Low-Risk Trading in Financially Strong Stocks (Part 3)

10/07/2009 12:01 am EST

Focus: STRATEGIES

This five-part series is a basic guide to investing in stocks that return 20% or more per year with minimal risk. Part 1 took a look at the advantages of investing in financially strong companies, and Part 2 told how to identify them. In Part 3, we will discuss how to maximize returns and minimize risks.

Monsanto (MON) had a great ride until mid-2008 when the market collapsed. While Monsanto is indisputably a strong company and its stock price should continue to increase, a savvy investor would not ride the stock from $145 to $70 per share.

Investing in strong companies is always the strategy of choice. Smart investors also pay attention to indicators about the right time to get in-and get out.

The Moving Average Convergence/Divergence (MACD) is a trend-following indicator that guides me to discern entry and exit trade signals. It shows the difference between a fast and slow exponential moving average.

Please refer to Figure 4 below. An entry signal is given when the lower line crosses up through the signal line. An exit signal is given when the upper line crosses down through the signal line.

chart
Click to Enlarge

The MACD is prone to whipsaw, however, when used with a long-term weekly chart of the stock being analyzed, as a guide only, it provides useful information.

From 2004 until late 2007, Monsanto's stock rose from $15 per share to $127 per share. (See Figure 5 below)

chart
Click to Enlarge

The MACD gave a clear signal in January of 2008 to sell. Using this signal as a guide, let's suppose conservatively we sold when the stock was $105 per share. It would have yielded a seven-fold price increase in five years. This compares to the five-fold increase with buy and hold, seen in Part II. I like these results.

This low-anxiety investment strategy takes minimal review time weekly. Use the MACD as a guide only. If you miss the signal, don't worry. Stocks of financially strong companies will generally outperform the general market. Investors enhance this strategy by using option strategies, such as covered calls and in-the-money (ITM) calls.

Coming up, Part 4 will discuss the psychology of trading and how to learn from the way successful traders think. Part 5 will assist you in creating your trading business plan so you may trade like a professional.

By Dale Brethauer, trading mentor, Pacific Trading Academy

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