BETTER THAN AVERAGE
Most periods of contracted price action will be followed by periods of expansion. SMAs can help measure the strength of the expansion by the relationship to each other, while also serving as guideposts to profit taking within the framework of sound trade management. For example, consider Baidu Inc. (Chinese language Internet search provider, symbol BIDU), using the 10-day SMA and 20-day SMA when price expands from an area of contraction into a bullish move.
The general market was still in a downtrend, but BIDU was showing a lot of strength and had been in a contracted price range for more than two months since December 2008. Notice the 10-day and 20-day SMAs and how they are flat, indicating no trend is present (see “Sideways action,” above).
In the beginning of February, the 10-day SMA crosses over the 20-day, alerting you to a possible buy set-up. Then, on Feb. 24, 2009, after showing bullish signals within the price range, you see a large price range bar higher than the previous day’s volume break out through the upper trendline to the upside of the trading range. The price bar is the largest price bar of the 20 previous days, plus it closes in the upper third of its range, which is a strong trigger.
If you happened to miss that breakout, there was good news a few days later.
After the initial thrust to the upside, BIDU pulled back to minor resistance for a possible pullback setup. Notice how the two moving averages are beginning to shape up.
On March 2, 2009, price pulls back to the 10-day SMA without violating the 20-day. If it did, then the setup would have been void and you would have had to step aside. This was followed by an inside trading day on March 3, 2009.
On March 4, 2009, you get your signal to pull the trigger and you enter on the open at $152 as price gaps completely outside the previous day’s price range. Now that you’ve entered, you’re going to risk no more than 5% off your entry while taking half your position out at two times your risk. This will give you a quick reliable gain. This is the tortoise phase of this trade management strategy.
On March 11, 2009, your first target is hit at $168 and you gain $16 on the first half of your position (see “Off and running”). Now you let BIDU reveal if it’s a hare or tortoise on the second half of your position while using the 20-day SMA as your trailing stop. The following day, on March 12, 2009, the general market confirms a bottom, and BIDU takes off while leading the rest of the market during one of the greatest short-term bull runs since the stock market crash of 1929.
Finally, on June 22, 2009, BIDU pulls back to the 20-day SMA and your trailing stop was hit at $274. The last half of your position gained $124, an 80% gain inside of three and half months. That works out to a 274% annualized gain.
While it seems like common sense to scale out at the appropriate levels, the reality is that most traders don’t because of the overemphasis on entries. This is understandable but obviously becomes a glaring blind spot once an entry is already made with no plan afterwards.
The good news is that gaining a solid understanding of how to make consistent small gains (the tortoise phase), while putting yourself in the position to capture runaway moves (the hare phase) and make spectacular gains not only builds your profits but builds the unshakable confidence of a master trader. Whatever approach you use, though, remember to keep in mind the importance of building it around the cornerstone of consistent gains and confidence by making steady profits in your trading approach.
By building a strategy of trade management that results in a string of consistent gains, you will stay profitable and keep yourself in play for occasional runaway moves.
Billy Williams is a 20-year veteran trader specializing in momentum trading in both stocks and options. Read his market commentary on www.StockOptionSystem.com