Most investors focus on buying the right stocks but it is even more important to consider buying these stocks in the right situation. Every trade you make should consider the relationship between reward and risk. You can make a better stock trade even by paying a higher price – if the reward for risk scenario is favorable.
First, let’s consider the risk component. Stock investing is always a guess, no matter how educated on the company we are. Losing is part of trading but how much you lose is something you can control. We should know the price level where we need to call the trade a loser and exit with a small, manageable loss. Do this by looking at the stocks chart and identify the most recent floor price before you buy. This is the last time the stock stopped going down and started going up, something I call an inflection point:
The blue arrow shows the inflection point low. This is where the sellers lost their motivation to push the stock lower and the buyers started to overpower them. It demonstrates the minimum price that investors were willing to accept for the company’s fundamentals. At the green line buy point, the buyers broke the downward trend line, a sign that they were taking back control. The difference between the buy point ($6) and support ($4) is the risk per share of the trade ($2).
Ultimately this stock went up to $35, a $29 a share gain which represents a reward for risk ratio of 14.5 ($29 reward for $2 of risk).
What if you bought T.TECK.B three weeks later at $10? At that point, support was still $4 since no new inflection point low had formed. This made the risk of the trade $6 at a $10 per share entry price. The move up to $35 now represents a reward for risk ratio of 4.2 ($25 reward for $6 of risk).
At this point, you are likely thinking that the reward of the trade should be less since the price paid was higher. True, but consider what happens if you bought the stock a few months later at $14 a share:
The entry signal at this point is called a flag pattern break, quite a reliable technical indicator for stocks well in to upward trends. What is great about this signal is that it comes with a tighter support price at the low of the pull back, in this case $12. So, entry at $14 brings $2 a share in risk. The move up to $25 is $11 on $2 of risk for a reward for risk of 5.5. The overall profitability of the trade in reward for risk terms is higher even though the entry price was $4 higher than the $10 entry.
When making trades, check the chart to see how the reward for risk profile shapes up given the recent moves and inflection point lows. The more you chase stocks above their last floor price, the less desirable the trade becomes.
You can use this concept with important fundamental events as well. We are in the midst of earnings season right now which means there is lots of potential for big moves when companies announce their quarterly financial performance.
Consider what expectations are in to their earnings announcement by looking at what their price performance has done in the recent past. Here is the chart of Cirrus Logic, a stock that I owned and sold on Feb 1. The stock has gone up a lot in the past year and expectations are high. They announced earnings after the close on Feb 1 and failed to meet market expectations. The stock gapped down on Feb 2:
Now consider JC Penney which has been pummelled lower over the past month, making expectations low. They announce their earnings on Feb 23 and although a great argument can be made that retail and department stores are getting beat up by online retailers, that story is already priced in to the stock by the sharp downward move. If there is any optimism in their earnings announcement, the stock should rise since few expect anything promising:
This is a situation where I am comfortable holding the stock in to the earnings announcement because I see much more upside potential than downside risk. I have no idea if their business is doing well, I just think that there is a good probability that they can do better than the market expects.
Chasing stocks higher is what often leads traders to suffer with losses. For every trade you make, whether based on charts or fundamentals, make the reward for risk potential an important part of your analysis.