Techniques To Reduce Your Trading Risk

11/20/03 01:48:05 PM

by Kevin Hopson

By using a number of different trading methods, as opposed to relying on just one, traders can effectively lower their risk.

Security: XOM
Position: N/A

When trying to determine temporary tops and bottoms in price (or potential exit and entry points), I like to use a combination of sentiment and technical indicators, the reason being that the more tools you have at your disposal, the more secure you can feel about your investment or trading decision. This is not to say that you should use every tool in the book. Actually, it is quite the contrary. However, if you can find a few techniques that work successfully over and over again and most (if not all) of them support your trading theory, you can feel much more confident in your decision.

For example, I like to use pitchfork analysis, Fibonacci ratios, put/call open interest ratios and simple technical indicators to help determine key support and resistance levels. These techniques are illustrated in the one-year chart for ExxonMobil Corp. (XOM). More specifically, you will notice that ExxonMobil has been bouncing off the black median line most of this month. The black median line was constructed by drawing a line from the June high through the middle of July's low and October's high (high-low-high combination). Since prices tend to reverse (or at least temporarily stop) at the median line, it is no surprise that ExxonMobil has been finding support here.

Graphic provided by: Stockcharts.com.

Also coming into play is a potential double bottom formation, which is illustrated by the dotted green line. This is where ExxonMobil bottomed out in July so the stock could once again find support here. Additionally, you will notice that the relative strength index (RSI) and moving average convergence/divergence (MACD) indicators have been putting in flat to higher lows despite a continued decline in the stock price. This is known as a bullish divergence on the chart and indicates a potential bottoming pattern. These are just a few simple - but effective - technical indicators that help support my pitchfork analysis.

Another technique I like to use is Fibonacci ratios. These are basically extension and retracement ratios for prices. In other words, when a stock (for example) breaks out and moves substantially higher, the price will normally retrace a certain percentage of the move before proceeding higher again. The most popular retracement ratios are 38.2 percent, 50.0 percent and 61.8 percent. In terms of ExxonMobil, the 50 percent retracement level from January's low to October's high is roughly $35.15. As a result, there appears to be additional support at current levels.

The last technique I will touch on is put/call open interest ratios, which are a good gauge of market sentiment, the reason being that tops and bottoms tend to occur at extreme sentiment levels. For example, tops tend to occur when investors are overly optimistic (high call open interest), while bottoms tend to occur when investors are overly pessimistic (high put open interest). When you see put open interest at a specific strike price exceeding call open interest by a significant amount, it is usually a good indication that prices will find support there. This is because the sellers of these put contracts will have to buy the stock around this strike price in order to keep the options out-of-the-money. This -- in turn -- creates buying pressure. Fortunately for ExxonMobil, the front month $35.00 options contracts (extending out to April '04) have significantly more put open interest than call open interest. This means that the stock should find support around the $35.00 level. Given the confluence of support in the $34.80 to $35.40 range, as indicated by the various techniques I have used, you could feel confident in buying ExxonMobil at current prices. These methods do not guarantee that the stock price will move higher from here. However, when a number of different techniques are all painting the same picture, the risk tends to be lower so traders can feel a better sense of security. What techniques a trader uses is strictly up to him or her.

Kevin Hopson

Kevin has been a technical analyst for roughly 10 years now. Previously, Kevin owned his own business and acted as a registered investment advisor, specializing in energy. He was also a freelance oil analyst for Orient Trading Co., a commodity futures trading firm in Japan. Kevin is currently a freelance writer.

	Glen Allen, VA
E-mail address:	hopson_1@yahoo.com

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Techniques To Reduce Your Trading Risk

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