Sunday, April 08, 2007

Entries Are Important, Exits Are Critical

I'm definitely old enough to remember when broker calls (cold or otherwise) touting a stock were a pretty frequent occurrence. The stock always would come with a story. It could go something like this: DEF Corporation has discovered a way to extract gold from gold tailings outside of old mines. The price of gold is rising. The cost of extraction with the DEF magnet is much less costly than actually digging into new veins. The stock has already gone up $25 a share and so on and so on and so on.

Rarely in my experience did these tales pan out. Whatever the story, it always seemed to presume that based on the information the stock had to go up even farther. The pitch was always based on fundamental projections. Usually, there was a clear implication and speculation that earnings would be rising. It seems like there was never any thought that the increasing earnings had already been built into the $25 a share price increase. If we think about it, how likely was it that Mr. Broker called us first with this great story. Unless we were the broker's dad or best friend, I'll bet we were closer to the bottom of the calling list than the top. Of course, the fund managers whose job it was to look for great growth companies like DEF had learned the story long, long before the broker was ever likely to call us. It, of course, was those managers and other institutions who did the buying that led to the $25 a share increase. Now they were all in and that just left the retail customer to buy the stock. Guess what, after I bought on the broker's advice, I often saw the stock turn down fairly quickly. The story had nothing relating to the "when" of buying, only the "what."

That scenario continues to play out over and over again, though no longer so often resulting from a call from a broker. Many retail traders buy a stock because they have heard their friends talk about it or because they read about the company in a magazine or something on television. Taser (TASR) is an interesting example. The company manufactures the Taser gun used by so many law enforcement agencies. Many smart police officers bought the stock as they learned about the Taser. Unadjusted for several splits, they may have ridden it from under $1 in 2003 to over $120 in late 2004. Of course, as the stock rose and rose, those that owned it bragged or at least mentioned their great investment. As the "buzz" increased so did the number of people buying the stock. Some bought it at over $120 a share. As I write this article in August 2006, the stock is trading at $7.01.

There are a number of lessons. The first is that exits are critical. If the buyer was wise enough to have an exit strategy before he ever entered the play, he would either have enjoyed a profit, or, at worst, suffered only a relatively minor loss. Even the person who bought at the very top (around $125) should not have been hurt too badly if they had an initial exit strategy other than "buy and hold." However, with only a buy and hold strategy, that poor (literally perhaps) soul would have purchased the stock at $125 and now would hold it at $7. To say "it's coming back" isn't too comforting.

It has been said that fundamentals can help guide us about what to buy. Earnings, debt structure, price to earnings ratio, returns on equity, revenue and many other fundamentals certainly will have an affect on stock performance over time, but they have little bearing on when price movement will occur. The fact is that a company is great doesn't necessarily mean the stock will perform well. I consider Microsoft (MSFT) to be a great company, but between 2003 and the present it has traded up and down between about $20 and $28. Hardly a significant move when compared, for example, to Google (GOOG) that moved from $100 to over $470 in a year.

If fundamentals tell us what to buy, then I think technicals tell us when to buy it. Using proper technical entries and exits a trader could have done quite well just trading Microsoft (MSFT) up and down as it moved between $20 and $28, but the key would have been to make good entries. Entries that were close to a predetermined exit in the event the move turned against the trader. If an entry is made without regard to a preplanned exit that is set to minimize losses, then the trader can find himself in the position of the TASR holder who watches the stock go from $120 to $7 or the buyer of the fictional DEF who buys at the top on a broker's cold call.

Entries are important, but exits are the key. In my estimation, no entry should ever be made unless the exit strategy is in place first. I believe a trader needs to have an initial exit that is predefined and that is close to our entry. He should then continue the exit strategy by following behind a positive movement with some exit method such as a trailing stop loss, or by moving a stop loss, or by having an alert that he follows, etc. Again, the trader's business plan should incorporate the exit strategy that will be used and then it should be followed.

In our upcoming class and in the DVDs, in addition to teaching several strategies, we emphasize risk and exit strategies. I believe that exit strategy is one of the vital elements of successful trading. Without a good exit strategy, the liklihood of success in trading is very slim in my view.

Bill Kraft, Editor
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1 comment:

Sell@Market said...

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