Investors who own a stock which has performed strongly over the years are well positioned to undertake some short-term trading to further boost their returns.
These investors are in a win-win situation. If they take a short-term trade that turns out to be profitable, then they boost their returns. If the short-term trade results in a loss then they have a capital loss and a potential tax deduction to offset any other capital gains they might have for the fiscal year.
When an investor has a significant capital gain from a particular stock, they have a lot of open profit to play with. These investors are in a position where they can afford to risk some of this open profit in order to potentially make more profit. For example, an investor who bought Travelers Inc. (a Dow Industrial stock) about five years ago (near the start of the current bull market) would now have a capital gain of around 170%. A monthly chart for Travelers Inc. is shown below in Chart 1.
Chart 1. Five year monthly chart – Long-term uptrend
Chart by stockcharts.com
The above monthly chart shows the strong gains over the last five years. Investors could have bought Travelers Inc. for around $30 to $35 and the stock is now trading at around $84 after a pullback in prices.
Now a lot of investors would be pretty happy with the gains, but there is potentially even more profit that can be obtained. Some investors might feel that the current pullback is actually the market top and that Travelers Inc. has peaked and will now sell back down. These investors fear that the long-term uptrend may have ended.
Chart 1. above shows the one-year Moving Average (12-month MA) which does a good job of highlighting the long-term trend. Basically the long-term trend is still upwards since the 12-month MA is still sloping upwards. While the current pullback has dropped the stock price below the 12-month MA, this is probably due to a medium-term downtrend.
The current pullback can be studied in more detail with a daily chart as shown below.
Chart 2. Daily chart showing medium-term Trends
Chart by stockcharts.com
Chart 2. above shows the 50-day MA (Dark Blue line) which does a good job of highlighting the medium-term trends. On the chart the 50-day MA has turned down confirming that the current pullback shown on the monthly chart is a medium-term downtrend.
Travelers Inc. now sits at the crossroads. The short-term trend (highlighted by the 10-day MA with the Red line) has rallied. The 10-day MA continues to slope upwards and the stock is starting to trade higher again after a minor short-term pullback. This price action is known as the First Rally and First Pullback and is a chart pattern that displays when a medium-term trend has reversed. In other words, there is a likelihood that the medium-term pullback has finished and that this is now the next medium-term uptrend. If this is the case then the 50-day MA will soon turn upwards to confirm the new medium-term uptrend.
This is an opportunity to get in early for the next uptrend. The investor who already owns Travelers Inc. can hold their original position and they could add another position and monitor this position as a separate trade.
Example: An investor might already own 100 shares which cost $35 per share around five years ago giving an investment of $3,500.
This investment is now worth around $8,400 (100 shares x $84).
The investor might now feel comfortable allocating say another 20% of the initial investment and so they might buy 20 shares and monitor this position as a trade which is separate from the original 100 share investment. The investor would place an order the next day to buy the stock – and will pay around $84 per share.
The next consideration for the investor is whether to use a stop-loss strategy. While the investor might be comfortable with a buy and hold strategy for their original 100 shares bought at $35, the stock has increased significantly to $84 and the downside risk is much greater now.
Chart 3. below demonstrates a basic stop-loss tactic that investors can easily use to manage the trade.
Chart 3. Daily chart showing Trade Management
Chart by stockcharts.com
The above chart shows three initial Stop-loss levels. These are denoted as Initial Stop 1, Initial Stop 2 and Initial Stop 3. When using chart based stop-loss levels the investor often has a choice of levels to use based on the amount they are willing to risk.
Stop-loss levels:
- Initial Stop 1 is a stop that is placed under the short-term minor pullback. This is a tight stop that has a higher chance of being triggered but the loss amount is the smallest.
- Initial Stop 2 is a wider stop that has lower chance of being triggered but the loss amount is now more.
- Initial Stop 3 is placed at the bottom of the medium-term downtrend. This is the widest stop which has the lowest chance of being triggered but the loss amount is the highest.
Which initial stop to use (if any) is a personal choice?
When using stop levels the investor has the choice of exiting the trade if the stock closes below the stop or exiting the trade if the stock merely trades below the stop (but the stock may well close above the stop).
Exiting if the stock closes below the stop allows the investor to stay with the trade for longer and is the stop method that is used with this article.
Once the stock starts to trade higher, the investor should consider raising the stop to help lock in the profit if the uptrend suddenly ends. The raised stop levels (Stop 1 to Stop 6) shown on Chart 3. above are based on the tight Initial Stop 1 and placed just below the lows of the minor pullbacks the stock makes as it trades higher. Travelers then closes below Stop 6 which alerts the investor to the possibility that the uptrend may have ended. The investor could sell the stock the next trading day and receive around $94 per share. This quick trade netted the investor an additional profit of $10 per share ($94 sell price less the trade purchase price of $84) which gives the investor a bonus $200 ($10 x 20 shares).
If the investor uses a wider stop such as Initial Stop 3 shown on Chart 3. above then the trailing stop levels needs to be kept further down from the current price action. A simple way to achieve this is to use the same principle used with the pullback lows on Chart 3. (which is a daily chart) and apply them to a weekly chart.
Chart 4. below shows the same trade entry from Chart 3. displayed on a weekly bar chart.
Chart 4. Weekly chart showing Trade Management
Chart by stockcharts.com
As Chart 4. above shows, the stop levels (Stop 1 to Stop 4) are placed below the lows of the pullbacks. Using the pullback lows on the weekly chart gives wider stops which allow Travelers to trade well past the point where it was stopped out on the daily chart. The trade is still open as it has not closed below Stop 4. The open profit for this trade is now $24 ($108 current price less the entry price of $84) which gives $480 ($24 per share x 20 shares).
It should be noted that when dealing with prices on a weekly bar chart the close is the last trading day of the week (usually a Friday). This means that the stock may well close below the stop on say a Wednesday but by Friday it may well have closed back above the stop.
Conclusion
The advantage of using an initial stop is that if the new uptrend fails and the medium-term downtrend continues then the investor is taken out the trade with a minor loss. The disadvantage is that if the new uptrend continues the investor could be stopped out prematurely on a pullback and the stock then continues to trade higher.
The primary purpose of the initial stop is to protect capital by limiting the losses to small amounts. If the investor is prematurely stopped then the investor can always re-enter the trade. The primary purpose of raising the stop is to protect the open profits should the uptrend reverse and turn into a downtrend.
Using a weekly chart generally allows the investor to stay with the trade longer than using a daily chart. Also the weekly chart requires less time to monitor the trade as the investor only needs to check the weekly closing price (which they can do on the weekend). Using a daily chart requires the investor to check the closing prices every day until their trade is stopped out.