Cyclical Stocks: Making Buy and Sell Decisions
An investor’s most difficult decision is deciding when to by and
sell. On the buy side the decision to buy is the moment of truth when
you actually commit your money to an investment. No matter how much due
diligence you perform or how much you believe in the efficacy of the technical
tools you use, committing real money always has some element of risk.
You always have a chance to lose money so it’s normal to be apprehensive
when you commit money to any investment.
On the sell side you are always pleased to make money but you do not want to sell too early or late and give up additional profits. Or if you are losing money, it is usually difficult to accept the reality of the situation and you may be reluctant to cut your losses. Selling a loser can be distressing. But not selling a loser may proof to be a disaster if its price keeps falling.
The greatest benefit of using rigorous technical analysis techniques such as the Price Direction Indicator (PDI) when you buy and sell stocks is to remove as much of the emotion and subjective reasoning from the decision making process as possible. CTM tells you to buy and sell on the upside and PDI tells you when the price direction changes to the upside or downside. But even with CTM and PDI, you must make the buy or sell decision. This chapter describes easy-to-understand buy and sell rules that are based on CTM and PDI analysis of prices.
Making Buy and Sell Decisions
Buy and sell examples in Analyzing Price Upsides and Downsides demonstrated that buying and selling on the upside gave you the best chance of making money. Obviously, you will make the most money if you buy near the bottom and sell near the top of the upside. Because in real time it is difficult to call the exact bottom and top, you can not expect to buy at the exact bottom and sell at the exact top. Rather you want to identify zones that include attractive (relatively low) prices in which to buy and zones of attractive (relatively high) prices in which to sell. The following chart shows a schematic example of the buy and sell zones for one compete price cycle.
Upside Early Buy Zone
The early buy zone includes the beginning of the upside. Here you have the best chance of making money because the entire upside is ahead of you. And because buy prices are at their lowest, you can make very large profits. However, the transition from the downside to the upside can by very tricky to identify in real time. In the late downside the rate of decline in downside prices usually slows but prices can move up and down for weeks or months and appear to be attractive buys because they have declined so much. After lingering at low prices for weeks or months, they can start a gradual upside direction. Here the upside is difficult to confirm because the upside move could be a price rise on the downside that is followed by further price declines.
If you intend to buy in this zone, be prepared to watch prices and interpret the PDI results each day. Examine the return per day, CTM cumulative percent winners and CTM cumulative returns. As the measures turn up so will PDI. However, you must be very cautious because you do not want to be fooled into buying on a downside price dip after which prices decline further.
Sometimes the transition from the downside to the upside is not gradual but is very abrupt. Here prices change to the upside in a few days or weeks resulting in a sharp quick turn to the upside. The downside to upside transition for KLIC cycles 3 and 4 were of this nature. For this type of transition you need to buy quickly to take advantage of the low buy prices.
Be aware that often there is a price correction during the early buy zone. Short-term traders sell to take profits and investors who bought on the previous downside trim their losses. Such selling causes prices to drop but the dip is a good buying opportunity.
If you buy in the early buy zone, you have the entire price upside is ahead of you, so there is need to sell in the early buy zone. To do so means that you would give up substantial potential profits. Wait until the upside is more mature and prices have risen.
Upside Buy Zone
The next zone on the upside is the buy zone. This zone includes the bulk of the upside. Here the upside is well established and you are confident that prices are on the upside. Buying in this zone is conservative because prices have risen off the bottom for weeks or months so you are sure prices are on the upside but you have given up potential profit because you will buy at a higher price than in the early buy zone. You can sell anytime in this part of the upside because prices are high enough to provide acceptable profits. When you sell depends on your profit objectives. Set a profit goal and corresponding price target and when they are attained, sell your stock.
Upside No Buy Zone
The upside no buy zone includes the upper portion of the price upside. Prices are relatively high so do not buy in this zone. Never pay too much for a stock. The downside is near and you do not want to buy high on the upside only to sell on the downside. Of course you could make a profit on a very short term trade but leave those risky trades to the professional traders. Rather than buy near the top, spend your time looking for the start of the downside.
If you are holding stock and prices are late in the upside, be prepared
to interpret the PDI results everyday and
sell as soon as PDI hints that the downside is coming. Keep track of the
duration of the upside. As it becomes mature, pay particular attention
each day to the PDI results. Look for a slow down in the return per day,
CTM cumulative percent winners and CTM cumulative
returns. As these measures decline, PDI will decline and you should sell.
Downside No Buy Zone
The downside is off limits for buyers except for, perhaps, the late downside which is presumably near the bottom. You can make money if you buy near the bottom of the downside and sell on the next upside. But you must be extremely careful. Even though prices have declined significantly, they can still fall further. For example a four dollar stock can go to two dollars. And a two dollar stock can go to one dollar.
Also prices can rise enough in the late downside to make you think a new upside has started. But when they decline, you find that the chart pattern is the right shoulder of a head and shoulders formation for the cycle.
If you bought on the upside and then confirm a change to the downside, sell. Unless you bought near the top of the upside, you probably made money so take your profits. And if you have a loss, sell. Prices can fall very quickly on the downside so the prudent investor gets out.
If you bought a stock thinking that prices were on the upside but you later confirm that prices are on the downside, immediately sell the stock. Take your profit, if you are fortunately to have one, or your loss. Buying and selling on the downside is a loser’s game so do not be tentative. Sell.
Downside Cautious Buy
The one exception to the do not buy on the downside rule is when you are confident that downside prices are in the late stage and prices are near to the bottom.
But you must be vary careful buying at low prices on the downside because
if you are wrong and prices continue to decline, you will experience realized
or unrealized loses. Buying on the later part of the downside is not for
the faint of heart. Always remember that a four dollar stock can quickly
go to a one dollar stock.
What Can Go Wrong?
Even with the aid of sophisticated technical tools you can make mistakes in interpreting price patterns. And such mistakes usually cost you money. For example, suppose you bought because you thought prices had moved to the upside, but later you discovered prices are on the downside and prices continue to fall. Now you have to sell at a loss or hold the stock until it starts a new upside and hope the upside move makes you a profit. Here is a list of the mistakes you can make, their consequences and fixes, if any:
Buy and Sell Mistakes and Fixes
|Assumed prices moved to the downside but prices were still on the upside.||Did not buy.||Will pay higher purchase price.||None.|
|Assumed downside prices were near the bottom but they were well above the bottom.||Bought on the downside.||Will lose money as prices drop.||Sell to cut losses or wait until next upside and hope prices move above purchase price.|
|Assumed downside prices were near the bottom but they were on the early upside.||Did not buy.||Will pay higher purchase price.||None.|
|Assumed downside prices were not near the bottom but they were.||Did not buy.||Will pay higher purchase price||None.|
|Assumed prices moved to the upside but prices were still on the downside.||Bought on the downside.||Will lose money as prices drop.||Sell to protect a profit, cut losses or wait until next upside and hope prices move above purchase price.|
|Assumed prices were near the top but they were well below the top.||Sold too early.||Will give up some profit.||None.|
|Assumed prices were near the top but they were on the downside.||Sold too late.||Will give up some profit.||None.|
|Assumed prices were not near the top but they were.||Bought on upside but paid too much.||Will make small profit or lose money.||Sell to protect a profit or sell to cut losses.|
This table is interesting to study. Some of the mistakes that you can make have fixes and others do not. If you sell too early or late, you give up profit and that is that. You cannot undo a sell. If you pass up a buying opportunity, you can always buy later but at a higher price. If you buy on the downside or paid too much on the upside, you can protect a small profit if you are lucky to have one or you can sell immediately to cut your losses. Or you can wait for the next upside and try to sell for a profit or smaller loss.
What are the consequences of the mistakes you can make? Selling too early or late simply means that you reduce your profit and that is not necessarily serious. It may dent your ego more than your wallet. Also missing a buy opportunity is not all that serious because you will have other chances to buy at reasonable prices. But buying on the downside and paying too much can lead to serious losses. The most serious error is to let losses continue to mount. If you goofed, admit it and get out.
Execute a Systematic Buy and Sell Plan
Making money buying and selling stocks is not as simple as buying low and selling high. The table of the eight types of errors demonstrates that the road to profitable investing is fraught with pot holes and dangerous curves. Buying on the upside and avoiding the downside are keys to make money but identifying the transition from the upside to the downside and from the downside to the upside is tricky. The Complete Trading Model (CTM) and the Price Direction Model (PDI) can help you detect major changes in price direction but you still can misjudge price patterns and buy too early, buy on the downside, pay too much or sell too early.
The best way to avoid, or at least mitigate, most of these errors is to execute a systematic buy plan in which you spread out your purchases over weeks or months at relatively low prices. You can begin buying in the early upside and continue buying on the upside until it begins to mature. This plan of dollar-cost averaging your purchases should result in a profit when you sell your shares on the upside. Also, you can stagger your sales, but be sure to sell the last group of shares on the upside or just after the downsides starts.
Diversify Your Holdings
You should always diversify your stock holdings regardless what type of stock you own. No matter how well you do your research unexpected bad news happens to good companies. And if you concentrate in a company whose stocks tanks, you will suffer a loss either in unrealized paper losses, if you do not sell, or a realized loss if you do.
How many stocks is the right number to own? Three of four stocks are sufficient. That way if one were to go bad because of company specific events, your portfolio remains in tact. If you own many stocks, the positive returns of one or two big winners are diluted by the performance of the other stocks. Three or four stocks give you protection but if one stock does very well, it can have a significant positive impact on you entire portfolio.
Do Not Buy and Hold Cyclical Stocks
The primary reason to buy a cyclical stock is to buy at a reasonable price on the upside, make a profit and then sell the stock before the downside of the cycle begins. The game is to take your profit on the upside, ride out the downside and buy on the upside of the next price cycle. Because cycles repeat again and again, you have many chances to make money using this scheme.
Investors who bought cyclical semiconductor stocks before the 2000 bubble and held them are probably not making any money as December 2004. And those who paid the high prices just before the peak will have to wait many years before they have a chance to make a profit.
Do Not Reinvest Dividends for Cyclical Stocks
You should not buy cyclical stocks for income or to systematically accumulate shares through dividend reinvestment. Dividend reinvestment is for the long-term investors whose goal is to buy and hold stocks to slowly accumulate a pile of money for some future need.
Summary and Conclusions
Buying on the upside and avoiding the downside are keys to making money but identifying the transition from the upside to the downside and from the downside to the upside is tricky.
The Price Direction Model (PDI) can help you detect major changes in price direction but you still can misjudge price patterns and buy too early, buy on the downside, pay too much or sell too early. The best way to avoid most of these errors is to execute a systematic buy program in which you buy three or four stocks several times at low prices.