NEW YORK (TheStreet) -- Everyone loves a bargain, so it may feel wrong to buy stocks when they are near 52-week highs. But what many investors forget is that we don't invest because we can predict the future. When we invest, we are predicting the odds.
Predicting the odds means we don't care where the stock has been, we only care about what the odds are for it to move either higher or lower.
For example, if we look at Apple's (AAPL) price chart, we see that in February it traded above $500 for the first time. Buying Apple stock for more than $500 may go against our bargain-seeking instincts, but it's clear now that purchasing Apple at $501 in February would have been a great buy.
However, mindlessly buying any stock near 52-week highs can put you in the precarious situation of being a "bag holder," someone who buys a stock right before it falls in price.There are some things we can do to avoid bag-holder status. I search for stocks near their 52-week highs and attempt to filter out as much emotion as I can. I remove stocks with nosebleed price-to-earnings ratios and buyout rumors, one-hit wonders (especially prevalent in the pharmaceutical industry) and other emotionally charged "runners." My goal is a compilation of high-liquidity, longer-term holds (at least six to 12 months) that we can write options on for risk mitigation. Selling covered calls or selling cash-secured puts is a lower-risk strategy to gain exposure. I use a filtering process that includes:
- A minimum liquidity requirement -- This eliminates the thin stocks that keep so many up late at night.
- Improving year-over-year results relative to the stock price increase -- We want plenty of reasons why the stock should continue to move higher.
- Analyst price targets that are significantly higher than the current price -- We want others to believe the stock will continue to appreciate.
- Limited insider selling -- Generally we want to see no insider selling. But because of compensation methods and diversification goals, some insider selling is acceptable.
- Low short interest -- I consider short sellers to be the smart money. They don't always get it right, but bet against them enough and you probably won't come out ahead.
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