Why Investors Should Embrace “Failing Fast”

by Christopher Rowe, Technical Strategist, The Oxford Club Technical Analysis Technical Analysis
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Fail fast.

Those two words sound negative. But believe me when I say this could be the best advice you’ll ever hear.

Any successful entrepreneur already knows what it means.

You see, time is our most valuable commodity. So any business builder would rather fail fast than wait a long time to see if they’ve made a profitable decision. In other words: It’s better to fail fast and move on to the next thing.

If you’re a good investor, then you probably view your trading account like a business. The phrase “time is money” certainly applies, since opportunity cost is an everyday consideration in investing.

To show you what I mean, let’s look at the chart of CBOE Holdings Inc. (Nasdaq: CBOE). Its chart tells us it’s a great example of a stock that is as likely to lose $1.50 as it is to gain $13. So if shares do take a hit, investors will feel it sooner than later - with minimal damage done to their portfolios.

By the time you read this, CBOE may have already triggered an exit signal. Or it might be a lot higher.

Why? Because it’s trading right at a key support level where if it moves just a tiny bit lower, it will probably be in trouble for a while. But if it bounces higher, it stands to gain about 20% in a short time frame.

I’ll explain...

In the three-year chart above, you can see CBOE is in a nice strong uptrend. Of course, what stands out is the fact that it recently sold off from a $68 closing price to its current price of $59.22.

In a stock market that many are calling “short-term overbought,” it’s hard to find strong stocks that aren’t trading near 52-week highs. But we have that in the case of CBOE Holdings Inc.

If you’re familiar with my “relative strength”-based investment methodology then you know I don’t typically buy into trends that aren’t working. Especially when the general stock market is advancing.

But in this case, the long-term trend for CBOE is strong - as is its Wall Street peer group as a whole. And considering the broad market may need to readjust lower soon, it might pay to be in a stock that has already endured some selling pressure.

An 8-1 Reward-to-Risk Ratio

I drew two lines on the previous chart. The blue horizontal line shows the “support level,” which is a key metric any technical trader should focus on. Computers are programmed to buy or sell based on this and other technical levels - which accounts for the majority of stock market volume.

Let’s zoom in.

As you can see, the support level is $58.61. This is considered a support level for two reasons:

  1. Old resistance levels, once broken, become new support. Back in March 2014, where the blue horizontal line begins, the stock ran into resistance at $58.61.
  2. It already proved itself as a support level. See where CBOE bounces off the blue line in late November-early December?

So returning to our “fail fast” motto, a good place to enter a stop loss order might be slightly below the support level at $57.72. With the stock trading at 59.22 as I write this, that’s a difference of $1.50.

If the trade doesn’t work, we won’t have to wait around long to find out.

I’m building in some flexibility here because institutions may try to trick us into selling our stock if it breaks below the support level.

There’s no hard and fast rule on how much wiggle room you should give yourself with stop loss orders. But the more flexible your stop loss is, the more risk you will expose yourself to.

 

The dotted vertical line above shows the 13-point difference between CBOE’s $58.61 support level and its 2014 low.

Many chartists consider that difference to be the expected distance of the stock advance from the breakout point. Adding that 13-point distance to the breakout price gives us the “minimum price objective” of approximately $71.60.

Again, the highest price seen by CBOE was $68. If the stock bounces higher from here, $71.60 is the price we anticipate it moving to.

Head-and-Shoulders Reversal?

Now if you look at the point past the breakout you’ll see a bunch of red markings. This is a chart pattern called the “head-and-shoulders top formation.” It is a very bearish pattern.

So you may be saying to yourself: “Chris has officially lost it... Why would I buy a stock that just completed such a bearish pattern? The answer is simple.

As mentioned, computers automatically trade the majority of market volume based on technical signals. So it stands to reason that a “short position” has been initiated here. This means bearish investors have sold CBOE with the intention of buying it back at a lower price and profiting from the difference.

The head-and-shoulders formation was completed once the stock broke below that diagonal red line, called the “neckline.” Because of the bearish pattern, charting rules dictate to bearish traders that the stock should actually be trading down around $54.

But this stock is in a strong sector and in a very strong long-term uptrend. There’s a bullish play here because if the short-sellers start losing money due to the stock advancing, they will be forced to buy the stock back. This will cause more buying pressure, also known as a “short squeeze.”

If the stock moves just a bit lower, it’s a sell signal. Investors who’ve placed their stop loss orders will fail fast - but they won’t lose much. And if this baby moves higher, bearish investors had better get out of the way because CBOE is likely to start breaking highs again.

Good investing,

Chris Rowe

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