This Market Requires That Investors Adapt or Die
By Ken Wolff
Special to TheStreet.com
Originally posted at 7:49 PM ET 6/11/01 on RealMoney.com
Ever see the movie Copycat, starring Sigourney Weaver, Holly Hunter and Harry Connick Jr.? This 1995 drama was about the hunt for a serial killer; Hunter plays a detective who enlists the aid of Weaver's character, a criminal psychologist who specializes in serial killers, to catch the culprit.
After Weaver studies a stack of crime photos, she realizes there is a pattern to the homocides and determines that the killer is a copycat murderer who is repeating the crimes of famous serial killers of the past, such as the Boston Strangler, the Hillside Strangler and the Son of Sam.
The killer's downfall comes when Weaver reminds the police that in the Son of Sam murders, the killer used a Volkswagen in his killings. Thinking that the copycat murderer may be recreating the events to the last details, the police check with the department of motor vehicles and find a match with a student that attended one of Weaver's "Serial Killer" lectures in the recent past. Ultimately, the killer is caught and killed. Harry Connick Jr.'s performance as another captured serial killer was worth the price of admission.
So how can I possibly relate a movie about serial killers to Momentum Trading? Oh ye of little faith. The connection is this -- repeating the mistakes of the past is ultimately what leads to losses. Any police detective will tell you that the hardest killer to catch is one that follows no set patterns. The easiest to catch is the one that repeats the same old patterns and mistakes over and over again.
This is, after all, how they catch serial killers. The police study their patterns, determine what their next step will be and then intercept them at some point. A good serial killer, if there is such a thing, is one that changes tactics when conditions change. (Boy, that didn't come out right, but let me continue.)
A Momentum Trader who keeps repeating the mistakes from the past and does not adjust with the changing market is doomed to get tripped up by the market. On March 20, 2000, I wrote a column in which I defined a gainer stock as one that climbs 20% or greater from the previous day's close on good news and momentum. I described a good example of a "predictable" gainer as a company that reports positive earnings after the bell, causing it to gap up the next day (open higher than it closed the previous day). I went on to describe the three ways I play them the next morning: First, buy at the first dip. Second, short at the open. Third, short at the first high. I went on to describe specifics. Give it a quick read when you get a chance.
In the past month or so, many traders have told me that they wait and wait for a 20% gainer, but they are few and far between, so these traders ask if it is possible to play those stocks that are up less than 20%. Well, the market has changed in the past year or so, and these readers are correct -- there are less and less stocks that meet the "requirements" to be classified as gainers. And yes, you can play a gainer pattern in the exact same manner even if the stock is up less than 20%, but I have found after tracking this particular pattern for years, that 20% or greater is the most predictable pattern.
Let's say Ciena (CIEN:Nasdaq - news) closes at $60 and gaps up 20% the next day to $72; the reaction the next day would be the most predictable. Not always, and there are exceptions to every rule, but there is a 90% chance of it selling down at the open. If it gaps up to $66, there's an 80% chance of it selling down; at $64, a 70% chance and so on. So, if Ciena gaps up from $60 to $72, I would say there is a 90% chance of making acceptable profits by shorting Ciena at the open.
So the answer is yes, you can play gainer patterns if the stock is up less than 20% from the previous day's close, but your chances of success or profit potential are less. In this market, I am currently accepting this additional risk, but I am doing it with my eyes wide open and factoring in this additional risk. I make this exception with gainers only, and have changed my pattern criteria from the past. The criteria for 20% drops from the previous day's close and methods for playing a Dumper Stock that I described in my February 28, 2000, column still hold up in this market.
Let's throw in one more variable -- time. The shorter the amount of time it takes to climb or drop, the better. If Ciena climbs slowly all day long from $60 to $72 (20%), by the end of the day you will see less selling than if it went from $60 to $72 in 10 minutes. Here is an example of this time factor. On Wednesday, June 6, I was watching Network Appliance (NTAP:Nasdaq - news) because it showed considerable momentum a few minutes after the open.
As you can see from the chart above, Network Appliance opened at $19.02, dipped down to $18.78 at 09:37 EDT, then started to climb. I missed the bottom, but take a look at the time it took to climb from $19.02 to $20.03 at 10:05 EDT -- only 27 minutes. This is far less than 20%, and had this taken place over the course of two hours, I would not have even considered it for a short at the top. But because it happened over a relatively short period of time, I knew once it reversed the drop would produce considerable gains. The entry was easily identifiable at the top where the momentum and direction changed abruptly. The exit was just as easy to identify at 10:31 EDT, for a little less than a point profit.
Consider this time relationship when you're trying to calculate the predictability of the play you're about to enter. If you're not putting some sort of value or attempting to calculate the predictability of your play, then you're gambling with the masses and are destined to lose in the long run. If the predictability factor you calculate is not within the risk standards you're setting for yourself, don't trade it! Don't get caught repeating the mistakes of the past; re-evaluate your methods, and if the market changes, change with it!
thestreet.com |
