in April on good volume and
appreciated over 300% over the next few months.
TENT is another example of a stock which formed a Flat
Base for 10 months before breaking out in the early part of
2002. After breaking out TENT appreciated nearly 450% over the
next 6 months.
These are some of the chart patterns you should be
looking for when deciding which stocks to invest in. Investing
in a stock which doesn't have a favorable looking chart pattern can
lead to poor performance while other stocks which are breaking out
of a favorable chart pattern ("Cup and Handle", "Double
Bottom" and "Flat Base") undergo significant price
appreciation. Also if you examine the stocks mentioned above
they all broke out of a favorable chart pattern on strong volume as
well.
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When Investors Should Short a
Stock
Shorting a stock is the exact opposite of buying a
stock. When you short a stock you are hedging your bets that
the stock will go down in price unlike when you buy a stock and
believe the price will go up.
Many investors try and short a stock way to early as
they believe the stock price is way overvalued. However many
times a stock that is overvalued in price may become even more
overvalued especially when the stock market is in an extended upward
move. The proper time to short a stock is after it
has encountered its first major sell off and bounced which sets the
stage for a second stronger move to the downside.
Let's look a specific example form the Spring of
2003. COKE made a strong run from July of 2002 until January
of 2003 and gained nearly 75% over a 6 month period.
After peaking in January COKE then sold off but found
support near its 38.2% Fibonacci Retracement Level near $59 (point
A) and then preceded to rally over the next few weeks on low volume
(point B).
COKE then ran into strong resistance as it rallied
back to its 61.8% Fibonancci Retracement Level near $65.50 (point C)
calculated from the early Janaury 2003 high to the low made during
the first week February. This was then followed by an even
stronger sell off in which COKE dropped from $65 to $47 over the
next three weeks (points C to D).
Thus the best time to short a stock is to wait for it
to bounce after it makes its initial sell off and then try and catch
the second stronger move downward. When looking for stocks to
short make sure they are exhibiting these three characteristics.
1. The stock has already undergone one
significant move downward after making a top.
2. The stock
then finds support at a certain Fibonacci Retracement Level or
Moving Average and rallies on poor volume.
3. The
stock then stalls out near its 38.2%, 50% or 61.8% Fibonacci
Retracement Level after rallying.
By following these simple rules investors will have a
much higher success rate when attempting to short stocks.
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Why Earnings Growth is
Important to a Stock's Performance
If you go back through the history of the stock market
there is a recurring theme among those stocks which have had some of
the strongest price appreciation and it's related to their Earnings
Growth. If you plot a chart of Earnings Growth versus a
companies Stock Price there is a usually a strong relationship
between the two.
Here are a few examples over the past few years.
First lets look at ELNT and its associated table of Earnings Growth
and Stock Price over the past two years.
| ELNT |
3/99 |
6/99 |
9/99 |
12/99 |
3/00 |
6/00 |
9/00 |
12/00 |
3/01 |
6/01 |
9/01 |
| % Earnings
Growth |
-29% |
+17% |
-58% |
+130% |
+180% |
+243% |
+313% |
+184% |
+43% |
-67% |
-73% |
| Stock
Price |
2.40 |
5.53 |
8.91 |
14.13 |
39.25 |
44.25 |
91.25 |
39.25 |
21.50 |
33.00 |
33.00 |
Meanwhile if we take the table above and make a
graphical plot of ELNT's Earnings Growth versus its Stock Price show
a very strong relationship. Notice how ELNT's stock price
(blue line) began to rise significantly as its Earnings Growth (red
line) started to accelerate beginning in December of 1999 (point A)
and continued through September of 2000 (point B). From
September of 1999 until September of 2000 ELNT saw its stock price
rise from $9 to over $90 a share for a return of nearly 900%.
Next look what happened as ELNT's Earnings Growth
peaked in September of 2000 and began to decelerate over the next
several months. As you can see ELNT's stock price dropped in
unison with its Earnings Growth (points B to C) and eventually gave
back much of its gains that had occurred in
2000.
Now lets look at another example which proves that
even in a Bear Market stocks can do well if they have strong
Earnings Growth. BEL was a company that had major
problems with its Earnings Growth in 2000 as shown by the table
below. BEL didn't start to see any positive Earnings Growth
until 2001 but when it did finally occur BEL's Earnings Growth
accelerated strongly in the latter half of 2001 into early
2002.
| BEL |
3/00 |
6/00 |
9/00 |
12/00 |
3/01 |
6/01 |
9/01 |
12/01 |
3/02 |
| %
Earnings Growth |
-33% |
-120% |
-112% |
-155% |
+125% |
+175% |
+500% |
+355% |
+3100% |
| Stock
Price |
7.00 |
4.00 |
4.00 |
3.00 |
4.00 |
6.00 |
4.00 |
6.00 |
20.00 |
As shown by the graphical chart of the table above
BEL's stock price went nowhere in 2000 (points D to E) as their
Earnings Growth remained negative. However as BEL's Earnings
Growth accelerated in 2001 into early 2002 investors took notice as
BEL's stock price exploded in early 2002 (point F to G).
Since the Fall of 2001 BEL's stock price has risen from around $4 to
over $20 a share for a return of 375% even in a negative market
environment.
As these examples show regardless of market conditions
companies which have strong accelerating Earnings Growth have the
potential to perform very well until their Earnings Growth begins to
decelerate. If you don't believe this go back and research
some of the best performing stocks of all time and a majority of
them will exhibit similar characteristics.
The key is to recognize those companies which are
starting to establish a trend of accelerating Earnings Growth before
everyone else does which takes a lot of time and
research. This is what I do every week as I spend over
20 hours a week looking for companies that are starting to show
signs of accelerating Earnings Growth. This is how I found BEL
and ELNT well before their stock prices took off.
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