Finding support and resistance on a stock chart takes just a couple of minutes. You can make the annotations on your computer, or you can print out the charts and mark them with a pencil and ruler.

Three minutes of work can save you from making a mistake that would potentially cost you thousands of dollars.

Today, I’m going to make a few quick annotations to some of the charts you’ve sent in this week. I’ll then tell you whether I would buy or sell the stock in question.

Let’s get to it…

I purchased the Canadian stock Enerplus which is now down almost 50%…I know that natural gas is deeply depressed, probably resulting in the terrible drop of Enerplus. What I want to know is whether the stock has any possibility of recovering? Also, is it worth buying in more shares at this very depressed level?

— M.J.

Here’s a look at Enerplus Corp. (NYSE:ERF):

Sure, there’s a possibility that the stock will recover — at some point. But at this point, it’s important to get defensive. The market is falling, commodities are out of favor and this chart is terrifying. The breakdown in price accelerated in early April when ERF broke below horizontal support (blue line).

Also, I never recommend buying more shares just because a stock has dropped in price. It’s a dangerous tactic that’s more trouble than it’s worth. Don’t do it. The red line is resistance in this powerful downtrend. Even if the share price recovers to $16 from here, the downtrend remains in force. Yes, the stock is technically oversold. But it has been oversold since $21. It can easily move lower from here.

I’m thinking of buying 500 shares of Prospect Strategy Group (NASDAQ:PSEC). It’s a BDC. I believe this is a strong buy for at least the next 24 months. Could you give me your advice on this stock?

— J.P.

Prospect Capital has held up well during the recent market turmoil:

The stock has consolidated just below $11 since late February. On the chart, you can see how PSEC has registered a series of higher lows, indicating that buyers are stepping in at higher and higher prices every time the stock dips.

I can see why you’re interested in this stock. Judging by a quick look at the fundamentals, PSEC looks dirt cheap. It’s trading right at book value, its multiple is less than seven and I see plenty of insider buying recently.

In this case, the technical can provide a solid backstop to your fundamental research. Buying shares between $10.50 and $11 is not a bad price for a longer-term timeframe (you mentioned a 2-year holding time). I would also look to add a stop loss between $10 and $10.25. Look for this stock to break out if it can close above $11.25 on strong relative volume.

Sincerely,

Greg Guenthner
for The Penny Sleuth

Reader Mailbag: Buy or Sell? was originally featured in the Penny Sleuth.

These are called oversold rallies. If you can learn how to predict these counter-trend moves, you could book significant gains in just one or two days.

Here’s what you need to know…

First, you should keep a close eye on a weekly sentiment reading, such as the AAII US Investor Sentiment bullish and bearish readings. Sentiment indicators like the AAII gauge how market participants view stocks. For the bullish sentiment chart below, a higher reading indicates investors are more optimistic about the market’s prospects, while a lower reading indicates market pessimism:

As you can see, the sentiment reading is a fairly straightforward look at how investors are feeling about the market on any given week. But it’s important to note that extreme readings on any sentiment indicator should be viewed as a contrarian signal.

Think of it this way: when the crowd alligns itself on one side of the market, chances are very good that you will see a strong move in the opposite direction.

The peak in these recent readings occurred around mid-February. Investors had already watched the market’s strong start to the year. They were feeling more confident since the turmoil from the eurozone sovergien debt crisis had slipped from the headlines. Stocks were moving higher — and investors were convinced that it was safe to buy.

We now know that the market’s upside move was running out of steam exactly when the majority of investors were becoming bullish. And if you turn toward the moments of extreme pessimism, you can see that the current reading on the far left is even lower than bullish sentiment readings from back when the market was in free-fall in August 2011. This alerts us to a possible bounce in the making…

Now let’s take this data and see where these extremely low bullish readings appear on a chart of the S&P 500:

The red arrows on this S&P chart link up with the red arrows on our sentiment reading. Now, we can use a momentum indicator (in this case, RSI) to act as confirmation for our sentiment readings. Extremely bearish sentiment readings coupled with extreme oversold levels will give us a higher probability of a bounce.

In hindsight, you can see that the first low sentiment reading from July 2011 would not have offered a significant bounce. Our momentum indicator was still bullish (above 50; first blue circle). It did not confirm the necessary oversold conditions.

However, the second low sentiment reading coincided with an RSI reading below 50 (center blue circle). Our momentum indicator was just coming off an extremely oversold reading (below 30) in August, making this a slightly better confirmation than our July signal. It’s not perfect, but it did coincide with the October bottom that began an impressive move higher. If you bought in late September, you had the chance to have a very nice fourth quarter.

Fast-forward to present time and you will see the strongest buy signal on the chart. The sentiment reading is at its lowest level in months. And RSI just bounced off extreme oversold conditions during yesterday’s rally.

Since sentiment and momentum confirmed a potential bounce early Monday, the S&P has risen nearly 2.5%. I’m not predicting an extended move higher just yet. But with these readings, it’s entirely possible that the market continues to push higher in the short-term to alleviate oversold conditions.

Sincerely,

Greg Guenthner
for The Penny Sleuth

How to Predict an Oversold Bounce was originally featured in the Penny Sleuth.

If you were paying attention to the big momentum plays this quarter, you could have pinpointed when the market was ready to turn lower.

Now, with short-term losses mounting, you might have the chance to spot the first buying opportunity by monitoring these very same stocks. When the momentum names begin to catch a bid, we could see the beginnings of an oversold bounce that would send stocks higher in the short-term…

During the first half of 2012, investors fully dedicated their efforts to Wall Street’s momentum darlings. These are the “hot stocks” in the midst of multimonth bull runs. Expectations run high with these momentum names. Valuations run even higher.

It is a ridiculous notion to wait for a correction (or even a pullback) before buying these red-hot stocks. After all, the share price will never fade. Or so the frenzied logic goes…

It’s probably no surprise to you that Apple was the de facto drum major of the momentum marching band. Apple shares shot up more than $230 between Jan. 1 and mid-April — when the furious momentum rally finally topped out.

Apple’s pullback — and the eventual pullbacks in several other overhyped stocks — was inevitable. Apple was displaying all of the classic signs of a blowoff top. The investing public was convinced shares could go nowhere but up. Analysts and the financial media joined the party with their own irrational expectations, including $1,000-plus price projections and declarations that any fund manager who didn’t own Apple should be immediately fired…

But just when the stock appeared to be completely unstoppable, shares abruptly reversed.

The selling wasn’t outright panic. As of this writing, it remains orderly. The market didn’t take an ax to the Apple tree. It only shook it a bit.

It’s how turning points are born. Shorts shake the branches to see if any weak hands fall from the tree. They’re after the low-hanging fruit. These are the folks who bought shares near the height of the rally. Their conviction is far weaker than that of the long-term investors sitting on substantial gains. So they sell. The selling puts enough downward pressure on the price to convince other longs to part with their shares.

Of course, disbelief prompts many buy-and-hold investors to hold shares of a falling stock much longer than they probably should. There are (and will continue to be) many investors who will stand by Apple — even if its decline accelerates. After all, Apple is a great company that makes interesting, in-demand products. But even if expectations from Apple faithful remain high, we doubt the stocks’ incredible performance during the first half of 2012 will be matched anytime soon…

It wasn’t just technology or high-priced stocks that caught the attention of momentum investors.

Smith & Wesson Holding Corp. (NASDAQ:SWHC) — which I recommended to my premium readers in December 2011 — was swept up in the rally that began on Jan. 3.

I didn’t somehow predict the buying frenzy would begin as soon as we recommended the stock. We knew Smith & Wesson shares had held up well during the height of the European crisis last fall. And we had multiple fundamental reasons for picking up shares when we did.

From a fundamental perspective, Smith & Wesson was improving its operations. Management had already started the process of unloading the company’s underperforming security division. Revenue and guidance strengthened as management concentrated on building the company’s core gun manufacturing business.

Gun sales were growing across the board. In fact, gun sales actually booked a one-day record the day after Thanksgiving 2011. The FBI reported a record number of background checks, adding up to nearly 130,000 gun buyers on the day. The old record was set in 2008 — at only about 98,000.

Stories highlighting record-breaking sales throughout the gun industry began to gain traction in the media shortly after our initial recommendation. Attitudes regarding firearms ownership were improving. More and more women were taking to gun ranges across the country. These tangible stories took hold with investors — and the trend that initially pushed shares of Smith & Wesson above $4 in December began to accelerate. A momentum play was born.

By early April, Smith & Wesson shares more than doubled, to $8. With the successes of high-priced momentum plays fresh in their minds, traders and investors jumped at the opportunity to own shares of this fast-moving stock.

But Smith & Wesson was not immune to the momentum sell-off. Shares gave back more than $1 in a matter of hours in early May as new concerns over the economy and eurozone surfaced. Shares have recovered somewhat. And we’re still hanging onto open gains of approximately 95%. But the warning bell has sounded. It’s time to be extra vigilant as skittish investors rush to raise cash during uncertain market conditions.

While the secret of Smith & Wesson’s potential is now more widely known, the stock has a much better chance at weathering the momentum sell-off than some of the more closely followed names on the market. Traders shook Smith & Wesson’s tree. But investors have stepped back up to the plate and bought back shares.

Only time will tell if the stock will consolidate and move higher from here. If Smith & Wesson and other momentum names catch a bid, we could get our first signal of a move higher.

Sincerely,

Greg Guenthner
for The Penny Sleuth

How to Time the Market with Momentum was originally featured in the Penny Sleuth.

If you don’t, you will probably lose money this summer. It’s as simple as that…

After a furious four-month rally, traders are selling stocks again. It’s a buy-and-hold investor’s worst nightmare. No sooner do stocks begin to move higher than the surge is cut short by volatile trading and fear.

No wonder so many people are walking away from stocks…

“Even though American stocks have doubled in price in the last three years, investors and traders large and small keep giving the market the cold shoulder,” declares The New York Times.

The fact is the average investor wants little to do with a stock market that has burned him one too many times over the last decade.

The numbers don’t lie. Trading on all U.S. exchanges has yet to recover since the 2008 financial crisis. Just last month, the average daily trades in American stocks remain about half of what they were before the financial crisis — 6.5 billion shares, compared with 12.1 billion. That stands in sharp contrast to the market shocks of 1987 and 2001. During these two events, normal trading levels resurfaced within two years of the initial crisis, according to The New York Times. Any way you look at it, the recovery in trading activity this time around has been painfully slow.

The Old Gray Lady isn’t the only mainstream news outlet latching onto this story. Even USA Today is chiming in. In early May, the paper forked over front-page real estate to a story about everyday investors shunning the stock market.

Are these front-page declarations that the market is a dead zone true contrarian signals? If so, is the market set to embark on a new epic bull run, due to the magazine cover indicator?

It’s possible. But from my vantage point, it’s simply too early to declare that the market is ready to charge sharply higher. It can be maddening to try to play these huge shifts in sentiment — especially when economic news and data both at home and abroad continue to unnerve investors. So instead of fixating on the stock market as a whole, I want to cut through the noise by focusing on the individual names that have the best opportunity to outperform their peers.

It’s no secret that we’re dealing with a tough buy-and-hold environment — that much we’ve already said. It’s why a carefully planned approach to small-cap investing is so important. More specifically, you should be concentrating on evolving your strategies to insure you will stay ahead of the market.

Ask yourself — What’s working right now? Which strategies will continue to work if the market moves lower — or when economic and market conditions begin to improve?

Obviously, staying ahead of the market should be the primary goal of every long-term investor. And I’m confident that with a little planning and foresight, we can continue to deliver market-beating results, despite uncertain economic conditions.

Here’s how a longer-term investor should be approaching the market right now:

Value: Many smaller stocks are expensive. You should turn to shares you can acquire at a substantial discount. During the first half of 2012, investors fully dedicated their efforts to Wall Street’s momentum darlings. These are the “hot stocks” in the midst of multimonth bull runs. Expectations run high with these momentum names. Valuations run even higher. But over the past month, these stocks have performed poorly. Avoid them. While the market’s trend is in flux, look for an extra margin of safety. These are the stocks with the fundamental backing to weather a storm of selling. Chasing the popular stocks with inflated multiples simply isn’t working in this environment

Timing: If the markets continue to fluctuate, timing your entries into new positions could be the difference between a losing trade and a great investment. You must use all the tools at your disposal to pinpoint ideal entry prices. If a stock’s chart isn’t backing up the fundamental story, move on to other options. There’s just too much risk in trying to guess when a crashing stock will stabilize. Unless you can target a low-risk entry point, walk away. Don’t try to catch falling knives.

Portfolio Management: When the market gives you opportunities to book profits, you take them. On the flip side, when the market warns you that one of your stocks might underperform, you should sell. What’s left is a lean portfolio containing the stocks that offer the best chance to lead you to profits. There’s nothing wrong with taking profits on a name you really like — even with the intention to buy it back when the dust settles.

Sincerely,

Greg Guenthner
for The Penny Sleuth

3 Ways to Survive a Volatile Market was originally featured in the Penny Sleuth.

It doesn’t matter if you’re a long-term value investor or a short-term trader. When you’re dealing in stocks, timing isn’t everything — it’s the only thing.

As I was sorting through the mailbag this weekend, I found that many of your questions were about when to buy into a stock or a big investment idea. Today, I want to look at some of the potential trades and investments on your collective radar. I’ll analyze the charts and tell you if you’re looking at a solid buying opportunity — or a potentially disastrous trade…

Let’s get started:

What do you think of Cisco Systems (NASDAQ:CSCO) and Silvercorp Metals (NYSE:SVM)? Is now a good time to buy shares of both?

— S.R.

Here’s what Cisco looks like right now:

Yikes. Cisco is more or less a household name. But this chart is just awful. No one wants to own this stock — and with good reason. The company issued terrible earnings just last week — as evidenced by the massive gap down from $18.50 to $17.25. This gap will now act as resistance. So even though we’re seeing a decent rebound today to the high $16’s, I wouldn’t count on this stock recovering past the mid $17s anytime soon.

Any way you look at it, this thing is toxic. I would avoid it at any price.

Next is Silvercorp:

Here we see a very similar chart — minus the big gap lower. Still, a strong downtrend remains intact. Before you pull the trigger on an investment, draw a line connecting two or more peaks in the price. That’s where you’ll find resistance. Until your stock can break out of its downtrend, chances are it will continue to move lower…

Both of these examples could be considered falling knives. Neither CSCO nor SVM has indicated that it has put in a solid bottom. The important takeaway here is that an out of favor stock needs to time to consolidate after a move lower. Unless you see legitimate signs of life, the stock will probably see additional downside/sideways action before it begins to recover.

As far as questions go, I have one that may fall into your “it’s a bad stock, run away” category. Cameco (NYSE:CCJ), the world’s largest uranium miner. It got hammered after the accident in Japan, and I bought in about a week later. So, you can see what has happened since then. Personally, I still feel that nuclear power is an important cog in the energy machine, and I expect it to return. My question is: is that a rational view, and, if so, is it smart (for the long term) to even consider adding to the position?

— M.N.

Yes, you are expressing a very rational view. Unfortunately, there is nothing rational about the stock market.

Here’s a long-term look at Cameco:

I think you’re analysis is sound. Nuclear is and will remain an important source of energy. But this sentiment is not shared by the market right now. That’s your problem. While you are able to project a stronger future for nuclear energy, the market has yet to move past the events in Japan and the reactions that followed.

Solid analysis will occasionally produce substandard investment results. This is why timing is so important. In this case, you jumped back into nukes way too early. Think of it this way: the market continues to deal with the residual effects of the 2008 financial crisis to this day. And were’ only about a year removed from the nuclear crisis in Japan…

As far as adding to your position — I generally do not advocate averaging down. However, some longer-term investors are fine with buying more shares at lower prices in the hopes that the stock will eventually rebound. It’s more about your investing personality than anything else. As long as you can sleep at night without worrying about your portfolio, you’re probably doing something right.

Keep sending me your charts, questions and concerns to editor@pennysleuth.com.

Sincerely,

Greg Guenthner
for The Penny Sleuth

Monday Mailbag: When to Buy Stocks was originally featured in the Penny Sleuth.

It takes guts to admit you are wrong. As a trader or investor, you will take losses. If you understand that you won’t book profits on every single trade, you will be better prepared when the time comes to part with a loser.

Remember, the deck is stacked against you. The market is not a level playing field. You are an individual investor going up against Wall Street professionals armed with massive amounts of cash, superior tools and access to endless research. You have to plan ahead— and you have to think like a skeptic in order to survive.

That’s why I helped you develop a basic trading plan last week. Since I published the column, I’ve received countless e-mails asking about losing stocks. You recognize that you’re in a bad spot. Or something about one of your investments just isn’t right. But you’re not sure what to do next.

Today, I’m going to use your questions to reveal three critical investing traps. If you learn to avoid these situations at all costs (or sell out and move on to your next idea) I all but guarantee you will quickly become a more successful trader.

Let’s go to the first question:

What do you think about Radio Shack?

— C.P.

Radio Shack (NYSE:RSH) continues to push to new lows. And I’m not just talking about lows on the year. Shares of Radio Shack are actually trading lower than they have in 30 years…

Any way you look at it, this chart is ugly. From a technical perspective, I wouldn’t touch Radio Shack stock with a 50-foot pole. If you ever pull up a chart that looks like this, just run away.

Here’s the trap: an untrained eye might consider Radio Shack to be a “cheap” stock worth a second look. It’s a recognizable brand that’s down big, so it has to recover at some point, right?

Wrong. You can’t assume a stock presents some sort of value opportunity just because its shares have taken a beating. In the case of Radio Shack, the company appears to be in trouble. It’s sales are dropping. The business is under a ton of pressure from online retailers such as Amazon. And the only products the stores seem to be selling are lower margin items.

In short, this “cheap” stock is a trap. Avoid at any price.

I work for a living and I can’t be glued to a computer during the day. So can I purchase a penny stock and put a stop order in and if so what percent would you suggest?

— M.C.

When you are dealing with smaller stocks, stop losses can be tricky. I’ve always recommended “mental stops” instead of a hard and fast stop order. Here’s why…

If stocks have a volatile day, you might get stopped out of a position that immediately recovers from its initial drop. Usually, smaller stocks are not as heavily traded. So shares tend to suffer from large temporary price swings.

That’s where the trap lies.

If a smaller stock drops on lower volume anywhere near your stop loss, chances are it will be taken out, only for the stock to recover and move higher.

As long as you’re not daytrading or dabbling in very small names, you should be able to rely on closing prices for your stop losses. If you have a predetermined mental stop based on where the stock closes, you can easily check the market in the evening. If you have to sell, you can have an order ready to go for the next morning.

There is one tiny company that I’ve been watching for months and while it has won awards and even huge contracts, this stock still sits below 10 cents a share and just seems to sit. Sometimes I’ve seen it jump 20-30% then fall right back down.

— M.R.

The problem here is lack of volume. A stock isn’t going to move if there’s no one interested in buying or selling shares.

Lack of trading volume can trap you in a stock with no way to get out at a reasonable price. I don’t care how well the company is performing — or how nice its chart looks. If no one is trading it, there’s little to no chance of it breaking out.

When you’re looking at smaller stocks, one of the first things you should note is the average volume. I like to see at least 100,000 to 200,000 shares traded every day. And that’s on the low end. Anything less than that can get you into trouble. If you do get trapped in a low volume stock, try to sell at the best price and move on to your next idea.

Sincerely,

Greg Guenthner
for The Penny Sleuth

How to Avoid 3 Critical Investing Traps was originally featured in the Penny Sleuth.

A financial crisis brewed on Wall Street. No investment was safe from the carnage. Chris — who happens to be an old college buddy of mine — struggled to understand where he went wrong.

The next time we spoke, he recounted the horror of seeing his investment disappear in the blink of an eye. I did my best to commiserate. But I didn’t have much to say. After all, no one was safe from falling stock prices in 2008.

Chris wanted to know how to cope with such a big loss.

“What happens now?” he said.

I responded with a simple question: What are your investing goals?

Chris didn’t have an answer for me. He knew he was interested in the markets. He also knew he wanted to make money. But he never considered the specifics — or the process. Instead of fine-tuning an investment strategy, Chris was throwing darts. It only left him confused and unsure about his next move.

To be clear, Chris’ first mistake wasn’t investing in stocks in 2008. His mistake was that he did not have a plan. He never even considered it. He liked the idea of the stock market, but he didn’t know how to get started.

It’s absolutely crucial to trade with a plan. You have to set goals. And you must know how to achieve them. I receive countless e-mails every day from novice investors just like Chris. They want to get involved in the markets, but they aren’t sure how…

I have no idea how to develop a trading plan. I subscribe to several newsletters which recommend specific stocks, and then I choose ones that fit my values.

How does one develop a trading plan?

— M.S.

I understand that investors have many styles of trading plans. Are you able to share a simple but safe stock trading plan for the novice investor in your newsletter?

— R.P.

Today, I want to show you how you can avoid starting off your investing career on the wrong foot. I have an easy-to-follow plan that will help you dominate the market’s steep learning curve, giving you the confidence you need to invest in a way that works best for you.

Your journey will begin with the simple question I asked my old friend: What are your investing goals?

It’s a short question that requires a detailed answer. The first part of this answer is a litmus test that every new investor should consider…

Personality is Key

What are your investing goals? Are you interested in growing your account or preserving wealth? Do you like taking risks or do you play it safe?

This is how you begin to find out what part of the market you should concentrate your efforts. In truth, there are many ways to make money and protect your investments. Individual investors have made fortunes buying stocks, shorting stocks, buying options, dabbling in commodities and even investing overseas. The key is finding a niche that works well with your personality.

If you don’t want to actively manage your account every few hours, you probably don’t want to be a day trader. The same goes if you can’t sleep at night knowing that a chunk of your money is tied up in a riskier growth stock.

It’s all about your comfort level. When you figure out your acceptable investing risks, you will quickly narrow down your choices. Then, when you’re comfortable with your expected risks, you need to gravitate toward your interests.

Do you like looking at stock charts? If so, maybe technical trading will appeal to you. If you’d rather sift through financial statements, value investing might become your preferred game.

As with most choices you make, you’ll have a much better chance at success if you pick the techniques that best fit your interests. It’s that simple.

Who Has Time For Stocks?

The second piece of the puzzle involves the amount of time you can dedicate to the markets.

One of the biggest mistakes that beginners make is jumping into new investments without a set routine. If you’re working a high-demand job 60 hours per week, you won’t have time to make trades on your computer during the middle of the day. And if you can’t dedicate a few minutes on the weekends to keep up with the latest market-moving news, you’ll want to explore more longer-term investment options.

Conversely, if you have plenty of free time during the day, maybe actively trading stocks is right for you. But I must caution you — short-term trading of any kind requires research and discipline. Day trading is an especially risky proposition for a newcomer. Don’t jump into this discipline expecting to win right away!

No matter what your strategy, I urge you to paper trade before putting your hard-earned money on the line. Some online brokers even offer paper trade accounts to help you practice. These resources can be invaluable. I also recommend you keep a journal of your winning and losing ideas. This will help you begin to fine-tune your strategies. When the time comes to put real money on a trade, you’ll be confident and prepared.

Find the Right Resources

Finally, you need to know where to look for quality resources and tutorials. Find blogs or e-letters that offer impartial ideas and advice — like this one! Learn from more experienced traders and investors. And be sure to read the great standards of your chosen discipline.

If you want to get into trading, you should check out the personalities profiled in the Market Wizards series by Jack D. Schwager. If you fancy yourself a value investor, you should pick up a copy of The Intelligent Investor by Benjamin Graham. These great works will lead you toward new ideas and sources that will help you develop the strategies you need to find success…

One More Thing: Ask Questions!

Never hesitate to ask questions. You always drop me a line at editor@pennysleuth.com. Feel free to send me your questions, tickers, and charts. I can annotate the charts for you and give my honest feedback, tell you if a penny stock looks like a scam, or even offer some insight into different investment philosophies. I’ll compile the best questions into a “mailbag” section every week. This way, we can all benefit from the discussion.

Sincerely,

Greg Guenthner
for The Penny Sleuth

Winning with Stocks Begins Here was originally featured in the Penny Sleuth.

At the time, the short-seller’s decision made perfect sense. Stocks looked heavy. The S&P 500 once again failed to retake its rising 50-day moving average. The momentum from the powerful first quarter run had all but disappeared. More sovereign debt trouble in Spain and elsewhere across Europe stole the headlines. You could sense the desperation of the moment. Stocks were in trouble…

However, the trade did not play out as planned. Despite the nearly perfect set-up for additional downside action, stocks stabilized. On Wednesday, the S&P rallied back above its moving averages, encouraging more buying.

The trader was dumbfounded.

‘Surely the market will move lower,’ he said.

But the sellers did not back up our trader’s theory. Stocks rallied into the weekend, forcing our trader friend to cover his shorts and book his losses.

Now, I don’t personally know the mystery trader from our story. But I do know he and others like him exist. Last week, the stock market appeared to be on the verge of falling apart. Almost every market-watcher in the country anticipated a move lower. At the time, it looked like a safe bet. Yet it ended in disaster for our trader who jumped on the early move lower.

The trader in our story lost a lot of money. But his losing trade wasn’t written in stone. In fact, our trader had an amazing (and potentially very profitable) trading opportunity flashing right in front of his face. If he knew more about market psychology, he might have been able to reverse his fortunes…

Today, I’m going to show you how to take trading gains when you’re wrong. It’s a simple concept based on crowded trades — and how investors tend to react when the market quickly moves against them. Any experienced trader will tell you that losing is part of the game. The trick is to take small losses to allow your winners room to run.

However, many traders forget that many of their missed calls can actually turn into their most profitable trading opportunities. All that’s required is a little planning — and a quick trigger finger.

Here’s what you need to know:

First, you have to recognize when you are about to enter a potentially crowded trade. A crowded trade is exactly what it sounds like — a big move in either direction anticipated by a large number of market participants. Usually, crowded trades emerge with some of the market’s most obvious set-ups. Other times, a crowded trade appears when you’re dealing with an exceptionally popular stock.

Last week, I wrote that you should avoid crowded trades whenever possible. I cited Apple as one of those stocks traders should avoid — long or short. That’s because there has been too much attention on the company and too many predictions and speculation as to where this hot stock will finally land. In this case, it’s a crowded trade that became more of a gamble than a safe bet.

In some cases, you’re forced into a trade that’s closely watched by a large majority of market participants. Looking back at the story of our mystery trader, we can see why he wanted to position himself short. The market was flashing distress signals, so his best bet at the moment was to take a short position in the SPDR S&P 500 ETF.

But if our trader had recognized he was entering a potentially crowded trade, he could have planned ahead with a contingency plan. It all comes down to this one simple principle — if an obvious, popular trade fails, chances are you will see a strong, short-term move in the opposite direction.

So our trader’s improved plan would look something like this: If the S&P breakdown fails and moves higher, he would then cover his short play and go long to capitalize on the abrupt shift in momentum. Instead of getting stuck with a losing position, our trader would have a great chance at making money as other shorts are squeezed out of their positions, pushing stocks even higher.

This plan also works well for individual stocks. If you enter a long position in a stock only to see the breakout quickly retrace and fail, you could be staring at a solid short opportunity.

Remember, this plan is based on crowd psychology. Countless other traders are acting on the same data you are viewing. If the obvious fails, the momentum shift will be fast and powerful.

The next time you’re about to execute a short-term trade, think of how the ‘crowd’ of other traders might position themselves. If you are more aware of how a trade might fail, you are far more likely to put a plan in place that will show you consistent gains.

Sincerely,

Greg Guenthner
for The Penny Sleuth

How to Book Gains From a Losing Trade was originally featured in the Penny Sleuth.

This market is a minefield. You must prepare to deal with unpredictable prices, panic, and disorder. Ever since stocks began to sputter, investors have frantically jumped back and forth between long and short positions. Most of the time, the crowd has been dead wrong.

You cannot afford to be a delirious stock-chaser. In fact, your actions during the market’s most turbulent weeks will ultimately determine whether you will hang onto first quarter gains — or lose everything because of a few poor decisions.

MacNeil Curry, head of foreign exchange and interest rate technical strategy at Bank of America Merrill Lynch, offers the perfect explanation of the market’s mob mentality. “We lose our minds collectively, but we come to our senses individually,” he said.

These words of wisdom are especially true today. The market’s quick drop has punched unsuspecting investors in the face. Now, as we struggle to get back up and regain our senses, it’s important to use the market’s collective insanity to your advantage.

Here’s how:

Wait for confirmation before you act.

There is no prize for someone who guesses on a trend early. This rule is especially true when the trend is changing in the blink of an eye.

It’s never smart to guess on a breakout (or a breakdown) before it happens. You’ll be right sometimes, but wrong enough to offset any of the gains you booked when you got lucky. When the market is coming back to its senses, stocks will suffer from countless false moves. Breakouts will fail. Or a stock will break above a key moving average and then promptly fall below it the very next day. Indecision reigns supreme right now. Many traders will shorten their time horizons, meaning they will take profits almost immediately after a trade turns green.

That’s why waiting for confirmation is so important. If you’re attempting to trade a breakout, wait for the stock to retest the breakout zone and move higher before buying. Once the traders with shorter time horizons have been flushed out of a trade, additional buyers stabilizing the stock and sending it higher signal that the breakout was real. A retest of the initial breakout is additional confirmation that resistance has turned into new support. Buyers are willing to pay higher and higher prices for the stock, allowing the new trend to develop.

Avoid crowded trades.

Twitter has become a fascinating hub of stock market opinions. Every day, millions of market watchers share trade ideas, brag about their winning moves, and argue with those posting dissenting opinions. It’s the perfect place to go to see how investor psychology shapes the markets.

Take Apple Inc., for instance. As the most popular publically traded company in the U.S., Apple elicits strong opinions from longs and shorts alike. On Twitter, these opposing forces battle in real-time. At any given moment, you can unearth thousands upon thousands of tweets about Apple stock. It’s an epic argument with no end in sight.

The Apple saga came to a boil yesterday just before the closing bell. The stock had dropped in ten of the previous eleven days. Shorts positioned themselves for a weak earnings report, while longs scooped up shares at a discount from recent highs. So when Apple announced spectacular numbers last night, the squeeze was on. Shares immediately rocketed double-digits, trapping shorts and rewarding anyone who bought before the bell (at least for today).

However, Apple is one of those stocks traders should have avoided — long or short. There’s too much attention on the company and too many predictions and speculation as to where the hottest stock in the world will finally land. It’s a crowded trade that has become more of a gamble than a safe bet.

When everyone’s eyes are glued to a stock, it’s best to stay away. The obvious play can easily turn into the wrong play. A far as I’m concerned, betting long or short on a crowded trade is gambling. Any surprise information can cause wild price fluctuations. If you’re caught on the wrong side of the coin, you stand to lose big.

When in doubt, stay out.

My final tip may seem simple. But it’s one of the most difficult pieces of advice to heed…

If the trend is volatile and sideways, it’s usually best to say on the sidelines. Remember, cash is a trade. When you are in a cash position, you’re effectively betting that market conditions will change to a strong up or down trend at some point in the future. It’s a strategic, defensive move. You don’t always have to be “in” the stock market.

One of the main reasons investors buy into stocks at the wrong time is because of fear. They are afraid they will miss out on a new trend if they stay on the sidelines. But more often than not, always taking either long or short positions is not always best for your portfolio. And if you do end up sitting on your cash for several weeks, you will be better positioned than many of your trading peers. You won’t be stuck paying commissions on several stopped-out trades. You’ll also be mentally refreshed and ready to take advantage of the market’s next move.

Sincerely,

Greg Guenthner
for The Penny Sleuth

3 “Turning Point” Trading Tips was originally featured in the Penny Sleuth.

I wasn’t eavesdropping — I was simply finishing my meal at a local restaurant. Just as I was about to pay the bill, I overheard the conversation at an adjacent table turn to stocks.

At first, I didn’t give the comment much thought. Complaining about the market amongst friends sometimes happens after a few drinks. I was in no position to help, either. There’s really no way to casually insert your two cents into a stranger’s conversation about investing. So I signed the check and left, thinking that would be the last I would hear of it.

It wasn’t…

A couple of days later, I was on the phone with a stockbroker. I was asking a few questions about new features on his firm’s online platform. The rep was helpful and polite, and he had a few words of wisdom for me as our conversation came to an end.

“Don’t forget to buy low and sell high,” he said.

There it was again. The old Wall Street adage had crept back into my life twice in only 48 hours. I know it might seem like an innocent comment — but I am deeply bothered by the idea of “Buy low, sell high.” And I certainly don’t think an investment professional should be passing the slogan off to customers as if it were a can’t-miss nugget of stock market wisdom.

Whether you’re a novice investor or a professional money manager, you shouldn’t look to pattern your investment philosophy on the “Buy low, sell high” philosophy. After all, what does “Buy low, sell high” mean? More importantly, how does this Wall Street adage help the average investor make money in the markets?

In short, it doesn’t mean anything. And it won’t help you make money.

Instead of blindly following this tired Wall Street mantra, I have a better strategy to show you. If you have the guts to follow the spirit of this rule, you should have no trouble beating the pants off the market — and the “Buy low, sell high” crowd. But before I get into the details, I’m going to show you exactly what’s wrong with the conventional wisdom behind “Buy low, sell high” thinking.

When you were learning economics in school — or even when you first began to look seriously at the markets, the charts all seemed so clear. It’s simple to look back over the past 20, 30, or even 50 years and pick out the best times to buy and sell stocks.

With hindsight as our guide, it would be a no-brainer to buy stocks the day after the crash of 1987 and ride stocks through the bull market of the 1990s. Or sell our Nasdaq winners before the tech bubble burst and the markets tumbled in 2000.

But in reality, that’s not at all how the market operates. None of us can hop in a time machine with the hopes of buying a dead-certain market bottom. No one has the ability to look beyond the right margin of the charts.

This is precisely why “Buy low, sell high” is so meaningless. What is low? What is high, for that matter? And when do these mysterious opportunities occur? Not only does “Buy low, sell high” fail to answer these questions. It also gives bad advice at crucial market turning points.

As an example, let’s imagine a stock on your watch list just fell to a new 52-week low. Judging by our rule to buy low, buying this stock as it breaks to the downside is the perfect move. The entire objective is to buy shares on the cheap. Mission accomplished.

However, anyone with a shred of market experience will tell you that buying a stock as it posts fresh lows usually ends in disaster. You might be buying the stock for a low price, but you have to remember there’s no rule keeping your cheap stock from dropping even lower. In fact, a stock with enough downside momentum to make fresh lows is more likely to continue to travel lower before it finds higher ground once again. The company is out of favor, making it all the more difficult to attract new buyers. Instead of buying a stock at its true low, you’ve instead picked up shares of a stock that’s just beginning its decline…

On the other end of the spectrum, selling a stock at the high point can become even more difficult without the aid of hindsight to guide your decisions. If a stock you owned began making new highs, the sell high rule would kick in and you would have to prepare to take profits.

But why would anyone sell a stock that was trending higher? Unless the market gives you a reason to sell your shares and book the gains, it’s always a good idea to let your winners run. The same rules that affected our stock hitting new lows are in control of our stock that is making new highs. But in this case, you have an even better reason to hold onto your shares. You’re already sitting on open gains if you bought a stock that starts to move to new highs. Your risk is actually lessened because the investment has already moved in your favor. You have the opportunity to move your stop loss up to break-even and watch the stock outperform.

If you adjust your thinking a little, you can see how we could also justify replacing “Buy low, sell high” with the lesser-known trading mantra “Buy high, sell higher.” After all, it’s obviously a smarter decision to buy a name that’s making new highs than it is to sell an outperforming stock — even if you do have a longer-term holding time in mind.

It’s easy to see why you should forget the meaningless “Buy low, sell high” adage. It’s merely a catchy slogan masquerading as investing advice. Now, it’s time to get down to some true investing wisdom. I’m talking about a powerful, reliable strategy that has been used by some of the greatest investors in the world…

This strategy is simple to use because it relies on one of the most basic and important emotions affecting the markets: fear.

In his 2004 Berkshire Hathaway chairman’s letter, Warren Buffett penned a short segment that perfectly sums up how to use fear to your advantage when you’re looking to buy stocks.

“Investors should remember that excitement and expenses are their enemies,” Buffett wrote. “And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.”

In my view, this is a decidedly better version of the buy low, sell high slogan. It’s much more actionable because the vagaries of price and time are replaced by a key market emotion. Instead of blindly guessing what an acceptable low buying price for a stock might be, you can gauge market sentiment to determine when fear has peaked.

Of course, this doesn’t mean you should jump on any stock that causes a panic on Wall Street. In order for this strategy to work, you have to wait for the panic to subside and the deep disappointment to set in.

It’s not enough to simply buy a stock when the price is “low.” You need a clear signal — a trigger that will tell you when to buy markets where investors have given up all hope. Every economic indicator (and every analyst) should shun the stock. The company, industry or sector you’re researching should be universally loathed. Negative news stories should outnumber the positive at a rate of 10 to one. That’s how you know fear has truly taken hold.

Once the scales have tipped and everyone has abandoned hope, you are left with an incredible opportunity. This is when the skilled contrarian investor makes his move. Everyone has already abandoned any hope of the stock going higher. No one is left to sell and push the investment lower. This is how turning points are formed.

In a sense, fear is the ultimate buy signal. If you have the foresight and the strength to buy when others are fearful, you will fill your portfolio with stocks that will deliver market-crushing returns.

Sincerely,

Greg Guenthner
for The Penny Sleuth

The Only Long-Term Investment Strategy You’ll Ever Need was originally featured in the Penny Sleuth.