*This blog is approved for beginning stock market chefs.

It’s a well-known saying that money makes money, but how much money do you really need to make money? That’s a tough one to answer but perhaps we can gain some perspective on it by reframing it in more concrete terms such as: How difficult is it to make, say, $100 on a trade given a specific investment amount?

Now there’s many ways we can make our hundred bucks in the stock market. We can buy bonds, futures, stocks, or options and other derivatives. Since futures and bonds are outside the scope of my blog (at this time), we’ll be focusing on the other two—stocks and options.

As we shall see, the real reason that money makes money is because the larger your investment capital, the lower your trading risk. Money managers know that lower-risk trades are preferred, but lower risk usually comes with lower returns. There’s no such thing as a free lunch!

Everyone has his or her own comfort level on the risk/reward scale, and it’s up to you to know yours. If you’re not quite sure, the following table might help you decide how to position your trades.

Initially, I was going to lump both the stock and options discussions together in one blog, but I realized it was going to be too much so I’m splitting them up into two articles. Today, we’ll be looking at the trading risk profile for stocks.

Trading Table for Stocks
Below is a table that represents the trading statistics given a desired fixed outcome of $100 per trade. Yes, I know it seems obvious that the larger your trading capital, the lower your trade risk, but I bet many people don’t actually realize how much of a risk they’re taking on by using smaller trading amounts. Let’s take a look at the actual numbers:

The table shows that in order to make $100 on a $500 investment, you’ll need the stock to move 20% which is also the amount of investment risk that you’re be taking on. Are you comfortable with that?

Compare this with trying to make $100 with a $5000 investment. Here, the stock only needs to move 2% to attain your desired return.

What do you think is an easier goal to attain, a 2% stock move or a 20% stock move? If you can answer this correctly, you have all the knowledge you need to be a day-trader. Successful day-traders know that they can make significant amounts (generally $50-$200 per trade) on very small stock moves. In day-trading parlance this is known as scalping.

But I digress.  The point is that to make money on a small move requires a big investment. My day-trading teacher (way back when!) insisted that one should start with at least $50,000 in trading capital—any less and you risk losing all of it before they you the hang of day-trading. (I got out because I found after two months of paper trading that I didn’t have the stomach for it and couldn’t imagine putting my own money on the table.)

All or none?
The real question that capital-limited traders need to ask themselves is this: Should I risk all of my investment capital on one trade or spread it around among several?

Again, the answer to this isn’t cut and dried. I say that if you have less than $500, risk it all on one good trade until you can build up your trading account. The caveat here is that you must be absolutely diligent in setting a tight stop/loss, not risking more than 5% and going for a 20% gain may be an unreasonable goal except in violently trending markets. If you set a looser stop/loss and incur a string of losses, you could be forced out of the game in no time.

The big, bad brokerage fees
The numbers in the above table do not include trading commissions or other fees, and this is something that those of you with small trading accounts need to consider. If your broker charges you $20 per trade and you want to net $100 on a $500 investment, you’ll need the stock to move 28% instead of 20% (you’ll need $40 extra to cover the buy and the sell commissions). I know that TradeStation and Interactive Brokers (I have no affiliation with either one) offer lower commissions than most of the other popular online brokers, but do your own research and go with the one you feel most comfortable with.

Tomorrow I’ll do the same analysis for options which isn’t nearly as straightforward. Beginning options traders especially may want to tune into this one!

Today while surfing the market, I tripped over the chart of Jones Soda (JSDA).

Jones Soda…hmm….hadn’t that been one of Jim Cramer’s darlings a couple of years ago? Looking back at his predictions (culled from the Lightning Round blogs on SeekingAlpha.com), Jim felt that the stock was undervalued in December of 2006 and initiated a long position near $11. He stopped adding to his position just after the stock began its precipitous fall from its $35 high in April of 2007, but he didn’t publicly pull the plug on the trade until November 5th when it was trading just under $9, about $2 short of  his initial purchase price.

Despite the fact that Jim claims he knows how market technicals work, if he had understood the first thing about support and resistance levels, he would have known when to initiate his long position, when to add to it, and when to begin unwinding it. And if Jim was a shorting man, he could have eventually made a boatload on the down side, too.

The chart of Jones Soda clearly illustrates how to use support and resistance levels to your trading advantage.

Let’s a take a look at the company’s daily chart around the time of its all time price high in April of 2007. Key trading dates are identified by numbers; the lines represent support/resistance.  Click on image to enlarge.

Trading strategy
Below is a summary of how one might use support/resistance levels to enter and exit both long and short positions on Jones Soda. Entry and exit points are identified by the numbers in the above chart. Please note that all prices mentioned in the following discussion reflect end of day quotes.

#1 (12/22/06): Cramer touted this stock in his CNBC “Mad Money” show the day before causing the stock to break out of an eight month base. Although it’s sometimes difficult to know if a stock move is “real” versus a potentially short-lived phenomenon created by the so-called Cramer Effect, the 13% jump on much higher than average volume is a good indication that the move contains more of the former element rather than the latter one.
Action: Buy partial position at $12.11/share.

#2 (3/9/07): The company handily beats earnings estimates and pops up 19% on the open.
Action: Add to position at $17.13.
Price difference from previous point: +$5.02 (41% gain)

#3 (4/26/07): Following the its all-time high of $35.60 on 4/16, the stock retreats. Note the massive volume accompanying this high along with the topping tail on the candlestick. The next day, the stock tumbles, also on high volume. All of these are early warnings that investors are beginning to sell. The stock then tests the $25 level before it pierces it on 4/26.
Action: Short-term traders should begin taking profits at $24.11. (Note that this is the day where the 20-period CCI (commodity channel indicator) crosses into negative territory.) Longer-term traders may wish to wait for further downward confirmation.
Price difference from previous point: +$6.97 (41% gain)

#4 (5/10/07): Technically, the stock broke this resistance level on 5/4 after it missed earnings but rebounded briefly before breaking this level decisively, closing at $21.55.
Action: Short-term traders should exit most of their positions; longer-term traders should begin unwinding their holdings.
Price difference from previous point: -$2.56 (11% loss)

#5 (5/29/07): The $20 major support level is broken on higher than normal volume. Note that the longer period 50-day CCI is now solidly in bearish territory.
Action: All long positions should be exited at this point and a short position can be initiated at $19.38.
Price difference from previous point: -$2.17 (10% loss)

#6 (6/12/07): Support is again broken.
Action: Short sellers can add to their positions at $16.37.
Price difference from previous point: -$3.01 (15% loss)

#7 (8/3/07): The company misses earnings for the second quarter in a row. Note the huge spike in volume.
Action: Short sellers can add to their position at $11.35.
Price difference from previous point: -$5.02 (31% loss)

(Not on the chart) The Stock reaches its low (1/2/09): From here, the stock breaks another key support level at $10 for the first time on 9/6/07. It recovers briefly before breaking it again on 10/29/07. From here on out, the stock continues declining, taking more than 14 months before it finally finds its bottom on 1/2/09 at 30 cents, down 99% from its peak value!
Action: Had you been lucky enough to hold onto your short position for this long and cover it, you would have realized a gain of $11.05 from point #7 for a gain of 97%.

Strategy comparison
Jim jumped into this trade on 12/21/06 and didn’t unload his position (at least not publicly) until 11/5/07. Assuming these entry and exit points, here’s how his fundamentally-based strategy performed versus ours based purely on support and resistance levels. In our strategy, I’ll be taking only full positions at entry and exit points to simplify the calculations.

Cramer’s Strategy
Buy price (12/21/06): $10.65
Sell price (11/4/07): $ 8.85
Profit/loss -$1.80 (17% loss)

Our long strategy (based on Entry points #1& #2):
Buy full position either at:
#1: Buy price (12/22/06): $12.11
#2: Buy price (3/9/07): $17.13

Sell at Point #3 (4/26/07) at $24.11
Entry #1 Profit: $12.00, 99% gain
Entry #2 Profit: $6.98, 41% gain

Sell at Point #4 (5/10/07) at $21.55
Entry #1 Profit: $9.44, 78% gain
Entry #2 Profit: $4.42, 62% gain

Sell at Point #5 (5/29/07) at $19.38
Entry #1 Profit: $7.27, 60% gain
Entry #2 Profit: $2.25, 13% gain

You can see that even if we had missed some of the earlier entry and exit points, we still would have made money. I won’t go into calculating profits on the short side but you can see that a short-seller would have had a field day with this stock, possibly netting up to $20/share.

Conclusion
My goal for today’s blog was not to rag on Jim Cramer (although it is fun to do on occasion), but to show you how to use support and resistance levels as an entry and exit strategy. In the interest of full disclosure, not every chart has such clearly defined support/resistance levels, but with practice you’ll soon be able to identify even the less obvious areas of price consolidation and be able to incorporate them into your own trading schemes. Happy trading!

Addendum: What prompted me to write about Jones Soda was the action in today’s chart: a huge bottoming tail accompanied by explosive volume, typically a sign of major short-covering. According to today’s news, I see that the company is being courted as a possible take-over candidate. Although the current deal is for about half of the company’s market value, it is a positive sign that someone is interested in the business model.

If this is the case, the stock could soon rocket in the other direction. You risk-takers out there might consider tossing a few schekels at this trade if it rebounds tomorrow. Considering that the price per share is less than the price of one of their sodas, this could be one trade that’s easy to swallow!

It’s been clear in doing my daily *Blue Plate Specials* that low-priced stocks have been leading the pack both in price appreciation and in trading volume. For many stocks, volume increases have been huge–on the order of five to as much as fifty times normal–which can only mean that institutions are gobbling them up.

This tactic was echoed by Henry McVey, the head of Global Macro and Asset Management at Morgan Stanley, who said in a CNBC interview last week that his firm is currently targeting undervalued companies with high growth potentials. (McVey defines “high growth” as companies with annual sales growth > 15% and top line growth > 5%.) Although “undervalued” does not necessarily equate to “low-priced,” the following discussion will show you that at least for right now, it’s the lower priced stocks that are stealing the limelight.

To find out more, I went to MSN MoneyCentral where they have a Power Screener that finds those stocks with increased institutional interest in the past month. (Note: I don’t have any affiliation with MSN and chose this screener because it’s free and available to everyone.) Below is a list of the top 50 stocks generated by the screener as of this writing (12/07/09).

Institutional Ownership up since last month ranked according to % price change:

Click to enlarge

Table Observations
All of these stocks are up at least 37% from their price a month ago with the top 23 stocks up more than 50%! So what, if anything, do these issues have in common?

1. Micro-Small cap stocks: Most of these companies fall into the micro (<$250 million) and small ($250 – $1 billion) market capitalization categories. Of the top fifty, only four are over $1 billion and then not by much.

2. Under $10. Obviously, low-cap stocks typically trade at low prices. Over half (27) of the above listed issues trade under $8; 47 trade under $20; and the other three trade below $40. It seems as if Wall Street is looking to make up for lost revenues just like the rest of us.

3. Sector specific: What’s interesting about this list is what sectors aren’t represented. The commodities (metals, mining, and basic materials) sector that has been on fire as of late is virtually absent from the list. The exceptions are the junior Canadian firms with the five letter stock symbols. Of these seven, three are involved in metal and mineral exploration (GBBRF, IPMLF, CPQRF), two are involved with pulp and timber (IFSPA and CFPUF which is a trust with a nice 5.2% dividend yield) and one is involved with oil and gas exploration (CDDRF). Perhaps these lesser known names still have price appreciation potential as compared with their higher-priced and more well-known compadres such as Freeport-McMoran (FCX) and Rio Tinto (RTP). The other energy names on the list fall into the alternative energy category (wind, solar, biofuels) which is a sector with a large expected growth potential.

Institutions may also be buying on takeover speculation. The hot takeover sectors include biotech of which there are four in the $4-$6 range (SNTA, CYTX, NABI, KERX) and regional telecoms of which the two, CTEL and MXT, are foreign-owned and operated. Takeover speculation could also be a consideration factor in some of the other sectors especially the airlines and the semiconductors.

While the agricultural sector has been hot for the larger domestic companies, the Chinese equivalents may be greatly undervalued. Underestimated valuations could be one good reason for the presence of so many Chinese firms on the list.

For some, I couldn’t find any good reason why they should have made the list. Take for example La-Z-Boy. Sure, the stock reclined more than it should have during the height of the recession but I’m wondering if there’s more to it than meets the eye–perhaps it’s a play on the aging of the baby boomer generation?

4. New companies: Roughly half of these companies have been trading on US exchanges for less than 5 years. (Some of them represent Chinese firms and have only recently begun to trade in the US.) Institutions know that it’s the nascent companies with exciting new products that typically offer the most room for growth.

5. Unfairly beaten down?: Skimming through the charts of these companies, I found many of them whose share prices suffered significantly during the recent recession. Money managers probably realized that many of them were more than unfairly beaten down and are now scooping these unloved orphans at still discounted prices.

Should we follow their lead?
Many of the stocks on the above table have been on my radar screen for a while and make frequent appearances on my daily Blue Plate Specials. Whether one should rush out and buy them is of course a personal decision to be made after doing your own research and analysis. Right now, the market seems to want to go higher but there’s been a definite lack of conviction. After the holidays the forecast might be clearer and then I, for one, will be much more confident of following in the footprints of the professionals. 

Further thoughts
I’m sure there are other reasons for the pronounced institutional interest in the low-priced spreads but they’re not including me in on their reasoning. One thing, though, that they are letting us in on is their emphasis on commodities, especially  metals. In his interview McVey said that he thinks that commodities are the new real-estate for that’s where the future price appreciation is going to take place due to increasing demands in the emerging markets as well as a hedge against the falling greenback. He’s certainly not alone in these views!