Chapter 6. Timing the Entry

Most people believe that the stock market represents what is taking place within the economy at that time. The successful trader, however, knows that this couldn’t be further from the truth. It is this very misunderstanding that separates most people from their money. Although a firm grasp of the economy might assist you in formulating a thesis or a theme from which you may consider your investment options, we have already discussed the extreme importance of allowing price action alone to be your primary guide, rather than your own opinion on where the market should go. Throughout my career, I have seen countless extremely educated people lose fortunes in the market as they have bet in the direction of their economic opinions rather than with what the market is actually doing at that time. Unluckily, most of these investors end up being right as to their forecasts and market predictions. However, by the time the price action begins to confirm their economic opinion they have lost a tremendous amount of money or given up completely. Before going any further into this book, you must understand and accept the fact that the market can do anything at any time regardless of how irrational it may seem. Once you have truly embraced this, you can move on to the next step, which is to capitalize on this movement.

Whereas many traders apply their economic opinions to their market endeavors, many others seek out quantitative information to guide them in their investment selection process. Never before have you had such accessible information, from economic reports to fundamental research. With one click of the mouse, you can gather all publicly available information about a company: its financial status, projections, analyst research, and opinions about the future direction of a stock or market as a whole. Even if you have the time to sift through all the research available, rarely does this path provide a true market edge. In my experience, it is not enough to understand the inside and out of a publicly traded company or its prospects for future growth. You must also time the purchase correctly so that the price action correlates with your opinion of where it should go. The timing of the purchase may be the most crucial element. Unfortunately, rarely does a person who understands the fundamental aspects of a company study this key part of the trade.

Let’s assume for a moment that two traders have spent a considerable amount of time digesting all the information about a local publicly traded company: ABC Corp. Both investors come to the same conclusion that the company has incredible prospects for growth, which should translate into a much higher stock price. The stock and market as a whole has been trending lower of late, so both assume that the stock is of good value, at that time selling at $30 per share. Investor 1, believing that attempting to time the market is a futile endeavor, does not hesitate and places an order immediately to buy 100 shares of ABC Corp at the market. Investor 2 moves from a study of the fundamental aspects of the company to the technical movement of the stock, seeking to learn where the stock has traded in the past and whether, in fact, the stock is ready for a turn. Instead of just jumping in, Investor 2 wants to try to improve not only his purchase price but also the time he has to wait with his capital committed for the upward move to begin. Upon further investigation, Investor 2 believes that although the stock is fundamentally attractive at the $30 price, he sees no other evidence supporting a turn and that previous bottoms in the stock have come only after prolonged sideways action signaling the stock is done going down. Unlike Investor 1, who already purchased shares, Investor 2 waits patiently while the stock continues its slide. Investor 1 initially pays no attention to the continued decline in price of ABC Corp, reminding himself he will rarely purchase a stock at the exact bottom and it is his perseverance that will prevail. Investor 2 continues to wait patiently, stalking the stock’s movement and attempting to time his purchase appropriately. After several weeks, the stock declines from $30 to $25 and starts to head toward $20. Despite Investor 1’s research and fundamental belief about the stock’s valuation, he starts to believe he was wrong in his evaluation. He thinks that by now the stock should have turned around. Investor 1 continues to devour all the information readily available to him but learns nothing more than he already knows. His frustration grows as he watches his investment decline. More time passes, and finally both investors recognize that ABC Corp has stopped going down. On one particular day, the stock hits a low of $18 and rapidly surges back to $21. After a long time of waiting patiently, this reversal gets Investor 2’s attention, and he begins studying the stock even further on a daily basis. After some time, he realizes that the stock is now trading between $20 and $22, moving sideways in this range for several weeks. After this consistent back and forth, one day the stock breaks above $22, at which point Investor 2 immediately places his order for 100 shares. Over the next few weeks, the stock rallies 5 points, leveling off around $27 per share. After several months, the trade has so far shown Investor 1 a $3 (or 10%) loss, while Investor 2 has a $5 (or 23%) profit. Despite the vast difference in returns in the short term, some would hear that story and ask what the big deal was? If both investors desired to hold the stock for a significant amount of time, would an $8 difference in purchase price make that much difference? The short answer is a resounding yes, in that repeating this example several times over the course of both investors’ careers adds up to a significant amount of capital. The emotional effect the exercise can have as a lasting effect on an investor’s success rate is even more important, something we discuss in a later chapter.

Ultimately, the stock market is made up of human beings, and its movement is based on the cumulative emotions of all people participating. Although many variables may aid you in trading, the success rate of these trades can be increased substantially if you will also incorporate a study of price or the actual movement of the stock before committing capital to your idea. Furthermore, if you desire to set aside the outside qualitative variables, such as economic forecasts or fundamental prospects for the company or market, making a study of price and price alone, it is in my opinion that this is adequate enough to create a consistent and successful edge from which you may exploit and garner your profits. To study price, you must find a way to see the historical movement of a stock over time, in graphic form. Fortunately, like the plethora of fundamental information available at your fingertips, price can be seen through stock charts, which are just as easily accessible in a variety of places.

Charts have been used for centuries as a way to display a historical record of an index or stock’s progression through time. Over the past several decades, stock charts have been increasingly used as investment tools. Despite their current ubiquity, I believe most people still do not truly understand how best to use a chart to give them an edge in making money.

To understand why a chart can provide any edge at all, we must first break down the basic emotions tied to a stock purchase, and thus lay the foundation for analyzing stock charts. First, however, I must stress that just understanding this basic principal and attempting to apply a strategy based on it will not work. Understanding charts and applying technical analysis is not as simple as understanding the human emotion behind investing and attempting to exploit it.

People buy a stock for any number of reasons. The previous example discussed two investors who pursued their own fundamental due diligence, but the simple fact is that most people either gather their stock ideas from others or they are directly connected in some way with the company in question. Perhaps you purchase a stock because it was recently written about favorably in a widely read publication. Or maybe a knowledgeable industry insider mentioned it on television. Perhaps you work for the company, did at one time, or know someone who does. Although the reasons behind the purchase may differ from person to person, the emotional cycle after the purchase has been made is typically the same. It is this emotional cycle that you must understand if you’re going to seek to capitalize in the market based on price.

Let’s consider another example. For whatever reason, suppose you decide to buy a local packaging company stock: XYZ Corp. You have had an electronic trading account for years that you use occasionally to dabble in stock trading. So, with one easy electronic click, you buy 100 shares of XYZ at $40 per share. The purchase is new and exciting, and so for next several days you check your account continually, looking to see how XYZ Corp is doing. You immediately show a profit as the stock climbs from $40 to $41 and then to $42. You wonder why everyone is always so caught up with how hard the markets are, when clearly you have a knack for picking stocks. You do a quick calculation in your head: If the stock advances just $1 per week, you will easily double your money over the course of one year. You go so far as to wonder what it would be like to be a full-time trader, leaving your mundane work for the exciting life and easy money of trading. A few weeks later when you are checking your account, you see that XYZ Corp has had a slight correction. After climbing as high as $43.50, is now back to your purchase price of $40. You shake it off, telling yourself that your patience will prevail and successful trading is all about riding out the ups and downs. You are a bit frustrated by having given back your $350 in phantom profits; after all, you had already spent the money in your mind. You quickly make the decision that when the stock reaches that level again, you’ll cash out for a quick $3.50 gain, or $350, and call this trade a success. The following day, you check your account and are floored to see that the price has continued to drop from $40 and is now trading at $38.50. While you’re quite annoyed now that your stock is showing a loss, you again chalk it up to normal market movement and let it be. You do, however, do a bit research into why the stock is trading lower and read a few news stories about the stock (after never having done so before). This new knowledge of why the stock dropped helps you to justify your hold. As the days go by, the stock slowly drifts lower and lower. One day, you check your account to find that your once $4,000 investment is now worth $3,000 (because the stock has dropped $10). Your frustration builds as you start to believe the game is rigged and you were duped. You hastily decide to sell the stock when it returns to your original investment amount. You remind yourself that time is on your side and you can wait patiently for the $30 stock to return to $40, at which time you’ll promptly cash out and stay away from this ridiculous game of trading forever. As weeks stretch into months, the XYZ Corp stock continues to drift lower and lower. It is now that you might choose one of the many paths available to you and chosen by so many others in your situation. After months of languishing returns, frustration may lead to such discouragement that you just want to rid yourself of this stock and sell for a significant loss. Although that might seem logical, and is the case so often for so many, it has been my experience that most individuals hold on to the stock forever, whether it returns to its once famed price level or not.

I am always shocked to see stocks that will never return to the price at which they were purchased still held within portfolios. At some point, a stock’s decline becomes so great that some people prefer to accept the entire loss rather than sell the stock to recoup the dwindled capital amount. I call these portfolio graveyards; the stocks held are dead and will never again return to life. You might be able to identify with this, and perhaps you have a few graveyard picks still in your portfolio. After you read through this material, however, I hope that will never again be the case.

The purpose of the preceding scenario is not just to relay the psychological journey of an amateur stock operator. It is also intended to show you how a chart can help define your edge. Knowing where a mass of traders is within the emotional cycle of a trade is critical information. Readily understanding this information would be nearly impossible without charts, which in many instances are free.

In our example, the stock never did return to the original purchase price. Had it done so, odds are you would have sold out for even money to rid yourself of the trade. It is this emotional connection to price that is the basic foundation for all technical analysis. The key to remember is this: Each significant price point that you experienced correlates to an emotional response shared by many others. Therefore, recognizing and understanding these areas of critical emotion on a chart may provide you the edge necessary for future profits.

Suppose, for a moment, that you originally learned of XYZ Corp in a national magazine outlining the top ten small companies in the United States. Or maybe you heard about the company from an analyst interviewed on television. However you learned of XYZ Corp, odds are that many others did, too. You can safely assume that after digesting the same information, many acted as you did and is why the stock showed an initial profit. If you are our base case, but also a good representation of a larger group of traders, your key price points assume even more significance going forward.

At this point, you might be wondering whether it is realistic to assume that people may act in harmony without knowing about each other’s transaction. Yes, it is. The common thread among all those investors is that they are human and will experience similar emotions as the price moves accordingly. Some will argue that financial status differs significantly across the spectrum, and that more affluent investors will be less psychologically impacted by price moves. I would argue that an investor generally purchases an amount of stock relative to portfolio size and net worth, thus leveling the emotional playing field. Whereas $1,000 might mean nothing to Billy Bigshot, he may in fact have purchased 1,000 shares and therefore be experiencing a $10,000 loss. The key is to understand that average investors follow a path similar to our example more times than not. This cycle allows the astute observer to gather information about key levels from which to then garner an edge to support trading decisions.

The preceding example highlights the emotional roller coaster that creates the key prices that hold significant meaning for a particular stock, which you can see when analyzing a chart. Technical analysis as a strategy begins with the chart itself, instead of starting with a look at how the chart was developed. Ultimately, it matters not how these inflection points were created, only that we find a way to act on these emotional price points and use them to our advantage. In the beginning, your job is to interpret and exploit these inflection points for profit. This is the basic foundation of technical analysis, which has become the common pursuit of so many. Once you’ve mastered this, you may move on to the next level and actually trade the traders who are just trading the basics. At this new level, you suddenly have a world of opportunity unavailable to most others.