In keeping with earnings season, I
recently explained how you can hold a stock for the long term but simultaneously trade it in the short term to take advantage of normal volatility from earnings, news and other events. I call it the "buy and trade" strategy.
Learning to do this -- what I also call trading around a core position -- should help you outperform because you can capture bigger gains as stocks trade back and forth between important predetermined levels that you're keeping an eye on, even as the stock makes longer-term moves higher. In this strategy, the core positions are in companies that you know and want to hold for the long term.
Several readers requested further description of the guidelines for making these short-term trades using my models. I'm happy to oblige.
Catching the Stock Price Cues
This strategy involves both fundamental and technical analysis techniques.
On the fundamental side, the most important factor to watch when you're eyeing one of these trades off of short-term volatility is stock price. We're concerned with how a stock is trading in relation to fair value.
Two important inputs for determining fair value are the stock's 12-month trailing EPS and its 12-month forward estimated EPS: When a stock drops but it is not accompanied by a change to the 12-month trailing EPS or its 12-month forward estimated EPS, it becomes more undervalued or less overvalued. That's because the decline would have only a minimal effect on the calculation of the stock's fair value. When a stock becomes more undervalued or less overvalued, it's more attractive to purchase -- that is, to buy additional shares for trading around.
When a stock rises in price with no change to the trailing or forward EPS, the stock becomes less undervalued or more overvalued. This is a cue that it's time to take profits in a stock, or sell out of those "trading around" shares of your core holding.
The third important input in determining a stock's fair value is the yield on the 30-year bond, but the rise and fall of that yield affects all stocks. What changes fair value the most is actual earnings reported and changes in consensus analyst estimates as posted to Thompson Financial.
On the technical side of the buy-and-trade decision is the weekly chart profile. I say a weekly chart profile is positive when it displays a rising or overbought 12x3 weekly slow stochastic and a weekly close above the stock's five-week modified moving average. A negative chart profile is the opposite; it shows a declining or oversold 12x3 weekly slow stochastic and a weekly close below the stock's five-week modified moving average.
The 12x3 weekly slow stochastic is a measure of momentum on a scale of zero to 100, where a reading below 20 is oversold, and a reading above 80 is overbought. The five-week modified moving average starts with a five-week simple moving average. The five-week MMA is then calculated as ((Prior five-week MMA * 4) + (Latest Close))/5. A positive weekly chart profile is tracking a rising stock price, while a negative weekly chart profile is tracking a declining stock price.
When rising stock reaches a risky level (a level at which investors are likely to reduce holdings, according to my models), it's the price at which to become less long.
When a declining stock tests a value level (a level at which my models project that buyers will emerge), it's the price at which to become more long. Buying on weakness and selling on strength captures the downs and ups of stocks you want to own, hence "buy and trade."
The challenge is effectively combining fundamental and technical considerations to establish core portfolio holdings and then manage the risk/reward of each stock using buy-and-trade strategies. Once you are in a position, the strategy is to buy additional shares on weakness and to sell additional shares on strength, going to a maximum position at the low and to the minimum position at the high.
Obviously, you won't be buying at the exact low or selling at the exact high, but with discipline, you can capture some of the volatility while maintaining your long-term core holdings.
Readers also wanted more information about the specifics of applying the buy-and-trade strategy, such as amounts and where I got my data. Here are some particularly good ones:
I find the explanation of your system very intriguing. What percentage of your position do you hedge when you are just trading around it? Do you have metrics for that as well? -- David
There are no set rules for quantities, but here's a guideline to consider. Let's say you own 1,000 shares of XYZ Co., with 500 shares as your core holding, what you own for the long term. I would trade two lots of 250 shares based on the short-term levels. You always buy on weakness, and sell on strength in 250-share increments. With this guideline, you are always long 50% of your maximum allotment to the company, and trading two additional lots of positions of 25% of that maximum.
I need the stock to have nine years of data to provide value and risky levels for the long term. Google has not been around long enough.
This is the first time I've run across your "buy and trade" approach, but I was immediately intrigued. I've been trading around core holdings for a couple of years, but clearly without the level of analysis and methodology that you seem to have developed. Where can I find information on your valuation techniques and determination of pivot points? -- Jeff
My models evaluate all sectors and industries, but I concentrate on technology on
. I am the author of
TheStreet.com Technology Report and often write columns covering tech stocks on
. I describe different aspects of my valuation techniques depending on what's salient to the discussion, so keep reading to see how I apply them to different situations.
My model price uses 12-month historic and forecast EPS values and the current 30-year Treasury Yield as primary determinants. In calculating risk/return values such as the Sharpe ratio, the historic or forecast EPS periods are five years. Overly simplified, when the yield on the 30-year is declining, the model price of the stock increases. When the current or projected earnings per share increase, the model price increases. When the yield on the 30-year is rising, the model price decreases.
I get my data from ValuEngine, which uses three data vendors. The 20-minute delayed quotes come from Data Transmission Network. Analyst data and estimates come from IBES, a division of Thomson Financial. Other fundamental data come from CapitalIQ. As these data come in, my models are immediately updated.
Richard Suttmeier is president of Global Market Consultants, Ltd., chief market strategist for Joseph Stevens & Co., a full service brokerage firm located in Lower Manhattan, and the author of
newsletter. At the time of publication, he had no positions in any of the securities mentioned in this column, but holdings can change at any time. Early in his career, Suttmeier became the first U.S. Treasury Bond Trader at Bache. He later began the government bond division at L. F. Rothschild. Suttmeier went on to form Global Market Consultants as an independent third-party research provider, producing reports covering the technicals of the U.S. capital markets. He also has been U.S. Treasury Strategist for Smith Barney and chief financial strategist for William R. Hough. Suttmeier holds a bachelor's degree from the Georgia Institute of Technology and a master's degree from Polytechnic University. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he invites you to send your feedback --
to send him an email.