Gingerly Trading the Internet

GBS is on a tech-stock trading jag. Join him.
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And today, I want to lecture you on...

Oh, forget it! I've done enough lecturing, whining, complaining and general overall blah, blah, blahing to last me well into the summer!

Therefore, today we get back to charts and trading. But, I'd be remiss if I didn't first put the finishing touches on my recent Wednesday

column. First, the response was overwhelmingly positive. And that's certainly heartening, especially to a thin-skinned writer. (And trust me, we ALL are!) But, whether you agreed or disagreed with my point of view, I appreciate everyone who took the time to read the column. Let's face it, I can be wrong. A lot.

But, who isn't? You think I read through Herb's and JJC's stuff and don't occasionally say, "Those guys are NUTS!" Of course I do. Everyone does, if you have half a brain.

The important thing to do, though, is to use that brain. Plot your own course. Card and discard. But above all, THINK!

OK, I'm done now. Thanks.

Now, where was I? Oh yeah, today I'm going to trade the Internet. And I'm also going to address the fine fellow who wrote in and said: "Oh yeah, well

you're

the idiot for not trading the Internet stocks!" Now he left out the part about my mother and the army boots, but I get his point: I'd be an idiot if I wasn't trading the hottest sector around.

Well, I may be stupid, but I'm no idiot. In fact, I

have

been trading the Internet stocks, and you can too! But, first, let me go back in time and give you some background.

When I first started thinking about trading these guys, I started off with a short list of things I knew about the

Amazons

(AMZN) - Get Report

, the

CMGIs

(CMGI)

and the

eBays

(EBAY) - Get Report

:

    Like every other stock, they still conform to the basic tenets of technical analysis. That is, they still have breakouts, congestion, support and resistance. In addition, risk/reward on any one trade can be figured out by measuring the potential move of any breakout. Volatility is incredible. That's not necessarily bad, but it does mean that my standard 5%/6% money management parameters are useless. When these stocks break, particularly to the upside, they move quickly and almost in a straight line. There's just too much of the "buy on the dips" mentality to think about shorting them.

Given those parameters, I knew I could use my standard breakout strategy, but would have to modify my money management techniques. In addition, these stocks move fast, so I'd have to at least think about entering intraday.

Therefore, I came up with a simple Internet breakout strategy, which I'll call GBS.com. (I'll file my S-1 next week.)

The setup, or entry signal, for GBS.com looks -- duh! -- almost identical to GBS classic. All I look for are breakouts from a resistance line, on heavy volume. However, since I'm using different money management parameters, I specifically do not screen out candidates that are more than 6% above prior resistance.

No, I'll still take those, and I'll still enter the following morning at the open. But here's the key: I vary my lot size so that if the stock comes back and breaks support, I've lost no more than 2% of my equity.

As an example, let's say AMZN breaks out and closes 10 points above where I draw the resistance line. If my equity is $500K, and I want to lose no more than $10K (2% of 500K), then the biggest lot size I can trade is 1,000 shares. If I'm dead wrong on AMZN, and it reverses 10 points, then I'm out 10 times 1,000 shares, or $10K. (Note, in this example, I'm assuming AMZN opens about where it closed. Sometimes they gap up on the open, though, so make sure you look at preopening quotes if you can.)

Ah, but that's only my risk on day one. Because these stocks move fast I wanted to develop a method that both locked in profits and contained any possible losses.

And, after some experimenting, I came up with a concept I quite frankly scoffed at in the past: a trailing stop. And in a double whammy in the "scoff" department, I'm using a moving average for a trailing stop. Yeah, I know, two tools that are anathema to Gary B. But, this Internet stuff calls for some new ideas.

Now, the moving average trailing stop is not magic, and I'd encourage you to play around with your own parameters. For me, I use a six-day exponential moving average. Why six days? Why exponential? The six-day period is tight enough to lock in the bulk of profits. Remember, when these stocks break out, they tend to go straight up.

As for the exponential, with one-day moves of 25, 50 or even more points, you want to place a lot of emphasis on current, not past, activity. An exponential moving average does this for you.

The trailing stop does do a good job of limiting your losses, but does it also do a good job of locking in gains? In general, I'd say yes, but there's another alternative, and that's the concept of the "measured move." Regular readers of my weekend columns are probably familiar with this approach, but simply put, all I do is measure the "depth" of the congestion the stock broke from, and add that number to the breakout point. If AMZN broke from a 50-point "bowl," and the breakout area was 100, then it's likely to go to at least 150.

Therefore, taking my AMZN example one step further, I'd be risking 10 points to get 50 points. Not a bad trade-off.

Of course, this approach still leaves the question of what to do with a stop loss. And I'll confess I don't have a firm answer on this. My approach has been to simply move my stop to break-even when the trade is "halfway home" and sit through the various shakes and turns until the trade hits my number. But, again, this is an area that needs refinement. For now, I generally stick to the trailing stop concept as I hate the thought of giving back the bulk of my profits.

All right, enough blubbering, let's look at some charts of

@Home and

Amazon. (Note: For clarity, I simply have to use the bigger chart size. Hopefully this isn't inconvenient for most of you.)

OK, pretty straightforward, right? Great, so now let me add a little twist. Earlier I mentioned the subject of entering intraday. Of course, if you have a job other than trading, that might be difficult because you need both real-time quotes and a way of getting alerts when your target is hit. But if you're able to, entering on the breakout, instead of the day after, can be a significant advantage. For those of you who have read Darvas' book,

How I Made $2 Million in the Stock Market

, this is his technique and worthy of some discussion.

To trade this way, you need to be prepared, and to do this, I compile a short list of Internet stocks that look poised for a breakout. Then I draw my resistance line and set an alarm to go off on my quote screen when that stock trades a quarter-point above that point. I could just use a buy stop, but I like to quickly check the intraday chart to give me the all clear sign.

If I do decide to get in, the benefit is that I can trade with a larger lot size because my risk is smaller. The downside, though, is that these breakouts can sometimes be false, with the stock slipping directly back into congestion. Therefore, as soon as I get my fill, I put my stop --

a la

Darvas -- just a few ticks below resistance. It either holds or it doesn't, so you get chopped up a lot, but you can also get some beautiful gains.

Examples? Just one this past Friday:

AMZN

And that, folks, is how I've been gingerly trading the Internet. Building on what I know, using prudent money management and applying the basics of technical analysis. Still, it's new to me, and this approach is most definitely a work in progress. Obviously, the gains here can be huge, and if you do it right, you can severely limit your downside. No, with this method, you probably won't make $100K in a day. But you won't lose that much either.

Gary B. Smith is a freelance writer who trades for his own account from his Maryland home using technical analysis. At time of publication he had no positions in the stocks mentioned, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. This column, Technician's Take, appears every Monday. Smith also writes Charted Territory, which appears every Wednesday, and TSC Technical Forum, which runs Saturdays and Sundays. While he cannot provide investment advice or recommendations, he welcomes your feedback at

gbsmith@ibm.net.