-- David M Gordon / The Deipnosophist
Yesterday I promised you a tactical answer for what, many years ago, I had termed the trader's ultimate dilemma. When a stock breaks strongly to the upside from a trading range, what do you do? Do you chase it? Or do you wait for a pullback. If you opt to wait for a pullback, how do you decide just how far it should pull back before you will buy it?
The dilemma is this: The stocks that do not pull back will prove, on average, to be the stronger stocks. The stocks that are cooperative and pull back to, say, the breakout point will prove to be inferior performers compared to their less cooperative buddies.
Most investors wait for the pullback and buy at the breakout point. Consequently, over time, these investors look back and find they have, for the most part, been holders of middling stocks. Some of these stocks, after welcoming all comers at the breakout point actually continue on down, down, down. Others put the breaks on and embark on the upward journey foreshadowed in the breakout. But ultimately they seldom compare to the dazzling performances turned in by some of those who, once out of the gate, never looked back.
In this situation, as in other market situations, it occurred to me that we devote our attention almost exclusively to the Y-axis, neglecting the X-axis like a used milk carton. Think of the terminology we use. Support and resistance. We are referring to price levels on the Y-axis. Loss-cuts. Buy on stop. Stop-loss points. Even trendlines are essentially measures of rates of ascent on the Y-axis.
What about the X-axis? What does it measure? It measures TIME.
Can we harness TIME as a tactical measuring device, the way we harness price movement? The answer is yes, and in so doing we can protect ourselves from much of the markets uncanny ability to mislead us. The market is always throwing fakes at us, luring us into making decisions that we simply don't have the facts to justify.
When a stock breaks upward from a base, we don't have the necessary facts to know whether this will be one of the flying darlings we want, or is it a shabby pretender. A golfer would equate the breakout to the initial drive on a hole. It's long and straight. It has promise. But as many a golfer has learned the hard way: You drive for show, but you putt for dough.
Since we lack the wherewithal to make a rational decision, second best is to be sure of not falling into a rut that produces uniformly mediocre results. No, we don't want to buy everything at the breakout point every time we get a chance. No, we don't want to chase these things and lose them in the clouds. And yes, wouldn't it be nice if we could pick up a few of those that pull back very deeply, well below the breakout point itself.
What we really need is a RANDOM method of entry. A method that ignores the market's little tricks.
Now remember, this is only a method of entry. We already have a list of reasons why we want to buy the stock. But we don't want to look like spastics getting on an escalator. We don't want to wind up hating ourselves for making lousy decisions. Instead, well leave it to fate and destiny. Because thereby well get a fair shake on average. And I mean literally a fair shake.
Get yourself a die (singular of dice). After the breakout, throw the die once. That tells you when you're going to buy this stock. A one for tomorrow, two for the next day, etc. -- up to six days.
Throw it again. This is for which hour of the trading day to buy the stock. (From one to six).
These are rules you have to customize for yourself. Maybe you want to buy within three days under any circumstances. Maybe a one to three means buy on the open and a four to six means buy on the close. If you want to use a three-day instead of a six-day span, throw until you hit a number between 1 and 3.
And, of course, there are many ways to generate random numbers. Your computer has a random number generator. I sort of like the dice. They're more romantic.
I call this TIME STOP.
You are buying at a small window in TIME - REGARDLESS OF PRICE. You are using the X-axis for signal points instead of the more common Y-axis. On breakouts, sometimes you will buy above the breakout point, sometimes below.
Ah, but enter common sense. Obviously there is some level above, beyond which you don't want to enter. And also obviously, there is a point below beyond which you do not want to buy. So you must set limits. On the upside, this may be something like ten, or 15 or 20 percent. It may be a volatility modified percentage. Same on the low side, although in many cases a natural loss-cut point works best. Imagine seeing your loss-cut point broken when you haven't even bought it yet.
Yes, some of the time you're going to get lucky. You deserve it. Other times you are going to get unlucky. But always within limits that you set yourself (before you open the trade). You have the ultimate control and you can stick your tongue out at the market's little tricks. Because you are guaranteed one thing on average, THAT'S A FAIR SHAKE.
The rules you choose for the die shakes can be customized to each separate stock venture, providing you do it before you buy. After you're in it, do not change the rules - PLEASE. However, there is an exception. If the stock should change character for the worse while you're waiting, you can scratch the trade like racing horse before post time. And you don't have to feel you're cheating. (But don't do it too often.)
I should mention that this is not the first use of the X-axis as a tactical tool. In his first book, back in the 50s, The Battle for Investment Survival, Gerald Loeb pointed out the wisdom of diversifying in time. He was referring to setting up a portfolio over a period of time - adding to them at intervals. Also, the technique known as dollar averaging is an X-axis strategy.
Incidentally, the TIME STOP concept itself has other applications in the market. It's very useful for devising exit systems. But that's another story for another time.