Chapter 20
Position Trading Strategies
In This Chapter
• Position traders compared to investors
• Fundamental research drives stock selection
• Important business, market, and economic cycles
• Holding a position until the trend reverses
Position trading anchors the other end of the holding spectrum from short-term trading. Instead of a holding period of no more than one day and sometimes no more than a minute, characteristic of the short-term trader, the position trader is in for the long haul. The long haul in this case is as long as the stock is doing well and the price is moving up, even gradually. Position trading, also known by some as trend trading, looks to ride an upward (or downward) trend for as long as it runs, which could be months.
Active traders, which as a group are not known for their patience, may find the pace of position trading too slow for their taste. In fact, some refer to position trading as short-term investing. However, if practiced correctly, position trading departs dramatically from short-term investing. Position trading gives traders an alternative when a stock appears to have longer term prospects.

Trading, Not Investing

Active traders by definition remain engaged with their positions. They remain aware of price changes, trend reversals, and other factors that could increase or decrease profits. Traders have little patience for securities that don’t produce profits. As we have seen in exploring short-term trading, momentum trading, and swing trading, when the trade shows signs of reversing a profitable position, the trader exits and moves on to the next opportunity.
Investors, by contrast, are less concerned with daily pricing and more concerned with long-term growth and value. They pick investments based on the fundamentals of the company and the relative price of the stock. If they get the stock at a reasonable price, investors will stick with the stock for years, even if the price is battered by market or economic factors. As long as the business fundamentals remain solid, “buy-and-hold” investors will stick with a company. If the price should stumble because of market conditions, investors might consider that an opportunity to add to their holdings.
Market Place
Position traders are prepared to exit their position any time it appears the price trend is reversing. This distinguishes them from investors.
 
 
 
This “buy-and-hold” philosophy is a sound and proven strategy that has been borne out over years of experience. Warren Buffett, one of the richest men in the world, became so, in part, by using this strategy. Of course, for a strategy of buy and hold to succeed, investors have to choose a great company that is going to remain great throughout their holding period. This is no small task in itself. The other problem occurs when investors need cash (as in retirement) and the stock is the victim of market doldrums. Investors are faced with selling at a loss or hoping the stock will rally in the near term—and neither are welcome prospects for a retiree needing cash to pay bills.
Market Place
Many traders speak disparagingly of buy-and-hold investors, but the facts back up the philosophy when executed correctly as a superior long-term wealth-building system.
 
Because the anticipated hold time may be months, position traders must have a better understanding of the company, its products, and markets than other types of traders. The longer holding period means the trader is exposed to more risk that events in the market, economic, or business cycle could have an adverse effect on the stock.
As with all trades (and investments, too), it is important that the position trader enter the trade at a good price. If the stock has already been bid up in price, there may not be much left in growth possibility before it becomes overbought and profit-taking begins pushing the price down. Ideally, the position trader will catch the first part of a stock’s upward trend and take a position. If the trend is built on solid fundamental growth (as opposed to a single event, such as an earning report), the stock should be in a groove for a sustained growth. Technical analysis and charts will help you determine where the stock is in a price trend.
The position trader may be more tolerant of small retreats if the overall trend remains upward. Weekly and monthly charts of moving averages among other technical analysis indicators will help the position trader keep an eye on the trend’s progress and spot any potential reversals.
The trader’s position is safer if the stock doesn’t attract much market or media attention. A run on the stock may hike the price in the short run, but it will almost certainly kill the long-term growth trend, at least for the immediate future.

Fundamental Analysis Is Key

Position traders can’t rely on technical analysis to give them answers to which stocks have longer term growth potential. For that information, traders must turn to fundamental analysis, which is the study of a company’s key financial ratios along with an understanding of the company’s business and market.
This is an area investors are familiar with, and if you are coming from that discipline, you know what is required to identify companies with growth prospects. However, position traders are not interested in value investing. A value investor will pick up the stock at a cheap price and sit on it, often for years. When the market does correct its underpricing, the stock often records an extraordinary gain. Successful value investors do very well over time. However, the risk is the company’s true potential will never be recognized and the stock price will remain stagnant.
def·i·ni·tion
Value investors look for companies that have been overlooked by the market or had their stock beaten down for no good fundamental reason. Value investing is not about buying cheap stock. It is about buying stock that is underpriced by the market, meaning it is trading for less than its fair market value.
Position traders are more interested in growing companies with immediate potential. Growth investors look for companies with prospects for growing their business and hope to share in that growth through long-term appreciation of the stock’s price. In many cases, growth companies reinvest any profits back into the company to fund more growth, rather than pay dividends. The danger of investing in growth stocks is that at some point the company may stop growing. When that happens, the market often punishes the stock with a sell-off that dramatically reduces the price.
Active traders are by nature interested in trades that exhibit activity. There is a certain amount of skepticism that traders can sit still long enough to let position trades play out to their full potential. Although position trades don’t require the oversight of other more rapidly moving strategies, you can’t doze off either.

Using Both Technical and Fundamental Analysis

The position trader more than any of the other active traders uses tools from both fundamental and technical analysis. Technical analysis proponents are almost fanatical in their faith in charts and indicators. They turn to them for guidance on all their trades. In many situations, technical analysis can prove helpful to traders and investors. However, some things technical analysis can’t predict, and some decisions are best left to the tools available through fundamental analysis.
Technical analysis is best used to look at price and volume patterns. These factors when combined with other indicators help traders determine buy and sell signals. They also help traders spot trends and trend reversals. Technical analysis is not a perfect predictor, but it can be helpful when position traders have identified a stock and needs to determine when to enter or exit their trade.
Fundamental analysis will tell the position trader whether the company behind the stock has the credentials to carry a growth agenda into the near future. Charts may tell you a stock has done well in the recent past, but they can’t tell you whether the president of the company has just been indicted for looting the pension fund. Less facetiously, charts can’t tell you whether the company is financially healthy or in a dying market or about to merge with a competitor. All these factors would be considered in fundamental analysis and would have a bearing on whether this was a growth stock.
161
Trading Tip
Volume is the best way to verify a trend or indicator. If you are unsure whether a trend is forming or reversing, volume is one key point to consider. Without strong volume, most indicators are questionable in their guidance.
If position traders are looking for a stock with upside potential, they will need to confirm that with fundamental analysis. Technical analysis can only suggest an upside if history repeats itself (which it does sometimes). While fundamental analysis can suggest the intrinsic value of the stock, it can’t tell you where the market will price it tomorrow. Certain financial ratios reflect what the market is paying for the stock, but only guess at what it should pay in the future.
Fundamental analysis doesn’t reveal pressure building on the sell side or the possibility that a trend is about to halt or reverse. You can’t use fundamental analysis to plot your exit strategy as effectively as you can with technical analysis.
If your stock candidate is particularly susceptible to certain market or economic events, you can use technical analysis as a historical tool to gauge how the event affected the stock’s price in the past. For example, homebuilders are sensitive to changes in interest rates. If you anticipate an interest rate change, you could go back to a previous change and chart prices along with moving averages to see what happened. A hike in rates is usually not good for interest-rate sensitive companies, so what happened to the stock the last time rates went up? What happened when rates went down? Depending on the economic environment you are trading in at the moment, an anticipated hike or cut could influence whether you bought the stock or shorted it (also a viable strategy for position traders, but not often, because of interest charges).
Market Place
Most charting software services will provide historical prices so you can construct charts. If not, Yahoo.com Financial offers historical stock prices so you can build your own charts.

Choosing the Right Cycle

Position traders can find candidates in just about any market. However, it is easier in some situations than others. A full-blown bear market, when very few stocks are rising, is a tough market for the position trader. Still, this market sets the stage for some great opportunities when recovery begins.
Analysts who study the market’s behavior and follow technical analysis are fond of breaking the market into four phases: accumulation, markup, distribution, and mark-down. These phases each hold a special opportunity for position traders. The most significant problem is identifying which phase is presently in control at any particular moment. Think of these phases as part of a circle that rotates at various speeds.
Sometimes we zip through one phase, but are hung up in another. Here’s what they mean to position traders.

The Accumulation Phase

The accumulation phase is where smart buyers are bottom fishing for good stocks that have been beaten down in price. At some point during the accumulation phase the market bottoms out, but that point is usually confirmed after it happens. This may not be a great place for position traders because there is not an easy or effective way to determine how long stocks will be stuck in this phase. You could buy in cheap but sit on a stock that is going nowhere for a lengthy period. This works for value investors, but not position traders who need something on the move.
162
Margin Call
Position traders should not try to time the bottom of
a trend (or the market), but wait until they can confirm the upward trend with confidence. Otherwise, you may be stuck in a stock that goes nowhere and is not even a candidate for a swing trade.
The best buys are going to be found in this phase, but position traders will want to wait until the market is moving on to the next phase and stocks are beginning to head up. In a perfect position-trading world, you would have a good fundamental candidate in mind and watch the charts for the patterns that indicated the stock was breaking out of this phase. As this phase ends, prices of leading stocks begin moving up when more buyers come into the market. Position traders should be among the buyers who have seen the technical indicators that breakouts from the low prices are happening.

The Mark-Up Phase

There is not a sign that says, “The market is now entering a new phase,” so you’ll have to be sensitive to the news. However, during this phase you will see a continuation and acceleration of price increases that marked the end of the previous phase. One of the indicators that the market is in the next phase is a substantial increase in volume. At this point, many investors who left the market during the dark days of the accumulation phase are coming back in and driving up prices on premium stocks—the type position traders should own. The early part of this cycle is where position traders want to establish their trades, because the people waiting on the sidelines for a sign will begin to buy.
Prices will increase throughout this phase and accelerate toward the middle and end. You will soon be witnessing the less intelligent money jumping on after many stocks have already posted substantial gains. Stocks will become over-valued and that will begin setting off technical alarms of a pending price reversal. Position traders should watch the smart money and begin moving when they see institutional investors do the same.
As the unsophisticated money moves into the overbought market, it is time for the position trader to plan an exit. While it doesn’t always happen, the end of the markup phase may be capped by an artificial surge driven by unreasoned buying—such was the case toward the end of the dot.com boom in the late 1990s. This unreasoned feeding-frenzy of buying is for amateurs only, but if you are confident of where the market is headed, this is a great time to establish short positions in the most volatile and overbought stocks. It’s a risky play, but if you are right, the bottom will drop out and your shorts will produce a nice profit when the market moves into the next phase.
163
Trading Tip
Active traders make money off amateurs who jump into the market at all the wrong times. This may seem harsh, but trading is not a game where everyone wins.

The Distribution Phase

The distribution phase is when things begin to turn ugly. Sellers take control and prices begin to fall. Note that this is not an across-the-board reaction. Some stocks may not fall as fast as others do. Big-cap stocks may hold their prices longer than more volatile smaller cap stocks. If an industry sector is hit with bad news, those stocks may fall faster than other stocks. Fewer stocks are hitting new highs than in previous phases, while the number of new lows begins to grow.
Investors grow increasingly pessimistic, even if there are several false starts that make it look like the market is bouncing back. Concern drives some out of the market and into cash. This lowers prices even more and the “it’s going to get worse before it gets better” feeling grows.
Position traders, except those who shorted stocks at the height of exuberance, are out of the market unless they see more short opportunities.

The Mark-Down Phase

The mark-down phase is when all the wheels come off and prices drop to their lowest. True buy-and-hold investors will be tested during this phase. If their time frame is long enough and they have chosen quality firms, their best strategy is to wait out this phase and hope prices come up as the market cycles through its phases. Other investors will finally give up and sell, often at a loss. These are the folks who bought near the market top in the accumulation phase and now choose to sell near the bottom. They will complain the loudest about the stock market being unfair.
While this phase can be difficult for investors, it sets the stage for position traders and others to pick up stocks at deep discount prices.
Market Place
No one wants to see bear markets, but the fact is there would be no bull markets if there were no bear markets. Bear markets squeeze the excess out of the market and prepare it for the next expansion.

Timing Cycles

A market cycle (all four phases) doesn’t have a fixed length. Some cycles are short, while others are longer. Some categories of stocks may fall into a fast cycle, while other stocks just poke along through one or more phases. Stocks have their own individual phases and you can see them in charts of various periods. These indicators help traders understand where the market or an individual stock is at a particular moment and what that might mean for future price changes.
When looking at an individual stock, remember that it can jump through a particular phase very quickly. It takes more time for the larger market to move through a cycle, but count on it happening. When you can identify where the market (or stock) is in its cycle, you have an edge in predicting where it may be headed next. For the position trader, this is very helpful information.

Economic and Market Cycles

You can match market and economic cycles to some extent with the understanding that the market usually leads the economy by several months. The point of matching cycles is to look for industry sectors that might do well in the various economic cycles. Like the market, the economy periodically cycles through phases that you can roughly match to the market’s phases for purposes of identifying investment candidates.
Politicians, especially around elections, do what they can to avoid downturns in the economy. However, there is ample evidence that relatively mild recessions, like mild bear markets, are good for the economy and the financial markets. Excess is eliminated and weak companies purged, making way for new entrants into markets.
Here’s how market and economic phases line up and the industry sectors that do well in each.
164
Trading Tip
Economic cycles are affected by election-year cycles. Politicians want the economy humming around election time and will often do what they can to make that so. There is some evidence their efforts do more harm in the long run and help in the short run.

Accumulation—Economic Downturn (Recession)

The economy is in trouble and the Fed is cutting interest rates to get things moving. Unemployment is high and manufacturing is down. Noncyclicals and service sectors may produce candidates.
def·i·ni·tion
Noncyclical stocks are from industries that are not as subject to the condition of the economy as other industries. For example, health care is non-cyclical since people still get sick even if the economy is bad. On the other hand, the automobile and housing industries are cyclical. When the economy is weak, cyclical industries suffer. However, they can experience significant growth in a robust economy (people have more money to buy cars and houses).

Mark-Up—Beginning Recovery

The economy is coming around and people are beginning to feel good about their personal financial situation. Interest rates have leveled off and companies are hiring. Look for opportunities in industrials, energy, and technology.

Distribution—Waning Recovery

The boom is off the economy and growth may be slowing. Businesses and investors who aren’t paying attention will act as if the economy is still booming, setting themselves up for a harsh fall when it slows down even more. Look for continued opportunities in energy, services, and staples.

Mark-Down—Early Economic Downturn

The market will generally drop off first, followed by the economy. Consumer sentiment will shift from cautious to concern and politicians will be in denial. Look to utilities for safety as well as noncyclicals.

Playing Market Cycles

Market cycles are not always as neat as outlined here, but because position traders may hold trades open for months, it is possible they could span a phase or two of a market or economic cycle. Knowing where the economy is in the business cycle will give the position trader a hint about which industry sectors may hold likely candidates.
For other active traders, this type of information is generally not important. As we have noted, today’s active trader is likely to employ more than one trading strategy depending on the market conditions and opportunities that present themselves.
 
The Least You Need to Know
• Position trading is not investing but usually requires a longer hold than other active trading strategies.
• Stock selection is driven in large part by fundamental analysis.
• Technical analysis plays a role in determining entry and exit points.
• Position traders must be aware of economic and market cycles when selecting stocks.
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