Stock Market Momentum, Find it with Stockcastics, Keep it with Stops

For 2012 I have decided to change my investing strategy. In my inMessment Game Portfolio, if you look at my 3rd Quarter and 4th Quarter results from 2011 you can see some drastic swings in my portfolio value.

In the 3rd Quarter of 2011, worry about the European debt crisis hit the market hard. From July 22 to August 8, 2011 the US market dropped 15%, that is just 11 business days. Through September the market was volatile but did not hold any gains. It bottomed out on October 3, 2011.

For 2011 my strategy was basically buy and hold. At the end of the 2nd Quarter of 2011 my portfolio was up over 13% for the year. At the end of the 3rd Quarter my portfolio was down -12% for the year. This was very painful to watch.

(NOTE: With a buy and hold strategy, watching is part of the problem. Sometimes it is best not to watch. Just make good choices in your investments and asset allocation and then let it ride.)

Thank God the market bounced back at the end of 2011. At the end of the 4th Quarter I was basically back to even with my portfolio. Now with the bull market at the start of 2012 I am back up to the high point I had in 2011.

Even though I can see signs that buy and hold works I have to think there is a way to avoid at least some of the down turn that happened in July to October of 2011.

My New 2012 Strategy

For 2012 I have added two major changes to my to my inMessment Game Portfolio strategy.

  1. Set Stops to try to keep profits
  2. Use Stochastic Oscillator to help determine when to buy into the market

Stop-Loss Orders

A stop-loss order is a sell order placed on your holding that will only sell if the price goes down to a certain level. You set the price level at which you are willing to risk.

In a bull market stop-loss orders can be a good way to keep the gains that are made. As the stock goes up and up you can move the stop-loss up. Then when the price turns around, the hope is that your stop sells the stock near the top of the trend.

The problem I am seeing with stop-loss orders is that they typically sell my holding at a point that could be a good point to buy into the holding. With tighter stop-losses and shorter time frames this is especially true.

Where do you Set Stop-Loss Orders?

How tightly to set your stop-loss order is not an easy decision. I have seen recommendations everywhere from 0.25% to 8% of the current or purchase price. There are several things to consider:

  • How much are you willing to lose if the price goes down? If the stop loss sells, you will lose the amount you risk. I have experienced this a few times. If the prices goes back up after your stop hits, you miss the bounce. If the price continues down after your stop, then you are spared further loss.
  • How long do you plan to hold the position? The shorter terms should probably use closer stops.
  • What is the normal volatility of the stock? If the stock goes up and down 2% on a regular basis then you have to set the stop outside that range.
  • What direction do you think the market is going? If you think it is heading up you can give yourself more room in the stop to stay in the holding longer. If you think it may go down soon, a tighter stop loss may be better.

For now, I am planning to set stops near 2% of the price as long as I think the market is going up. My goal is to hold the position as long as the price is going up. 2% will be my starting place with each holding. From there I will ask myself the questions from above and adjust as needed.

After a Stop, Stochastics Help me know When to Buy Back In

I plan for most of my holding to be market index ETFs. With that in mind, if a stop loss hits I want to get back into the ETF when the conditions are more favorable. Like I said earlier, my stops sometimes seem to hit at a point when it may be good to buy back into the position.

I have recently learned about the trading indicator called the “Stochastic Oscillator.” Investopedia defines the Stochastic Oscillator as, “A technical momentum indicator that compares a security’s closing price to its price range over a given time period”

The chart below shows a one-year history for SPY (SPDR S&P 500 ETF). This is from Yahoo’s Basic Tech. Analysis page. One of the Indicators you can choose is “Slow Stoch” or “Fast Stoch”. These will show the Stochastic Oscillator with different settings.

Below I show the Slow Stoch based on the one-year daily price chart for SPY.

The Stochastic Oscillator tries to show when a stock is oversold or overbought. When the indicator rises above 80 (see my red circles above) then the stock is considered overbought. When it falls below 20 (see my green circles above) it is considered oversold.

The Stochastic Oscillator is a mathematical formula based on the closing prices for a certain number of periods. In the one-year chart above it is based on the daily closing prices. You can also base the oscillator on hourly closing prices or just minutes if you want. It depends on the trading time frame you are working in.

For my new 2012 strategy, I will use a slow stoch based on hourly closing prices to find the next best time to buy into a position. I will not buy unless the hourly slow stoch is close to 20. I will also review the daily slow stoch to keep a longer term perspective.

Join The inMessment Game

Come and join the inMessment Game with me. You can learn along with me and others. You can set your own stop-loss orders and see how they work. Best of all, it is with play money so there is no real risk. The reward is a good education in how the stock market works.

This and other articles on this blog are for entertainment purposes. I am doing the best I can but I am still very much in a learning process. These posts are an effort to share this learning process only and should not be considered financial advice.

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