Are You Going to Pounce on the Bounce?

Pounce on the Bounce

Are you thinking of pouncing on the bounce?  Great.  But before you pounce, wait for the bounce!

One of the costliest misakes a trader can make is trying to anticipate when a stock is done going down.  We see the falling knife but we’re confident that we can catch it on the handle. 

Yes, we want to buy low.  But while “low” is a relative term, it is also an absolute term.  Here’s what I mean.

Say a stock has been trading at $200 for quite a while.  Then, as traders ran for the exits last week, the stock falls to $185.  Wow!  That’s low!  No — it’s merely low relative to where it has been trading at $200.  It has fallen 7.5% from where it was before.

Yes, it is relatively low.  Buy it, right? 

Not so fast, Skippy.

Lets say you buy the stock at $185 because it is “low”.  Or you buy a bunch of call options on it to really “pounce on the bounce”.  The problem is that the stock then falls to $150.  Well, now you’re experiencing the decline in “absolute” terms.  Your position has declined by nearly 20%.  You’ve lost $35.  That absolutely hurts.  [If you’re an options trader, your options just went to about worthless.  Now what are you gonna do?]

But if you bought the stock at $185, you’re sitting on a 20% loss and are not really thinking about the stock having traded at $200; you’re thinking about why you pounced before the stock bounced, and you’re fearful that the stock will continue to fall and you’ll continue to bleed.

That’s not what we do here, gang.  We do not pounce before the bounce.  Instead, we watch for the bounce…and then pounce.  We acknowledge (heck, we embrace) the fact that we will not catch the low.  We will not buy at the bottom.  But we darned sure will know our risk prior to buying because we will be seeing some type of bounce.  No, it may not be THE bounce (only hindsight can know for sure).  But it will be A bounce that allows us to say, “There is the low.  There is the maximum selling pressure!  Right there!!!”

When we can point to a price on the chart and say, “There is the line in the sand”, then we’ve got the first part of our trade because that line defines whether we are right or wrong. 

We can then say, “We’re buying right here; right now”.  When we have a “right here, right now” moment, then we can buy with confidence because that line in the sand defines our risk.  The rest is just position sizing.

If the line is crossed, we’re out with a small loss.

Team, this is the art of trading as a risk manager rather than a gambler.  You put the odds on your side if you wait for a sign of real support.  If you instead insist on trying to catch falling knives, rest assured that you will wind up selling right at the bottom every time.

How do I know?  Been there, done that…and ain’t never gonna do it again!

—Dan Fitzpatrick

[By the way, now is a great time to get used to using the “1% Rule” taught in the current Weekend Update.]