If you are actively involved in
trading or investing, it’s inevitable – someone will ask you, “How do
you pick a stock?” The corollary is that those who like to watch Jim
Cramer won’t wait to be asked. They have stocks they want to tell you
all about. Followed by a “booyah” or two.
If you’ve been trading for any length of time with any measure of
success – then you likely have your own system. Maybe you’ve taken the
time to write it down for meditation and refinement. This is one man’s
hack at that. My system uses a trading timeline of usually at least a
week, but the position could last much longer or be closed quickly. It
could be called swing trading, it could be trend following. I’m
not a day trader – I have a real job that I really enjoy and can’t/don’t
want to follow every tick of the market.
Notably absent from this discussion will be when to close the
position. Profits, of course, are locked in at the close of the trade –
but really they are set up when the trade is initiated. Entry into any
position must also include firm and clear expectations, with
contingency plans if things turn out otherwise. Those considerations
will have to be the topic of another article.
Today, I’ll write from the bullish perspective – but this method can
be inverted to identify shorts also.
1. Market Supply and Demand: I always start here.
Are buyers or sellers in control right now? Is the tide changing? My
tools for measuring this are bullish percents and cumulative market breadth. If the New York Stock
Exchange bullish percent is rising, then demand is overpowering supply
and prices must rise over time. The reverse is also true – a falling
NYSE bullish percent with supply overwhelming demand will lead to lower
prices. The turning points take some care to navigate, but established
trends (especially as they pass the 50% mark in either direction) make
for high confidence. By the way, if you don’t understand how bullish
percents work I highly recommend Tom Dorsey’s excellent book “Point and Figure Charting“. I also mention
cumulative market breadth, of which McClellan breadth is a variation. This is a faster
moving indicator than the NYSE bullish percent, and serves as a good
confirmatory reference. Again, the trend is key: I prefer the weekly
chart of cumulative market breadth compared to a 5 to 10 week moving
average. Cumulative market breadth above the moving average shows that
buying pressure is causing stocks to rise. These indicators should
tell me which side of the market to be on: long, or short. If
supply is in control, I don’t want to look to buy long positions – I’d
be swimming upstream!
2. Sector Supply and Demand: Same method and tools
listed above for the broader market, applied to the sectors. Just
because the broader market is controlled by demand or supply, doesn’t
mean that all the sectors are experiencing the same bull or bear
market. The exercise of looking at bullish percents or cumulative
breadth trends within each sector often doesn’t so much identify which
sectors to invest in, as which sectors to currently avoid.
3. Sector Relative Strength: Having determined which
side of the broader market to trade on, and narrowed down which sectors
are of immediate interest – I want to focus on the best and strongest sectors. Better and stronger
sectors will gain value faster than the overall market, as well as their
peers. Put another way, if you’ve got a sector that shows demand to be
in control within a bull market – but it’s not outpacing the market –
maybe you should put your money elsewhere. I should note that this
isn’t an eternal chasing of performance. I don’t want to be late to the
party, but I’ll try to figure out which one looks like it’ll be more
fun and then hang out there.
4. Screen for Fundamentals: Quality over penny stock
speculation here. You may have your own fundamental criteria for
ratios like P/E, or you may prefer to use the ratings of a research firm
like Standard and Poors. Although the suspect and capricious debt
ratings of S&P may be partially to blame for the housing bubble and
subsequent recession, their company reports can help to weed out
companies with obviously bad balance sheets. It can be a bit of a
beauty pageant to determine which of several leading companies have the
strongest fundamentals, but the rest of the trailing pack is often
easier to sideline. Many online brokerage sites will give you access to
these sorts of reports, I like to look at (on the long side) S&P
four and five star rated companies.
5. Individual Supply and Demand: By this time I
generally have a short list companies to consider, from a few to a few
dozen within any given sector. Here I like to look at all the charts
iteratively and in somewhat quick succession. This helps me to identify
trends within the group, and also outliers. The first thing I’m
looking for is a buy signal on the point and figure chart. I like
P&F charts, as they clean the noise out of a chart and help “see the
forest for the trees.” I’m also starting to eyeball if there are clear
entry/exit points on the chart, but there will be more on that in #7,
“Support and Resistance”. Before moving closer to buying, I really
would like to see that the chart is on a P&F buy signal, for that is
a clear and unambiguous identification that demand is overpowering
supply and driving prices higher.
6. The Trend is Your Friend: From the point and
figure chart, I’ll move to looking at a weekly and then a daily
candlestick chart. This part isn’t voodoo, it’s just being able to note
the intermediate and short term trends. I don’t want to fight the
trend. If I’m looking to buy, I want a weekly chart that shows
steadily increasing prices. Perhaps the chart fell recently (right
now, most have). Since the fall, has the bleeding stopped? Has it
established an unambiguous uptrend since bottoming out? Is the overall
line sloping up or down? Here’s my favorite: if I didn’t
believe the market was currently controlled by demand, would I be
willing to short this stock? That question right there can
really shake up the decision process and weed out “wish trades.” This
step and the previous is where I dismiss a lot of charts. It’s common
to be afraid to miss out on a lucrative entry – but lost opportunity is
always preferable to lost capital.
7. Support and Resistance: This step could also be
titled risk vs reward. It is key to identify where I want to enter and
then eventually leave the position. Chances are (and I’ve made this
mistake often), RIGHT NOW IS NOT THE BEST TIME/PRICE TO INITIATE THE
POSITION. Think about it – what are the chances that this process of
research has not only identified the right stock, but you are also
coincidentally poised at the ideal time to buy it? This occasionally
happens, or you could be near the right price. In this game you want
every advantage possible. Again, lost opportunity is always preferable
to lost capital. It’s far better to have entry orders never execute
because the stock never met your limit price, than to buy immediately
and find that it was really at an inflection point and now in a
downtrend. Bottom line – if the stock has been wiggling in a channel, I
should wait and try to grab it at the next swing low. If it’s in a
steadily plodding up trend, then I don’t wait for a dip that may not
happen.
8. Insider Trading: I don’t start my process at
insider trading, but I like to look here to identify potentially hidden
gems. The only insider trades that will really catch my attention is
unusually large purchases – I don’t care about award of options, small
purchases, or even sales. On the bullish side, insider buying can be a
real confirmatory signal. Look, if some director or vice president
recently parked a large amount of personal cash in their own company’s
stock – then I’ll share some of that confidence and possibly prioritize
this trade. If there are no insider buys on record, or even just sales,
that won’t stop me from buying. Why don’t I care about insider sales?
It’s doesn’t send the same clear message as buying. Who knows why they
sold (perhaps even a large amount of shares)? Maybe she’s buying a
McMansion, perhaps he has to pay his kid’s college tuition, or somebody
just bought a yacht. Can’t tell from the SEC filing.
9. News and Rumors: Has there been a recent,
dramatic price move by the stock I’m considering? A gap up or sudden
cliff, followed by trading in a tight range? Check the headlines. It
could be that there’s something that the market knows about this company
that you don’t. These events could drive it to temporarily outperform
the market, but that pace may not be sustained. You have heard the
axiom, “buy the rumor, sell the news”. That’s great if you’re in a
position to know the rumor in advance. I don’t try to find those “hot
tips”, but I do try to have a general idea of what’s driven unusual
price activity. If it’s not abundantly clear, I’ll avoid initiating
that position. Many times a crisis could have driven a stock way down,
but once the storm has cleared the chart will pick up its previous
uptrend. That’s actually a really nice setup, because that publicity
spotlight serves to expose many of the dark corners of the company’s
operations – and they could be stronger after the housecleaning. For
this reason I’m watching BP.
10. Company Calendar: This is one last sanity check
before initiating a position. Is the company about to release a
quarterly earnings report, and do those reports have a history of
driving large price moves? Is the company involved in a widely
publicized class action lawsuit with a verdict expected any day now? Is
the stock I’m considering shorting a big dividend payer, and about to
go ex dividend? Those first two considerations may actually be reasons
to initiate the position before the news release, but then I have to ask
whether I’m gambling or trading. The dividend question is one to
consider on both the long and short side – and it could be the decision
point, or no big deal. A few minutes research can prevent being left
holding the bag.
You’ll note that nowhere in this list is “company was the topic of a
cover story”, “bottom fishing at the new 52 week low”, or even
“mentioned by Jim Cramer”. Especially not the latter.
I welcome your comments and insights, thanks for reading. Please
feel free to subscribe
to my writing at AbjectAvarice.com
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