Editor’s Note: One component of our research services is to provide specific trading ideas in individual stocks and ETFs. The common belief among many investors is that if you can figure out what to buy, you’ll make money. In our view, much more important than knowing what to buy is knowing where to buy.
When I was a young man working on the trading floor of the Chicago futures exchanges in the 1980s, I often heard traders saying something like this: “I was right about that market all the way up, and still lost money!”. Although it took me a long time to figure out what that meant, what these traders were saying is that they were making good picks, but buying them when the risk/reward characteristics were unfavorable.
For example, buying a stock that has already risen by 10% over the past 2 months, as attractive as it may be to do so, is often not a great time to buy. These stocks are usually vulnerable to a corrective pullback, which means that you can theoretically buy a good stock that immediately moves against you by 5%-6% percent, perhaps forcing you out, before you can reap the benefits of ultimately higher prices. Or, if you choose to hold on to it, it may take another 2 months for it to get back to the price you bought it, which can present opportunity risk of not buying another stock that is still going up.
With this in mind, we employ a strict criteria of what, and where to buy stocks and ETFs.
- The stock/ETF must first pass our initial quantitative and technical screen, which identifies assets with strong trends and good internal strength.
- The stock has to be moving back to the previous trend following a period of sideways trading (consolidation).
- The initial risk on the idea has to be 5% or less.
- The initial risk to reward ratio on the idea has to be 1:3 (risking $1 to make $3) or better.
With this methodology, we address both what to buy and when to buy it.
A good recent case study of this is Edwards Life Sciences (EW), which we displayed and discussed in our January 22nd Asbury Alert report entitled Edwards Lifesciences Corporation (EW) Resuming 2014 Advance (access requires subscription). EW provides products and technologies to treat structural heart disease.
The chart below shows that, at the time of our January 22nd report, EW was rising above its September 2016 major downtrend line following about 17 months of sideways investor indecision. This emerging breakout indicated the stock’s larger 2014 advance was resuming and targeted an eventual, additional 30% rise to 161.00 with only 5% of initial risk, giving us the initial leverage we needed to present the idea to subscribers.
The next chart, a newly updated version, shows that EW has since risen by 14%, to $141.34 per share, but still has an additional 15% to go before meeting our $161.00 target.
The point here is not that this idea has worked out well, but rather that the risk to reward ratio was a very attractive 1:6 (risking $1 to make $6) when we initiated it. This kind of favorable ratio gives us the ability to go into a tough period (which every trader goes through) where we may only be correct on half our ides, and still be profitable.
Finally, we incrementally move our protective stop up as the stock rises, to lock in open trade gains as we go.
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NEW: In April our new firm, Asbury Research Management (AIM), will begin producing a free monthly video that that includes an overview of the US financial markets, and discusses our investment style and current ideas. To sign up, Click Here to go the AIM website or call 844- 4 ASBURY (844-427-2879).