Grading Your Trades
As we stressed in Timing Exits, your objective shouldn't be to try and buy at the bottom and sell at the top, but rather to get on board an upmove as early as possible and ride the trend higher to take a big chunk out of the move. We're indebted to Dr. Alexander Elder for his idea of Grading Your Trades.
All software charting packages allow you to draw Moving Averages, either simple or exponential, and most will allow you to draw a channel either side of that moving average (MA) at a certain percentage distance away - for example a 10% channel would draw one line at 10% above the MA line and another 10% below it. What percentage should you use? The idea is to try out various percentages until you find the one that will encompass around 95% of the price action for your chosen period, normally the last three months. The correct channel can be visualized as fitting the prices like a shirt,with just the collars and cuffs sticking out!
Now you measure the width of the channel, by deducting the lower line from the upper line. This is the value of the recent 'normal' fluctuations in that stock's price. For an A grade, you are looking to capture 30% of that channel or more. Any trade that captures 20-30% of the channel gets a B; 10-20% gets a C; below 10% is a C-, and below zero is a D. So for instance if the channel width is $20 you would be looking to capture an upmove above your purchase price of at least $6 for an A grade.
The channel width can also give you a reality check on your proposed purchase. Some stocks have a very narrow channel and may not be worth the risk - so if your proposed purchase has a channel width of $5, you would be looking for a gain of at least $1.50 (30%). However, if your stop loss is $2 the purchase doesn't make sense - you would be risking $2 to potentially earn $1.50. There is no fixed number, but normally you should look for a reward-to-risk ratio of around 3-to-1 to make the trade worthwhile.