TheRumpledOne
6,407 posts
msg #49257
- Ignore TheRumpledOne |
1/14/2007 11:05:19 PM
Good Stock, Good Trade?
Stockscores.com Perspectives for the week ending January 14, 2007
We should not forget that there is a big difference between a good stock and a good trade. Generally, we only know if a stock is good by the performance of that stock after we buy it. We could say a stock is good because it has gone up a lot lately, but that really only means the stock was good for someone else. Without ownership before the price gain, there is really nothing good about it. In fact, watching a stock go up without owning it is probably a bad experience.
A good trade is something very different because a good trade is one that has a positive expected value. One where the probability of profit times the expected profit is greater than the probability of loss times the expected loss. If the trade is made and results in a profit, then the good trade has led to a good stock. A good trade can evolve in to a bad stock if it leads to a loss. However, we should only concern ourselves with avoiding bad trades and pursing good trades, regardless of what the results may be.
Understanding the probability of success and the expected profitability is a skill that experience affords. The Stockscores StockSchool teaches many of the skills necessary to make that judgment, but it still takes some time to really understand trading probability. Anyone can do it, you just need the determination and effort to get there.
Let's look at two stocks generally believed to be good stocks because they have done well lately. Both were in the news last week, on opposite sides, so it will be interesting to decide if there were good trades.
Our focus is Apple Computer (AAPL) and Research In Motion (RIMM). Apple has been a good stock because they sell a lot of iPods and that has improved almost all other aspects of their business. Research In Motion has been a good stock since it settled a patent infringement lawsuit and launched their Blackberry Pearl phone which has sold very well.
These stocks were in the news last week because Apple announced the launch of a phone that would play media and make that all important call to your stock brokerage. That made Apple stock go up and Research In Motion stock go down. Important news, but did it generate a good trade?
Intuitively, the news would make Apple a buy and Research in Motion a sell, which is why Apple stock went up on the news and Research went down. However, the market has a tendency to make short term mistakes and logic should not always be applied. Therefore, it is important to look at the charts of these stocks to decide if there really is a good trade.
When assessing a trade, there are a few things that you need to think about. Most traders just think about the information, and usually the headline that they read in the newspaper. "Apple Launches New Cell Phone" means good time to buy the stock. But should it?
Take a look at the chart of AAPL. Notice the trading activity on Tuesday, when the news came out. The stock went up over $7 on very strong volume. Buying the stock on Monday or sooner would have made AAPL a good stock for those that owned it but I don't think buying on the news was a good trade. Here is why.
When you make any trade, you should plan your loss point. Identify the point where the market proves you wrong and you need to accept the mistake and take a loss. I do this at support on the stock chart which was at $76.75. Because AAPL jumped up so much on the news it was about $15 away from support. That was a lot of downside risk for a stock that has moved up $20 in the last two months.
Go back to the AAPL chart and draw an imaginary line across the tops, starting in August, continuing across the top in late September and just cutting through the top in late November. Extrapolate that line a little farther and you see that this line, which forms the upward boundary of a channel pattern, established resistance at about $95. That limits the short term upside to about $3 from the day the news came out while the downside risk was $15.
That makes buying AAPL on the news a bad trade.
Now go look at the chart of RIMM. RIMM has been a good stock that sold off almost $12 on the news from AAPL. But it has been a good stock for most of the people that own it, having more than doubled in the past six months and having good upward momentum. So, was buying RIMM on bad news a good trade?
To answer this, we must first look at where support is, the point where we are going to take our loss if we are wrong; put that at $125.11. Resistance is at about $145 and the stock closed on the bad news at $131. So, we have $6 of downside and $14 of upside. Given the stock's long term upward momentum, I would say the stock had a 65% chance of holding above support, making this a trade worth taking.
The news was good for AAPL and bad for RIMM. But, the good trade was to buy RIMM.
This line of thinking is what separates good traders from the masses. The masses read headlines, good traders understand risk, reward, probability and discipline.
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Could it be it's not WHAT you trade but HOW you trade it?
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