How to Pick Your Price Targets
“The trick of successful investors is to sell when they want to, not when they have to.”
– Seth Klarman, Margin of Safety
With all the time investors focus on buying stocks, it’s no surprise that the selling often gets ignored. But that’s a huge mistake. Most experienced investors agree that selling is the real challenge for folks trying to do battle with the markets — it’s not that buying is that easy, mind you, only that knowing when to sell is so hard!
So it’s with that in mind that we turn to a reader question that I got last week…
“In a future article, it would be great if you would explain how technical analysis can be used to identify a target exit price, as well as a time frame to be in the trade. Thanks.”
Technical analysis is probably one of the best tools we have to figure out when to sell. But I’ll be the first to admit that it’s tricky to put into practice. Today, I want to help you avoid the confusion by showing you a couple of tricks you can use to pick your price targets quickly and effectively.
Part of the reason why selling is such an afterthought is that most investors have been conditioned as traditional buy-and-hold investors. Warren Buffett is famous for claiming that his favorite holding period is forever. Even if that’s not exactly true (Buffett is more of a trader than his public persona lets on), it helps to explain why selling is an afterthought for most investors.
Let me say this in no uncertain terms: As a trader, you need to know your exit strategy before you even look at the “buy” button.
By that, I mean you have to ask yourself what price a stock has to hit to let you know you’re right and what price it has to hit to let you know you’re wrong. Figuring out those prices is the trick — today, we’re just looking at the price that tells you you’re right (figuring out if you’re wrong is actually a lot easier, but it’s a topic for another day).
Classical technical analysts that focus on an arsenal of price patterns typically have a set of price target rules called “minimum measuring objectives” that they apply to each price pattern they use (you can find an exhaustive guide to these rules if you dust off a copy of Edwards and Magee’s classic Technical Analysis of Stock Trends). But knowing all of those rules takes a lot of rote memorization — I’ll show you a quicker way.
To start, we’ve got to set the scene. Let’s say that you’re taking a look at a stock that you think has potential as a trade. Before you buy, you’ve got to pick your price target. I’ll show you three simple ways:
Look for Resistance
The simplest way to pick a price target is by looking for the nearest overhead resistance level. The chart below of RF Micro Devices (NASDAQ:RFMD) offers a pretty good example of that:
As you can see, this stock is currently forming a rectangle pattern and just starting to break out. So looking for resistance, we can spot a level at $5 and then another at $5.40. The fact that there are two nearby resistance levels in this stock is a good thing — it means that if RFMD busts through $5 without losing momentum, the stock is likely to move to $5.40.
When you look for resistance levels, you’re basically looking for pockets of sellers. Resistance prices are places where sellers have previously been more eager to sell and take gains (or get out of a losing position) than buyers were to buy, so they make good potential stumbling points down the road. After all, how many shareholders in this stock have been telling themselves, “I’m selling if it gets back to $5” for the past few months?
Measure the Pattern
Another simple method of determining price targets is measuring the height of the pattern. For our RFMD example, it looks like this:
Basically, we’re measuring the height of the pattern and then projecting a move of that same height. That’s based on the rule that bigger patterns have bigger trading implications, an idea that makes a lot of real world sense because larger price setups come with larger volatility. It’s also the basis of many of the classical measuring rules I mentioned earlier.
In RFMD’s case, measuring the pattern also matches up exactly with the $5.40 alternative price target that we got using the first method — that means $5.40 is a very strong price objective. It also gives this stock around a 19% upside potential from the time I took those screenshots. We’ll see how the trade unfolds…
While it’s not uncommon for both methods to give you a single price target, you shouldn’t count on it. If they don’t match up, I recommend using the more conservative target price.
It’s also worth noting that if you’re a trend follower (more on that here), you don’t use price targets at all. Instead, your exit strategy is the same for any stock you buy — you can see that in action in this article I wrote back in September. With trend following, the system kicks you out of a stock at a predetermined time whether a stock’s a winner or a loser.
Even though picking price targets can be tricky, it’s critical to understand before you put your money on the line. As you might expect, the more you trade, the better you’ll get at spotting likely moves.
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