Seagate on the Turnaround

The more traders I work with, the clearer it becomes that making money is not always the primary reason people trade. Yes, they want to make money, but it's got to be a certain way. They need the satisfaction of making a trading decision, being proven right in the trade and then taking profits. That's all good, and this simple three-step process is what good trading is all about.

The problem is that nobody bats 1.000 in trading. Losses will occur as a result of making the wrong move. We buy when we should stand aside, or sell when we should be buying. Losing is an inescapable facet of trading. Everyone knows this, but in the heat of the moment, many still fall back on the three-step process described above: Make a decision, wait to be proven right, take profits.

When a trade moves against these folks, they don't take the loss. Instead, they get stuck in step two and wait. And wait. And wait.

Perhaps they'll average down. This lowers their cost basis, bringing it closer to the current market price. By averaging down, they are paying to be "less wrong." Now they've got an outsized position relative to their normal size, but they are "less wrong" than they were at the start.

Absent a stock going to zero (which is rare, but not unheard of), an unlimited amount of money can usually buy a profitable trade. Buy enough stock throughout the decline, and any reversal in the downtrend will ultimately vindicate your wrong decision and reward your total lack of discipline. But there are problems with the strategy of averaging down.

First, most folks don't have an unlimited amount of money. As such, this strategy is a nonstarter.

Second, some stocks do indeed go to zero, and all the averaging down in the world won't help you.

Third, there is a huge opportunity cost to this strategy. When you stick with a trade that's moving against you by continually adding to the position, that money is tied up. As such, it's not available to capitalize on better opportunities.

Instead of going through that ugly mess, just accept the fact that the three-step process is a goal, not a guarantee. Good traders recognize an alternative three-step process. Make a trading decision, be proven wrong in the trade and then take the loss.

Let's look at some reader picks.

Celgene (CELG - commentary - Cramer's Take) has reversed the pullback that began in December. Since the most recent low at $52, the stock has ramped more than 10% and is consolidating in a fairly tight flag pattern. This type of minor consolidation pattern typically occurs on declining volume. The low volume indicates a lack of selling interest, despite the substantial run-up. So, once the profit-takers have done their work, buyers will need to pay up for the stock, which will drive through current resistance. I'd wait for a move to around $59 before buying.

Albemarle (ALB - commentary - Cramer's Take) recently broke out of this symmetrical triangle, though volume has been on the decline. Uptrends do better when they occur in a high-volume environment, so this light volume is a bit troubling.

However, a trend is a trend, and it rarely pays to fight it. So, if you like Albemarle, then the safest entry is a pullback to the 50-day moving average with a stop just a bit below it. An alternative entry point would be at the current level, with a stop just below last week's low. Either way, a tight stop is necessary to respect the lack of volume.

This weekly chart of Garmin (GRMN - commentary - Cramer's Take) shows a stock that has almost tripled since the 2005 low. The uptrend has been slowing a bit over the past quarter or so, but it's still intact. I've drawn the 40-week (200-day) moving average as a reference point for support. Each time GRMN has fallen back to the 40-week moving average, the stock has bounced. So, if you're long, then keep a stop just below that level. It'll only be hit if the uptrend is over.

A reader wanted my take on whether Seagate Technology (STX - commentary - Cramer's Take) had finally bottomed out and was worth buying. Looking at the chart, I see the huge volume bar last week. Such heavy volume within a downtrend often indicates a washout of the remaining bulls. Once they're out of the way, the stock is free to move higher.

I can't say whether that's the case with STX, but it's starting to look that way. If you're long, try keeping a stop just below the most recent low. If the stock makes a new low, then we know that this is yet another step on a descending staircase.

Newpark Resources (NR - commentary - Cramer's Take) is now above the December high with no sign of letting up. When a stock is moving in a steep uptrend, sometimes it doesn't just track along a straight trend line. That's why I've drawn the 10-day moving average as a reference for support. If the stock falls below the 10-day moving average, I'd close out the position.

Be careful out there.

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At the time of publication, Fitzpatrick had no positions in the stocks mentioned, though positions may change at any time.

Dan Fitzpatrick is the publisher of StockMarketMentor.com, an advisory newsletter and educational forum dedicated to teaching effective risk management and trading methodologies to aspiring traders and investors. He is a former hedge fund manager and a member of the Market Technicians Association, and he now trades from his home in San Diego, Calif. While Fitzpatrick holds various securities licenses, he does not give recommendations to buy or sell stocks. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He appreciates your feedback; click here to send him an email.