Trade Review on LF - Does the outcome determine whether it was the right trade?

Going into last week, one of the stocks at the top of my watchlist was LeapFrog (LF). I was particularly drawn to the weekly chart, which showed a 6-week base preceded by a strong uptrend that repeatedly found support at the 10-week moving average (in red). I liked the volume patterns, specifically how the stock had advanced on very heavy volume (see the two consecutive weeks in early February, as well as the last week of April), and pulled back on much lighter volume. See the weekly chart of LF (as of last weekend) below:

I identified the buy point as being above 10.60, which was the high from the week of 5/29 and was also a level where the stock found resistance over the prior three weeks. If buyers could push price above that level on good volume, it would validate to me that the stock was done consolidating and ready to resume its uptrend.

On Thursday morning, I got an e-mail with an alert saying LF had crossed above my 10.60 trigger. I pulled up the chart and noticed volume was coming in at a strong pace, which I viewed as confirmation of the move. I went long LF...only to get stopped out later that afternoon as the stock fell a few percent below the buy point. See the daily chart below:

Clearly, something was wrong, right? I lost money on the trade, and my whole intention of buying the stock was to try and grow my account. Therefore, something I did must have been wrong, since the trade ended up shrinking my account, right?

I would disagree with the two questions I posed above. Yes, the trade lost money. But when I reflect on it, I view my decisions and reactions as being proper. I bought the stock as it was clearing a multi-week base on great volume. I cut the loss quickly so that it damaged my account by less than .7%. Given the same setup and same scenario again, I wouldn't hesitate to buy the stock. In LF's case, maybe the trade failed because the market wasn't ready to support breakouts. But the setup was right.

In most activities, we judge whether a decision was correct or incorrect based on the outcome those decisions produce. If you choose to drive a car without a seat belt, and you get to your destination without an accident, then your decision to not wear a seat belt was correct since you avoided the hassle and discomfort of a seat belt. Of course, just because you got there in one piece, it doesn't mean it's the smart thing to do. A better way to analyze these situations would be as follows: if I were to play this scenario out a million times, is my decision still justified? In the seat belt example, clearly not - just one accident could be fatal. As it relates to LF, I'll continue to take similar setups in the future because, over time, these chart patterns have a strong probability of leading to outsized gains, especially when losses on losing trades are cut short.

Potential Change of Trend, Plus Stock Setups

In my most recent post (seen in the post below), I went over why I felt in mid-April that the strong uptrend from the first quarter of 2012 had run its course. Specifically, I pointed to the heavy level of distribution that had hit the market in a short period of time, along with the 10-day moving average undercutting the 20-day moving average. The chart below depicts the reasoning behind my heightened sense of caution:

These two factors - price/volume action of indexes and positioning of the moving averages - give me a sense of what big institutional money is doing and indicate the overall trend in the market. When I saw caution lights, I raised cash and limited my actions to simply following the market action on a daily basis, looking for clues of a change in trend.

This past week, we saw some developments that I would characterize as bullish, leading me to finally dip my toes back into the market after sitting out the past month and a half. First, Wednesday's booming 2.3% move to the upside on higher volume had all the characteristics of a follow-through day, except it occurred on the third day of a rally attempt instead of the fourth day or later. While I don't want to sound heretical by discounting the "fourth day or after" rule, I am encouraged by the indication of institutional accumulation, something that was severely lacking during the month of May. Secondly, I've started to see a good number of stocks setting up in recognizable patterns (I'll detail these setups below), which is a prerequisite to any sustained rally. Without leading stocks with strong fundamentals leading the charge, any uptrend in the market is not likely to be sustainable. As a result of these factors, I took two positions on Wednesday in LQDT and ROST:

LQDT has been basing for five weeks above its rising 50-day moving average, and has managed to stay near a new 52-week high throughout the correction in the overall market. The base shows relatively low volume, with the exception of a dip to the 50-day moving average, which was bid up aggressively by the bulls. Finally, the stock's strong relative strength tells me it wants to go higher, and has only been restrained by the headwinds of the overall market.

After a strong uptrend, ROST spent the month of May consolidating sideways, whereas the overall market slid precipitously. The stock has climbed up the right side of its base, and is currently basing right below the breakout point of 64.65. The 10-day moving average has recently provided support, a good sign that bulls are eager to snatch up shares on even a slight pullback. 

If these stocks begin to reverse and show signs of real weakness, I have stops in place that will put me back into cash. If they work, and the market builds on some of the strength it exhibited last week, I feel they could be two of the leaders of the next uptrend. Below are some similar stocks that are basing nicely, displaying relative strength, and sporting strong fundamentals. I'll be tracking these names closely as potential new long candidates: