For most investors, buying more of the same stock is a bit of a touchy subject. There are basically two risk management rules for when it’s appropriate to buy more stock: you can (1) add on a pullback, or (2) add on a breakout. The best option depends largely on market context, but each requires a specific strategy and mindset.
We’ve discussed previously how to approach buying more stock in this YouTube video Building Positions. But here I will discuss some additional mechanics.
Adding on Pullback: Use Volume
All stocks pullback, but not every pullback is the same. The best type of pullback to add is one where the selling occurs on very light volume & comes into a logical support area.
A few important characteristics to look for:
- The initial breakout occurred on heavy volume indicating institutional-level buying
- Pullback occurred on relatively light volume, indicating institutions were not selling
- Resumed upward trajectory after pullback with more favorable risk/reward parameters
It sounds easy to do, but pullbacks are difficult to withstand, mentally. The temptation will be very strong to sell your remaining (and lessening) profits. But the degree to which people are selling will give you the real story of what you should be doing.
Adding on a Breakout: Use Relative Strength (More on Relative Strength here)
William O’Neill, founder of the Investor’s Business Daily, discovered an important characteristic of stocks that outperformed others prior to their big moves: These stocks had both high relative strength and group leadership rankings.
In practice, stocks with high relative strength can be up as much as 10% from their recent lows. Perhaps they are coming out of a deep base, or v-bottom setup. To the average trader, it seems counterintuitive to add to a position that is higher in price. But while this can be intimidating, the stock is actually telling you that it has the strength to go higher – and usually does.
If you have a decent profit cushion, and your stock offers a second entry at a breakout point, try shifting your mindset from “I should sell this” to “How can I add to this position?”
Ask yourself if you would enter this stock (higher) for the first time. If the answer is no, you may be forcing the trade. Calculate the risk/reward for the second add. Remember, each additional buy requires a new stop loss for that purchase.
ZS recently presented a great adding opportunity for us on its recent breakout.
Special Case: Earnings Gap Ups
If your initial entry is low enough, you may be able to withstand a potential drawdown from an earnings report. It some cases, this risk is worth the bet. Stocks with a solid earnings record and market leadership have a better probability of reporting well, which can send the stock higher!
The price “gap-up” created by strong earnings can offer an additional entry point, so long as the gap-up can hold its higher price level and “digest the move” well.
PAYC recently provided an add-on opportunity following strong earnings. On Feb 6th, 2019, PAYC gapped to $170 and created 3 days of price support around $165 with highs at approximately $179. The best area to have added to this position would’ve been through $179 with a stop a bit below $165 – a 7% risk for those additional shares.