Google's New Buy Signal

12/04/12 11:22:14 AM

by Donald W. Pendergast, Jr.

Shares of Google have flashed a new buy signal in the wake of October's rapid decline. Will this nascent rally have staying power?

Security: GOOG
Position: N/A

In my most recent Traders.com Advantage article, I described how to build a basic trend-following system by using the Trading Alchemy Trend Catcher indicator and an eight-bar relative strength index (RSI) in concert to help time entries and exits in stocks and exchange traded funds (ETFs). (You can find the rules and guidelines in that article, so if you haven't already read it yet, take a moment now and review the basic rules and premises of this system before going any further here.)

Here's a look at the same system at work in one of the most widely followed stocks -- Google, Inc. (GOOG) -- it has just fired a new long entry signal, and we have a prime opportunity to get in on the ground floor of this new rally, using the same trading rules previously described. See Figure 1.

FIGURE 1: GOOG, DAILY. By committing only a modest fraction of the total share allocation at the beginning of a trade, trend-followers can greatly reduce their risk, especially on trades that don't work out.

Graphic provided by: TradeStation.

Graphic provided by: Trading Alchemy Trend Catcher.

The basic entry trigger is momentum-based, occurring when an eight-period RSI either closes above 60 or below 40; entries are made once the high (low) of the bar causing the surge above 60 or below 40 is exceeded, using a buy (sell) stop order.

Additional buy/sell signals are created as new 60/40 trigger bars manifest, and as long as the entry price of such add-ons are greater (lesser) than the previous entry, the new position is put on. Add-ons can also be created when there is a pullback with the RSI staying above 60 or below 40. In this case, a buy or sell stop order is created when the swing high (low) preceding the pullback is exceeded. In most cases, you should limit the total number of entries for a given trade to four, and you may want to put on positions based on these percentages of your total allocation for the trade:

Entry 1: 30% of total position
Entry 2. 35% of total position
Entry 3. 25% of total position
Entry 4. 10% of total position

You can see the logic here. You want a decent-sized position to get the trade going, especially if it's going to ultimately turn into a big winner (but remember, you have no way of knowing that at the start of the trade), so you put on 30% of your total position. In case the trade fails to catch a bid, stopping out early, the damage to your trading account will be relatively small. But if it moves in your direction, you put on the next position with 35% of your total allotment, and then the next one with 25% and the last one with 10%.

Since extremely large trends are infrequent, you don't want to put on very large positions for add-ons #3 and #4, as you would be taking on too much risk. Of course, you always have the Trend Catcher (TC) trailing stop moving along with the trade, gradually reducing your risk and locking in gains (or limiting losses) as the trade moves (Figure 2). In this example with GOOG, the TC parameters are as follows:

Length: 8
Factor: 2.382

Yes, those are Fibonacci-based ratios, and the factor is a bit smaller than the 2.618 one used for SLV in the previous article. Stocks tend to not trend as well as certain commodity-based ETFs or futures markets, hence the tighter trailing stop.

FIGURE 2: GOOG. GOOG experiences minor bullish follow-through on November 29, 2012, the day after the Trend Catcher-based system fired a long setup signal.

Graphic provided by: TradeStation.

Okay, let's say you want to go long GOOG with 20 shares total. Here's how you would begin the process of trading it with this system:

1. Buy six shares of GOOG (20 shares x 0.30 = 6 shares) on a break above 684.91
2. If filled on the order, place a good till canceled sell-stop for six shares at the TC trailing stop level of 649.42
3. Your next add-on position will be for seven shares (20 shares x 0.35 = 7 shares), and you can put that on if GOOG:

a) Pulls back so the RSI drops below and above 60, creating a new buy trigger bar, or
b) Rises in price and pulls back over several bars without the RSI ever dropping below 60 while staying above the trailing stop. A subsequent rise above the prior swing high will serve as your next long entry point

4. If GOOG continues to rise, repeat step 3 again, putting on five shares for position #3 and two shares for position #4.

Be sure to adjust your TC trailing stop to reflect the total number of shares you have working in the trade at any given time. You'll have your full 20-share position on by that point and the TC trail will be guiding you the rest of the way, stopping all of your GOOG shares out in one GTC stop-loss exit trade.

Now, of course. GOOG might just rise a little beyond Thursday's initial entry point, stopping out around 650.00 or 655.00, causing a minor loss. It could also embark on a trending move that could take it back into the 720.00 to 740.00 range, allowing for some decent profit potential from this method. It would be a good idea to trade this setup in a simulator so you can get a feel for identifying the add-on points, adjusting the trailing stop, dealing with early stopouts, and so on.

One of the most important concepts to grasp (especially if you are a long-term trend follower) is the importance of scaling into a full position, rather than putting your full share or contract allocation on at the first entry point. This will help save you from taking unnecessarily large losses that occur when a trend-following move just doesn't pan out -- saving your precious trading capital for those few trades that ultimately will turn into monster winners. Trade wisely until we meet here again.

Donald W. Pendergast, Jr.

Freelance financial markets writer and online publisher of the Trendzetterz.com S&P 500 Weekly Forecast service.

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Google's New Buy Signal

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