Wednesday, December 13, 2006

Stick to the Original Plan

A couple days ago, I was at a client’s Christmas party that he was hosting for his staff. After drinking about three eggnogs, I find my client - chatting away with a group of his business friends, and their topic is, naturally, the stock market.

Now, to date, we have been in a four-month intermediate bull market (starting in mid July till present). One person in our group was discussing how he was able to capitalize on the recent market, making profits on, basically, every trade. And that makes sense – the Dow has gone from a low of 10,683 (July 18, 2006) to today’s high of 12,369 (December 13, 2006) – an unbelievable feat! Therefore, if you put any money in the stock market, most likely, you would have made money (of course, there were stocks that didn’t see such gains).

The problem is this (and this was what the gentleman had pointed out): it is so easy to get sided by a new opportunity. This is what he meant: every point in the trading day, there is a new stock that is poised for a technical breakout. Now, many people (myself included) used to close trades where I felt that the momentum had started to slow down. Then, I would take the money I made in my original trade, and invest in this new stock that is ready to explode in a certain direction. Sometimes, the stock doesn’t move the certain way, or it requires more time than expected for “the ball to start rolling.”

Let me tell you what I mean by an example: It was late January 2005-February 2005, during the period when the market was pushing higher. I was able to easily find new stock picks that were prime to move upwards (since the market was moving up). What I used to do was close trades where the stock started slowing down, and invested the money into these new picks that were ripe for moving. And in 80% of the cases, I was correct – they moved as predicted.

However, it was only after all the dust settled, and I looked at my net gains that I realized a very interesting tidbit: if I had stayed in my original trades, I would have ended up with the same amount of gains than the constant buying and selling of positions that I had done.

I would have made the same amount of profit!

Why? Well, I thought about it for a second, and thought of two main reasons:

First: Most people find stocks ready for a technical breakout because it has completed a technical pattern: for example, a penetration of a support/resistance line, completion of a standard technical pattern, or a bounce off a moving average, or price channel. Usually, on a day such as this, the stock has moved a substantial amount already – for example, if a stock breaks a key resistance barrier, it usually does so on great volume, and a great price move. What happens next is a period of trending sideways, or reverses for a brief period (slight profit taking), before continuing as anticipated. In which case, you have already missed the short-term breakout, until it regains strength, and pushes higher (with momentum).

Second: Most stock issues move with the market. Thus, if the market is going up, most likely, your stock will go up as well. That is why if you maintained your original positions (rather than just selling out, and buying new stocks that you think are ready to move), you would see gains no matter what stocks you are invested in.

Net effect: If you stayed with your original portfolio (instead of chasing new breakout), you would see occasional days of nice gains as well (and you wouldn’t’ be chasing them, because you already would be in the position). Second, if the market is going up, your portfolio will go up as well (in most cases). That is why one shouldn’t get swept away with new opportunities, and buying and selling positions to profit from these opportunities – because in the end, you’re going to make the same amount. In fact, I probably made a little less money by constantly buying and selling positions, because of the commissions that were involved.


Anonymous ~ Nona said...

In addition to the commission costs, don't forget the amount of time and attention (which is a cost) devoted to buying and selling. Unless you are giving short-shrift to other pursuits or interests, this may be irrelevant; if trading is your interest and passion, this could be totally irrelevant.

There's a lot to be said for buy and hold -- using TA to find good entry points, of course.

I just found your blog. I like it!Thank you for creating it.

2:02 PM  

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