Click chart to enlargeThe lines that define the top and bottom of the channel can be set at any distance from the computer-generated linear regression line in the center, depending on an individual investor's tolerance for risk. We choose to set them conservatively, meaning there are often areas on the chart where the stock will trade above and below our offset lines. It is important to note that the line that really matters is the one in the center. The center line never changes. Once established, it tells you quickly whether or not the stock is overbought or oversold, and roughly how much so. Look at this new chart of CF with larger offsets than the one previously posted. It suggests that CF could reach 142/143.
To complicate matters even further, we should mention that there is a great difference between an arithmetic chart (which we use), and a logarithmic (log) chart. The arithmetic chart is scaled such that each dollar equals the same unit of height. The logarithmic chart is scaled such that each percent has the same unit of height. While the difference is hardly noticable on a short term chart, it becomes substantial the further the chart extends into the past. We use the arithmetic chart because, once again, it is the more conservative one. A log chart of CF suggests that the top of the channel is at 153, and a log chart of POT suggests that the top is at 195.
We are aware that these discrepencies exist, and appreciate that charting is not an exact science. If the market were very bullish, we would adjust the lines to allow for more upside. Given that we believe we're in a bear market, our conservative stance should be understandable. If we do get to a point where we are more short than long, we will likely hold small amounts of the long positions above the top of the channel to offset the imbalance.
The point of trend channel trading is not to nail the very top and bottom, but rather to have your positions properly scaled for the amount of risk vs reward at any given point in a chart's natural cycle. CF's rally could end here at 138, or continue to 143 or even to 153. That part is unclear. What is clear from the trend channel is that regardless of whether CF has 5 points or 15 points of upside, there are 24 points of downside.
Another way of calculating potential short term upside is by figuring out at what percentage above its moving average a stock typically tops out. We've done this for CF and found that at 30%-33% above its 50dma, it's rallies end. This method puts CF's top at 151-154, similar to the log chart, as both work off of percentages.
So each individual must make adjustments to suit their own level of risk tolerance. If you choose to hold CF in hopes of capturing another 10 points, we wish you well. If our risk tolerance allowed for that, we would certainly be selling at 150, as we know that with the exception of raging bull markets, stocks are attracted to their moving averages like moths to a flame. And in the case of CF, its 50dma is currently at 116. Food for thought.
6 comments:
Outstanding stuff Snot. If only Etrade had a linear regression tool. I have to draw the line by eye but certainly the concept is still true. Thanks again for explaining how these things work as its great information.
Conor
Gret analysis. I wish that here in Germany, I had turnover - but there are no CF-stocks sold. Potash is ok.
Do you have another stock, which currently runs in these predictable channels?
Greetings, newfrankyboy
Snot,
In your use of linear regression lines it appears you are going out about 8 months....way longer then I was using. Can you comment on how you select a time frame to use?
Thanks
squarpeg
Suprised to hear Etrade doesn't have a linear regression tool. It's one of the basic ones!
As for time frame, the longer it takes for a trendline to form, the more significant it becomes. We use 6-12 months as a time frame for our lines because that gives it a higher level of credibility then, say, a line that takes only a month to form. Shorter term trendlines are good for short term timing, but a break of them is less significant, and therefore less dependable, than the longer term ones.
It all comes down to your own preferences and tolerance for risk. We, too, are guilty of trying to time the market on an intraday basis by applying these same principles to a one minute chart.
Your student here...If I apply the rule of only buying things above the 50day MA it seems very difficult to find stocks that are above this level and yet are near the bottom of any type of longer term channel. I did find some though and would like to take a crack at some picks If you have the time.Your feed back would be great.
Don't even know what some of these companies do, just picked them from charts. The first is TRA seems to have room to move up the channel?
Next is HEW long term up trend
Also three stocks that have been moving down the channel for several weeks. I would watch for a bounce any minute
BZP
FCN
FDP
Last AMSC that shows it is sitting on what might be a strong bottom trend line, Plenty of head room above.
Feel free to criticize I'm not in it for the love :)
Thanks
Squarpeg,
You're exactly right, it is difficult to find a stock trading above an uptrending MA in a defined channel in a bear market.
In a bull market, you'll feel like a kid in a candy store compared to this.
Some of your picks do look good. The charts look good, that is. But we usually go for larger companies with higher daily volume. As a rule of thumb, $5B market cap and 1M volume minimum.
The stocks you've picked have the relative strength required to make them reasonable picks, but they are smaller companies, making them more risky. We look for stocks that have a lot of institutional sponsorship. Look at FSLR. It recently made new highs. Value investors would tell you that it shouldn't be outperforming LDK. Look at the difference between their p/e's and pegs. It just goes to show you what institutional sponsorship does for a stock. You just can't fight smart money.
We put a lot of effort into picking that one sector and particularly, that small handful of stocks that define each era of stock market history. These are the DELL's, GOOG's, AAPL's, CSCO's of the world. Of course those companies are past their growth cycles at this point. Too big for our taste. As much as it seems we are all about the chart, we are well aware that we've specifically chosen the highest relative strength charts in the strongest sector with the highest earnings growth, great story, and Wall Street's support.
You may become a millionaire on stocks like HEW and BZP by simply applying TA to them, but we've tried that on random charts and have found that it wasn't so easy to get them to do what we wanted.
Look at a chart of CMO, for example. Occasionally we'll find a great chart of a small company, like the ones you've found. Then we'll stock our hand in, and get it chopped off. Problem is, no one knows about these companies. So when they drop, they really drop hard. Hopefully a chart of CMO will help you realize the importance of trading the larger, more stable, fund-owned companies. It is very unlikely that a company like POT will drop 50% in two days like CMO did.
After getting burned a few times on the smaller names, you'll likely gravitate towards greater stability, too.
P.S. TRA is another Ag name. One of the weaker ones finally staging a comeback. It's channel was broken (to the downside) a short time ago, so we haven't traded it. We stick with best of breed, high relative strength, new 52 week highs, you know the type... POT and CF.
Hope that helps.
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