BALTIMORE (Stockpickr) -- As investors, we put a lot of emphasis on buying -- but knowing when to buy is only half the battle. Figuring out the right time to exit a trade is just as crucial for success.
Luckily, you don’t have to take a shot in the dark when it seems like time to take gains; the same sort of technical analysis principles that dictate solid buying strategy can also provide selling guidance.
But there’s a little more to it than that.
>>Does Technical Trading Really Work?
In today’s Technical Primer, we’ll take a look at the other side of the trade with an overview on how to pick price targets for your stocks. We’ll get into how to calculate price targets in a minute -- first, it’s worth looking at some of the trading strategy behind worrying about price targets.
How to Think of Technical Price Targets
Price targets aren’t exclusive to technical analysis, but the psychology behind the fundamental price targets that most investors set couldn’t be more different from what we’re talking about. In the fundamental world, “price targets” generally mean the amount of return investors would like to collect on a stock. At best, they’re based on models that try to reconcile a firm’s fundamental performance with market prices -- not an easy thing to accomplish, as this market proves. At worst, they’re arbitrary.
On the other hand, technical traders treat price targets sort of like stop losses in reverse. They’re based on technically relevant price levels. Instead of the returns traders would like to see from their stocks, technical price targets are based on returns they’re likely to see from them.
To accomplish that, they’re based on levels of supply and demand in the market. Put another way, once a move has been made in a stock, technical price targets identify where demand for shares is likely to sputter out.
>>4 Key Indicators for the Technical Trader's Toolbox
Preset price targets are crucial from a trading strategy perspective. Generally speaking, you should already have a strict price target defined before you even enter any trade. The reasons are twofold. First, a preset price target helps to determine whether a trade is even worth your time -- if the payoff isn’t worth the risk or cost, you know in advance. And second, entering positions with price targets already in place means that you’re better prepared to pull the trigger if shares move quickly.
That doesn’t mean that your price targets should be set in stone. Like most other price levels of significance (like stop losses), price targets should be reevaluated as market conditions change.
Calculating Price Targets
There are a few ways to calculate price targets. Often, the different methods result in a similar target, but occasionally they don’t. Some subjectivity enters the equation when determining which of these systems are going to be most effective. Remember, though, that our goal in determining price targets is to find the likely price behavior of a stock -- no target is going to be accurate 100% of the time.
1. Support and Resistance Levels
One of the most effective means of determining a price target is by identifying the nearest relevant support or resistance level in the direction of the stock’s movement (it also happens to be one of the easiest methods). Basically, support and resistance levels are pockets of demand and supply (respectively) for shares of a stock -- they’re places where a stock’s movement has the greatest probability of stalling as transactions become one-sided.
>>Profit From These 3 Trading Mistakes
Let’s say you’re buying shares of Apple (AAPL) on a breakout higher. In that case, you’d want to aim to unload the trade just before shares reach a significant resistance level. Doing so greatly reduces your risk of a gain-eroding reversal. Which support or resistance level you choose depends largely on your timeframe. If you’re a shorter-term trader, the nearest overhead resistance level might be an attainable target, whereas if you’re a longer-term trader, you’re likely buying on a stronger shift in demand that can overcome shorter-term resistance.
It doesn’t matter what kind of support or resistance level you use for your price target – moving average, horizontal, or trend line support or resistance all work fine. Instead, you should be looking for relevant levels that have held up prices or spurred reversals in shares of your stock in the past.
2. Measuring Rule
Obviously, the biggest shortcoming of using support or resistance to determine price targets comes when there isn’t a nearby level to use as a reference. A breakout trader might take a new all-time high as a bullish trading signal, but he won’t have the requisite overhead resistance level to determine a target. In that case, the measuring rule is very helpful.
Put simply, the measuring rule (also sometimes called the “minimum measuring objective”) is a method that uses the size of a stock’s technical price pattern to determine the likely size of a subsequent move. The measuring rule isn’t market magic -- instead it is based much more on market psychology, and the fact that the size of a previous base has a lot to do with when investors are likely to think that a move has “run its course.”
>>Screening for Actionable Investment Ideas
The part of the pattern that gets measured is different for every major type of technical pattern. That means that an ascending triangle has a different measuring procedure than a double-top. (Generally, price targets from the measuring rule are based on the vertical height of a pattern projected above the top of the pattern). One of the most exhaustive studies of pattern-based price targets was conducted by trader Thomas Bulkowski; readers can find a free index of measuring rule procedures by pattern at his Web site,
ThePatternSite.com.
3. Point and Figure Charts
Finally, investors who use point and figure charts have an added advantage when it comes to picking out price targets. That’s because point and figure charts actually provide explicit price targets for any trading signal. While the investors who use point and figure as the primary chart type for their trading are certainly in the minority, it’s a strategy that’s worth considering if quantitative price targets are a priority.
Evaluating the Aftermath of a Trade
After any trade, it’s important to analyze the effectiveness of your price targets. Don’t second guess your targets if shares fall short or if they’ve been exceeded -- remember, you’re trying to determine the likely move of a stock, and some margin of error will always be present. That said, you should be looking for patterns in that error. If you’re consistently overshooting or undershooting target prices for your trades, adjustments may be required to the method you’re using.
Even though most casual investors don’t give as much thought to their price targets as they should, technical traders who do can benefit immensely. Next time, we’ll add to your technical repertoire with another primer that will bring you closer to implementing technical analysis for your portfolio.
In the mean time, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.
RELATED LINKS:
>>5 Big Stocks to Trade for Gains in This Market
>>The Importance of Trading Volume
>>5 Stocks Insiders Are Buying
Follow Stockpickr on Twitter and become a fan on Facebook.
Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.
