Active-Trader - Stairs up, Elevator Down

Welcome back, Active Traders and Wealth Builders.

One popular staying you hear about the markets is that stocks take the stairs up, but they take the elevator down.  Put simply, stocks sell off much faster than they go up.  How much faster you might ask?  Observe on this chart of AAPL that it took nearly 10 days for the stock to go from the 97 area to its highest closing high at about 103.  Also notice that the stock sold off hard from that level and gave back the entire 10-day advance in a single trading day.  How's that for fast?

Another example occurred this week in Gilead (GILD).  Note how the stock took 13 daily bars- almost 3 weeks of trading to go from the 99 level to its high at just about 110.  But the stock sold off the entire distance in just 2 short trading days!   Notice however that GILD had a much sharper reaction off the low and formed what we call a bottoming tail bar.  That means the stock sold down and quickly recovered that sell off within the same trading day.

I bring up these 2 examples because I got caught on the long side with both stocks.  After a long bull market you get lulled into a sense of complacency and don't consider putting in stop loss orders, particularly if these positions constitute less than 5% of your portfolio which is a reasonable maximum percentage allocation for a position in which you have an average degree of conviction.

So what can you do to avoid situations like this?

1) Put a stop below the low 2 bars back.

This strategy would have kept you on the long side of the moves in AAPL and GILD, but gotten you out before much of the damage was done.

2) Put a stop below the low of the high bar

I learned this strategy from John F Carter's excellent book Mastering the Trade.   This strategy would have gotten you out of both AAPL and GILD about halfway through the advances and is therefore more suited to those who actively trade full time.  They also would have gotten you out of the sell-off much sooner and with less of a loss assuming you were long going into the top.

As to when to re-enter, here a few rules of thumb:

1) Don't buy the first bar down after big sell off!  Many players do not watch the stock market during the day and only see the end of the day bar.  Once they see that, they panic and sell at the open the next day adding further to the slide.  Usually, but the 3rd day everyone who was going to sell into the panic has done so already and stock is ready to start to base.

So whenever you get a big sell off, whether its earnings related or not, wait for the 3rd day after the announcement for the stock to base before considering longs.  At this time, you usually get some reversion to the mean, for example fills of prior gaps, etc.

2) Buy when the stock breaks above the high of the low bar.  For GILD, that would be 106.6 and for AAPL it would be 100.9.

As for another angle, look for stocks which have been unfairly punished but the fundamentals are still good.  In the Energy space, we are seeing a 14-month low in the price of gasoline.  As scary as it sounds, I expect fossil fuel prices to double in the next 10 years. That means $8 per gallon gas which is what it costs in many other parts of the world already.  Get your shopping list ready and take your pick, COP, RIG, XLE, OIH.

Have a great trading week ahead.