One commonly heard axiom in trading is to avoid chasing stocks. The most important aspect of being successful as a trader is learning how to manage risk, and avoiding getting into difficult situations. Chasing a stock will prove to be successful at times, as stocks have been known to make runaway breakouts. However, by chasing a stock, a trader will often find him or herself holding through large drawdowns as a stock fluctuates in a perfectly healthy and normal manner. Traders must then make a difficult decision; their poor entry has put them in the hole, often just as a stock is approaching a support level. The ideal situation is to buy as close to a stop level as possible, while still maintaining an edge in your system. This allows a trader to tightly manage his or her risk and thus provides a better risk-reward ratio.
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There are many different ways to trade using this concept, but for swing traders, one option is to buy a stock as close to a support level as possible, while still allowing for some type of confirmation that a trend change is occurring. The chart for Dreamworks Animation SKG, Inc. (Nasdaq:DWA) is showing one such possible scenario. Looking back, the $41 level has been an important area for DWA over the past few months. DWA was able to clear this area in late February and is in the process of testing this level as support. If DWA can hold this level and turn higher, the risk by setting a stop just under this area is infinitely small compared to the prospects that DWA would be trading at all-time highs on a resulting breakout. It would be much easier to hold DWA through a pullback in the future with a solid entry in this area than after chasing it on the hypothetical breakout.
The chart for American Axle & Manufacturing Holdings Inc. (NYSE:AXL) is a little different in that AXL remains in a base, but the concept is similar. AXL is trading in a base on base pattern and is trading in a tight range just under resistance. There are a few different levels that can be used as support by traders of differing timeframes such as the 20- and 50-day moving averages, or even the bottom of the base near $8.50. Risk can be tightly defined, even if a trader were patient enough to wait for AXL to clear resistance just above approximately $10.50.
Healthspring, Inc. (NYSE:HS) is another stock still trading in a base and is therefore not too extended from a proper buy point. HS had been consolidating for a few months after a sharp rally late last year. It peaked early in 2010 and pulled back to a prior support level. HS has been trading in a very tight range the past few weeks and if HS were to show strength and clear the $19 area the narrow trading range would offer aggressive traders a well-defined area with which to manage their risk.
Snap-On Incorporated (NYSE:SNA) is another stock that is trading in a base on base pattern. It cleared the prior base in December, but promptly retraced the entire breakout in early 2010. However, it has bounced to just under the prior high and is also trading in a very tight range recently. It has been holding above its 20- and 50-day moving averages and this could offer a good area for stopping out if SNA can break above the $44 level.
While much of the analysis above keys on hypothetical breakouts, the key is to understand how a trader can manage risk by entering a stock just as it emerges from an important level. If a trader can time his or her entry correctly, it has multiple benefits. First, if the trade does not work out immediately, the risk is usually small and well defined. Second, if the stock breaks out and then retraces a portion of the breakout, it will often remain above the trader's entry assuming a valid breakout. This puts the trader at an advantage by not having to suffer through the anxiety of a drawdown during normal stock fluctuations. Traders who chase a stock well after the breakout forfeit these luxuries and end up facing difficult decisions that can take a toll on their psyches. With the current markets quite extended, it makes this concept all the more important. Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
At the time of writing Joey Fundora did not own shares in any of the companies mentioned in this article.