Book Reviews, Trading

Book Review of Stan Weinstein’s Secrets for Profiting in Bull and Bear Markets

I first learnt about this book from David Ryan’s reading list quoted in Jack Schwager’s Market Wizards. This is a good book in many aspects:

  1. It presents simple concepts in an organized manner with lots of examples
  2. There are quiz questions at the end of each chapter to test your understanding
  3. It presents a complete system for trading, covering entry/exits, stop losses, etc.
  4. It presents the key concepts for trading without cluttering the material with lots of nitty gritty patterns which typically just confuse readers.

One area that I felt can be beefed up more though is on money management, position sizing, and how to size continuation trades.

The trading methodology taught by Sam Weinstein is of the same style as that of Jesse Livermore and Nicolas Darvas. Basically, identify the market trend, identify strong industry groups, identify strongest individual stocks within the strong industry groups. Buy into stocks where all 3 directions (market, group, stock) are in agreement. Those criteria give you the edge, while stop losses manage the downside.

As you will read later below, Sam Weinstein uses the following 5 basic tools to analyze the individual stock.

  1. Little obstacles in the stock’s path: Any nearby support/resistance
  2. Performing better than the market and improving: Relative strength (relative to market, not the RSI)
  3. Stock moving into an uptrend: Stage analysis using 30-week MA
  4. Stock breaking out of resistance: Support and resistance using horizontal and trendlines
  5. Volume confirmation: Significant increase in volume on breakouts

One problem with implementing exactly the system in the book is that a number of indicators may not be readily available on the mainstream websites or the data may not be tracked publicly. For example, the Mansfield 30-week MA uses a proprietary formula (close approximation here), the Momentum Index defined here is not plotted in any chart service, etc.

Nonetheless, the ideas in the book remain valuable and the book is definitely recommended reading for the trader starting out.

The Basics

Definitions

  • Types of players
    • Trader: Catches 2 – 4 month moves
    • Investor: Catches 12 month moves
  • Time frames
    • Short term: Cycles that last 1 – 6 weeks
    • Intermediate term: Cycles that last 6 weeks – 4 months
    • Long term: Cycles that last 4 – 12 months
  • Pullback: Price of stock goes back close to the initial breakout / breakdown point
  • Relative Strength:
    • Basic formula
      • Price of stock / Price of a market average
    • Advanced formula
      • Let X = Price of stock / Price of index
      • RS = (X / SMA(X, 52 weeks, weekly frequency) – 1) * 100
      • Essentially this variable is comparing its relative strength with the SMA of the relative strength. It is 0 if it is equal to its SMA, positive if stronger than SMA, negative if weaker.
    • AAII formula
      • AAII has a Relative Strength formula that gives a value of 0 when they are of equal strength, a positive value if the stock is stronger, and a negative value if the stock is weaker.
      • ((New stock price / Old stock price) / (New index price / Old index price) – 1) * 100

Support and Resistance

  • The more times a support/resistance zone is tested, AND the longer the time period during which the testing takes place, the more important the signal when the zone is violated.

Trendlines

  • A significant trendline will be touched at least 3 times.
  • The steeper the trendline slope, the less meaningful is the breakout / breakdown.

Moving Average

  • A 30-week MA is the best for long-term investors, and 10-week MA is the best for traders.
  • These MA takes the average of the closing price of the Fridays each week, not the daily prices.
  • Stocks trading below their 30-week MA should never be purchased.
  • Stocks trading above their 30-week MA should never be shorted.

Breakouts / Breakdowns

  • The greater the expansion of volume on the breakout, AND the longer the time spent below the resistance, the more significant it is.
  • Breakdowns do not require volume to be significant, although a volume increase makes it even more significant.
  • Compare the breakout / breakdown with the long-range history (over many years), it is especially favourable if it is in “virgin territory”.

Relative Strength

  • Don’t consider buying the stock if the RS is in a downtrend, even if it breaks out.
  • Don’t consider shorting the stock if the RS is in an uptrend, even if it breaks down.
  • Watch for the RS moving from negative to positive, this is bullish. Vice versa for the other direction.
  • Thomas Bulkowski did some very interesting research on relative strength. You can find the general results here, including results for industry relative strength here. His research basically supports buying stocks with rising relative strength, and industries with high relative strength. They lead both on the upside in a bull market, and on the downside in a bear market, so they are prime candidates for both the bull and bear positions.

Stages of a Major Cycle

  1. Stage 1 – Basing Area
    • Volume: Usually dries up.
    • Price: Criss-crosses with the 30-week MA, usually below the MA as the MA flattens.
    • Signs of moving to Stage 2: Volume starts to expand but prices no longer moves down. Price breaks above resistance and MA with increasing volume.
    • Opportunity: Usually at least 1 pull back to near the breakout point after the initial breakout rally. This is a low-risk buy point. The reason why it is low-risk is because you would be able to see the strength of the breakout and the pull back. [if you bought your entire position at the breakout and set a stop below the resistance, there is no point buying again. If you didn’t buy at the breakout or bought half your position, it may be worth considering entering here.] 
  2. Stage 2 – Advancing Phase
    • Price: Maintains above the 30-week MA, with higher lows. In Stage 2, the later it is the more volatile the price swings because buyers panic more on reactions.
    • Signs of moving to Stage 3: Price starts to converge with MA.
  3. Stage 3 – Top Area
    • Volume: Usually heavy.
    • Price: Choppy, criss-cross with the MA.
    • Meeting of the excited herd buyers vs. the aggressive sellers that bought at much lower prices.
    • Signs of moving to Stage 4: MA stops rising, price breaks below support.
    • Opportunity: Get Out! If you want to stay, take profits on half the position, and set a stop below the latest support level.
  4. Stage 4 – Declining Phase
    • Price: Below MA, lower highs.
    • Opportunity: Get Out!

Bigger the Base, Bigger the Move

  • The longer a stock is in Stage 1, the stronger the move later.
  • This is because a lot of stock has changed hands many times during the extended period, including disenchanted holders that hoped to get out at break-even but finally gave up. This reduces the amount of overhead resistance.
  • Stocks that have steadily risen 40-50% before breaking out do the best, rather than stocks having wide swings in Stage 1.

Overall Strategy for Both Long and Short

  1. Check the market indicators for overall direction.
  2. Scan the industry groups to know which ones to focus on.
  3. Choose those few stocks with the most potentially profitable formations within those favourable groups.

Going Long

Criteria

  • Market trend
    • Bullish
  • Industry group
    • Bullish, look for industry group breaking out from Stage 1 to 2, or already in Stage 2, with minimum resistance overhead.
    • Stocks having the same bullish chart, may perform very well in a bullish group but so-so in a bearish group.
  • Individual stock
    • Overhead resistance: Preferably no nearby overhead resistance, clear blue skies are the best!
    • Price: Breaks out above resistance.
    • Stage: Going from Stage 1 to 2. Price above 30-week MA. MA flat or increasing. Beware of buying too late in Stage 2.
    • Relative strength: Trending higher. If crosses from -ve to +ve, even better.
    • Volume: Significant increase on breakout. Volume on breakout day at least 2x the average volume of the prior week, or one-week volume spike at least 2x the average volume of the past month, or volume over the past 3-4 weeks at least 2x the average volume of the past several weeks with some increase on the breakout week.

Buying Pullbacks

  • After a strong breakout, if the price pulls back closer to the MA, with volume significantly contracting, that is another good entry point.

Continuation Buys

  • Only if a consolidation pattern forms above the increasing MA and then a new breakout occurs.

Buy Orders

  • Use a buy-stop-limit good-’til-cancelled order, the stop is set 1/8 above the breakout level, the limit is set 1/4 above the stop.
  • If volume is favourable on the breakout and contracts on the decline, buy your other half position on a pullback toward the initial breakout.
  • If volume is not significant on breakout, sell the stock on the first rally, or sell when it breaks below the breakout level.

Stop Loss Orders

  • Use a sell-stop good-’til-cancelled order if trading on a liquid exchange / stock. This will turn into a market order and not a limit order. You want out and can’t be choosy.
  • For OTC markets with low liquidity, get a broker that can implement it manually.
  • If the sell-stop is near a round number, set it just under the round number, because people like to put buy orders at round numbers. This works for halves as well, especially for prices under $20 (e.g. $16.50).
  • For Investors
    • First sell-stop set below the bottom of the trading range (just below support).
    • When the next support level is determined, raise the sell-stop to just below the MA point that was below the new support level. If the support level is below the MA, set the sell-stop just below the support level.
    • When the MA stops rising and flattens out (i.e. Stage 3 top is forming), raise the sell-stop to just below the most recent support level.
  • For Traders
    • Breakouts that are going to be big winners almost never pull back more than 4-6% below the breakout point.
    • Set the initial stop under the closest support level, or 4-6% below the breakout level.
    • When the next support level is determined, raise sell-stop to just below the support level. Ignore corrections of less than 7% when determining support.
    • When the MA stops rising and flattens out (i.e. Stage 3 top is forming), raise the sell-stop to just below the most recent support level.
    • If there is a valid trendline (3 points), you can raise the sell-stop for half your position to just below the trendline during the period before the next support level has been determined (hence the sell-stop can change day-to-day following the trendline). The sell-stop for the other half of your position remains at the sell-stop set at the previous support. When the next support is found, raise the sell-stop for the full position to just below the support found.

Going Short

Criteria

  • Market trend
    • Bearish
  • Industry group
    • Bearish, look for industry groups that have broken below their 30-week MA, going from Stage 3 to Stage 4.
  • Individual stock
    • Support below: Preferably no nearby support below.
    • Price: Breaks down below support.
    • Stage: Had a strong Stage 2 advance, preferably with little stopping along the way (which creates support which is bad for shorting). Going from Stage 3 to 4. Price below 30-week MA. MA flat or decreasing.
    • Relative strength: Trending lower. If crosses from +ve to -ve, even better.
    • Volume: Not important, but if volume increases, that makes it even more negative.

Shorting Pullbacks

  • Don’t wait for pullbacks to short, because stocks typically drop down fast and seldom pulls back.

Continuation Shorts

  • Only if a consolidation pattern forms below the declining MA and then a new breakdown occurs.

Sell Orders

  • Use a sell-stop-limit good-’til-cancelled order, the stop is set 1/8 below the breakdown level, the limit is set 1/2 below the stop (its 1/2 for the short instead of 1/4 for the long because of the uptick rule, since the stock will have to go up first, that increases the risk of shorting, so a 1/2 is used to ensure that the stock drops down more convincingly).

Stop Loss Orders

  • Use a buy-stop good-’til-cancelled order if trading on a liquid exchange / stock. This will turn into a market order and not a limit order. You want out and can’t be choosy.
  • If the buy-stop is near a round number, set it just above the round number, because people like to put sell orders at round numbers. This works for halves as well, especially for prices under $20 (e.g. $16.50).
  • For Investors
    • First buy-stop set above the top of the trading range (just above resistance), should not be too far (30-40% is no-no) away.
    • When the next resistance level is determined, lower the buy-stop to just below the MA point that was above the new resistance level. If the resistance level is above the MA, set the buy-stop just above that resistance level.
    • When the MA stops declining and flattens out (i.e. Stage 1 base is forming), lower the buy-stop to just above the most recent resistance level.
  • For Traders
    • NEVER stay with a short position that moves above its 30-week MA, even momentarily.
    • If there is a prior peak very close to the breakdown level, use that as the initial buy-stop. Else, set the initial buy-stop 4-6% above the breakdown level.
    • When the next resistance level is determined, lower buy-stop to just above the resistance level. Ignore oversold rallies of less than 7% when determining resistance.
    • When the MA stops declining and flattens out (i.e. Stage 1 base is forming), lower the buy-stop to just above the most recent resistance level.
    • If there is a valid trendline (3 points), you can lower the buy-stop for half your position to just above the trendline during the period before the next resistance level has been determined (hence the buy-stop can change day-to-day following the trendline). The buy-stop for the other half of your position remains at the buy-stop set at the previous resistance. When the next resistance is found, lower the buy-stop for the full position to just above the resistance found.

Diversification

  • 5-6 stocks for a small portfolio ($10,000 to $25,000)
  • 10-20 stocks for a larger portfolio (>$100,000)
  • Diversify across industry groups if possible.

Theories Best To Be Ignored

  • To move from Stage 1 to Stage 2, the price should go down with a spike in volume to show final panic dumping, followed by a shrinking of volume to show lessening selling pressure.
  • Volume is not a good indicator of future upside potential for head-and-shoulder bottoms.

Patterns

Four-year Presidential Cycle

  • Election Year: +ve
  • Election Year + 1: -ve
  • Election Year + 2: -ve 1st half, recovery in 2nd half
  • Election Year + 3: +ve

Days of the Week

  • Mon: Worst, -ve
  • Tue-Thu: +ve
  • Fri: Best, +ve

Swing Rule

  • Swing Up
    • A = Peak price (i.e. resistance level) made just before an important decline sets in
    • B = The next low price (i.e. support level) at the bottom of the important decline.
    • After the stock recovers and moves past price A, the near-term target price is A + (A – B), i.e. the height from A to B is projected upwards from A.
  • Swing Down
    • A = Support price made just before it shoots up.
    • B = Peak price reached by the stock before it drops down below A.
    • The near-term target price will be A – (B – A), i.e. height from A to B is projected downwards from A.

Head and Shoulder Top

  • Volume is usually lighter on the right shoulder rally. Don’t trust the formation if the heaviest volume appears on the right shoulder, because if that much buying power is still present, there is a high probability that the formation will prove a short seller’s trap.
  • The bigger the top (from neckline to peak), and the longer the formation takes to form (hence trapping more buyers that will contribute by panic selling later), the bigger the drop.

Long-Term Indicators

Stage Analysis

  • Track the 30-week Simple Moving Average of the Index with weekly closing prices to determine the market’s Stage.

Advance-Decline Line

  • Change in the A-D line = Previous A-D line value + no. of advancing issues – no. of declining issues
  • Signs of a new bear market
    • Non-confirmation: New high on the Index without a corresponding new high on the A-D line.
    • Negative divergence: Index charges ahead but the A-D line loses upside momentum.
    • A-D line will peak first because money moves from secondary stocks into higher-quality blue chips (no. of blue chips is less than no. of secondary stocks), so Index will continue moving up while A-D stops rising.
    • NYSE A-D line reaches its ultimate peak 5-10 months before the blue chips top out.
  • Signs of a new bull market
    • Positive divergence: Index reaches ultimate low, but A-D line continues to move lower.
    • Index refusing to drop further shows some sectors are shaping up even while others continue to go down. Buyers initially gravitate toward the quality issues while shunning the more speculative ones.

Momentum Index (MI)

  • Calculate each day’s NYSE advance-decline figures, i.e. value = no. of advances – no. of declines (this is not the same as the A-D line)
  • Momentum Index (MI) = 200-day moving average of each day’s value (this will fluctuate around zero)
  • Important signals
    • Crossing of the zero line in either direction.
    • The longer the indicator has been deep in +ve/-ve territory, the more significant the move when it crosses the zero line.
    • In a bull market, the MI will almost always reach its peak before the Index does.
    • In a bear market, the MI are somewhat late in signalling, and acts more as a confirming signal.

New Highs and New Lows

  • Track the number of new highs and new lows of common stock (exclude preferreds) on a weekly basis.
  • High-Low Differential (HLD) = No. of new highs – No. of new lows
  • Important signals
    • If the HLD is consistently positive, that is favorable.
    • If the HLD is consistent negative, that is unhealthy.
    • Positive divergence: Index trends down while the HLD trends up. HLD shows subsurface technical strengthening.
    • Negative divergence: Index trends up while HLD trends down. Tipping off a bear market.

International Stock Markets

  • The most profitable moves occur when the overwhelming majority of world markets are in agreement.

Dominant Listed Company

  • At that time, General Motors (GM) was dominant.
  • Apply Stage Analysis to GM.
  • If GM does not make a new high (or low) within 4 months, it is a signal that GM’s prevailing trend is reversing. If this does not agree with Stage Analysis, stick with Stage Analysis.
  • GM’s change in trend is an early signal for the market.

Price / Dividend Ratio

  • Calculate the price/dividend ratio for the Index.
  • Ratio above 26 is dangerous, above 30 means stocks are extremely overvalued.
  • Ratio declining towards the 14 to 17 area means stocks are undervalued.
  • This needs to be used as a confirming indicator in conjunction with other timing gauges.

The Financial Press (Contrary Opinion)

  • Markets top out on good news, and hit bottom on bad news.
  • Leading financial magazines / newspapers tend to show cover stories and headlines, opposite of what is going to happen, near the peak or bottoms.

Playing Other Instruments

Funds

  • Stage analysis can be used to switch in and out of mutual funds.
  • Traders may want to use a 30-day MA instead of a 30-week MA.

Options

  • Buy a call option only on a stock that is in Stage 2 or is moving into Stage 2. Buy a put option only a stock that is in Stage 4 or is moving into Stage 4.
  • Selectivity is crucial. Buy an option only on a stock that has a tremendous potential. You need to only buy on an A+ situation. For stocks, you can be right must less than 50% of the time and still make money. For options, you need to swing only at the best pitches.
  • Ideally have options ~3 months from expiration, never less than 45-50 days.
  • Buy an option that is close to the strike, and if possible, slightly in the money. This is to strike a balance between wanting leverage and high returns (i.e. out-of-money options), and being too safe with lower reward/risk (i.e. deep-in-the-money options).
  • Use a very tight protective stop that is tighter than for stocks. Stop-loss orders are not appropriate because of the illiquid market.

-END-

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Discussion

4 thoughts on “Book Review of Stan Weinstein’s Secrets for Profiting in Bull and Bear Markets

  1. Stan Weinstein, no Sam, right?

    Nice notes.

    Posted by Mike | January 2, 2012, 2:08 pm
  2. Haha, you’re right. I’ll make the change. Thanks for the catch!

    Posted by whatheheckaboom | January 2, 2012, 2:22 pm
  3. Have you implemented any of his indicators? I was looking into the advance decline line, and was not able to find a charting service that plots preferred stocks.

    Posted by GS | June 14, 2013, 11:18 pm

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