Traders quickly realize that knowing when to exit a trade is as important as knowing when to enter one. This year began with such an extended rally that many traders found it difficult to determine how much bullishness was too much. At what point should a trader say “bull” to a bull market?
Bull markets trade with lower volatility than bear markets. In general, people respond more quickly to pain stimulus than satisfaction stimulus. In the markets this means investors are satisfied to do nothing as long as stocks rise, but feel spurred to action as prices trend lower; stock holders become stock sellers and prices fall rapidly.
Volatility-adjusted measures can help determine when a stock has moved too far. This article explores using volatility-based measures for calling a top, how to use volatility-based stops to ride the trend until it changes, and a method for predicting resistance and consolidation periods (or trend reversals) in a market after entering a trade.
When to call a top
When trading outpaces expectations of future price growth, a temporary top is likely reached. But how can traders anticipate this in a position that is rising as a result of distinctly optimistic uncertainty?
For example, on the first trading day of 2012 Regeneron Pharmaceuticals (REGN) opened for trading at $56.51 (Figure 1).
By Valentine’s Day the stock had nearly doubled in price, topping out near a frothy $117 per share. The company had recently been given FDA approval to market its nonsurgical treatment for age-related macular degeneration, which is the leading cause of blindness in aging adults. Investors may have believed the treatment would be profitable, but they didn’t know how to value shares without any sales data. As information became available about rising sales, the stock price rose dramatically.
For the complete article, see the May 2012 issue of Active Trader magazine. Click here to subscribe.