Winners Do Not Expect the Unexpected — They Expect the Expected!
Remember that popular game show “The Weakest Link”? In trading, there’s no question about who the weakest link is. It’s you and me! The weakest link is always the person pulling the trigger because of the inconvenient but inevitable role that emotions play in deciding when to buy or sell.One of the more difficult aspects of trading is turning decision into action; after deciding to buy a stock, we must take action and actually buy it. That’s where timing enters the picture. Remember the first rule of successful investing: Buy low and sell high. This is especially important with stocks that are experiencing an uptrend.
The Trend Within the Trend
When I am turning analysis into action, I am careful not to buy based on the current action. I buy based on what I expect to happen after I buy. And I frame my expectations according to the current trading pattern.
Sounds simple, right? If the stock is moving higher, it is understandable to assume that trend will continue, to buy the stock and to expect to ride that position to profitability, right? But the sad truth is that there are opposing trends within broader trends, and that can make it difficult to manage your risk.
Have you ever bought an advancing stock, only to have it pull back substantially as soon as you bought it? As the stock continues to fall, you end up selling for a loss in order to avoid an even bigger loss. Of course, as soon as you sell, the stock magically rips higher without you, almost as if the chart gods were looking over your shoulder. You may have been right about the stock, but still managed to lose money.
You can get around this by deciding on a frame of reference for assessing the price action before you buy. The most common frame of reference is a moving average, though we can also use simple trend lines, linear regression lines, or trading channels. For now, let’s just focus on the 50-day moving average.
To Buy Right, Expect the Expected!
The thing about patterns is that they tend to repeat themselves — after all, without repetition, no pattern! In order to qualify as a barking dog, the dog must bark! To qualify as a price pattern, there must be a pattern! Yes, magnitude and duration within the pattern will vary, but you’ve got to place your reliance on the repetitive nature of the pattern — without that reliance, then chart analysis is not particularly helpful. For example, don’t fight a pattern of higher highs and higher lows by trying to predict when it will end. Instead, assume that it will continue, and trade according to where the pattern is likely to take the stock.
To illustrate what I’m talking about, let’s look at a series of price movements in Intuitive Surgical (ISRG) and focus on the behavior of the stock along the 50-day moving average.
Notice how the stock had been bouncing along the 50-day moving average for several months before taking off like a rocket on a bounce at $240. Now, an impatient trader might have been tempted to buy this stock out of fear of missing further gains in this steep uptrend. But let’s extend this pattern in two alternative directions.
As you look at this chart, which direction do you believe the stock is likely to move, higher or lower? Well, it COULD continue moving higher, but wouldn’t that be pretty difficult considering all of the folks who bought near the 50-day moving average just a week or so ago? Wouldn’t they start taking profits at some point? Perhapsright about the same time as those on the sidelines see ISRG as being in nosebleed territory and refrain from buying? You’ve GOTTA think about this stuff when you are considering buying a stock that is on a tear!
Yes, the stock certainly could keep moving higher without pause — but if so, it’s a newsmaker! That pattern is too unusual to count on. The more likely outcome is that the stock will pull back to the 50-day moving average, which has generally provided support on pullbacks.
Don’t expect the unexpected! Expect the expected — which is precisely what happens.
This chart shows that the stock did indeed pull back. In retrospect, this was the logical outcome, yet the volume bars show that there were plenty of folks who were buying right at the top. They expected further gains even though the established trading pattern had given every indication that the stock would ultimately return to the 50-day moving average.
Those traders who bought near $340 were probably selling around $280 for a big loss. But let’s follow the trade.
About a month later, ISRG broke to a new high, eclipsing the October high. Once again, trading volume was a bit higher than usual as many traders assumed that the steep rise would continue unabated. But what happened?
Once again the stock pulled back to the 50-day moving average, penalizing those traders who disregarded the established trading pattern of the stock and instead assumed that the “trend within the trend”–that is, the current rally that began at the end of the last pullback — –would simply continue.
In essence, they were expecting the unexpected because they were not looking at the bigger picture. Simply stepping back and taking a look at how a stock, index, future, or other instrument is trading around a reliable reference point like a moving average will enable you to frame realistic expectations. You’ll see the established pattern of highs and lows. You will expect that pattern to continue. The pattern might break down, but that’s the exception, and not the rule.
And when you have reasonable expectations, you will be able to execute on your decision to buy the stock at the right time. Anybody can buy a stock with a click of the mouse. But it takes some skill, patience and discipline to buy it at the right time.
Focus on these repeating patterns within an uptrending stock and you’ll go a long way toward shoring up the weakest link in your trading strategy–you!