A Simple Way to Buy Low and Sell High
Objective experience shows that stock markets fluctuate, through bull and
bear cycles, corrections and rallies, inter-day and intra-day market movements.
Such fluctuations lend themselves well to market cycle theories; the oceanic
metaphors of tides, waves, and ripples of Dow Theory; the Fibonacci
Sequence-related Elliott Wave Principle; or even the generation-encompassing
Kondratieff Wave. All these theories seek to describe, track, and forecast
market movements as they ebb and flow with unceasing regularity. Many observers
of a technical bent seek to use the chart patterns that such fluctuations create
over a period of time to capture a bottom or top in either a stock or a market,
with buying or selling action taken accordingly.
Contrarian investing is an investment style that is often regarded as a
subset of value investing. It has a number of devotees who look to achieve
successful investment returns by going against the crowd. While few would
suggest that the crowd is always wrong, there is occasion enough where perceived
wisdom on a stock or market sector irrationally pushes prices downwards. It is
the skill of the contrarian investor to understand ahead of everyone else that
there are good reasons to believe that a stock is under-priced and ripe for a
recovery in the near future. Note, however, this recovery can only happen once
the crowd also comes around to the same view and starts purchasing the
undervalued stock. As buying pressure reappears and sends the price back up, the
contrarian investor will show a profit on his or her contrarian move. The beauty
of a contrarian stock purchase is that it is made by definition when the stock
is relatively cheap, leading if successful to a classic buy low, sell high
investment or trade.
Contrarian Ripple Trading borrows the word “ripples” from Dow Theorist Robert
Rhea, who in his 1934 book The Story of the Averages used the terms “tides,”
“waves,” and “ripples” to illustrate market movements. “Tides” were bull and
bear markets, “waves” described market corrections and rallies, and “ripples”
were fluctuations over the short term. The trading technique bases itself on the
existence of very short-term (inter-day or intra-day) market fluctuations that
characterize all markets, bull or bear. The contrarian ripple trader takes
advantage of these fluctuations, and because they are frequent and repetitive in
nature, he or she is able to make profits over and over again with repeated
in-out round trip trades.
The principle cause of these fluctuations is the constant pendulum swing in
prevailing sentiment among market participants at any given moment in time. Day
to day and during the course of one day’s trading, general market sentiment
swings wildly back and forth between greed and fear in a way that is peculiarly
characteristic of the somewhat bipolar moodiness of Mr. Market. Is it any
different at the level of individual stocks? No, as empirical observation of
market action on any day makes clear, the vast majority of stocks move in
exactly the same direction as a group, up or down, and so by definition these
same price moves are then reflected in moves in the indexes such as the Dow
Jones Industrials Average and the S&P 500. Major company news or financial
releases or merger announcements may trigger moves in sentiment, and so may more
macro economic news including employment and housing statistics and interest
rate cuts or hikes.
But sentiment changes do not wait for such important triggers. The ebb and
flow of greed and fear washing in and out of the market is such a constant
factor that it can probably be seen as an expression of the fundamental
personality of the market, and perhaps the means by which market equilibrium is
ultimately maintained. Indeed, to borrow from the dialectical materialists, this
could be viewed as a case of thesis-antithesis-synthesis, where each price rise
or fall carries within it the seeds of its own destruction and creation of a new
price move. But such philosophical musings are probably best left for another
forum. Our basic message here is that from simple empirical observation there
are constant fluctuations in the overall market and in individual stock prices,
and it is possible for a contrarian ripple trader to exploit these fluctuations
for profit. How?
The contrarian ripple trader’s approach to buying and selling is a
essentially a mechanistic one. To harness the power of contrarian thinking, he
or she seeks to buy a stock initially when it is close to its 52-week low of the
year. This initial purchase is also only made at a time that both the stock
itself and the overall market are strongly down on the day. In this way the
trader buys when stocks are “on sale.” This approach has for the authors an
intrinsic logic and appears more sensible than the admittedly more comfortable
tactic of buying a stock that is going up in price. As contrarians who are
strongly cognizant of constant and regular market fluctuations, we question why
a trader would feel comfortable purchasing something that by its very nature
fluctuates in price at a time that it is priced higher than it was just a few
hours or days ago. The principle in Contrarian Ripple Trading of buying when a
stock has been sold down to the lower levels of its 52-week range, and is
trading lower on the day, enables the trader to be more confident of catching
the typical reverse upward move of the fluctuation in the majority of cases.
Because the trader is seeking to exploit the short-term ripples, he or she
also needs to target a relatively modest profit margin on each individual trade.
If the trader adheres to a rigid discipline of selling a stock as soon as it has
reached its predetermined target price, then he or she will in many cases be
able to “ride the ripples” or buy the stock again and again at that same initial
price or lower, thereby making relatively modest but repeated profits on the
same basic stock trade, exploiting repeatedly both the downward and upward moves
of the short-term ripple fluctuations in the stock. Take a look at Johnson &
Johnson’s
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PowerRating) movement over a 52-week period and note the constant
fluctuations that characterize the stock price movement.
As outlined above, the secret to the successful exploitation of these normal
fluctuating price patterns is the trader’s ability to get into a contrarian
mindset when purchasing a stock. Therefore, among the vital underlying
principles of this approach are a rigid self-discipline and an ability to follow
through without second-guessing the mechanistic, almost automated rules of the
technique. As is true with all investing and trading based on a contrarian
approach, however, nerves of steel may often be required.
Contrarian Ripple Trading is a low-risk approach for several reasons.
Firstly, the trader is in the majority of cases in and out of any stock position
fairly quickly. Secondly, the technique is designed for trading almost
exclusively in large-cap stocks of well-established, well-reputed, profitable
and successful companies that usually pay dividends. These provide comfort if
the stock needs to be held for a period of time before the targeted profit
figure is reached. Thirdly, the technique generates most buy signals at
relatively low price points and fewer as the market chases higher, thereby
increasing the tendency to “buy low.” Also risk is mitigated by the “know your
stock rule.” This states that the trader will only trade in the stock of a
company with which he or she has a reasonable amount of familiarity, to the
extent that the trader is able to engage in a two to three minute soliloquy on
what the underlying company’s business involves, what it manufactures or
produces and to whom and in which markets its products are sold. The “know your
stock” rule helps avoid initial purchases of stocks based on nothing more than a
mention in newspapers and magazines, or from a talking head on TV, something
that tends to lure the hapless trader into buying “hot stocks”, which is
precisely the opposite of a contrarian approach.
Through the combination of contrarian thinking and the “riding” of ripple
fluctuations, the authors have been able to achieve market average beating
returns, even if, as should be expected from a technique that is designed to be
“low-risk,” such returns typically beat the market by a relatively modest rather
than by a spectacular margin.
This article was written jointly by Aidan J. McNamara and Martha
A. Brozyna. McNamara and Brozyna are co-authors of Contrarian Ripple
Trading: A Low-Risk Strategy to Profiting from Short-Term Stock Trades,
published by John Wiley & Sons in October, 2007. Further information is
available at the authors’ website
www.ridetheripples.com.