The Power of Trading Using a Risk/Reward Framework

One of the biggest "grey areas" in trading is knowing when to sell a position that is at a gain. It's certainly much easier to develop rules for when to buy a stock (i.e. buy fundamentally-strong stocks breaking out of sound technical bases on powerful volume) and when to sell a stock at a loss (i.e. never let a stock fall 5% below your buy point). Once a position shows you a gain, however, the correct course of action becomes less clear and is often susceptible to emotionally-driven decisions. For example, greed could cause a trader to overstay his welcome in a winning stock in hopes it will continue to ratchet higher, while fear of losing your current gain could result in a premature sale in a potential big winner. Selling a position and locking in a profit too early in a stock's move can certainly be frustrating as you watch the stock vault higher without you. On the other end of the spectrum, it's equally disappointing to see unrealized gains evaporate on a stock that you once had a sizable gain on, as it falls back to or even undercuts your entry point. On Friday, 10/18, with many leading stocks extending gains after breaking out of basing patterns, I posted the tweet below, which sums up the predicament described above:

In reviewing many of my past trades, I've noticed that one of the best ways to strive for consistent trading results is to view every trade within a risk/reward framework. To clarify, I define risk as the amount of potential loss on a trade, which is determined by the placement of a stop-loss (ie. I'm willing to lose $2/share on this trade). This amount of risk serves as the benchmark for calculating potential reward within this framework (ie. 2x risk would be a $4/share gain, 3x would be $6/share gain, etc.). What I found in studying my results was that stocks will often move up a certain multiple of my risk (often 3x or 4x), and then either correct or settle into another basing pattern. To illustrate this point of how to view trades through a risk/reward lens, let's examine one of my past trades in Facebook, which I began to trade starting in the winter of 2012:

I bought FB on 11/21/12 at $24.30, as the stock broke out of a bottoming basing pattern on the daily chart. Facebook had knocked out a trading range between roughly 19 and 24, and I entered the position on a break of the upper resistance area, which was accompanied by above-average volume. I set my stop below that day's low, giving me a risk/share of $1.30, which still allowed for slightly over 5% wiggle room should the stock pull back. Based on these parameters, it's simple to calculate the various multiples of my risk by adding multiples of my risk/share to my cost basis (ie. 3x equals my cost basis [24.30] plus 3 times my risk [1.30], or 28.20). When I exited the position on 12/3, I wasn't aware that I had sold FB at 3x, as I had yet to integrate this framework into my trading. Instead, my sale was based on the negative reversal, as FB tried to punch higher but got firmly rejected by sellers. Based on similar reviews of my past trades, I've developed a strategy for selling winners that combines multiples of risk (looking to sell at 3-4x) with price action (a move extended and "stretched" from its moving averages, a reversal, or a break of prior support). Although this approach makes it unlikely I'd hold a stock for years and rack up a 200-300% gain on an individual position, I've found this framework promotes consistency and, as shown below, can lead to outsized gains. In the exercise below, let's assume a starting portfolio of $100,000 adopts the technique of selling once a stock has reached 3x, cuts all loses at 5% (meaning 3x will equate to a 15% gain), and the trader is only correct on one-third of his trades, to be conservative.

Number of Trades	Account Size	Win/Loss
1	115,000	Win
2	109,250	Loss
3	103,788	Loss
4	119,356	Win
5	113,388	Loss
6	130,396	Win
7	123,876	Loss
8	117,682	Loss
9	111,798	Loss
10	128,568	Win
11	122,140	Loss
12	116,033	Loss

We find that after only 12 trades, the account is up over 16%, and this is assuming a win rate of only 33%. Now, let's look at the results if the win rate is bumped up slightly, to 41%:

Number of Trades	Account Size	Win/Loss
1	115,000	Win
2	109,250	Loss
3	103,788	Loss
4	119,356	Win
5	113,388	Loss
6	130,396	Win
7	123,876	Loss
8	117,682	Loss
9	111,798	Loss
10	128,568	Win
11	122,140	Loss
12	140,461	Win

These are obviously simple exercises, but they illustrate multiple points:

First, it's clearly necessary to have your average win exceed your average loss in terms of percentage return. In the examples above, the portfolio was able to accumulate significant profits by cutting all losses at 5%, while taking gains at 15%. This highlights the benefits of taking a "multiple of risk" approach, which we examined with the Facebook trade above. 

Second, you can lose money on the majority of your trades in this framework and still deliver hefty returns. In the second example, the portfolio returned over 40% after 12 trades with only a 41% win rate. By focusing on top-quality setups of stocks with explosive earnings and sales growth breaking out of sound bases, traders should certainly aim for an even higher win percentage than 41%, which would obviously result in even greater returns.

Feel free to leave my any comments on StockTwits or Twitter (@CommAveTrader).

The Importance of Post-Trade Analysis in Defining Your Timeframe

Every weekend, I scan through different stock screens to isolate stocks that look ready to break out and potentially be on the cusp of major moves higher. I jot down names I like, put their charts up in the chart grid page in ThinkOrSwim so I can track them in the upcoming week, and post the most compelling setups on Twitter. While pattern recognition and screening criteria are important aspects of a successful trading strategy, one area that doesn't get as much attention requires you to take a step back and ask yourself a broader question - What is my time frame for my trades? If a stock makes a decent move a few days or weeks after I buy it, should I cash out? Or should I hold on for a potentially larger move? With so much focus on areas such as risk management, chart patterns, and the proper balance between technical and fundamental analysis, defining one's time frame is perhaps the most important ingredient to putting together a winning strategy in the market.


One of my favorite books on investing - How to Make Money in Stocks by William O'neil - has a great collection of historical charts of stocks that went on astounding runs. The first 100 pages feature marked-up weekly charts from past market leaders like Northern Pacific in 1900 all the way up to Apple, Google, and First Solar at the turn of the 21st century. Just as there has been great diversity in the sectors from which winning stocks have emerged - from railroads, radio producers, automobile manufacturers, all the way up to internet companies - there are just as many strategies on how to profit from these leading stocks. Deciding on the proper buying and selling techniques to implement in order to take advantage of these stocks' moves is a critical component to an overall successful market strategy, and it's often best learned from past experience.  

When the market slips into a correction as it did this past week, it's often a good opportunity to go over past trades and analyze what you did properly, and what you could have done better. As I looked over my recent trades, I've noticed that I tend to hold on to my purchases a little too long, to the point where I overstay my welcome. Most of my past successful trades have worked out because I sold once a stock has become extended in the short term, as this is often when a stock will form another consolidation and potentially give back a portion of its gains. To illustrate this point, let's take a look at a stock I traded during the most recent uptrend to see how I could have handled it better:

  On 7/2, I bought AMZN as it broke out of a base and hit new highs. Let's fast forward just a few days later to 7/12, where we find the stock up 23 points from the breakout point:

At this point, the stock is clearly extended and due for some sort of consolidation. There's no set formula or percentage I use to gauge whether a stock is "extended" or not; rather, I like to look at the stock's price on a chart in relation to its 10-day moving average, which is often a short-term level of support for high-momentum stocks. In retrospect, this would have been a good spot to lock in profits, or at least move up my stop considerably to protect gains. Despite knowing that a consolidation was likely, I got greedy and hoped my 23 point gain would turn into 30, 40, or 50 points. What was once a nice gain got booked as a small profit last week, as the stock subsequently pulled back from its highs and I moved almost entirely to cash over the past week. My trade analysis - not just on AMZN, but on all trades - has uncovered a few major points that I've since written in a "Rules/Lessons" list so as to always remind myself: 

1) Taking 10-15% gains in individual trades can have a big effect on a portfolio when those proceeds are reinvested in another fundamentally-sound stock that's breaking out from a proper base. While one stock you own may be currently extended, there's likely another stock setting up that could be ripe for big gains. For example, Z was just breaking out to new all-time highs on 7/12, as shown in the chart below:

 Rotating gains out of AMZN and into a fresh breakout like Z can result in serious compounding of returns, and playing just a few of these stocks during market uptrends - with sufficient size - can lead to outperformance. 

2) Who knows how long or deep a consolidation will last? And when other stocks are breaking out, why sit through them? You can always buy the stock back after it rests and bases - there's no reason to hold during the consolidation. My rationalization for staying in AMZN despite it being extended was that I wasn't in it for a measly 10%; I wanted to hit a home run. The flaw in this thinking was the fact that no stock can just keep chugging along in a steep ascent without pausing to "catch its breath" and form periods of consolidation along the way. Let's take a look at a multi-year chart of REGN to demonstrate this point:

 REGN was a stock I owned last summer, with my buys and sale denoted on the chart. My handling of the stock was consistent with the approach I've learned from my post-analysis, in terms of taking profits when a stock becomes extended and not holding through consolidations. However, this chart speaks to another point: Once a stock gets ahead of itself and forms another base, it'll set up again if it's ready for more upside, at which point this second breakout could be purchased. In other words, it's not sound money management to hold a stock during a four-month base while it fluctuates back and forth in a contained range; rather, hit the breakouts and only own the stock during the ascent after the breakout. 

Below is a full list of rules and lessons I've taken from my post-trade analysis. This is certainly not to say these are my suggestions to everyone; rather, it's what I've found has worked best for me:

• Try to concentrate on only a few (3-4) stocks 
• Hit breakouts/pocket pivots (constructive action in bases) with size (risk 1% of capital)
• Only buy stocks when the market indices are in confirmed uptrends with bullish moving average alignment (10-day MA above 20-day MA above 50-day MA)
• Take cues from the general market price action - when to be defensive and when to be exposed
• Take profits into strength as a stock gets extended from its 10-day moving average
• Don't try to hit home runs - oftentimes, it'll result in a round-trip
• Focus on multiples of risk; consider taking profits around 3x or 4x
• Can always buy the stock back if it sets back up; once it's extended, it's likely due for a consolidation  
• Try to buy as close to the pivot as possible, so buys won't be extended
• Use high-level stops to protect profits; prevents round-trips
• Pay close attention to distribution days and lighten up on the 5th or 6th DD; be out on 7th
• Can turn to a SPY short as distribution days cluster on market indices 

The Race to 1,000: Two Stocks Closing in on Quadruple Digits

During market corrections like the one we've been in since early June, it's always a good idea to keep track of the stocks holding their own and showing good relative strength. Two stocks that have held up remarkably well over the past month are Google (GOOG) and Priceline (PCLN), which also happen to be liquid, high-priced institutional favorites with solid earning and sales growth. The fact that they've remained resilient in the face of this pullback indicates institutions are unwilling to part with these two darlings, and that they could be ready to lead once the overall market resumes its uptrend. To be clear, my overall take on the market remains slanted toward the bearish side, as the price action and volume patterns have indicated that the trend, at least for now, is lower. However, GOOG and PCLN sit high atop my watchlist for go-to stocks to buy whenever the overall pressure on the market is alleviated. Let's examine both stocks' charts below, first on a weekly basis and then on the daily time frame:

On the weekly chart of GOOG going back to late 2006, we can see the stock first broke above resistance at 650 in August of 2012 after basing below that level for more than two-and-a-half years. After pulling back in November 2012 to re-test that level, where the stock found support at previous resistance, GOOG proceeded to march higher and break out above the old 2007 highs. Currently, the stock just completed its sixth week in its base, which has corrected less than 8% off the highs set in late May. The base shows many tight weekly closes over the past six weeks, each week closing within roughly 1% of the prior week. This tightness has historically been found in past market winners before taking off to new highs, as it's an indication of institutional support. If big market participants were aggressively dumping their shares, the price action would obviously be much more erratic and less orderly.

Zooming in to the daily chart, we can get a clearer picture of GOOG's current base structure. The 50-day moving average has acted as support twice in June, the most recent of which created a higher low. This strength is especially impressive when juxtaposed against the chart of the QQQ or SPY, both of which are trading below their respective 50-day moving averages. Volatility has been contracting in the pattern, suggesting GOOG could soon make an attempt to break above its descending trendline. If the market were healthier, I'd likely put on a position now and add on a breakout above the downtrend line or above ultimate resistance around 920, but for now I'm just keeping it on watch.

PCLN has been a true market leader since the market rally began in 2009, increasing more than 400% since its first-stage breakout in August of '09. The stock spent nearly a year basing from mid-2011 to early 2012, until finally breaking above resistance in the 560s. PCLN would go on to form a base-on-base pattern, using the prior old highs as support, until making another move to new highs this May. Similar to GOOG, PCLN has also closed tightly the past few weeks, as it's formed a new six-month-long base between roughly 850 and 790.

PCLN's daily chart shows the long consolidation from which the stock recently emerged. Recent turbulence in the general market hasn't caused PCLN to give up its breakout; in fact, pullbacks have been getting support right around the old highs of 775. At less than 2.5% away from new highs, PCLN's relative strength is certainly impressive. In full disclosure, I am long the stock and have held it through the market correction, as it never broke below my original entry point. If the market were to follow through and PCLN crossed resistance at 841, I'd likely add to the position.

To summarize, GOOG and PCLN are both: 1) above their rising 50-day moving averages while the market indices remain trapped below theirs; 2) trading tightly over the past six weeks despite the correction in the overall market; and 3) appearing poised to break out to new highs should the market firm up. Once we return to a healthier overall market environment, I'd look for these two names to lead the way higher.