Understanding And Using The Buy Zone

Summary

  • Building a position in a stock or ETF should generally be done over 2 or 3 purchases at different price points, i.e. scale in.
  • I have created a buy zone for each security for you to use for scaling into a position.
  • The buy zone is constructed using both fundamental and technical analysis.
  • It is rare that you won’t get a chance to buy into a security within the buy zone at some point, patience is key.
  • From time to time we’ll buy into an uptrend above the buy zone, that is a different type of buy and requires the use of stop losses.
Building A Portfolio

Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. — Benjamin Graham

Having a philosophy and a process for investing is very important to developing a portfolio with built in margin of safety.

My primary goal is to give you stocks and ETFs that are fairly or undervalued to buy into based on forward 12 months outlook. I’ll cover that first. 

Sometimes we will buy into an uptrend that is above the buy zone, but below our 3-5 year price target and not yet overbought. I’ll cover that in the bottom section. 

What Is The Buy Zone? 

Here’s a buy zone for Alphabet [Google] (GOOG):

The orange box represents the buy zone. 

The top line is two things: 

  1. roughly a fair value for the forward 12 months – the market rarely agrees with me. 
  2. a price I would consider buying the stock at if there is not heavy downward momentum towards becoming oversold.

Essentially, the top line is where to look to see if you can start buying. Somewhere at or below that line is where to make an initial purchase.

To determine oversold status and downward momentum you will have to look at the technical indicators at the bottom of the chart. 

Read Technical Trading Basics

The bottom line represents what I call “bottom fishing.”

The bottom line is an undervalued price based on the coming 12 months and longer term 3-5 year outlook that I think the market can give us if there is enough downward momentum for short-term market or company specific reasons.

The market can overshoot by quite a bit, but the bottom fishing price and below is where great cost basis comes from. I often do not make a purchase or a put sale unless my cost basis will be near the bottom fishing price. That’s a great strategy for having lower risk, you’ll miss some run ups though.

[3 to 5 year outlooks are common. Valueline, Morningstar and many other research firms use it. As I came up on Valueline, I have adopted it, although, I do try to nail the 2-3 year time frame because I know most folks, even me sometimes, need to make a buck faster to feel good about what they are doing.] 

Scaling In

There are no automatic buy prices. 

At the two lines, you will need to assess whether there is further technical and price damage likely to happen, especially at the top line. I will guide you when we get there with updates. 

At the bottom fishing line we usually need to hold our nose and buy a starter position, add if we are averaging down or at least sell a cash-secured put. 

The reason we hold our nose and buy the bottom fishing price (or sell cash-secured puts) rather than waiting, is because we often catch a pivot. Reversals are are usually fast and big, so we don’t want to miss it if it happens. Again, using technical factors (not guts or feelings) is essential.

We manage our risk by making small purchases and holding that extra cash for another purchase if we need to make one after we get more information.

I haven’t usually used stop losses after I buy a bottom fishing price, but am moving in that direction due to the extreme nature of markets today. If I use stop losses, I’ll use 12% and 20% or a little of both on at least a part of a position. There’s statistical reasons for those percentages, but we’re not going to cover that here, it has to do with momentum in corrections.

Buying An Uptrend

Buying an uptrend can happen within the buy zone, such as after buying at the bottom fishing price and then buying again as the stock breaks out. 

We can also buy an uptrend above the buy zone. Why? Because I am looking for doubles or triples or better from the top buy zone line. That’s in line with my 3-5 year outlook. 

So, if a stock we like has a small pullback above the buy zone, that is often a spot to add to our position or for late comers to get in. We will use daily and weekly technical indicators to guide us. 

Here’s an example with Liberty Sirius (LSXMK) a favorite of mine and some guy in Omaha. 

If you expand that chart, you can see a few things. First, the uptrend is very clear. The stock has been stair stepping higher for nearly 20 months. 

Based on what we know about the company, we can surmise that fair value is around $44. We also know that Warren Buffett’s Berkshire Hathaway (BRK.B) accumulates each time it approaches $40 per share. So, as it approaches $40 we know about where it gets really safe because of a big checkbook buying the dips.

If I were overall bullish on the market and on this stock (I am, see the 3-5 year target price upper right), I could buy the dip you see on the right hand side of the chart. Here are some things that we know that help make that decision:

  • RSI is not overbought
  • the two money flow indicators are about neutral
  • MACD is a bit negative, but not scary given what we know about Berkshire
  • there’s huge buying interest in the low $40s (again, largely Berkshire). 

This is how we use our fundamental knowledge to use technical indicators to our advantage. 

If we buy around $48, then we might want to use a $40 stop limit on the new purchase in case we run into a large correlated stock market sell-off or something bad happens to the company. That limits our downside to about 20% on a position that we have roughly 100% upside (or more if I’m right about Sirius doing well globally now that it owns Pandora). 

Investment Quick Thought

So, that’s the easy way to use buy zones. Use the orange box to buy on the cheap and when we can see downward momentum is likely to end (we won’t get that perfect by the way, that’s why we keep a little extra cash on hand). 

We can also buy an uptrend when price is moving away from the buy zone if the trend is our friend and we use stop losses for protection. 

I hope this helped. Remember, I’m around to answer questions in the chat and in the comments below. 

Disclosure: I/we have a beneficial long position in the shares of LSXMK, GOOG either through stock ownership, options, or other derivatives.

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