Stock investing would be so much simpler if those wretched shares would just move up in a straight line!
But of course stocks never go straight up, nor straight down for that matter. And over the years I've come to respect and actually enjoy pullbacks in my favourite stocks. Even in a bull market, pullbacks are a necessity and they're welcome. And what's more, without them, you can find that you are vulnerable to sudden correction.
Today I want to look at why these retracements occur, why it's healthy, and of course, how you can use them to your advantage – and I have three useful tips for you.
Profit taking is healthy
You'll often see a price fall put down to 'profit taking' – that is, after a run-up in the price, many investors will sell some stock and take some profits off the table. It's often a sound strategy. I'll often top-slice a holding after a decent run-up. Even if I still like the stock, it's worth selling down say a third of the holding – that's my first tip.
The way I see it, it's a kind of insurance policy. I can always buy back my stake if the share suffers a nasty fall, and if not, then at least the other two-thirds will be doing okay.
And remember, that for every seller there's a buyer. In this case, the new buyer (that took my stock) will have a higher entry point than mine. Hopefully, he won't be looking to take profits until some way down the line.
Profit taking is great. It allows the early entrants to get out and helps fill the stock register with fresh blood with higher expectations for the price. It's a healthy thing.
Don't let traders shake you down
Of course it's a concern when you see the share price slip. Is this the end of the bull run? Well, of course it may be, but it's just as likely to be a short term correction allowing holders to take a few quid off the table.
And these days, short term traders are increasingly making their presence felt. Much of it comes down to automated computer trading. These robots don't give a fig about the underlying business, so in some ways they could be dangerous.
A long-term investor's holding period is likely to be anything from a year to forever. They buy a stock at £1, and may be expecting to sell for £2 sometime in the future.
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But traders (and the automated trading by major banks) have fundamentally lower expectations. Having paid a pound they may be happy to take a couple pence profit. And what's more, if the stock starts to slip, they'll likely sell at a loss – if the trade isn't working, they'll want to get out before the loss multiplies. Thus traders can exacerbate short term pullbacks...
What started off as a fall of a couple of pence can quickly increase to a 10p pullback. The question is, should we care?
No we shouldn't.
As I say, these guys don't care about the underlying business. So long as you do, and the story is intact, you should welcome a pullback. And that's my second tip – keep asking yourself: is the story still intact?
If it is, you don't have to worry about the volatility too much. In fact the pullback works in your favour by effectively dumping the momentum chasers out of the stock – and allowing long-term holders back in. If there's no pullback, the stock will likely end up with even more 'chasers' on the stock register. They all follow the same momentum strategy. And with a stock full of momentum traders, it'll be set for a larger pullback down the line.
Ignoring short term fluctuations
Another way to help ignore short-term pullbacks is to make a small change to how you look at stock prices.
By overlaying a moving average on your stock chart you can remove some of the confusing volatility from a chart. Below, I've taken the chart for IG Group.
The blue line shows the regular price, whereas the pink line shows the 20-day moving average. That is, the average share price over the last 20 trading sessions (about a month). I think you'll agree, the pink line is a lot easier on the eye.
I know it's unrealistic to ignore day to day fluctuations and focus on more sedate average prices. I mean, we're all fascinated by the daily price action. And as I mentioned above, volatility can offer opportunities to trade some of your position for an extra bit of profit.
But moving averages are a fantastic addition to a chart – you can use them together. In fact, the Bollinger bands that I like so much also use the 20-day moving average to create a band within which a stock normally trades.
Whether you choose to ignore short-term pullbacks, or you use them to help trade in and out of your favourite stocks, the point is we should welcome healthy pullbacks. A bull run needs them.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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