In recent months, I have adopted a strategy of channel trading. I pick an undervalued stock according to fundamental considerations to ensure capital preservation (strong balance sheet, valuable business franchise etc.), identify short term support and resistance levels, and then buy when the price is closer to the support level than to the resistance level. Typically, I am looking for a 3:1 gain:loss ratio based on the support/resistance levels. I sell if the price breaches either the support or resistance levels. Unlike typical technical trading, I only channel-trade the stock if it is substantially undervalued according to my estimate of its intrinsic value. I rely on the intrinsic value estimate as insurance against a permanent capital loss. Due to the increased volatility of stocks these days, I frequently find myself hitting the support/resistance levels in a matter of days, therefore this strategy is a form of short-term value investing, as advocated in the book Active Value Investing by Vitaliy Katsenelson. I have adopted this strategy because I believe that buy and hold is suitable only in a period of general economic recovery and broadly rising stock prices, and that we are perhaps 1-2 years away from such a recovery. I believe that in the meantime, the market will trend horizontally, and profits can be made in channel trading and options strategies. The channel trading strategy also protects against a general decrease in valuation multiples (my own valuation multiple has shrunk to 10 for more speculative companies, and 15 for exceptionally strong businesses). I have also abandoned my previous strategy of diversification (which did not prevent the broad-based losses from Nov 2008 through Jan 2009), and am going back to my roots of holding a concentrated portfolio, except that I now watch my positions like a hawk and am willing to liquidate at a loss if they breaks support levels. Stock research is simply too laborious for me to cover many stocks.
In the 2 months that I’ve tried this strategy, it has been modestly profitable, with gains outnumbering losses by approximately 5 to 1. And for the first time in a long while, I am finally beginning to outperform the index modestly. I have learnt several lessons.
- There is no shortcut for fundamental research. One of my first speculative plays was Citigroup; I was unable to estimate an intrinsic value, yet decided to hold a small position. C promptly gapped through my protective stop. Thus, stops may fail, and there is really no substitute for gaining in-depth knowledge about your stocks.
- Be equally willing to take gains and losses. Initially, I was risk averse and was quick to sell when stocks breached my support levels, but slow to take gains when they rose above resistance levels. Eventually, I found that I was taking losses repeatedly yet taking very few gains. I promptly readjusted my strategy, and everything has been okay since.
- Monitor your strategy constantly. The greatest advantage of short-term trading over long-term buy-and-hold is that feedback is continuous. Therefore, you quickly gain an instinctive feel for what works and what does not. I also feel strongly that a trading strategy should be supported by an overall thesis (macroeconomic or otherwise). For example, I engage in channel trading because I do not think stocks are likely to make large moves upwards or downwards due to the uncertain economic climate. Once economic recovery begins in earnest, I expect the channel-trading strategy to begin to underperform a buy-and-hold strategy, and will adjust my strategy accordingly.
- Adjust support and resistance levels proactively. The advantage of a channel-trading strategy is that one can adjust the support and resistance levels constantly, even proactively to anticipate as yet unestablished levels. I realized this when I discovered that several of my best stock ideas (GEOY, MOS, AMTD) were making higher lows and higher highs over a few months, and when I stuck to the previously established lows and highs, I was consistently missing much of the move. I decided to estimate and anticipate the constant rise in both support and resistance levels, and have done better since. Interestingly, I found that as long as the volatility is large enough, channel trading outperforms buy-and-hold after trading expenses even if the underlying stock is on a long-term uptrend. Of course, I will immediately cease to channel-trade a stock if it is approaching my estimate of its intrinsic value.
In summary, it has been educational, and its good to be making money again after the devastation that was 2008.
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