Today’s Trading Lesson From TradingMarkets

 

PATIENT INITIALLY, CAUTIOUS WHEN PRICEY

 

The method we’re going to briefly cover is used before a stock becomes
overvalued.

–waiting for the breakout of a three- to four-week or longer consolidation

–putting stops below the low of that consolidation after you’ve just entered
a stock (as long as it is not becoming overpriced on a price/earnings basis)

This requires patience for the first quarter of a move after you’ve entered a
stock (first 50 or so bars after a trade on any timeframe).

However, when a stock starts to get a PE ratio that is both higher than its
historical high PE and above its forward one-to-three year growth rate projected
by Wall Street analysts, then it is potentially becoming overvalued, and
investors should tighten up trailing stops much more aggressively.

Once a stock becomes overvalued, it is generally in a blow-off. A blow-off
can last from weeks to months, and occasionally years – so the trick is to stick
with a stock for as long as it is likely to continue running up, no matter how
high the price and PE. This is the essence of attempting to let profits run.

Thus, when a stock rises to a PE ratio that is both higher than its
historical high PE and above its projected (by consensus analysts) growth rate
for the next one to three years, we use a different technique than the one we
used before the stock becomes overvalued.

When a stock becomes overvalued, we watch for any decline in the close for
two days in a row. Once we have a two-day in a row decline in the close, we
consider that stock to be in a “reaction”. Once a stock is in a reaction, we
wait for it to recover to new highs. On any new high following a reaction, we
will then move our trailing stop to the low of that reaction — and we’ll keep
moving it up in this manner on every reaction and subsequent new high. In this
way we are still waiting for a fairly significant support point to be broken on
the downside before exiting a stock, but we are moving our stops up much more
aggressively than is the case prior to the stock becoming overvalued.

Real World Examples

 

Let’s take a brief look at how this works in the real world using actual
trades we made from 1999.

Adobe (ADBE) broke out to new 52-week highs in March, 1999, and then
developed a nice, tight trading range from late-March to mid-April, creating
just the type of flag pattern we like to watch for an entry signal. It was
exhibiting strong relative strength, strong EPS rank, strong quarterly earnings
growth, had very strong earnings growth estimates for the next year, was the
leader in its field, and was being re-accumulated by funds–meaning that it met
most of our criteria for a runaway stock with fuel to go much higher.

When the four-week consolidation was broken to the upside in April (near the
30 level) we started buying ADBE for clients, it started appearing on the
TradingMarkets.com list of new highs.

The first trading range of three-four weeks following our entry occurred in
May, when ADBE declined from 40.53 to 33 1/2, a fairly large dip. In June, ADBE
broke out of this consolidation to new highs, and we instigated our first
trailing stop rule, using trailing stop at 33, and we were finally able to “lock
in” a profit by having our stop above our entry price. Other
three-to-four-week-plus consolidations developed in July-August and in
August-September, allowing us to again raise our stops via the
three-to-four-week-plus consolidation and new high rule.

Then in October ADBE took off and began to trade above a P/E of 40. Forty had
been a high P/E for the last three years and was above earnings growth estimates
for the next two years after the one-year spike in earnings expected in 1999.
This meant ADBE was potentially becoming overvalued, and was potentially
undergoing a blow-off in price.

Thus in October we began to use our tighter trailing stop method on ADBE.
Every time ADBE made a two-day-in-a-row decline and then later broke to new
highs, we would move our stop below the low of that reaction.

On Nov. 1 and 2 ADBE made a two-day in a row decline. On Nov. 4 ADBE bottomed
at 67 1/8 and then made a new high on 11/8. This was nothing close to a
three-week-plus consolidation, but since we were in potentially overvalued
territory, we used an open protective stop (OPS) at 66 3/4 (just below 67 1/8).
The stock continued to explode to 79 before collapsing, and we were stopped out
via our 66 3/4 OPS in early-December as ADBE began a decline to the 50’s.

While we didn’t catch the top perfectly, we caught the lion’s share of this
nice move, and we caught more of the move by using a trailing stop than we would
have had we just began selling the position in October, when it first began to
look overvalued.

 

Our final example is a foreign stock traded on the NASDAQ, Business Objects (BOBJ).
In mid-June, BOBJ broke out of a two-month consolidation on the upside on a
high-volume thrust and lap. It showed strong RS, exploding earnings growth,
increasing-but-low ownership by funds, and other elements of our runaway
criteria. We began buying BOBJ near the 30 level, and put it into our PSL model
portfolio in June.

BOBJ made a new high in July, corrected to the 37 level, and then
consolidated for two months before making a new 52-week high again – which
allowed us to move our trailing stops to just below 37 where we locked in a
profit via our trailing stops.

BOBJ took off on a runaway up-move, and in November it moved above a P/E of
90 (its projected earnings growth for the next year and a historic PE high).
Thus in November we switched to our tighter trailing stop technique. On 1/6/00
BOBJ hit our stop at 115, below the Dec. 14, 1999 lows, and we took some very
healthy profits.

In Conclusion

Remember no trailing stop technique is perfect. Trailing stops will often
take you out of a stock that ends up moving further in the desired direction.
But even more often, the trailing stop will prevent you from letting your open
profits erode substantially in a stock that has peaked for a considerable period
of time. You can always re-enter a stock if it meets your criteria on a new
breakout. Trailing stops therefore not only help you to let your profits run and
prevent you from giving back huge portions of open profit, but they also help
you to focus your trading capital on vehicles that are moving up strongly, right
now, and exit those that are in prolonged corrections