Two types of buying

I once heard a phrase that stayed with me for years—a man who owned a flower shop said that he had to “buy well to sell well.” Flowers have to be sold quickly, before they wilt. Buying at a low price gives the shop owner more pricing power. If business becomes slow, he can drop his selling price and still be profitable. Buying well—getting a low price—helps him sell well.

As we near the end of our brief discussion of buying, we need to discuss its two main types. One is value buying: “buy low, sell high.” The other is momentum buying: “buy high, sell even higher.”

A value buyer tries to identify value and buy near or below it. He wants to sell when prices become overvalued. To help define value I put two moving averages on a chart and call the space between them the value zone (see Figure 3.11). To help define overvalued and undervalued zones I add channels to my daily and intraday charts. The space above the upper channel line identifies the area of mania, and the space below the lower line the zone of depression.

Figure 3.11 Value Buying

In trading, we do not have the luxury of shooting at a standing target—the target keeps moving. Prices move very fast, but the value zone moves at a much slower rate. The concept of a value zone gives a trader a target that moves a little slower than prices.

We will discuss the tactics of selling using the concept of value in a later chapter, but even a quick look at Figure 3.11 will show that the concept of buying at or below value and selling in the overvalued zone makes logical sense.

Momentum trading calls for a completely different approach to buying and selling. The chart in Figure 3.12 shows how a stock, after spending several months in a narrow trading range, broke above its resistance line and accelerated to the upside. Several weeks later, after a half-hearted pullback that did not even reach its former resistance line, the stock accelerated and went up at an even sharper angle than before.

Here, the time to buy was whenever the stock showed renewed strength by taking out the previous day’s high. But where would you sell?

Figure 3.12 Momentum Buying

In retrospect, that point would have come during the false breakout above $20—but this became clearly visible only several days later. How would you decide when to sell at the right edge? Our next chapter is dedicated to the questions of selling.

The two charts we have just reviewed show that the way we sell will depend on why and how we buy. Are you primarily a value trader or a momentum trader? And how do you make this decision?

This tends to be one of many instances where people make market decisions on the basis of emotions rather than hard facts. We make some of the most important decisions in life this way, and it is not necessarily a bad thing. Some of us are temperamentally drawn to buying low and selling high, suspicious of runaway trends. Others scan the markets, looking for runaway trends, jumping aboard and trying to hop off before a significant reversal.

Only you can decide whether to be a value or a momentum trader. I cannot make this choice for you. Whatever you decide, please keep in mind that having a written plan for buying and selling will put you miles ahead of your competitors. Whatever your method, a person with a plan has a clear advantage in trading.

Remember, your mind is a trading instrument. When it gets clouded in the heat of action, as it often does, the quality of your decisions will deteriorate. Having a written plan will keep you rooted in the cooler, calmer times before the trade, when you were in a much better position to make decisions.

When you come to the market to sell, knowing whether you are a value or a momentum trader and having a written exit plan will give you a terrific advantage over the masses of impulsive traders.

Remember—buy well to sell well!