During the past week, the Dow, S&P 500, and Nasdaq Composite each broke down below the neckline of head and shoulders chart formations. Such a break is generally thought to be a fairly strong bearish signal, particularly when combined with weak fundamentals such as in the overall economy including things like high unemployment and low consumer sentiment. While no chart formation or, for that matter anything else, is ever a guarantee of market direction, it can be something that may be helpful if we are aware. I write that because when I make directional trades in a stock, I try to make entries that are consistent with the market and sector direction. The idea, for me, is to try to give myself an edge since obviously when a market is rising most stocks can also be expected to be rising and, naturally, the same is true with respect to sectors. The opposite would also be true in that we could expect most stocks to be down when the market is down. In that circumstance, of course, my bias for directional plays would be bearish.
One of the things I have seen with many traders is that they are so anxious to buy a stock that they make their entry when the price is on the way down. That phenomenon is affectionately known as trying to catch a falling knife. The problem they face is that no one knows how far "down" actually is. For stocks like Bear Stearns or Enron or Lehman Brothers or a host of others "down" wound up being zero. Back in February or March a friend asked me what I thought about buying General Motors and I shook my head from side to side. But it's GM, he said, it won't go under; it has to come back. We have to remember that simply because it was a good company or simply because a company is good now doesn't mean that the stock price will go up. All too often we confuse a good company with a good stock and the two do not necessarily go together. General Electric (GE), for example, has long been a good, even great, company that traded in the $30 and $40 area. This past March it hit under $6 a share. Those who bought at $25, $20, or $15 on the way down were trying to catch that falling knife. I can hear them saying: "It'll come back." Maybe. Probably. But when?
Instead of catching that falling knife, if we like the fundamentals and like the company, why not exercise a little patience and wait until not only it signals a return to an upward move, but also wait until the market and sector head the right way as well? That movement may miss catching the absolute bottom, but it is just fine in my book to take a bite out of the middle once the market, sector and stock suggest that you have a little edge.
I certainly won't argue with those who try to catch those falling knives because at times their timing is near perfect and among the scars on their hands will fall the knife handle just before things turn. However, a very successful and very experienced trader once told me that we only get one perfect high exit and one perfect low entry in our lives and I know I've had mine so, for me, taking a bite out of the middle is just fine.
by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved
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