A Simple Trading Rule That Works Wonders

10/25/2010 11:07 am EST

Focus: STOCKS

Corey Rosenbloom

Founder and President, Afraid to Trade

Baidu, Inc. (BIDU) has been one of those companies that just keeps on giving and giving; similar to Apple’s (AAPL) amazing price rally.

Let’s take a look at its weekly chart, noting the 10x move from the 2009 lows, and learn a few simple lessons on how to trade these kind of moves with a focus on simple charting techniques (way easier than you think).

First, the chart:


Click to Enlarge

First of all, it’s virtually impossible to foresee in advance—like at the lows—when a low-priced stock has the potential to become a ten bagger, another word for a stock that has multiplied ten times in value off a pivot low.

While you’re highly unlikely to have bought when BIDU was trading for about three months at the $10 level back in late 2008 and early 2009, it was possible to participate in the rise, particularly in 2010.

Also, keep in mind BIDU’s chart that we see now is the result of a ten-to-one split that occurred on May 17, when the price went from the $700 level to $70 overnight. So before May 2010, what you saw on the chart was multiplied by ten (so the $10 you see was $100).

It’s a good example of long-term plays, but in this case, the price won’t correspond properly. In other words, without the split, the stock would have “ten-bagged” from $100 to $1,000 (though the split probably helped propel the stock higher due to lower prices).

From a chart perspective, if we’re talking about long-term strategies, we want to buy stocks that are rising (hopefully with rising volume) and are showing a stable rise both in price and the orientation of the 20- and 50-period exponential moving averages (EMAs).

So, the first big clue you can look for is to see if price is “riding” (bouncing up off of) the rising 20-week EMA.

If so, look to make sure the 50 EMA is a stable distance under the 20-day EMA. This shows a bullish orientation where the shorter-term EMA is comfortably stretched above the longer-term EMA.

And the simple rule is “As long as price continues this pattern of stable EMAs, you want to buy all pullbacks to the rising 20 EMA and then place or trail a stop loss a few percent under the 20 EMA.”

It’s an extraordinarily simple rule, but look how effective it would have been.

I show four examples of BIDU pulling back to its rising 20-week EMA (green) throughout the course of the rally. Short-term traders can consider buying options around those times to play for a rally up and then sell the options after a rally forms.

Longer-term traders would generally hold their shares (or options) as long as the price kept bouncing up off the 20 EMA. The general rule is that in powerful trends, price can rally/rise far higher than most people think it can.

So, take advantage of that by holding on and monitoring price in relation to the 20-week EMA.

Keep in mind this rule didn’t really come into play until price broke to new highs above the blue resistance line at the $40-per-share level in late 2009.

Notice the big bullish candle and the corresponding big spike in volume that occurred in January 2010. That was a bullish trigger of potential future price strength. Don’t ignore those signals.

I understand that it’s very difficult to buy price at new highs, and many traders cannot do that. But it’s easy—or at least much easier—to put on a position when price retraces to a respective moving average, such as the pullback in June/July 2010.

A second, much quicker pullback opportunity occurred in August at the $75-per-share level. Of course, you can apply much more complex charting methods, but sometimes—as with really big moves—it pays to stick with simplicity.

Most complex methods likely called for you to exit your position, be it overextended/overbought oscillators, upper Bollinger Bands, reversal candles, etc.
But in very powerful trend moves, sometimes the number one indicator to use (aside from price itself) is the 20-week EMA (or 20-day EMA for shorter-term moves).
That’s not to say you can’t raise up your stop and take some profits at grossly overextended periods like right now, the bearish weekly engulfing candle in August 2010 at the $85 level, the weak/indecision candles at the $70 level in May 2010, etc.

I actually prefer that style of risk protection and taking profits in overextended conditions and then getting back in on the expected pullback.

The risk is that you miss a move—similar to that of early 2010—but remember, in hindsight, it’s perfect. In real time, we must make decisions under uncertainty.
So, all complexity aside, to capture really big moves, sometimes you just have to keep it really simple and don’t second-guess yourself with complexity.

By Corey Rosenbloom of AfraidToTrade.com

Corey Rosenbloom is a trader and will be speaking at the Las Vegas Traders Expo in November. Register to attend the Expo and Corey’s session FREE here.

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