Many traders now understand that buy-and-hold strategies can suffer from steep losses for years at a time. This knowledge was probably acquired from expensive first-hand experience. In a strong bull market that lasts for decades, buy and hold is a sound investment strategy. But in a long-term bear market like the one that has provided the backdrop for stocks since 2000, it is usually better to take profits when long-term sell signals develop.
Major stock market averages, like the S&P 500, have recently fallen below their 200-day moving averages (MA). Some have rebounded above the average, but throwbacks after a trading signal are common. A throwback occurs when the price is "thrown back" through the signal and generates short-term trades while the direction of the long-term trend is resolved.
Breaks of the 200-day MA, even with throwbacks, are often a sign that the long-term trend is changing. In this case, we could see a large price decline develop over the next several months. In an environment like this, it is important to take profits when the chart gives a sell signal like it is in The Coca-Cola Company (NYSE: KO).
KO is one of the classic examples of a buy-and-hold stock. It is one of the largest companies in the world with steady sales from a product that is among the most recognized brand names in the world. Its dividend is considered to be safe and the stock is a favorite of income investors, while long-term investors have been well rewarded by the company. In the bull market that started in 1982, KO gained more than 5,500%, plus dividends, but since reaching its all-time high in 1998, it is down about 16%.
Now, KO has formed a head-and-shoulders (H&S) pattern and fallen below its 200-day moving average (MA). In the chart below, the 40-week MA is shown because the pattern is easier to spot on the weekly chart. The trade strategy is the same whether a weekly or daily chart is used.
It is also possible that KO, and other stocks favored by buy-and-hold investors, could come under pressure from tax selling. As a classic buy-and-hold stock, many shareholders in KO have probably held their positions for years. Taxes on long-term capital gains are slated to rise next year no matter how the current negotiations over the fiscal cliff end. Because of the higher tax rates to come, some long-term investors may decide to take gains this year and free up capital to put into faster growing investment options.
Even without tax selling, KO seems destined to fall at least 10% based on the chart pattern and should reach $32 a share. That target is obtained by finding the distance from the top of the head to the neckline in the pattern and subtracting that from the neckline.
In a larger stock market sell-off, the price could go even lower. KO seems like a short trade candidate, but the dividend makes shorting the stock expensive. When you short a stock, you borrow the shares that you sell from your broker and are liable for the dividend payments in addition to other costs related to borrowing the stock. Given the high costs, a put option strategy could be more profitable.
February $35 puts are priced at about $0.43 and would be profitable if KO falls below $34.57, about 7% below the recent price. At the target price of $32, the puts would be worth $3. This is a low-priced way to profit from the H&S pattern in KO and a possible market decline.
Recommended Trade Setup:
-- Buy KO Feb 35 Puts at $1 or less
-- Set stop-loss at $0.25
-- Set initial price target at $3 for a potential 200% gain in three months
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