Post by Emperor AAdmin on Feb 11, 2008 1:30:31 GMT -5
A Simple Way to Buy Low and Sell High
By Aidan J. McNamara & Martha A. Brozyna
TradingMarkets.com
Objective experience shows that stock markets fluctuate, through bull and bear cycles, corrections and rallies, inter-day and intra-day market movements. Such fluctuations lend themselves well to market cycle theories; the oceanic metaphors of tides, waves, and ripples of Dow Theory; the Fibonacci Sequence-related Elliott Wave Principle; or even the generation-encompassing Kondratieff Wave. All these theories seek to describe, track, and forecast market movements as they ebb and flow with unceasing regularity. Many observers of a technical bent seek to use the chart patterns that such fluctuations create over a period of time to capture a bottom or top in either a stock or a market, with buying or selling action taken accordingly.
Contrarian investing is an investment style that is often regarded as a subset of value investing. It has a number of devotees who look to achieve successful investment returns by going against the crowd. While few would suggest that the crowd is always wrong, there is occasion enough where perceived wisdom on a stock or market sector irrationally pushes prices downwards. It is the skill of the contrarian investor to understand ahead of everyone else that there are good reasons to believe that a stock is under-priced and ripe for a recovery in the near future. Note, however, this recovery can only happen once the crowd also comes around to the same view and starts purchasing the undervalued stock. As buying pressure reappears and sends the price back up, the contrarian investor will show a profit on his or her contrarian move. The beauty of a contrarian stock purchase is that it is made by definition when the stock is relatively cheap, leading if successful to a classic buy low, sell high investment or trade.
Contrarian Ripple Trading borrows the word "ripples" from Dow Theorist Robert Rhea, who in his 1934 book The Story of the Averages used the terms "tides," "waves," and "ripples" to illustrate market movements. "Tides" were bull and bear markets, "waves" described market corrections and rallies, and "ripples" were fluctuations over the short term. The trading technique bases itself on the existence of very short-term (inter-day or intra-day) market fluctuations that characterize all markets, bull or bear. The contrarian ripple trader takes advantage of these fluctuations, and because they are frequent and repetitive in nature, he or she is able to make profits over and over again with repeated in-out round trip trades.
The principle cause of these fluctuations is the constant pendulum swing in prevailing sentiment among market participants at any given moment in time. Day to day and during the course of one day's trading, general market sentiment swings wildly back and forth between greed and fear in a way that is peculiarly characteristic of the somewhat bipolar moodiness of Mr. Market. Is it any different at the level of individual stocks? No, as empirical observation of market action on any day makes clear, the vast majority of stocks move in exactly the same direction as a group, up or down, and so by definition these same price moves are then reflected in moves in the indexes such as the Dow Jones Industrials Average and the S&P 500. Major company news or financial releases or merger announcements may trigger moves in sentiment, and so may more macro economic news including employment and housing statistics and interest rate cuts or hikes.
But sentiment changes do not wait for such important triggers. The ebb and flow of greed and fear washing in and out of the market is such a constant factor that it can probably be seen as an expression of the fundamental personality of the market, and perhaps the means by which market equilibrium is ultimately maintained. Indeed, to borrow from the dialectical materialists, this could be viewed as a case of thesis-antithesis-synthesis, where each price rise or fall carries within it the seeds of its own destruction and creation of a new price move. But such philosophical musings are probably best left for another forum. Our basic message here is that from simple empirical observation there are constant fluctuations in the overall market and in individual stock prices, and it is possible for a contrarian ripple trader to exploit these fluctuations for profit. How?
The contrarian ripple trader's approach to buying and selling is a essentially a mechanistic one. To harness the power of contrarian thinking, he or she seeks to buy a stock initially when it is close to its 52-week low of the year. This initial purchase is also only made at a time that both the stock itself and the overall market are strongly down on the day. In this way the trader buys when stocks are "on sale." This approach has for the authors an intrinsic logic and appears more sensible than the admittedly more comfortable tactic of buying a stock that is going up in price. As contrarians who are strongly cognizant of constant and regular market fluctuations, we question why a trader would feel comfortable purchasing something that by its very nature fluctuates in price at a time that it is priced higher than it was just a few hours or days ago. The principle in Contrarian Ripple Trading of buying when a stock has been sold down to the lower levels of its 52-week range, and is trading lower on the day, enables the trader to be more confident of catching the typical reverse upward move of the fluctuation in the majority of cases.
Because the trader is seeking to exploit the short-term ripples, he or she also needs to target a relatively modest profit margin on each individual trade. If the trader adheres to a rigid discipline of selling a stock as soon as it has reached its predetermined target price, then he or she will in many cases be able to "ride the ripples" or buy the stock again and again at that same initial price or lower, thereby making relatively modest but repeated profits on the same basic stock trade, exploiting repeatedly both the downward and upward moves of the short-term ripple fluctuations in the stock. Take a look at Johnson & Johnson's (JNJ | news | PowerRating | PR Charts ) movement over a 52-week period and note the constant fluctuations that characterize the stock price movement.
As outlined above, the secret to the successful exploitation of these normal fluctuating price patterns is the trader's ability to get into a contrarian mindset when purchasing a stock. Therefore, among the vital underlying principles of this approach are a rigid self-discipline and an ability to follow through without second-guessing the mechanistic, almost automated rules of the technique. As is true with all investing and trading based on a contrarian approach, however, nerves of steel may often be required.
Contrarian Ripple Trading is a low-risk approach for several reasons. Firstly, the trader is in the majority of cases in and out of any stock position fairly quickly. Secondly, the technique is designed for trading almost exclusively in large-cap stocks of well-established, well-reputed, profitable and successful companies that usually pay dividends. These provide comfort if the stock needs to be held for a period of time before the targeted profit figure is reached. Thirdly, the technique generates most buy signals at relatively low price points and fewer as the market chases higher, thereby increasing the tendency to "buy low." Also risk is mitigated by the "know your stock rule." This states that the trader will only trade in the stock of a company with which he or she has a reasonable amount of familiarity, to the extent that the trader is able to engage in a two to three minute soliloquy on what the underlying company's business involves, what it manufactures or produces and to whom and in which markets its products are sold. The "know your stock" rule helps avoid initial purchases of stocks based on nothing more than a mention in newspapers and magazines, or from a talking head on TV, something that tends to lure the hapless trader into buying "hot stocks", which is precisely the opposite of a contrarian approach.
Through the combination of contrarian thinking and the "riding" of ripple fluctuations, the authors have been able to achieve market average beating returns, even if, as should be expected from a technique that is designed to be "low-risk," such returns typically beat the market by a relatively modest rather than by a spectacular margin.
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