Book Reviews, Trading

Book Review of The Successful Investor by William J. O’Neil

The full title of this book is “The Successful Investor: What 80 Million People Need to know to invest Profitably and Avoid Big Losses” by William J. O’Neil (sometimes known as WON on the internet forums). This particular book, The Successful Investor, was published in 2004, after the stock market bottomed in the dot-com crash.

William O’Neil is a successful trader who founded the Investor’s Business Daily newspaper. His most famous book is “How To Make Money in Stocks”, with many editions published. His CAN SLIM method has a huge following, and also performed well in AAII’s implementation of his model.

William O’Neil’s trading system is a very nice blend of technical analysis on the price-volume movements, while taking into account fundamental factors relating to the business. It does not go into deep fundamental analysis but neither is it cluttered with complicated technical indicators.

This is a very good book. While it is not very thick, it is packed full of good knowledge that WON learnt and developed over decades. I would recommend reading the book at least twice as I found that I understood more and got a clearer picture of his techniques during my 2nd read. Also the book contains many colourful charts with annotations to show both successful and faulty chart patterns. The best way to learn is to really scrutinize the charts, make sure you really understand the annotations shown.

How WON developed his system

  • Studied what the very best people did
    • Jack Dreyfus
    • Ned Johnson and Jerry Tsai
    • Gerald Loeb
    • Jesse Livermore
  • Plotted on weekly charts where he bought and sold, analyzed what he did wrong, and designed new rules to prevent the same mistakes.
  • Noted the key characteristics of 50 top-performing stocks in terms of technicals (price and volume action) and fundamentals.

Step 1: Assess Market Direction

  • Accumulation
    • Price and volume rising in tandem.
  • Distribution
    • Price closes down from the day before, on higher volume. The spread should be average to a little wider than average. If the spread is very small, the distribution may not be large enough to cause the market to turn down.
    • Price moves higher but closes only slightly above the previous close, on same or higher volume than the previous day. This is a stalling action. [My note: the spread can be long (like a sword) or short. A short spread is a worse indication than a long spread because there was sufficient supply to prevent the price from swinging up. The close should ideally be equal or less than the mid point of the spread.]
    • If the price goes down but volume is less, it doesn’t mean anything.
  • Reversal of Uptrend
    • 3 – 5 days of volume distribution over 2 – 4 weeks is sufficient to turn the market’s uptrend into a downtrend. Count the volume distribution days.
    • Check the individual stocks that have led the advance. They usually top at the same time.
  • Reversal of Downtrend
    • Watch the decline day by day. Ignore the 1st and 2nd days of a rally (the 1st day of a rally is when the index closes up from its previous day).
    • When counting which day it is in a rally attempt, you reset the count when the recent low in the downtrend is undercut (i.e. rally attempt is considered failed when any of the bars in the rally have a Low that is lower then the Low of the downtrend it is attempting to reverse).
    • On the 4th to 7th day of a rally, if the volume suddenly picks up from the day before (typically better than its daily average), with one or more of the major indexes posting a significant increase (1.7% or more), the rally is confirmed (i.e. there is follow-through). The day is known as a follow-through day (FTD).
    • The reason for waiting at least 4 days before even allowing a day to be considered a FTD is to guard against institutions viewing the rally simply as an opportunity to dump their shares. Having the rally sustain and pick up after the 3rd allow gives us greater certainty that the rally is real.
    • No new bull market has ever started without a follow-through day.
  • Other points
    • WON appears to use a 50-day moving average for the index.
    • Most of the dot-com stocks top out together with the NASDAQ composite in March 2000, but a handful topped out earlier in January 2000.
    • Bear markets frequently open higher at the beginning of the day’s trading but then close down. Bull markets can open lower and close the day up.
    • When looking at volume, look at whether volume has increased/decreased over the previous day, and whether it is above/below the average daily volume.

Step 2: Use a 3-to-1 Profit-and-Loss Percentage Plan

  • Great stocks don’t stay great
    • WON’s study of all the best stocks of the last 50 years show that the period of greatest market performance lasts on average only about 1.5 to 2 years. Some last up to 3 years. Only a tiny number last for 5 years.
    • Stocks that outperform all the rest by doubling or tripling or more, fall by an average 72% once they reach their peaks.
    • Only 1 of every 8 leaders in a bull market reasserts itself as a leader in the next or a future bull phase.
  • Keep a 3-to-1 profit-vs-loss ratio
    • Consider selling a few of your stocks when they are up 20 to 25% from your purchase price, and cutting every single loss at no more than 7 or 8%.
    • You can be right in only 30% of your stock purchases, wrong in 70% and still not be in serious trouble.
    • In difficult markets, take profits at 10 to 15%, and sell when your stock is down 3 to 5%.
  • Diversifying over many stocks does not help when there is a general market downturn when all stocks go down.

Step 3: Buy the Best Stocks at the Best Time

  • Pick the #1 company in its industry
    1. Earnings per share (EPS) in the latest quarter at least 25% more than the same quarter a year ago.
    2. Earnings growth accelerating in recent quarters compared with earlier rates of change.
    3. Annual earnings for last 3 years increasing at a rate of 25% per year or more.
    4. Sales up 25% or more in one or more recent quarters, or at least accelerating in their % change for last 3 quarters.
    5. After-tax profit margin in most recent quarter either at or close to a new high, and among the very best in the company’s industry.
    6. Return on equity (ROE) should be 15 to 17% or higher.
    7. Technology companies should show cash flow earnings per share greater than regular earnings (e.g. typically cash flow should be 20% or greater than actual annual earnings).
    8. In normal bull markets, both EPS and relative strength (RS) ratings should be 90 or higher.
      • EPS rating of 95 means its earnings growth over the last 3 years, with added weight given to recent quarters, has been superior to that of 95% of all publicly held companies.
      • RS rating of 90 means the stock has outperformed 90% of all others over the past 12 months. In the early phase of a new bull market, a 6-month time frame may be used.
    9. Stock’s industry group should rank in the top 10 or 20 among the 197 groups tracked by IBD.
      • 60% of the best winning stocks historically have been part of a strong industry group move.
      • Only 5 or 10 industries will lead every bull market.
      • If your stock is not in a top-performing group, at least 1 ot 2 other stocks in its group should have high EPS and RS ratings.
    10. Stock should have institutional sponsors (e.g. mutual funds, banks, insurance companies), and the number of mutual fund sponsors should be increasing quarter by quarter for several quarters.
    11. Company is buying back its own stock — preferable 5 to 10% or more, or management owns a reasonable number of shares.
    12. Understand the story of the company.
  • Find the best time to buy
    • Use weekly charts as they provide a good overall perspective and its easier to spot sound patterns.
    • To spot abnormal volume
      • Draw a line through the weekly volume plot to indicate the average weekly volume over the last 3 months (use 50-day for daily charts).
      • Count the number of weeks a stock closed down in price from the prior week, on greater than average volume. Also count the number of weeks that closed on above average volume with the price being up.
      • Start counting from the beginning of the base (i.e. the first week that closes down) to the completion of the handle just before the stock breaks out.
      • Strong, healthy stocks should show more weeks up on greater than average volume than weeks down on greater than average volume.
    • Look for a base to form (i.e. stock consolidates) after an uptrend of at least 30%.
    • Many chart base patterns last 12-13 weeks or 24-26 weeks, which corresponds to professionals waiting for 1-2 earnings reports (i.e. 3-6 months) before committing their funds.
    • Cup with a handle
      • Cup: Stock moves down ~30% over 5-7 weeks, rounds out the bottom for a few weeks, moves up on the right side, more than halfway up the pattern to within 10-15% of the pattern’s old high price. It is normal for volume to pick up in 1 or 2 weeks during down moves here, definitely not 5 or 6 weeks..
      • Handle: Stock drifts down and shakes out near the end of the handle, volume in lower part of handle frequently declines or dries up. Handle should not slowly wedge / drift up, but should run up rapidly with significant breakout volume (e.g. breakout week volume should be higher than prior week). Beware of handles that form in the lower half of the overall pattern. In a bull market, the handle shouldn’t correct more than 10-15%. If emerging from a bear market, a wider handle of 20-30% can be justified.
      • Buy when the stock breaks out of the earlier peak price in the handle (not the cup).
      • Strong cup-with-handle patterns will have a strong uptrend prior to the cup-with-handle pattern, of at least 30% on large, increase volume over many weeks.
      • Overall pattern should be at least 6-8 weeks in length.
    • Saucer
      • A shallow cup-with-handle.
      • Handle pullback normally no more than 8 to 12% from peak to absolute low, can be 20 to 30% in bear market.
    • Double bottom
      • Second leg down should undercut the low price of the first.
      • Buy pont is the middle peak in the W, which should definitely be below the old peak price of the overall pattern (usually 5-15% lower).
      • Day’s volume at breakout must be 50% or more from its daily average.
      • Overall pattern should be ~7 weeks in length.
    • Flat base
      • Sideways without much correction (at most 10-15%).
      • Usually forms as a second-stage base after a stock has advanced 20-25% from an initial base.
      • Largest volume should not be a down week.
      • Pattern is around 5-6 weeks in duration.
    • Ascending base
      • Three 10-20% pullbacks in price, with each rally going a little bit into new highs.
      • Buy when it exceeds the peak made in the 3rd pullback.
      • Pattern is around 9-16 weeks in duration.
    • Triangles
      • Avoid a pattern that wedges up. No such “triangle” pattern has proven reliable.
    • Climax top
      • Bases forming after a climax top rarely works.
      • A climax top doesn’t happen too early (e.g. definitely after the 11th week from the beginning base). The volume with the down move after a climax top would also be significant, rather than subsiding.
    • Tight movements
      • Normal patterns will have weeks in which there isn’t much trading action. These will show up as small, tight movements. These are always worth noting.
      • It indicates that an institution could be acquiring a quantity of the stock in a certain price zone over several weeks.
    • The correction in a stock should not be more than 2.5 times the correction in the general market index. 60% correction is too wide. 25-35% correction is normal in bull markets.
    • Stocks with big swings never has a chance to rest. The stock is too active and erratic.
    • Absolutely do not buy breakouts during a bear market!

Step 4: When to Sell

  • The only way to nail down a profit is to sell on the way up, sell when a stock goes up ~20-25% from a proper base, and cut losses at 7-8%.
  • If in a strong bull market, a stock has great current and 3-year earnings and sales growth, a high ROE, and better quality sponsorship, and is a leader in a strong industry group, and if it goes up 20% on good volume in 1-3 weeks from a proper base, then hold this stock at least 8 weeks from its breakout buy point.
  • To hold on further, consider other rules
    • E.g. use 10-week MA as support. Look at the 50-day and 200-day MAs (or 10-week, 40-week MA).
    • E.g., use historical precedence – both AOL and Fairchild ran up 25% in 3 weeks, 50% in 5 weeks, then broke badly for one week on terrific scare-type volume. Both proceeded to triple after that. AOL, Boeing, and Redman all had intermediate-term corrections (8-10%) in an ascending base pattern, and ran up significantly after that.
    • Sell when you see a climax top
      • Stock suddenly takes off and runs up much faster than it has in any week since its original move. The spread of the week is wider than any weekly spread so far.
      • Stocks runs up 7-8 out of 10 days in a row, with one of those days showing the biggest point gain since the stock broke out of its original base.
      • After months of advancing, the stock gaps up in what is called an ‘exhaustion gap’. That’s the sign you’re at the very end and within 1-2 days of the top.
    • Channel lines
      • Draw channel lines connecting 3 major lows and another line connecting 3 major highs.
      • If a stock goes through an upper channel line, even during intraday trading, sell the stock. 75-80% of the time you’re near a top.
    • Number of bases
      • In a new bull market, for the stock leaders, the breakout from the 1st base will almost always work. They run up for 20-25% before correcting to form a 2nd base, break out and run for 20-25% before forming a 3rd base.
      • Most smart money would already own a piece of the stock by the 3rd base and are looking to sell, so the chances of breaking out of a 3rd base is lower.
      • If it breaks out and forms a 4th base, a large percentage of 4th stage bases fail and can break very rapidly.
      • If there is a shakeout (i.e. a base fails and the stock drops below the low of that base) and a new proper base is built, you start a new count of the bases.
    • Relative strength vs S&P500
      • When a stock breaks out of a buy point near or into new high ground, the RS line should break out to new highs at the same time, or frequently in advance of the stock.
      • A lagging RS line signals weakness and loss of leadership. Avoid buying such a stock.
      • The best performing stocks in the last 50 years showed an average RS rating of 87 before they broke out and advanced 100-1000%.
      • Sell stocks where its RS rating has dropped below 70.
    • Industry group
      • Watch the 1-2 other leaders in the same industry group to see if they are making major tops as a warning signal.
      • Avoid the laggards in the group.
    • Other warning signs
      • Stock splits that are too large or too frequent.
      • M&A binge for empire building.
  • When you sell, sell your whole position. You either want in or you want out.
  • Avoid hedging your position, you may close out each position at the wrong time and being wrong on both.

Step 5: Portfolio Management

  • Buying
    • For a conservative investor, take half-positions on your first buys. If they go up 20-25% and build new sound bases, make your second, somewhat lesser buy when they break out.
    • Less conservative investors should add to their first buy as soon as the stock has moved up between 2-3% from the initial buy price. If the stock rises 2%, add 30% to the position. If it rises an additional 2%, complete the buy by adding the remaining 20%. Don’t pyramid beyond a 5% increase from your correct buy point or you can get caught in the normal pullback.
    • Make sure you commit fewer dollars to the subsequent purchase so that you don’t run up your average cost too fast. E.g. buy 100 shares first, followed by 65 shares, and then 35 shares.
  • Shorting
    • Don’t short big dividend-paying stocks because you have to pay for each dividend.
    • Don’t short a stock that is running up and overvalued.
    • Don’t short thinly traded small-cap stocks.
    • Don’t pyramid more than once.
    • Best time to short a former market leader is 5-7 months after it has clearly broken down, i.e. it has topped and rallied back 3-4 times in a sideways basing area (shaking out the weak short sellers) and then starts to weaken.
    • Do not wait for a stock to break down below a previous low. Short after the 3rd or 4th rally (rally that goes up 10-20%) starts to fail, the stock crosses below its 10-week MA, and volume for the day picks up. The stock should always be at least 4-5 points above a previous low price a number of weeks ago.
    • Take profits when a stock drops 20-30% because at some point it will rally 20-50%.
  • Don’t have more than 50-60% of your portfolio in the same industry group. If you are less experienced, the limit should be 25-30%.
  • Don’t ever average down.
  • Don’t buy stocks below $15 as they lack professional buying. The median price of the 50 top-performing stocks from 1997 to 200 when they broke out of their initial bases was $46.78.


  • Successful stock selection is 60-65% knowing every key fundamental fact about a company and its industry, and 35-40% understanding chart and market action.

CAN SLIM (First 3 editions)

  • C = Current Quarterly Earnings per Share
    • Increase by at least 18-20% (compared to the same quarter in the previous year), and show recent acceleration.
    • The average % increase in current quarterly earnings of all great winners was 70%.
  • A = Annual Earnings per Share
    • Growth in each of the past 3 years, annual growth rate >= 25%.
    • Either pretax profit margin or ROE should be expanding.
    • ROE >= 17%.
    • Consensus estimates for next year should be up.
  • N = New Products, New Services, New Management, New Major Improvements in Industry Conditions
    • Many market leaders are newer companies that had IPO-ed either recently or in the previous 10 years.
    • Correct buy points will be within 10-15% of new price highs for the year.
    • At the buy point, trading volume for the day should increase 50% or more above the average daily volume.
  • S = Supply and Demand
    • Stocks with ownership management or companies buying back their own stock in the open market are preferred.
  • L = Leaders or Laggards
    • Concentrate your buying in the top 2-3 rated stocks in one of the strongest 10-15 of the 197 IBD Industry Groups.
    • Look for RS rating of 80 and higher and in a sound chart base pattern.
    • The company should be #1 in its industry in terms of annual earnings growth, sales growth, pretax and after-tax profit margins, ROE, and product quality.
  • I = Institutional Sponsorship
    • At least 25 or more institutional owners.
    • Number of mutual funds owning your stock should be increasing for each of the last several quarters.
    • A few of the smarter mutual funds should have purchased the stock in the previous quarter.
  • M = Market Direction
    • Follow and interpret the daily price and volume chart of the major stock market index every day.



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