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Anatomy of a Trade: Market Risk Analysis and Momentum Investing

Fin - Breakout - US

Welcome to another installment of Anatomy of a Trade, a feature in which we share the wisdom and experience of professional traders with retail investors. This time, Simon Baker, the CEO of Baker Avenue Asset Management, a $600 million San Francisco-based investment management firm, offers his take on a recent trade. Our goal is to enlighten -- and to make you a better investor.

By Simon Baker

Many market participants do not properly and fully consider market conditions when making buy or sell decisions. This is especially true for buy-and-hold investors who sit through both high- and low-risk markets.

At Baker Avenue Asset Management, we believe investors and traders can increase their chances of profitability by buying stocks only in markets where there is a high tolerance for risk and by raising cash in markets in which there is a lower tolerance for risk. We use a proprietary algorithm, called BAMSI, developed over decades of research that includes such indicators as moving averages and volatility to determine the risk levels of the market.

In markets where there is a higher tolerance for risk, we only buy stocks that exhibit both strong fundamental and technical factors. Most market participants only base their investment decisions on fundamental or technical analysis. We believe the chances for profitability increase if a stock has both strong fundamentals and technicals.

The Situation

The market experienced a rather nasty correction during the summer months in 2010 that lasted between May through August. In September, our market sentiment indicators moved from bearish to bullish territory, at which time we were interested in buying stocks again. During the time in which the market was negative, we researched stocks that we would be interested in buying should the market turn positive again.

One such stock was Silver Wheaton (SLW). The company is one of the largest metals streaming companies in the world -- buying byproduct silver from gold companies for $4 an ounce and then selling it at the spot price, which at the time of the trade was $21 an ounce. Silver is used in a number of industrial applications, which means a sustainable economic recovery would also support silver prices. We believed the company was likely to beat earnings expectations due to the favorable environment in which they were in.

On a fundamental basis, Silver Wheaton was exhibiting very strong earnings growth due to rising silver prices. The company had a three-year sales growth rate of 34% and a three-year earnings per share growth rate of 24%. Earnings surged 133% in the most recent quarter. The company had an extremely solid balance sheet, and cash flow generation was also strong.

On a technical basis, the company's price relative strength was very high -- in the top 4% of the market. The company traded above its short, intermediate and long-term moving averages, which suggested the stock was in a strong uptrend.

The Entry

We bought the stock's upside breakout in September at $25, with a stop loss at $20. The breakout occurred on very strong trading volume. The stock was consolidating for a while, forming a nice solid base between May and September. Breakouts out of long consolidations, like the one Silver Wheaton had, increases the probability of a successful trade.

The Exit and Outcome

We sold the stock in less than two months with a 40% gain, taking profits when silver prices moderated and the stock's relative strength started to decline. This is a good example of when a stock's strong fundamentals support a breakout to new highs. Now clearly, not all of our stock trades are this successful, which is why it's crucial to put in a strict stop loss and remove any emotion.

The Takeaway

Wait for the appropriate market conditions before committing investment capital. It is much easier to make money in positive markets that are tolerant of risk than it is in markets that are not. In positive markets, buy the stocks that are showing the strongest fundamental and technical factors.

When you make stock purchases combining favorable market conditions with stocks that exhibit strong fundamentals and technicals, you greatly increase your probability of success.

Simon Baker is the founder of Baker Avenue Asset Management, and he serves as the chairman of the investment committee. He is also president and partner of Great Gable Partners, Baker Avenue's affiliated alternative investment manager.

He previously was a managing director at Banc of America Securities, and before that, he was a director at Donaldson Lufkin & Jenrette, then at Credit Suisse First Boston. He began his career in wealth management at Morgan Stanley in 1994.

Baker Avenue Asset Management was founded in 2004. It is an independent, 100% employee-owned firm, and its management team is made up of a range of investment professionals. The firm is headquartered in San Francisco, and it has offices in New York, Boston, Dallas and Seattle. The majority of its assets are held by Fidelity Investments, its custodial partner.

Questions or comments? Let us know. Send us an email with your thoughts to breakoutcrew@yahoo.com.