HOW-TO convert craziness into results?

21 Jul 2023

Investment books are often full of lengthy explanations of how to buy stocks while selling them is unfairly little discussed. There is a view that the best time to sell a stock is "never". That is, you should pick a company so perfect for investment that you won't want to let it go. I strongly disagree with this.

Certainly, you should pay special attention to the selection of the company, because investing you risk your own (and sometimes other people's) money. However, you should not forget that the performance of your investment can be evaluated only by the closed position. If you do not sell the previously bought shares - all your results remain only on paper, not on the brokerage account. That is why the question of closing a position has always been one of the key issues for me. And it was not easy to develop my approach, given my commitment to the fundamental analysis of stocks.

Benjamin Graham's idea of the craziness of the market has been of invaluable help to me. To understand Graham's philosophy, imagine that the market is your business partner "Mr. Market." Every day he stops by your office to visit and offer you a deal on your mutual company stock. Sometimes he wants to buy your stock, sometimes he wants to sell his own. And each time he offers a price at random, relying only on his gut. When he panics and is afraid of everything, he wants to get rid of his shares. When he feels euphoric and blind faith in the future, he wants to buy your share. That's the kind of crazy partner you have. Why is he acting this way? According to Graham, this is the behavior of all investors who don't understand the real value of what they own. They jump from side to side and do it with the regularity of a "maniac" every day.

The task of the intelligent investor is to understand the fundamental value of your business and just wait for another visit from the crazy Mr. Market. If he panics and offers to buy his stock at an extremely low price - take it and wish him luck. If he begs to sell him the stock and calls an unusually generous price - sell it and wish him luck.

To find out the fundamental value of a business (before buying only), I use Fundamental Strength Indicator (+ Cash Flow dynamics). But to understand the degree of Mr. Market's craziness, when buying stocks, I use the P/E ratio and the Rainbow Indicator, and when selling stocks, I use only the Rainbow Indicator.

As you can see, I have more filters for buying stocks than I do for selling them. Why is that? I think alpinists will understand me. The preparation for taking a new peak is always longer than the journey itself. Therefore, when I am already on the way (have an open position), it is too late to prepare for the mountaineering - it is necessary to use the "equipment" that will help me to reach the goal (to close the open position). In this situation, the Rainbow Indicator becomes my main helper.

In the previous post, I told you what the Rainbow Indicator consists of. Now let's look at the conditions of opening and closing a position according to the indicator.



So, the Lower Rainbow has four differently colored spectra: blue, green, orange, and red. Each one highlights the desired range of prices acceptable for buying in an Obverse situation. The blue spectrum is upper with respect to the green spectrum, and the green spectrum is lower with respect to the blue spectrum, etc.

- If the current price is in the Blue Spectrum of the Lower Rainbow, that is a reason to consider that company for buying the first portion (*) of the stock.
- If the current price has fallen below (into the Green Spectrum of the Lower Rainbow), that is a reason to consider this company to buy a second portion of the stock.
- If the current price has fallen below (into the Orange Spectrum of the Lower Rainbow), it is a reason to consider this company to buy a third portion of the stock.
- If the current price has fallen below (into the Red Spectrum of the Lower Rainbow), that is a reason to consider that company to buy a fourth portion of the stock.

(*) The logic of the Rainbow Indicator implies that no more than 4 portions of one company's stock can be purchased. One portion refers to the number of shares you can consider buying at the current price (depending on your account size and personal diversification ratio - see information below).

The Upper Rainbow also has four differently colored spectra: blue, green, orange, and red. Each of them highlights the appropriate range of prices acceptable for closing an open position.

- If the current price is in the red spectrum of the Upper Rainbow, I close one portion of an open position bought in the red spectrum of the Lower Rainbow.
- If the current price is in the orange spectrum of the Upper Rainbow, I close one portion of an open position bought in the orange spectrum of the Lower Rainbow.
- If the current price is in the green spectrum of the Upper Rainbow, I close one portion of an open position bought in the green spectrum of the Lower Rainbow.
- If the current price is in the blue spectrum of the Upper Rainbow, I close one portion of an open position bought in the blue spectrum of the Lower Rainbow.

This position-closing logic applies to both the Obverse and Reverse situations. In both cases, the position is closed in portions in four steps. However, there are 3 exceptions to this rule when it is possible to close an entire position in whole rather than in parts:

- If there is a Reverse situation and the current price is above the thick red line;
- If I decide to invest in another company and I do not have enough available cash to purchase the necessary number of portions;
- If I find out about events that pose a real threat to the further existence of the company (for example, a bankruptcy filing), I can close the position earlier, without waiting for the price to hit the corresponding Upper Rainbow spectrum.

So, the basic scenario of opening and closing a position assumes the gradual purchase of shares in 4 stages and their gradual sale in 4 stages. However, there is a situation where one of the stages is skipped in the case of buying shares and in the case of selling them. For example, because the Fundamental Strength Indicator and the P/E ratio became acceptable for me only at a certain stage (spectrum) or the moment was missed for a transaction due to technical reasons. In such cases, I buy or sell more than one portion of a stock in the spectrum I am in. The number of additional portions will depend on the number of missed spectra.

For example, if I have no position in the stock of the company in question, all conditions for buying the stock have been met, and the current price is in the orange spectrum of the Lower Rainbow, I can buy three portions of the stock at once (for the blue, green, and orange spectrum). I will sell these three portions in the corresponding Upper Rainbow spectra (orange, green, and blue). However, if for some reason the orange spectrum of the Upper Rainbow was missed, and the current price is in the green spectrum - I will sell two portions of the three (in the green spectrum). I will sell the last, third portion only when the price reaches the blue spectrum of the Upper Rainbow.

The Rainbow Indicator also helps calculate the number of shares that can be considered for purchase at the current price position in the Lower Rainbow spectra. To do this, you need to go to the indicator settings.

+ Cash in - Cash out +/- Closed profit/loss + Dividends - Fees - Taxes

Here I indicate the amount of funds deposited to my account, withdrawn from it, profit/loss on closed positions, dividends credited to the account, and taxes deducted from the account.

-Diversification coefficient

The diversification coefficient determines how diversified I want my portfolio to be. For example, a diversification coefficient of 20 means that I plan to buy 20 share portions of different companies, but no more than 4 portions per company (based on the number of Lower Rainbow spectra).

-The cost of purchased shares of this company (fees excluded)

Here I specify the amount of already purchased shares of the company in question in the currency of my portfolio. For example, if at this point in time, I have purchased 1000 shares at $300 per share, and my portfolio is expressed in $, I enter - $300,000.

-The cost of all purchased shares in the portfolio (fees excluded)

Here I enter the amount of all purchased shares for all companies in the currency of my portfolio (without commissions spent on the purchase). This is necessary to determine the amount of available funds available to purchase shares.

After entering all the necessary data, I go to the checkbox, by checking it I confirm that the company in question has been studied with the Fundamental Strength Indicator and the P/E ratio, and their values are satisfactory to me. No calculation is performed without the checkbox checked. This is done intentionally because the application of the Rainbow Indicator for stock acquisition purposes is possible only after studying the Fundamental Strength of the company and an acceptable P/E value.

Next, I click "Ok" and get the calculation in the form of a table on the left.



-Free cash in the portfolio

This is the amount of free cash available to purchase stocks. Please note that the price of the stock and the funds in your portfolio must be denominated in the same currency. On TradingView, you can choose which currency to display the stock price in.

-Cash amount for one portion

The amount of cash needed to buy one portion of a stock. Depends on the diversification ratio entered.

-Potential portions amount

Number of portions, available for purchase at the current price. Can be a fractional number.

-Cash amount to buy

The amount of cash needed to buy portions available for purchase at the current price.

-Shares amount to buy

Number of shares in portions available for purchase at the current price.

The table also contains additional information in the form of the current value of the company's market capitalization and P/E ratio.

Mandatory requirements for using the indicator:

- works only on a daily timeframe;
- the indicator is only applicable to shares of public companies;
- quarterly income statements for the last year are required;
- an acceptable for you P/E ratio is required to consider the company's stock for purchase;
- the Rainbow Indicator only applies in tandem with the Fundamental Strength Indicator. To consider a company's stock for purchase, you need confirmation that the company is fundamentally strong.

What is the value of the Rainbow Indicator?

- clearly demonstrates a company's profit and loss dynamics;
- shows the price ranges that can be used to open and close a position;
- takes into account the principle of gradual increase and decrease of a position;
- allows calculating the number of shares to be purchased;
- shows the current value of the P/E ratio;
- shows the current capitalization of the company.

In the next post, we will talk about how to use Rainbow Indicator on the examples of stocks of well-known companies. See you soon!