Today’s Trading Lesson From TradingMarkets

Brice

Scaled Buying: How
One Professional Hedge Fund Manager Does It

By Greg Kuhn

It takes
demand, or buying pressure, to move a stock higher. But when it comes
to declining price action, a stock can very easily just fall of its own weight.
A falling stock doesn’t necessarily need selling pressure to move lower, just a
buyers’ strike.

When buying a stock prepping to break
out from a basing pattern, the most efficient way to do it is to buy in two or
three steps. However, following one of the sell signals that I outlined in the
Kuhn/Marder
Trading Course, it’s usually best to sell quickly — in one shot.

When it comes to buying a stock, we
want to buy for fundamental reasons and sell technically. When it comes to
timing our selections we want to scale in slowly, but sell out fast.

In managing my hedge fund, I normally
like to buy in thirds, three times, as a stock nears the completion of its
basing pattern. I will show you two different scenarios in using this approach
— one off a completed base, and one off of what I termed the “cheat” area in
one of the articles I published in Technical Analysis of Stocks and
Commodities magazine in 1995. As an individual investor with, perhaps, a
much smaller stake at hand, you can even defer to doing your buying in two
steps.

One of the ways I like to buy in three
separate steps is in the formation of a properly set up cup-with-handle pattern.

Rare Medium (RRRR)
was one such stock that I did this with in February 2000.

Following its three-day pull back to
form the handle to its eight-week cup-with-handle pattern, Rare Medium stopped
dead in its tracks — closing just above its 21-day moving average
(A).

Personally, I do not recommend buying
anything on a pullback while still in its basing formation. One just never knows
how low the stock will drop, or if it will just fall apart altogether. I don’t
care what oscillator one uses to buy pullbacks in a stock, I’ve found them to be
far too inconsistent, only serving to create a false sense of security to the
trader. The better way is just wait for the stock to stop going down and turn
up. Then, if your favorite oscillator was showing a short-term oversold
condition, the reverse movement in price will confirm the oscillator’s signal.
In other words, if you understand the pattern the stock is forming, and we’re
going to wait for the stock price to turn up anyway, why even bother with an
oscillator? You just don’t need it. This is an important attitude because we
really want to eliminate anything that will give us this false sense of
security.

Back to the issue at hand.

Once the stock stops moving lower in
the handle, I’m waiting for it to retrace about half the handle’s decline on the
upside. Now I begin building my position. The first third is put on. I did this
with Rare Medium on February 3 (B).

After pulling back the following day,
the stock moved higher once again on February 7 — rallying above the intra-day
high of the first buy point. My first buy is now showing a profit — this is key
— so I put on the second part of my position (C).

Now I’m just waiting for the breakout
above the high of the right side of the cup from January 26
(D), which will complete the pattern, and hopefully
set the stock’s new, upward trend in motion.

As soon as it crossed 1/8 of a point
above the high on January 26, I finished up my buying campaign with the final
third on the February 8 breakout (E) —
effectively lowering my overall average cost. Why is this important?

First, I made the stock prove itself
to me each time I bought it — each position showed a small profit before buying
the next. Moreover, the sticky selling decision we are so often confronted with
in the market is partly solved by buying a stock properly in the first place.

Veritas Software (VRTS)
is a current example of what I call a “cheat” play. By the time you read this,
however, the stock may already be charging back to its old high. I felt using a
current example, without the benefit of hindsight, would be helpful nonetheless.

Following its 43% swoon from the March
highs, VRTS has since formed a perfect cupping, or rounded, bottom. In some
cases, a stock will move up the right side of its cup formation and stop dead
about halfway up. That’s where Veritas Software has been in its basing pattern
for the past seven days (A). This isn’t the handle,
but what I call a “shelf”, which can be “cheated” off of with an initial buy.
The shelf will form like a handle — tight price areas and low volume as it
consolidates — but, because it’s still in the middle of the overall basing
pattern, it still needs to work through some more overhead supply before forming
a proper handle closer toward its old highs. Essentially, until the basing
pattern is complete, the stock is still relatively unproven at this point and
should only command half of our attention.

Therefore, provided this shelf spends
enough time consolidating — at least a week — I will only buy one-third of my
allocated position if it breaks out of the consolidation. If this is achieved, I
will simply wait for the stock to follow through in price toward its old high
and form a handle. Sometimes the formation of a handle will begin with a sharp
two- or three-day pullback in price toward my initial buy spot, which will now
represent support. However, I don’t have to get too concerned about the stock
completely falling apart, since I still only have one-third of a position on.

Once the stock stops going down to
form its handle, provided this stock does just that, and retraces one-half of
the handle on the upside, like in the case of Rare Medium, I will buy the second
part of my position. My position will then be completed with the final third on
the handle’s breakout move. Each position was at a profit each time a new
position was established.

One word to the wise. Cheating on the
completion of a cup-with-handle pattern doesn’t mean buying as the stock moves
up the right of the cup. Each time we buy, we need a point of reference — a
pivot price. Waiting for the initial run to stop, pull back, then proceed, gives
us that — an upward move, followed by a testing pullback, followed by a
continuation of the advance. By waiting for the first consolidation zone to
develop, we get a free look at how healthy the developing trend in the stock
truly is. A trader can never know exactly where a stock’s advance will stop. You
will avoid needless whipsaws more often by waiting for the advance to halt, then
resume.