Jason in my article on why I like High Frequency Trading wrote the comment.

However, when I think to set orders like this I always wonder “Why would the price of stock X drop 5-10%?” It could be a buying opportunity like with your recent trades. But what is the % chance that it is a big meltdown/liquidation event that triggers the 5-10% drop?

I oftentimes set alerts at these levels so I am notified of the price drop and can make the decision then to place an order. However, I’ll often miss the boat like this.

I suppose if you are extra sure on the fundamentals of whatever company you are putting the low limit orders in for, you could do it.

First Jason, please don’t take my commentary personal. I wanted to write about this topic and your comment makes a nice summarization.

The thing that you need to be clear about when in the market is whether you are trend rider or not. If you are trend rider sure you could say, “hey I am not that interested”, but then you need to follow the market and identify break out moments.

Though the problem with breakouts is that it requires constant vigilance. It also goes against the grain of many people because you are overpaying for a stock in the hopes that it will go up further. Thus many will like to set lower limits in the hopes of catching a moment of weakness.

Jason’s question is how do you know weakness from failure? Answer you don’t! I will tell you right now you don’t know one from the other and if you try to predict otherwise you are going down a fools errand.

Let me illustrate with an example, the car industry. Would you have bought shares in the car industry?

I did! Yes I bought shares in the various car makers; Fiat, BMW, Daimler, GM, Ford, and Renault. I bought shares of these car companies when the storm was the darkest and when everybody thought things would fall off the face of the earth.

Did I know that there was failure or weakness in the car markers? Answer not even close! I looked over the books, looked at future prognosis and jumped in and hoped. Yes I hoped because in the market there is no way of knowing one way or the other.

How did things work out? I lost 75% of my money in GM, made a 101% profit on Fiat, am 30% ahead with Daimler, 400% ahead with Ford, 80% ahead with Renault, and 75% ahead with BMW.

One of the ways that I manage my risk is through basketing, which is something that I talked about in my 2008 predictions. When I basket I look at an industry and look at the peers. I never buy a single company in an industry. I always buy multiple players to manage my risk.

In a sector there will always be winners and loser’s, and when buying in a downtrend you can distinguish between the winners or the losers. Thus you need some rules on which peers to buy.

Here is how I would decide which shares to buy:

  1. Avoid the number 1 player for the most part, unless their share price is hit so hard that it makes them very attractive.
  2. Buy a share in the biggest underperformer on the hopes that they fix things up.
  3. Select a bunch in the middle field that have good value based on their past and take a look at their news articles to see where the company is going.

Let me go through my thinking with respect to the car makers.

  • GM: My sympathy play in the hopes that the company actually gets their head on straight. Granted this play bombed out for me.
  • Fiat: I liked this company not for their cars, but because they are an industrial group that included farm equipment and trucks. Their overall bottom line is not bad, but they have a pretty good following throughout Latin America. Additionally their car lineup has dramatically improved. I sold when they wanted to take over Opel because that was too much for me.
  • Ford: A wild card play for a company that managed to bugger things up quite nicely (at the time this was the thinking), but had many interesting things in the pipeline. This is a car maker that I think will have plenty of upside potential.
  • BMW: A yuppie car maker that has always managed to keep ahead of the steam roller. Their product lineup is good and their future is stable. I bought on massive weakness.
  • Daimler: What can I say, a company where there will always be a client, because after all what car would dictators drive? Seriously though, Daimler was my stable play on a car company that was undervalued.
  • Renault: My future play. Goshn is a brilliant CEO and he has a good sniffer and has shown he can executed. The electrical vehicle Leaf is yet again an example of his sniffer.

Overall, my loss in GM was made up by my gain in Fiat. Though now my gains in all of the other car makers is making me good money.

At the time of purchase how did I think things would play out? I thought GM would make it. Fiat would muddle along, with their industrial group making the profits. Renault would be where I thought they would be. Ford completely surprised me, and Daimler while up seems to be stubbornly underperforming. But because I basketed things worked out for me.

So why did I not buy Toyota, and Volkswagen? Simple, they are the number 1 car makers and can only fall. And fall they did… Personally I am very bearish on Toyota and in a future blog I will make a case on why the Hybrid will turn out to be a big fat duck when looking at the long term.