It has been an interesting week. Or a painful week, if you trade without stops or allowed the rising market to lull you into a false sense of security. As Peter Lynch once said: “A sure cure for taking a stock for granted is a drop in price.”
One of the themes I regularly try to instil through this column is risk management. It is the most important part in trading (and probably investing). It is easy to get swept away when the tide goes out. The most regular question I’m asked is “Should I sell [insert stock]?" Even if I was a financial adviser, and legally allowed to give advice, it would still be impossible for me to answer this question. I would have no idea of your entry price, your position size, your target price, your risk tolerance, your expected account returns – all of which are required in order to evaluate a trade.n
It's also worth noting that a good trade for me may not be a good trade for you – and vice versa. Some people are comfortable taking on high risk on a regular basis in search of outsized profits. That is not a risk I am comfortable with. Therefore, it is a question for you and for nobody else. But if you’re asking someone else if you should sell, then maybe what you are really doing is seeking external validation – confirmation bias might mean you are looking for reasons to keep holding, rather than sell. If you are no longer thinking rationally how can it be expected that you would make the optimal choice?
And you could be forgiven for thinking that this only affects private investors. Professional money managers are just as prone to succumbing to biases as we are. Bill Ackman of hedge fund Pershing Square decided to double down on Valeant and buy more of the stock when it was becoming clear to the market that the story did not match reality. Everyone, after all, is only human. For that reason, I create checklists in order to remove emotion and automate processes (you can get these from my website). After a while it gradually becomes habit, yet habits still require constant vigilance. When markets dump, these habits pay off.
Another habit is to maintain a constant shortlist – even when markets are overwhelmingly bullish. In fact, this is often the best time to do it. Downside volatility is huge when least expected. Look back at the charts of autumn 2018 and the collapse this year in March. Having a hit list can be boring to maintain when everything is going up, but it pays off handsomely.
As well as having a shortlist it’s also worth keeping a list of potential stage 2 uptrending stocks. One of which is DX Group (DX.). DX isn’t SETS traded, so we can never go overboard with the position size, as we are at the mercy of market makers. But in terms of volatility it offers plenty.
Chart 1 shows what a terrible investment DX Group has been since its IPO. As a brief aside on IPOs – lots of IPOs are garbage. It doesn’t mean you can’t make money on them, but always check who is selling. If it’s private equity and the founders cashing out I can’t see why anyone would want to take the other side of the trade.
I’ve also drawn a big arrow where the stock fell from 84p to 24p in a single day. All of the warning signs were there: trending lower; moving averages pointing downwards; rallies sold into, and stock goes lower.
Notice in the weeks before the stock fell that the price actually rose above all of the moving averages and looked as though the bottom may be in.
Bottom picking is risky because we can only ever see it was the bottom in hindsight. This is why I prefer to buy stocks that are well off their lows – sometimes even a few hundred per cent off the bottom.
If the stock is up 200 per cent then there cannot be much selling pressure at the lows of the stock. If there was, the price wouldn’t be up so much. Therefore, we can be relatively confident that the tide has now changed and that we are joining a rising trend.
In Chart 2, we can see this idea in action. It shows the end of 2018 through to the current day. The stock dived around March, but rebounded strongly.
I’ve marked an arrow when I first bought the stock on 28 May 2020, when the company announced that it expected revenue and adjusted Ebitda for the full year to be ahead of current market forecasts. This position lasted only a few days as I cashed in for a quick profit and moved on. However, I kept the stock on my watchlist to monitor what happened. We can see after the initial rise that there was a period of consolidation before the stock broke through the red line again, triggering another entry buy, which I again sold for a quick profit.
I currently have no position in DX Group, but notice how the stock has repeatedly tagged the black line – the 50 EMA. Depending on how DX Group reacts this could potentially become a marker of support for the stock.
DX Group at the high was not far off 300 per cent from the low. Therefore, what I’d like to see now is an extended period of consolidation and sideways trading. This would allow profit taking and new shareholders to join the register. The best breakouts are consistently those that have material periods of consolidation followed by a breakout from the base on high volume. I’ll be keeping an eye on DX’s stock to see if it can deliver.
· Michael has released his UK Online Stock Trading Course sharing his knowledge and how he trades the stock market. Investors Chronicle readers can take advantage of an introductory offer (ending September) by visiting www.shiftingshares.com/online-stock-trading-course
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