Using Floors and Ceilings for Selecting a Buy Price for the Purchase of Shares

Using charts as criteria for buying and selling stocks is foolish.  Charts give a lot of information on where you are but give little information on where you are going.  Humans innately look for patterns even where there are none, and just because a pattern resulted in a certain price movement in the past does not mean it will repeat the same way again.  Good stock selection starts with good fundamental analysis of the company.  Still, there is some merit to using charting once you have selected a stock to buy for setting a buy price.  The same techniques can also be used to determine a good exit point if the fundamentals of the company you have purchased begin to change or you just need to raise cash for some purpose.

Continuing the series of posts on how to use charting in your stock trading, today I’ll discuss how to use charting to determine how to set a buy or a sale limit price for a stock.   To see the start of the series on charting, go here.

In previous posts I discussed floors and ceilings, as well as trends.  As said, floors tend to offer support for the price of a stock, particularly if the stock price has bounced off of that floor several times.  The reason is that people trying to value the stock tend to see the fact that the stock tends to trade no lower than a certain price to indicate that the floor price is at the low range for the stock.

Likewise, if a stock has traded within a given range for a long period of time and then drops in price, a lot of people will have bought the stock while it was trading within the upper range.  these individuals will sell the stock as it gets back to that price again since they’ll want to get out without a loss.  They also will begin to think that it is unlikely to go past the ceiling price because it did not in the past.

Realize also that there is a fair market price for a stock at any given time.  This price is based on the expected return which is a function of future earnings and the risk of the company not meeting those future earnings.  If a stock drops too far in price below that fair market price, it will be bought up by value investors who recognize the bargain price.  Likewise, if a stock moves too far above that fair market price, value investors will sell the shares, rightly seeing that the potential return on the stock is no longer worth the risk.

To use a floor in setting a buy price, first determine a round number around the average price of the floor.  No calculators are needed here – just eyeball the chart and round to the nearest 1/2 dollar.

Next, pick an odd amount somewhat above the average price.  For example, if the floor price is $21 per share, you might pick $21.07 as a buy limit price.  The reason to pick an odd value goes into the way order are executed.  If a trader enters a sell order at the market, the brokerage house will match it with a corresponding buy order with the highest offer price.  If there is more than one order at a given price, the first order at that price is executed first.

If you were to set a limit price of $21 even, there would probably be a lot of other buy orders at that price.  Even though the stock trades at that price, your order may not be executed.  By setting an odd number for a limit, it is unlikely that there will be other orders at the same price.  By setting a price above the floor price, it is more likely that yours will be the high offer.

Placing a sell price is exactly the same except you would set a price just below the ceiling price.  Use caution, however, when setting a sell limit because if you miss it, you could see a lot of your profit evaporate as the stock falls in price.  When it is time to sell, it is often wise to simply enter a market order and get out.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

When to Sell a Stock

Anyone who has followed this blog at all knows that I advocate long-term holding of stocks.  There are many reasons to hold stocks for the long-term rather than darting in and out of the market.  These include: 

1) Holding for long periods of time put the odds in your favor since stocks have a natural tendency to rise and you don’t need to  be right about timing, just direction.

2) Holding will lower your tax bills and fees paid.  Over time, this will significantly increase returns.

3) If you sell a stock just because of a gain, you may well miss out on much bigger gains.  Stocks going up tend to have momentum, and if you sell simply because you’ve made 10% you may well miss out on a 100% gain.

4) It is much easier to spot stocks whose intrinsic value will rise than make predictions about how the market will respond in the near-term.  Because price eventually tends to follow intrinsic value, it is much easier to predict which stocks will do well over the long-term than predict those that will do well over the short-term.

A few months ago I purchased shares of BJ’s Restaurants International (BJRI).  I felt that they had a good concept, steady earnings growth, and had a lot of room to grow.  The pick turned out very well as they rose by over 50% in a short period of time. 

While I had a good gain, I certainly felt they had more room to grow and in several years they may well be much higher than they are today; nevertheless, I sold out at around $38 per share.  Why?  The statistics for the stock can be found here:  http://finance.yahoo.com/q?s=BJRI

The reason that I decided to sell was that because of the huge rise in price, the Price-to earnings ratio (PE) has climbed to nearly 60.  Even great stocks that have very rapid earnings growth do not normally command PE ratios of more than about 30.  This indicates that the stock price has far outpaced earnings growth.  There is therefore very little chance that the stock will continue much higher in the next year or two, and a good chance that the price will reverse as investors get impatient. 

The stock has a large short position, which is a good trait since short selling tends to prop up stock prices (each time the stock falls, short sellers will buy back shares, providing some cushion against rapid falls).  The PE ratio, however, is just too large.  Even if the stock were to hold its current price, most of the return for the next few years has already been realized.  I will certainly keep an eye on the stock, but for now there should be better investment choices elsewhere.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Common Mistakes when Buying and Selling Stock

Everyone, from new investors to seasoned pros, make mistakes when investing.  Losing money at times it a part of investing.  Some lessons individuals will not believe, no matter how many times they are told, until they personally lose money.  I call this “paying tuition to the market.”  Other people might call it “stupid tax.”  Whatever you decide to call it.  An individual with the right temperament for investing will accept these mistakes, learn from them, dust himself off, and then move on.

I have taken my personal share of losses and made my share of mistakes.  As I’ve said, some things you cannot learn without losing money personally, but maybe some of my readers out there will take these lessons to heart and therefore not need to lose money-making the same mistakes I did.

1)  Stocks will go down and stay down much longer than you will expect them to.  At times I’ve had a great stock that I was following fall out of the sky.  Sometimes I have rushed in to buy shares, thinking that there was no way that they could go lower.  Some of these times the stock dropped to an even lower price and then sat there for years.  The lesson to learn here is that stocks do not fall for no reason.  Just because you may not see the immediate cause does not mean that the whole world except for you has had a momentary lapse of judgement.  A stock may have had a great quarter but issued guidance that future sales may slow.  There may be some shenanigans going on at the company that you have not heard about.  Markets tend to be very good at setting prices based on current news.  If one of your favorites tumbles, even if the price seems unbelievable, it is best to give it a little while to wait for the other shoe to drop.  If you must buy in, buy about half as many shares as you are planning to buy so that you can buy more later if prices continue to drop.

2) Stocks will stay up far, far long er than you expect them to.  It is amazing how some of the Wall Street Darlings, for example, Krispy Kream, Outback Steakhouse, and more recently, Google, can rise to astronomical prices.  Then, when you think that they can rise no more, they continue to rise higher.  Even worse, in cases like Snapple or AOL, they are bought out by another company for those astronomical prices and then give the company that bought them out heart burn.  Always be careful when looking to short stocks.  Just because the price is high does not meant that the price cannot go higher.  I was short Golden West financial in 2008.  Then, just before the mortgage bubble began to burst, they were bought out, causing me to lose about $10 per share in one day.  The fact that the company that bought them out later regretted the decision was of little solace to me since I’d already realized the loss.

3) To make $1million in options, start with $10 million.  Buying options is for the stupid.  I repeat, buying and selling options is for the stupid – you will lose your money.  In college I thought I could play the options game.  I took up positions in equity options and index options.  Within three months I had lost all that i intended to risk and about 4 times more!  In buying options, the odds are stacked against you because you do not only need to be right about the direction, but also the timing.  Even when you are right the spreads and commissions will kill you.  Every time you make money the fees reduce your winnings.  Every time you lose money the add to your losses.  If you want to gamble, head to Vegas.  At least you’ll get free drinks.

4) Never buy stock in a buy-out candidate.  I bought shares of a stock called stop-and-go back in the 80′s, hearing that they might be bought out.  Sure enough, a buy-out was announced — for $2 per share less than I had paid!  Once the rumors are flying, you will be too late to get in at a decent price.  Find some other stock to buy.

5) When management changes in a long-term successful company, watch out.  Citizen’s utilities (now citizen’s communications) was once an untouchable company.  They owned all of the utilities (telephone, water, electricity, waste water) for rural communities all over Arizona.  The company had not missed increasing earnings for a quarter for decades.  A person who had bought 1000 shares in the 1970′s would be a millionaire by the 1990′s.  Then, management changed and an individual who was fond fo starting telecom companies was installed as CEO.  He changed the character of the company into that of a wireless phone company, sold off the other assets, and the steady earnings increases stopped.  At that point the stock price, which would go up and split like clock-work, stalled and dropped by 50%.  Whenever a company that has done well under a certain manager or groups, it is generally a good idea to think seriously about leaving if that manager departs. 

6) If you’ve got a profit and are ready to sell, sell — don’t fool around.  It was around 2000 and we were caught up in the middle of the dot-com bubble.  I had purchased shares of a small internet companyat $4 per share and seen the shares climb up over $20 per share in a short period of time.  I was reading the yearly report at the airport and the realization came to me — this was just a pile of fluff and marketing.  There was nothing of substance there.   I called my broker from a pay phone.  The stock had dropped a couple of dollars from its high, but I figured it would return so I set a limit near the old high.  The stock never returned and proceeded to fall through the ether.  If I had simply put in a market order I would have been out.  As it was I don’t remember if I even made a profit. 

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How do I Invest Large Amounts

Ask SmallIvy

Dear SmallIvy,

I recently came in several about $50,000 through an inheritance.  I’m interested in investing it (don’t need it right now), but don’t know how to start.  What should I do?

Thanks,

JulieS

Dear Julie,

When investing large sums, it is best to wade in slowly.  This is because it is difficult to pick the right time to enter the market.  By buying in increments, you can reduce the average amount paid. 

Also, it helps psychologically to buy in increments since it is rough on your psychy when you invest it all and then see the stocks you bought decline.  If you buy in increments and then the stock price drops after the first purchase, you just buy more at the lower price.  This will also reduce the chances that you will sell when the stock drops because you feel like you made a mistake and also reduce the impulse to sell when the stock returns to your original buy price because you fell like you are “even”.  Both of these are common investing mistakes.

To implement the strategy, buy about 1/3 of the total amount of each stock/mutual fund you are planning to buy.  Wait a few months to see what the stock/market does, then buy some more shares (about 1/3 again).  If the market or stock price drops quite a bit in a day that would be a good time to buy in.  Repeat one more time 2-4 months after that.

On what to invest in, with that much money you should either buy mutual funds if you are risk averse and don’t want to mess with it (perhaps $15,000-20,000 in 3-5 funds of different categories) or put about half in mutual funds and put the rest in 2-5 growth stocks if you are willing to take on a bit more risk.  In picking stocks, look for companies that have consistently grown earnings for several years and still have room to grow.  Note that most companies took a hit in 2008-2009, so a dip there in earnings would not be a fatal flaw.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Economic Recessions and Investing

The recession and the anticipatory fall in stock prices that preceded it has scared a lot of investors away from the market.  This is unfortunate since it is during these times that the stock positions are built that result in the truly great returns.  Just like shopping at the supermarket, the time to stock up is when things is when they are on sale. 

Individuals tend to do just the opposite when it comes to investing, however, buying only after big run-ups and selling after prices have declined.  The result is so pervasive that there are strategies that actually try to follow the inflows and outflows of “the crowd” and do the opposite.  The more bullish the public is, the more stock one sells.  The more bearish, the more one buys.  This strategy has additional merit in that when everyone is bullish it probably means that they have already invested all of the money they have and there is little capital available to drive stocks higher.  (Note that with real estate, once home prices has risen to the point that individuals could not even afford the payments with no money-down, interest only loans, housing prices quickly went from straight up to straight down.)

The difficulty is that individuals tend to equate buying and seeing prices rise with “winning” and buying and seeing prices falling as “losing.”  One needs to get over this mindset to succeed at investing because it will cause one to miss out on great investing opportunities.  If one buys a stock in a falling market and sees the shares decline a bit, one should see it as an opportunity to buy more at lower prices.  If held long enough (and assuming that quality stocks are being purchased) the stock should be much higher than either price paid.  One should take advantage of the fact that a falling market causes all stocks – good and bad – to fall.  The difference is that the good stocks quickly recover while the bad languish.

Unfortunately, the style needed for successful investing runs counter to an individual’s normal psychology.  If a person buys a stock and it goes down, he may initially stay with his convictions and perhaps pick up a few shares (like doubling down in gambling), but if the stock continues to decline he will eventually sell out.  If he does not sell out, he may sell as soon as the price returns to the price paid, feeling that he “got his money back,” only to see the stock soar to new heights.

This can be avoided with a few simple strategies:

1.  When buying a stock, particularly in a down market, build up a larger position by buying only a portion at a time.  For example, build up a 500 share position by buying 100-200 shares at a time on dips.  One should have a targeted number of shares before starting, however, to avoid the other common mistake of averaging down in a losing stock.

2.  Plan to invest for the long-term.  If one is planning to be invested for 10-20 years in a stock, one will have a different perspective on 10-20% declines.

3.  Do not invest money that is needed in the near-term.  If a retirement is looming or college tuition bills are just around the corner, funds needed to pay for these expenses should not be invested in the stock market.  Because downturns can last for five to ten years, one should not have money invested in stocks that will be needed within the next five years or so.  While putting cash into a CD may seem like a waste, the psychological peace it will give will result in smarter investment decisions.

The other question that may be asked is “What types of stocks should one buy during a recession?”  As was previously stated, all stocks tend to go down during downturns in the market.  This means that the shares of the top companies in a sector will tend to fall along with those of the second and third-tier companies. 

Find the companies that are leaders in the industry, which probably had higher PE ratios than the industry average during the good times.  Other good signs are companies that have little if any debt, strong cash flows, and had consistent earnings growth.  These companies will tend to be stronger than their competitors and therefore better able to weather the recession.  They will pick up market share as their competitors fail, emerging from the recession stronger than ever.

Much as I enjoy writing about investing, it doesn’t make sense unless people are reading. If you’d like to keep the articles coming, please return often and refer a friend – http://smallivy.wordpress.com.  Comments are also greatly appreciated, as is lively and friendly debate.  Also feel free to link to or reference posts – all I ask for is fair credit.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.