Expecting a market pullback, I would focus on a buying on pullbacks stock trading strategy for FUNDAMENTALLY SOUND stocks. By buying fundamentally sound stocks, I can be more comfortable in buying them on pullbacks and not be as jittery (no holding power) for stocks whose fundamentals are not as great. In my next post I will detail how I screen for these fundamentally sound stocks, but for now I will focus on the technical timing. Take note first that I plan to only trade these stocks for the bounce (2 day to 1 week holding period) and I have no plans of holding them since I don't expect the real bull move to come till early 2010.
So how do we time these trades? Here are my five rules:
1) From your list of fundamentally sound stocks, look for stocks pulling back from a 52-week high (stock has Momentum, therefor easier for it to bounce).
2) The stock is at a near-term support; can be the parabolic sar (price chasing parabola) but it's best if its the 32-day moving average (why not 65-day or other longer term MA? Again we want Momentum to be on our side).
3) The CLINCHER for me in determining if the stock is oversold enough is the Slow Stochastics. If its below 20, I'm very comfortable. I ignore the MACD for this strategy (it will naturally look ugly).
4) Volatility is becoming smaller (in a candlestick chart, the candles including the tails are getting tighter).
5) OPTIONAL: uptick (open candlestick body), downtick rule (dark candlestick body). Why uptick then a downtick? The uptick signifies a sign of demand, while a downtick (without breaking the uptick's low) is a confirmation that that demand is strong enough to hold the stock above the support. Sometimes there is no uptick but a couple of downticks or upticks. It's still okay but a couple of downticks is better.
6) Buy the stock on the break of the downtick's high with a target to the middle of the pattern or previous resistance. The target is actually 50-50 in my experience; sometimes it reaches the previous resistance, sometimes it doesn't. At times if the stock is really strong, it punches through to a new high!
7) Place your stop loss at the low of the uptick-downtick or the low of whatever combination of candlesticks it is.
With regards to rule number 6, since I am aware of the stock's fundamentals, I anticipate 1/3 of my size even before it breaks the downtick's high, add another 1/3 when I'm ahead the end of the day, and add another 1/3 on the actual break. This allows me to comfortably chase a stock if ever it gaps up on me.
The advanatage of this timing strategy is that you usually end up having a 1:3 risk-reward ratio since you are buying at low volatility with a stop loss that is near. A good thing is to always measure your risk-reward by identifying your potential target (resistance) and stop loss point (support).
Let's take a look at some examples.
This is an updated chart of "STEC" as of August 11, 2009. We see the stock pulling back from its new high and settling on the 32-day MA (gold line) for 3 days. The Slow Stochastics clearly goes below 20, and we see volatility dying down from a $2 daily range to about a $1 range. The buying price is at about $31 with the target being at $36. The stop loss is near $28. So you have a risk reward ratio of 3:5... not a perfect trade, but you can adjust for this by LOWERING YOUR POSITION SIZE.
Here is a chart of Dongfeng Electric in Hong Kong, a wind turbine manufacturer. This time it settles at the parabola after pulling back from a 52-week high, with the stochastic going slightly below 20. The buying point is at $37, with the target at $42... with the stop loss at about $35.80. It's a 1.2:5 risk-reward ratio. PERFECT TRADE.
This is the chart of a fairly recent IPO called "SWI". Again from a new high, the stock pulls back to the parabola, with the stochastics going below 20. This time, since it is an IPO with very little resistance, it only needs one solid downtick before bouncing right back up again. With a buying price of about $19.40 and a target of about $21.50, with a stop loss of $18.50... we have a risk reward ratio of about 2:1. Not so perfect trade.
This is a chart of "FSLR" back in May and it's pulled back but not from a new high. However it is the perfect example of the uptick-downtick rule. It's also settled at the parabola and the stochastics has gone below 20. With a $20 reward and about a $5 risk, it's a 1:4 risk-reward ratio.
As you see, the rules are not rigid, I actually allow a little flexibility for one of the rules to be broken (except for the stochastic rule). If it's too rigid, then none of the fundamentally sound stocks from your list could be tradeable. A buying on pullback stock trading strategy can be very rewarding for someone who masters it.
Happy Trading!
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