The full title of this book is Trade Like a Stock Market Wizard: How to Achieve Super Performance in Stocks in Any Market by Mark Minervini (2013).
First off, this is a terrific book, especially for traders who subscribe to the OWL (O’Neil, Wyckoff, Livermore) approach to trading stocks. I took quite some time to finish this book as there are just so many gems throughout the book.
A brief history of Mark from the book. He started trading in 1983, and had a 6-year period in which he had a net loss in stocks. He persevered and put in tons of hard work, and managed to achieve success from 1989. Mark averaged 220% per year from 1994 to 2000 (33,500% compounded total return), and he is famous for winning the 1997 U.S. Investing Championship with a 155% return trading in stocks even though other leveraged asset classes were allowed in the same competition. Mark was also interviewed by Jack Schwager in Stock Market Wizards.
Mark classifies himself as a techno-fundamentalist. He relies on price and volume as well as fundamentals to increase the odds of success. The methods he described are pretty similar to the CANSLIM system that William O’Neil teaches through IBD. This is not surprising considering that Mark went through the same process as O’Neil, where he studied tons of past stock winners to identify what exactly led to stock performance. That led to him formulating his own SEPA (Specific Entry Point Analysis) system to pinpoint the best time to enter a stock.
Some things that he shared which are on top of the CANSLIM system include
- Mark incorporated Stan Weinstein’s stage analysis to identify what stage a stock is in, and would only buy a stock if the stock in a stage 2 uptrend.
- There is much more emphasis on the importance of earnings improvement and acceleration. He asked the question: what causes a stock to go into a stage 2 uptrend? What he found was that fundamentals (i.e. earnings growth acceleration) was usually what led a stock to be accumulated by institutions, leading to a stage 2 uptrend.
- Mark identified a Volatility Contraction Pattern (VCP), sort of a generalized version of the cup-with-handle, to basically use the gradual contraction in a stock’s volatility as an indicator signifying the drying up of the stock’s supply (i.e. distribution). That then leads to the identification of a pivot buy point. I like this version much better than the cup-with-handle, which for some reason, never resonated with me.
I like the fact that the book covers many key areas of trading stocks, including fundamentals, technicals, risk management, and just trading in general. Some areas which I hoped that he can cover more in-depth was on stop placement: exactly where would he place his initial stop, and how would he trail the stop, etc. Nonetheless, I did not expect him to give away the farm in a book, seeing that he conducts an annual two-day workshop with David Ryan and also offers a $999/month (or $499/month for annual package) subscription to his real-time analysis.
All in all, I highly recommend people to purchase a copy of this book to read, and even re-read.
Don’t Treat Trading Like a Hobby
- Trading stocks and running a business are virtually identical. In fact, to be successful, you must trade just as if you were running a business. As an investor, your merchandise is stocks. Your objective is to buy shares that are in strong demand and sell them at a higher price.
- Most investors treat trading as a hobby because they have a full-time job doing something else. However, if you treat trading like a business, it will pay you like a business. If you treat trading like a hobby, it will pay you like a hobby, and hobbies don’t pay, they cost you.
Success Occurs When Opportunity Meets Preparedness
- For years I worked on perfecting my trading skills, plugging away 70 to 80 hours a week, often staying up to pore over stock charts and company financials until the sun came up the next day. Even though the results weren’t there yet, I persevered. I spent years separating the proverbial wheat from the chaff, perfecting my process by analyzing my success and, more important, my failures. I invested countless hours in learning how great investors approached the market and how they created and executed trading strategies and developed the emotional discipline required to follow their models.
- Then something wonderful happened. My preparation intersected with opportunity. I had been honing my skills for years, and by 1990 I was fully equipped to take advantage of a new emerging bull market…. I was 100% prepared, like an Olympic athlete who has practiced and practiced and is now ready to perform with perfection.
- Opportunities in the stock market can spring to life on short notice. To take advantage of them you must be prepared and ready to act.
- Right now, somewhere out in the world someone is tirelessly preparing for success. If you fail to prepare, that somebody probably will make big money while you only dream about what you could have been and should have done.
Practice Properly, Objectively Analyze Your Results to Discover Mistakes
- When you repeat something over and over again, your brain strengthens the neural pathways that reinforce the action. The problem is that these pathways will be reinforced for incorrect actions as well as correct actions. Any pattern of action repeated continuously will eventually become habit. Therefore, practice does not make perfect; practice only makes habitual.
- In other words, the fact that you’ve been doing something for a while doesn’t mean you are guaranteed success. It could be that you’re just reinforcing bad habits.
Specialize in One Trading Style
- Nobody can keep switching styles successfully
- … you will enjoy market cycles when your trading style outperforms other styles, and you will also learn to accept periods less conducive to your style.
- I doubt you will overcome these less favorable phases by adopting a different style each time you run into difficulty. When it comes to stock trading, I know no one who, for example, can successfully trade value in one cycle and then switch to growth the next or be a long-term investor one day and then a day trader to suit the market du jour. To become great at anything, you must be focused and must specialize.
- You can’t squeeze every bit of profit
- If you are a short-term trader, recognize that selling a stock for a quick profit only to watch it go on to double in price is of no real concern to you. You operate in a particular zone of a stock’s price continuum, and someone else may operate in a totally different area of the curve. However, if you’re a longer-term investor, there will be many times when you make a decent short-term gain only to give it all back in the pursuit of a larger move.
- The key is to focus on a particular style, which means sacrificing other styles. Once you define your style and objectives, it becomes much easier to stick to a plan and attain success. In time, you will be rewarded for your sacrifice with your own specialty.
- Keep in mind that if you fail to define your trading, you will almost certainly experience inner conflict at key decision-making moments.
KEYS TO SUPERPERFORMANCE
Traits of Superperformers
- 90% of superperformance stocks began their phenomenal price surges as the general market came out of a correction or bear market.
- Superperformance phase occurs during the first 10 years after the stock’s IPO.
- Stock is a small-cap or mid-cap that hits a period of accelerated growth.
- Stock has a relatively small total market cap and amount of shares outstanding.
- Majority had periods of outperformance in terms of fundamentals as well as technical action before they made their biggest gains.
- Many traded at more than 30 or 40x earnings before they experienced their largest advance.
Key to Making Big Money in Stocks
- The key to making big money in stocks is to align supporting fundamentals with constructive price action during a healthy overall market environment.
- You want all the forces behind you: fundamental, technical, and market tone.
- What matters is what big institutions think, because they are the ones that can move a stock’s price dramatically. Therefore, it’s your job to find the companies that institutions perceive as valuable.
Fundamentals Drive the Stages of Stock Price Movement
- Virtually every superperformance stock made its big gain while in stage 2 of its price cycle…. I asked, What created the profitable stage 2 advance? Hunting for a key to identifying the advent of second stages, I plotted and overlaid the underlying fundamentals of superperformance stocks to see how they correlated with price movement.
- From a fundamental perspective, the cause almost always was linked to earnings: from lackluster performance to upside surprise and accelerating growth, eventually followed by decelerating growth and then disappointment.
- These underlying fundamental changes drove big institutional players into and out of stocks, phases that could readily be identified by huge volume spikes that occurred during both the advancing stage and the subsequent decline.
SPECIFIC ENTRY POINT ANALYSIS (SEPA)
Five Key Elements
- Trend: Price in definite uptrend
- Fundamentals: Improvement in earnings, revenues, margins
- Catalyst: Hot-selling product, approval by FDA, new CEO, new contract, etc.
- Entry Points: Enter at a low-risk entry point
- Exit Points: Establish stop loss points.
Ranking Process Overview
- Pass the Trend Template filter (see below)
- Filtered by earnings, sales, margin growth, relative strength, and price volatility
- Scrutinize for similarities to a Leadership Profile to determine whether they are in line with fundamental and technical factors exhibited by past superperformers.
- Manual review, considering
- Reported earnings and sales
- Earnings and sales surprise history
- EPS growth and acceleration
- Revenue growth and acceleration
- Company-issued guidance
- Revision of analysts’ earnings estimates
- Profit margins
- Industry and market position
- Potential catalysts (new products, services, or industry/company-specific developments)
- Performance compared with other stocks in same sector
- Price and trading volume analysis
- Liquidity risk
Ranking Process Goal
- To identify the potential for
- Future earnings and sales surprises and positive estimate revisions
- Institutional volume support (significant buying demand)
- Rapid price appreciation based on a supply/demand imbalance (lack of selling versus buying)
Run Separate Screens to Narrow Down Stocks Rather Than a Mega Stock Screen
- You may inadvertently eliminate good candidates that meet all your criteria except for one.
- A better approach is to run separate screens that are based on smaller lists of compatible criteria. Often, as you run isolated screens, you will see some of the same names recurring, whereas a few names will appear on only one list.
P/E Ratio Pitfalls
- No magic P/E number
- There is no appropriate level when it comes to a P/E ratio and superperformance stocks. The P/E can start out relatively low or high.
- The 25 top-performing stocks from 1995 to 2005 had an average P/E ratio of 33x, ranging from a low of 8.6x to a high of 223x.
- My suggestion is to forget this metric and seek out companies with the greatest potential for earnings growth.
- Beware of excessively low P/E
- As a rule of thumb, I’m very reluctant to buy shares of a company trading at an excessively low P/E, especially if the stock is at or near a 52-week low in price.
- What P/E tells you
- I use the P/E ratio as a sentiment gauge that gives me some perspective about investor expectation. Generally speaking, a high P/E means there are high expectations and a low P/E means there are lower expectations.
- PEG doesn’t work either
- Like its P/E cousin, the PEG ratio can exclude some of the most dynamic and profitable companies from a candidate buy list. The PEG ratio is limiting on the two sides of the equation that are most valuable: when a stock has an exceptionally high or low P/E. Should a stock with a growth rate of 2% trade at 2 times earnings? Probably not. However, valuing a high-technology stock such as Yahoo!, which traded at 938 times earnings (and went to 1,700 times earnings), was nearly impossible using traditional valuation measures.
- Historical study of superperformance stocks shows that the average P/E increased between 100 and 200% on average (or 2 to 3 times) from the beginning until the end of major price moves.
- First, you can get an idea of a stock’s potential. You can estimate what it might sell for as an average best-case scenario within a year or two down the road from your initial purchase price, that is, if you’re buying a dynamic leader in a bull market. You could estimate future earnings and apply the expanded P/E number to get a rough idea of the stock’s potential.
- Second, you can gain some perspective on how much of the company’s good fortune has already been discounted by gauging how much P/E expansion has taken place already. Let’s say you buy a stock with a P/E of 20 at its initial breakout from a sound base. Multiply 20 by 2 to 3 to see what the ratio could rise to. That gives you 40 to 60. You hope that the stock continues to rally. Though it’s always prudent to look for sell signals, pay extra attention once the P/E nears 2 and especially around 2.5 to 3 or greater. It could top soon afterward. If this occurs, look for signs of decelerating growth and signs of weakness in the stock price as your signal to reduce your position or sell it out.
Four Stages of Stock Price Action
- Stage 1 – Neglect Phase: Consolidation
- A company’s earnings, sales, and margins may be lackluster or erratic along with its share price. There may also be an uncertain outlook for the company or its industry.
- Price moves in a sideways fashion with a lack of any sustained price movement up or down.
- Price oscillates around its 200-day (or 40-week) moving average. This phase can last for months or even years.
- Often, this basing stage takes place after the stock price has declined during stage 4 for several months or more.
- Volume will generally contract and be relatively light compared with the previous volume during the stage 4 decline.
- Transition from Stage 1 to Stage 2
- There should always be a previous rally with an escalation in price of at least 25 to 30% off the 52-week low before you conclude that a stage 2 advance is under way and consider buying.
- Stock price > 150-day MA > 200-day MA
- 200-day MA has turned up.
- A series of higher highs and higher lows has occurred.
- Large up weeks on volume spikes are contrasted by low-volume pullbacks.
- There are more up weeks on volume than down weeks on volume.
- Stage 2 – Advancing Phase: Accumulation
- Build up in earnings momentum (or earnings expectations). May be ignited by beneficial regulatory change, a promising business outlook, a new CEO, or a big earnings surprise that beats estimates.
- A daily and weekly price and volume chart will show big up bars representing abnormally large volume on rallies, contrasted with lower volume on price pullbacks.
- Stock price > 200-day MA.
- 150-day MA > 200-day MA.
- 200-day MA itself is in an uptrend.
- Short-term moving averages are above long-term moving averages (e.g. 50-day MA is above the 150-day MA).
- Stock price is in a clear uptrend, defined by higher highs and higher lows in a staircase pattern.
- Volume spikes on big up days and big up weeks are contrasted by volume contractions during normal price pullbacks.
- More up days and up weeks on above-average volume than down days and down weeks on above-average volume.
- Stage 3 – Topping Phase: Distribution
- EPS momentum starts to slow, or earnings estimates become too high to beat.
- Volatility increases, with the stock moving back and forth in wider, looser swings. Although the overall price pattern may look similar to stage 2, with the stock moving higher, the price movement is much more erratic.
- There is usually a major price break in the stock on an increase in volume. Often it’s the largest one-day decline since the beginning of the stage 2 advance. On a weekly chart, the stock may put in the largest weekly decline since the beginning of the move. These price breaks almost always occur on overwhelming volume.
- The stock price may undercut its 200-day MA. Price volatility around the 200-day MA line is common as many stocks in stage 3 bounce below and above the 200-day MA several times while topping out.
- The 200-day MA will lose upside momentum, flatten out, and then roll over into a downtrend.
- Stage 4 – Declining Phase: Capitulation
- At some point there will be a negative surprise. The company will miss an earnings estimate or pre-announce earnings and guide Wall Street analysts lower.
- Vast majority of the price action is below the 200-day moving average.
- 200-day MA which was flat or turning downward in stage 3, is now in a definite downtrend.
- Stock price is near or hitting 52-week new low.
- Stock price pattern is characterized as a series of lower lows and lower highs, stair-stepping downward.
- Short-term moving averages are below long-term moving averages.
- Volume spikes on big down days and big down weeks are contrasted by low-volume rallies.
- More down days and weeks on above-average volume than up days and up weeks on above-average volume.
Trend Template (Stock must pass to be considered in a confirmed stage 2 uptrend)
- Stock price > 50-day (10-week) MA > 150-day (30-week) MA > 200-day (40-week) MA
- 200-day MA is trending up for at least 1 month (preferably 4-5 months minimum in most cases).
- Stock price is at least 30% above its 52-week low (many of the best selections will be 100%, 300%, or greater above their 52-week low before they emerge from a solid consolidation period and mount a large scale advance).
- Stock price is within at least 25% of its 52-week high (the closer to a new high the better).
- Relative strength ranking (as reported in Investor’s Business Daily) is no less than 70, and preferably in the 80s or 90s, which will generally be the case with the better selections.
Count the Bases to Know Your Reward /Risk Within the Stage 2 Advance
- Within an overall long-term uptrend, there will be short- or intermediate-term price action that consist of pullbacks and basing… Most commonly, base patterns forming within a stage 2 uptrend last anywhere from 5 to 26 weeks.
- Bases 1 and 2 generally come off a market correction, which is the best time for jumping on board a new trend.
- As the stock makes a series of bases along the stage 2 uptrend, base 3 is a little more obvious but usually still tradable.
- By the time a 4th or 5th base occurs (if it gets that far), the trend is becoming extremely obvious and is definitely in its late stages.
- By this point abrupt base failures occur more frequently. Some stocks however can turn up in a parabolic fashion and end in a climax run or blow-off top.
- Generally, the descent occurs after 3 to 5 bases have formed along the way in a stage 2 uptrend. The later-stage bases coincide with the point at which the stock’s accumulation phase has become too obvious, tapping out the last of the heavy institutional demand.
- Stocks very often top out while earnings still look good. Investors who wait for the earnings picture to dim before hitting the bid in the face of a stage 3 top or stage 4 decline often end up with a huge loss or at the very least give back much if not all of what they made on the upside.
Exit on a Material Change in Price Behavior
- If your stock experiences its largest daily and/or weekly price decline since the beginning of the stage 2 advance, this is a sell signal in most cases even if it comes on the heels of a seemingly great earnings report.
- Many times before a fundamental problem is evident, there will be a hint in the form of a material change in price behavior. That change should always be respected even if you don’t see any reason for the sudden change in sentiment.
FOCUS ON FUNDAMENTALS
Stocks Move For Two Reasons: Anticipation and Surprise
- Every price movement is rooted in one of these two elements: (i) anticipation of news, an event, an important business change, or (ii) reaction to an unexpected event and a surprise, whether positive or negative.
- [My note: In the ‘anticipation’ case, the stock movement leads the event; in the ‘reaction’ case, the stock movement lags the event.]
Focus on Quarterly Earnings
- In our study of past superperformance stocks, as well as in the Love and Reinganum studies, current quarterly earnings showed the highest correlation with big stock price performance.
- Three out of four times, the very best performers will show meaningful earnings increases in the most recent quarter from the same quarter a year earlier.
- You should demand not only that the most recent quarter be up by a meaningful amount but that the past 2 or 3 quarters also show good gains. Really successful companies generally report earnings increases of 30 to 40% or more during their superperformance phase.
Earnings Maturation Cycle
- Stage 1
- Value stock
- Stage 2
- Positive earnings surprise, earnings accelerate, estimates revised upwards.
- Institutional players using positive surprise quantitative models jump on.
- Earnings momentum buyers jump on.
- Price momentum buyers jump on.
- Growth stock
- Stage 3
- Loss of EPS momentum
- Stage 4
- Negative earnings surprise
- Estimates revised downwards
- Stock sold down
- Earnings surprises
- When quarterly results are meaningfully better than expected, analysts must revise their earnings estimates upward. This increases the attention paid to a stock.
- Large buyers must buy/sell over time to avoid moving the price too much. This is what accounts for post-earnings drift, a persistent bias in the direction of the surprise.
- Be on the lookout for companies that are beating earnings estimates; the bigger the earnings surprise, the better. Because earnings surprises have a lingering effect, we want to focus on companies that beat estimates and avoid firms that have negative earnings surprises.
- Trending analyst estimates
- Look for companies for which analysts are raising estimates (e.g. compare current estimates with 7 days ago, 30 days ago, 60 days ago, 90 days ago). Quarterly as well as current fiscal year estimates should be trending higher; the bigger the estimate revisions, the better.
- At the very least, I like to see the current fiscal year or the next year’s estimates trending higher from 30 days earlier; if both are trending higher, that is even better.
- Trending EPS
- Smooth out quarterly results by using a 2-quarter rolling average over the past 4, 6, or 8 quarters. You want to see a steadily improving trend in earnings growth.
- Accelerating earnings per share (EPS) and revenues
- More than 90% of the biggest stock market winners showed some form of earnings acceleration before or during their huge price moves, i.e. year-over-year earnings were growing by an increased rate sequentially, quarter to quarter.
- It’s not uncommon for new market leaders to show triple-digit sales growth in the most recent two, three, or more quarters. In fact, some great stock market successes deliver large quarterly sales increases consistently for several years.
- What really accounts for superior stock performance is strong earnings growth backed by brisk sales.
- EPS breakout
- Go back 2 to 4 years or more to a record year and see if current earnings are breaking out above the previous trend. It can be a fairly significant event if earnings suddenly break out to the upside from the range that was established over several years.
- Strong annual EPS change
- Strong quarterly results should translate into strong annual results. Just 1 or 2 quarters of good earnings isn’t going to be enough to drive a stock’s price significantly higher for an extended period.
- Turnaround situations
- With turnaround situations, investors should insist that the current earnings be very strong (+100% or better in the most recent 1 or 2 quarters).
- You could also insist that earnings and margins be at or close to a new high for added confirmation that the company is back on track.
- You can spot turnarounds by comparing the current annual growth rate or current quarterly results with the 3- or 5-year growth rate.
- Deceleration is a red flag
- A company can be doing great with high-double-digit percentage growth and then “deteriorate” to mid-double-digit growth (e.g. 60% drop to 30% is material deterioration)
ASSESSING EARNINGS QUALITY
Sustainable Earnings Growth Requires Revenue Growth
- Earnings improvement from cost cutting, plant closures, and other so-called productivity enhancements walks on short legs.
- The ideal situation is when a company has higher sales volume with new and current products in new and existing markets as well as higher prices and reduced costs.
- The worst situation is when a company has limited pricing power, its business is capital-intensive, margins are low or under pressure, and it’s faced with heavy regulation, intense competition, or both.
Assessing Earnings Quality
- Look for earnings from core operations. Gains from one-time or extraordinary events should be stripped away.
- On the flip side, if “one-time charges” keep showing up over and over, you should seriously question the earnings quality.
- Beware of a positive earnings surprise from a lowered estimate. If you see that estimate revisions were recently lowered due to downside guidance, and then the company beat expectations, this should raise a red flag.
Watch the Market’s Reaction to Company’s Earnings
- Three specific reactions
- What was the initial response?
- If the stock sold off, did it recover quickly and powerfully? Or did it fail to rally after a pullback or, worse, sell off?
- How well did the stock hold its gains and resist profit taking?
- Although it’s not uncommon for stocks to sell off on profit taking after a big rally and decline on news, a superperformance stock will come back and resume its advance. For a true superperformer, there should definitely not be a huge sell-off that breaks the whole leg of the stock’s upward move.
Track Company-Issued Guidance
- Companies generally issue guidance at or near the time a quarterly earnings report is released.
- In some cases, the reaction to earnings guidance is stronger than the reaction to the actual earnings report when it is announced.
- By tracking what a company says and then what develops later on, you can ascertain the quality and tendencies of the company’s guidance.
- Take long-term forecasts with a grain of salt. No one, not even management, can accurately forecast what a company will earn or what its rate of growth will be a year or two down the road.
Analyze Inventories and Receivables
- For certain industries, such as manufacturing, the comparison of inventory and sales is crucial. Specifically, I look at the breakdown of inventory (i.e. finished goods, work in progress, and raw materials) and how [the growth rate of] each segment relates to the [the growth rate of] others.
- Look at the trend in inventories versus sales. When inventory grows much faster than sales, it can indicate weakening sales, misjudgment by management of future demand, or both.
- Inventories can provide a heads-up as to whether business conditions are likely to improve. E.g. in late 2003-200, there was rapid escalation in the price of copper. Encore Wire (WIRE) had significant copper inventories and met the SEPA criteria, so it was a potential big winner.
- If receivables are increasing at a far greater rate than sales or if the trend is accelerating, this could be a warning that the company is having trouble collecting from its customers.
Look Out for Differential Disclosure
- Guidelines for reports to shareholders are far less restricted than those for reports submitted to the SEC… Make a point to compare footnotes and other disclosures related to taxes under the cash-basis accounting rules required for the Internal Revenue Service (IRS) with the earnings reported to shareholders under accrual accounting. If a company is reporting great earnings but is not paying much in taxes, be skeptical.
Look for a Code 33
- A Code 33 situation is when there are three consecutive quarters of acceleration in earnings, sales, and profit margins.
- If a company has hot-selling products, sales should increase as the company expands into new markets.
- If a company has a management team that’s on the ball, profit margins should improve as the company improves productivity.
FOLLOW THE LEADERS
The Big Money is Made in the Bull Market’s First 18 Months
- Most of the big money made in bull markets comes in the early stages, during the first 12 to 18 months.
- As a bear market is bottoming, leading stocks, the ones that best resisted the decline, will turn up first and then sprint ahead — days, weeks, or even months before the Dow, S&P, and Nasdaq indexes put on their running shoes.
Identifying the Market Leaders
- Market leaders are stocks that emerge first and hit the 52-week-high list just as the market is starting to turn up.
- Few investors buy stocks near new highs, and most investors focus on the market instead of the individual market leaders and often end up buying late and owning laggards.
Use a Bottom-Up Approach with Leaders
- Don’t concentrate on the general market
- If you concentrate on the general market solely for timing your individual stock purchases, you’re likely to miss many of the really great selections as they emerge at or close to a market bottom. The true market leaders will show strong relative price strength before they advance.
- Don’t concentrate on the industry groups
- Although it’s true that many of the market’s biggest winners are part of industry group moves, in my experience, often by the time it’s obvious that the underlying sector is hot, the real industry leaders — the very best of the breed — have already moved up dramatically in price.
- In the early stage of a relative strength leader’s uptrend, there may or may not be much confirming price strength from its group overall. This is normal… As the leader’s trend continues to advance and eventually its industry group and sector begin to show signs of strength, the price advance of the market leader will do one of two things: it will continue its advance while the group propels it even higher, or it will consolidate in a sideways fashion and digest its previous gains while the group and other stocks in the group play catch-up…. You should look for definite signs that the stock has topped before concluding that the move is over.
- Focus on the stocks
- The stocks that hold up the best and rally into new high ground off the market low during the first 4 to 8 weeks of a new bull market are the true market leaders, capable of advancing significantly. You can’t afford to ignore these golden opportunities.
- Market leaders tend to stand out best during an intermediate market correction or in the later stages of a bear market. Look for resilient stocks that hold up the best, rebound the fastest, and gain the most percentage-wise off the general market bottom.
- When a market is bottoming, the best stocks make their lows ahead of the absolute low in the market averages. As the broader market averages make lower lows during the last leg down, the leaders diverge and make higher lows… The relative strength line of the stock should show steady improvement as the market declines.
- Often, stocks that hold up well during bear market corrections are in their own earnings up cycle… When the bearish market exhausts itself and turns up, stocks in their own earnings up cycle will blast off and advance significantly, in some cases for an extended period.
Specific Industry Groups Lead New Bull Markets
- In general, 3 or 4 to as many as 8 to 10 industry groups or subgroups lead a new bull market…. Your portfolio should consist of the best companies in the top 4 or 5 sectors.
- Stocks lead you to the group
- To find which groups are leading, track the 52-week new high list. The industry groups with a healthy number of stocks hitting new highs early in a bull market will often be the leaders.
- Historically, more than 60% of superperformance stocks were part of an industry group advance.
- Keep an eye on the top 2 or 3 companies in an industry group. If they break down after a big advance, it is often the initial symptom that the entire group is about to get sick.
A New Bull Market Typically Locks Out Investors
- During the first few months of the new bull market you should see multiple waves of stocks emerging into new high ground; general market pullbacks will be minimal and probably will be contained to 3 to 5% from peak to trough.
- Many inexperienced investors will be looking to buy a pullback that rarely materializes during the initial leg of a new powerful bull market, which from the onset will appear to be overbought.
- To determine if the rally is real, up days should be accompanied by increased volume whereas down days or pullbacks have lower overall market volume. More important, the price action of leading stocks should be studied to determine if there are stocks emerging from sound buyable bases.
- Additional confirmation is given when the list of stocks making new 52-week highs outpaces the 52-week low list and starts to expand significantly.
Keeping Your Watch List
- As the broader market indexes start to bottom and begin the first leg up in a new bull market, you should concentrate on the new 52-week-high list. Many of the market’s biggest winners will be on the list in the early stage of a new bull market.
- You should also keep an eye on stocks that held up well during the market’s decline and are within striking distance (5 to 15%) of a new 52-week high.
- Generally, the correction for a healthy stock from peak to low will be contained within 25 to 35% and during severe bear market declines could be as much as 50%, but the less, the better.
- Fewer than 25% of market leaders in one cycle generally lead the next cycle, so expect to see unfamiliar names.
Buy the Strongest Leaders First
- Coming off a market low, I like to buy in order of breakout. The best selections in your lineup will be the first to burst forth and emerge from a proper buy point and into new high ground.
Leaders Lead on the Downside
- After an extended rally or bull market, the market’s true leaders have already made their big moves. The smart money that moved into those stocks ahead of the curve will move out swiftly at the first hint of slowing growth.
- History shows that one-third of superperformers give back all or more of their entire advance. On average, their subsequent price declines are 50 to 70%, depending on the period measured.
- Bull markets sometimes roll over gradually, whereas bottoms often end with a sudden sell-off, followed by a strong rally. As the leaders start to buckle, the indexes can move up farther or start to churn, moving sideways. That occurs before cash stays in the market and rotates into laggard stocks. The indexes hold up or even track higher on the backs of the stragglers. Watch out! When that happens, the end is near and the really great opportunities may have already passed.
- Typically, a second wave of post-leadership stocks start to perform relatively well as money rotates out of the true leaders and into some of the group’s constituents, laggard follow-up stocks, or defensive groups such as drugs, tobacco, utilities, and food stocks that are thought to be less sensitive to an economic downturn.
READING THE CHARTS
Play the Continuation of an Existing Trend
- Most of the chart work I rely on is based on the continuation of an existing trend… If you want to maximize compounding, you want to be where the action is and take advantage of momentum.
- You should limit your selections to those stocks displaying evidence of being supported by institutional buying. You’re not trying to be the first one on board; rather you’re looking for where momentum is picking up and the risk of failure is relatively low.
- To time my entry, I look for price consolidations,. which are momentary pauses or periods of rest within the context of a prior uptrend.
- The current chart pattern is only as good as where it resides within the context of its longer-term trend. If you are too early, you run the risk of the stock resuming its downtrend. If you’re too late, you run the risk of buying a late-stage base that is obvious to everyone and prone to failure.
- I never go against the long-term trend. I look to go long a stage 2 uptrend and go short a stage 4 downtrend, plain and simple.
Price Often Spikes Preceding a Consolidation
- Often a price spike will occur on the left side just before a price correction or consolidation begins.
- This may come on news and cause the stock to become extended and prone to a pullback, particularly if the overall market begins correcting.
Look for a Volatility Contraction Pattern (VCP)
- A common characteristic of virtually all constructive price structures (those under accumulation) is a contraction of volatility accompanied by specific areas in the base structure where volume contracts significantly.
- During a Volatility Contraction Pattern (VCP), you will generally see a succession of anywhere from 2 to 6 contractions, with the stock coming off initially by, say, 25% from its absolute high to its low. Then the stock rallies a bit, and then it sells off 15%. Then buyers come back in, and the price goes up some more, and finally it retreats 8%. The progressive reduction in price volatility, which will be accompanied by a reduction in volume at particular points, eventually signifies that the base has been completed.
- As a rule of thumb, I like to see each successive contraction contained to about half (plus or minus a reasonable amount) of the previous pullback or contraction. The volatility, measured from high to low, will be the greatest when sellers rush to take profits. When sellers become scarcer, the price correction will not be as dramatic, and volatility will decrease.
- Typically, most VCPs setups will be formed by 2 to 4 contractions, although sometimes there can be as many as 5 or 6.
- The time period of the price action can be over 3 to as many as 60 weeks.
- Use abbreviations as a quick way to capture the visual
- Time: How many days or weeks have passed since the base stated?
- Price: How deep was the largest correction, and how narrow was the smallest pullback at the very right of the price base?
- Symmetry: How many contractions (Ts) did the stock go through during the basing process?
- 40W 31/3 4T: 40-week consolidation, contracted 4 times, first contraction was deepest at 31%, last contraction was shallowest at 3%.
- My note: Multiple contractions of the same depth would be labelled as 1T.
A Variation: Flat Base
- There are some variations, such as the square-shaped Darvas box pattern, or a flat base structure that is 4 to 7 weeks in duration.
- With this type of base, there is no real volatility contraction as it remains a tight and narrow pattern or box, moving in a sideways range with about a 10 to 15% correction from high point to low point.
Tightness with Low Volume (Tight and Light) is Generally Constructive
- Tightness in price from absolute highs to lows and tight closes with little change in price from one day to the next and also from one week to the next are generally constructive.
- These tight areas should be accompanied by a significant decrease in trading volume. In some instances, volume dries up at or near the lowest levels established since the beginning of the stock’s advance.
- If a stock is under accumulation, a price consolidation represents a period when strong investors ultimately absorb weak traders. Once the “weak hands” have been eliminated, the lack of supply allows the stock to move higher because even a small amount of demand will overwhelm the negligible inventory. This is referred to as the line of least resistance.
Buy at the Pivot Buy Point
- A stock that is under accumulation will almost always show these characteristics (tightness in price with volume contracting). This is what you want to see before you initiate your purchase on the right side of the base, which forms what we call the pivot buy point. Specifically, the point at which you want to buy is when the stock moves above the pivot point on expanding volume.
- During the tightest section of the consolidation (the pivot point), volume should contract significantly.
- When a stock traces out a VCP and undergoes a series of contractions, …, [it is] an indication that the stock is changing hands in an orderly manner. You should wait until the stock goes through a normal process of shares changing hands from weak holders to strong ones. As a trader using a stop loss, you are a weak holder. The key is to be the last weak holder; you want the other weak holders to exit the stock before you buy.
- Evidence that supply has stopped coming to market is revealed as the trading volume contracts significantly and price action quiets down noticeably…. If the stock’s price and volume don’t quiet down on the right side of the consolidation, chances are that supply is still coming to market and the stock is too risky.
- Jesse Livermore described the pivot point as the line of least resistance. A stock can move very fast once it crosses this threshold. When a stock breaks through the line of least resistance, the chances are the greatest that it will move higher in a short period of time. This is the case because this point represents an area where supply is low; therefore, even a small amount of demand can move the stock higher.
Volume Dries Up at the Pivot Point
- Every correct pivot point will develop with a contraction in volume, often to a level well below average, with at least one day when volume contracts very significantly, in many cases to almost nothing or near the lowest volume level in the entire base structure.
- In fact, we want to see volume on the final contraction that is below the 50-day average, with 1 or 2 days when volume is extremely low. This may not always occur in the largest-cap stocks, but in some of the smaller issues, volume will dry to a trickle.
- The decreased volume means that stock has stopped coming to market. This is precisely what occurs right before a stock is ready to make a big move. With very little supply of stock in the market from sellers, even a small amount of buying can move the price up very rapidly.
Buy on Breakout
- After the last narrow contraction in a VCP pattern on light volume, ideally you want to see an upward move in the making on stronger than usual volume.
- Extrapolate the day’s volume based on the intraday volume thus far. When the expected volume exceeds the average daily volume, when the price goes through the pivot point, you can place your trade.
- Let the stock break above the pivot and prove itself. Assuming that a stock will break out is dangerous. If the pivot point is tight, there is no material advantage in getting in early, you will accomplish little except to take on unnecessary risk.
- Not all consolidations have tight pivot points. When a flat base occurs with no real pivot other than the high of the base, an investor can look to buy as the stock moves above the highest price at the top of the base provided that the base corrects no more than 10 or 15%.
- Other price patterns, such as a cup completion cheat (3-C), or a cup-with-handle, can form pivot points below the high of the overall structure.
Cup Completion Cheat (3C) Pattern
- The cheat area is a “pause” area where the cup portion (of the cup-with-handle pattern) is being completed. A valid cheat area should exhibit tightness in the range of price as well as a contraction in volume.
- This pause presents an opportunity to enter the trade at the at the earliest point, perhaps not always with your entire position, but you can lower your average cost basis by exploiting cheat areas to scale into trades. You don’t want to be involved any earlier than this point.
- It is common for a cheat setup to develop during a general market correction… The key is to recognize when the stock has bottomed and identify when the start of a new uptrend is under way, back in sync with the primary stage 2.
- To qualify, the stock should
- Have already moved up by at least 25 to 100% — and in some cases by 200 or 300% — during the previous 3 to 36 months of trading [prior to the cup].
- Be trading above its upwardly trending 200-day moving average.
- The pattern can form in as few as 3 weeks to as many as 45 weeks (most are 7 to 25 weeks in duration).
- The correction from peak to low point varies from 15 or 20% to 35 or 40% in some cases and as much as 50%, depending on the general market conditions. Corrections in excess of 60% are too deep and are extremely prone to failure.
- The cheat should be contained within 5% to 10% from high point [of the cheat] to low point [of the cheat].
- The optimum situation is to have the cheat drift down to where the price drops below a prior low point, creating a shakeout, exactly the same thing you would want to see during the formation of a handle in a cup-with-handle pattern.
- The stock is set up and ready to be purchased as it moves above the high of the pause.
Power Play Pattern
- To qualify as a power play, the following criteria must be met
- An explosive price move commences on huge volume that shoots the stock price up 100% or more in less than 8 weeks. This generally occurs after a period of relative dormancy.
- The stock price then moves sideways in a relatively tight range, not correcting more than 20 to 25% over a period of 3 to 6 weeks (some can emerge after only 12 days).
- There is very tight price action that doesn’t correct the stock more than 10%, or the stock must display VCP characteristics.
- This is also referred to as a high tight flag. The first requirement is a sharp price thrust upward. These setups can move the fastest in the shortest period of times; velocity begets more velocity. This pattern often signals a dramatic shift in the prospects of a company.
- This is the only situation I will enter with a dearth of fundamentals. With the power play, the stock is exhibiting so much strength that it’s telling you that something is going on regardless of what the current earnings and sales are showing you.
Look for the Primary Base After IPO
- A primary base is the first buyable base after a company has gone public. The base forms during a corrective period of 3 weeks or longer that is followed by the emergence to an all-time high or from a constructive consolidation near the stock’s all-time high.
- Some IPOs can take up to a year or more to form a proper base. In most cases, you should insist that the stock put in a base of at least 3 to 5 weeks and not correct more than 25 to 35% to be reliable.
- Corrections that last longer (usually around one year) sometimes result in a decline of as much as 50%, yet the setup can still be sound [my note: a greater allowance for the depth of decline is given due to the length of time]. Shorter 3-week consolidations should not correct more than 25%.
- The biggest part of a company’s growth usually occurs in the first 5 to 10 years after the company issues common stock and goes public.
Don’t Enter Just On A Trendline Breach
- The problem is that although a trendline has been broken, instead of starting a new trend, the stock could just have made a momentary move in the other direction until the prevailing trend resumes.
- How can you tell when a new trend is in force? The answer is to wait for the stock to turn… The odds increase dramatically in your favor if you wait for the stock not only to (i) rally and break its downtrend but (ii) for the price to pause and then follow through before you place a trade.
- The spot to begin buying is just as the high of the pause is taken out. This could occur at the cheat area or the handle.
Why Buy Near a Near High
- A stock hitting a new high has no overhead supply to contend with. In contrast, a stock near its 52-week low at best has overhead supply to work through and lacks upside momentum.
- TASR advanced 540% to reach an all-time high, then advanced an additional 1800%.
- YHOO advanced 170% to reach an all-time high, then advanced an additional 4300%.
- MSFT hit an all time high in 1989, and advanced 54-fold.
- MNST hit an all time high in Aug 2003, then advanced 8000%.
Deep Correction Patterns are Failure-Prone
- Most constructive setups correct between 10% and 35%. I rarely buy a stock that has corrected 60% or more; a stock that is down that much often signals a serious problem.
- Under most conditions, stocks that correct more than 2 or 3x the decline of the general market should be avoided.
Too Short a Time Period is Hazardous
- A buildup of supply takes time to digest and work thorough. A quick up-and-down gyration doesn’t give the stock enough time to weed out the weak holders; it takes time for the strong hands to relieve the weaker players.
- Depending on the depth of the correction, a proper basing period can last anywhere from 3 weeks to as long as 65 weeks.
Look for Price Shakeouts to Improve Your Odds
- Shakeouts allow for the elimination of weak holders and allow a sustained move higher.
- Major support areas are obvious to amateurs and therefore should be obvious traps to professionals. Like a minefield, they’re filled with stops, ready to blow when the share price brushes the trip wire.
- To the extent that you identify base formations that have exhibited and digested shakeouts before your entry, you are less likely to be thrown from the saddle. Informed investors who understand price action are on the lookout for evidence of price shakeouts within the base before they buy.
- When a stock that is seemingly in the process of building a base undercuts a support floor, it may be a price shakeout, or the stock could be entering a precipitous or sustained decline. This is why you wait to see if it results in a shakeout. Ideally you want to see this occur 1, 2, or 3 times, depending on the size and magnitude of the price base, before you enter the trade. Shakeouts can occur at the lows of a base, on the right side, and in the handle or pivot area.
Look for Signs of Institutional Accumulation
- A sign of accumulation is a spike up in price. Price spikes generally occur off the lows of a correction within the base and on the right side of the base; this kind of price action gains credence if it is accompanied by outsized volume. A spike in price on overwhelming volume often indicates institutional buying, which is exactly what we’re looking for. After a price shakeout, it’s a good sign if the stock rallies back on big volume.
- Price magnitude
- A stock may experience big price spikes in the form of gaps. Gap ups accompanied by a surge of volume reflects strong demand.
- Avoid a stock that follows a big demand day with even bigger down days on volume.
- Volume magnitude
- You’ll want to see a dearth of down spikes. In other words, the volume must be much bigger on up days than on down days, and a few of the price spikes to the upside should be large, dwarfing the contractions that have occurred on relatively lower volume.
- Look for big up days that are larger and occur more frequently than big down days.
Handling Breakout Day (Entry Day) Issues
- Sometimes a stock will break out from a pivot point only to fall back into its range and close off the day’s high. This is what I refer to as a squat.
- When this happens, I don’t always jump ship right away; I try to wait at least a day or two to see if the stock can stage a reversal recovery… In some cases it can take up to 10 days or longer for a recovery to occur.
- If the price action tightens and volume subsides, the setup could be improving, and it could be that you’ve just entered the trade a bit early.
- Early Day Reversal
- An early day reversal occurs when a stock moves up in the morning and then comes back down to the breakout before noon or 1:00 p.m.
- The stock may even undercut your purchase price…. Try to give the stock until the end of the day unless the reversal is so severe that it triggers your protective stop.
- Stick to your game plan and hold to your original stop loss. In a healthy market, often stocks that do this will recover later in the day and close strong.
- 20-day Moving Average Violation
- If the reversal [on the breakout day] causes the price to close below its 20-day moving average, it lowers the probability of success and it becomes a judgment call; sometimes I sell if this happens. However, as long as the price holds above my stop loss, I try to give the stock some room.
- Once the stock successfully breaks out, the stock price should hold its 20-day moving average and in most cases should not close below it.
- If it pulls in, holds above the 20-day average, and squats, often the stock will recover the next day or within a few days. However, if it hits your stop, get out and reevaluate.
- Stop Violation
- Of course, if the reversal is large enough to trigger my stop, I sell.
- The pattern should not get wider (meaning up and down movements). Up is good, but wild swings back and forth are not.
Handling Issues While in Position
- Often, a stock will emerge through a pivot point and then pull back to or slightly below that initial breakout point. This is normal as long as the stock recovers fairly quickly within a number of days or perhaps within one to two weeks.
- If I am knocked out of a stock, I keep the stock on my radar to see if it resets technically…. The fact that it had a shakeout could turn out to be constructive for the stock going forward.
- A pivot failure doesn’t necessarily cause an outright base failure, instead, it can reset a new entry point usually within a number of days or weeks.
The Livermore System
- Jesse Livermore had a system of buying and selling when a stock changed direction, but only if the stock followed through.
- By waiting for a stock’s price to confirm a new uptrend, he avoided being whipsawed on every minor countertrend rally. Instead, Livermore waited for the trend to be broken and two reactionary pullbacks to take place; then, as the stock traded above the second reaction high, he would enter a trade.
- [My note: Downtrend >> HH >> HL >> HH >> HL >> HH (enter when the high is taken out after a natural reaction)]
No Such Thing As House Money
- Once I make a profit, that money belongs to me. Yesterday’s profit is part of today’s principal. My account simply has a new starting balance, subject to the same set of rules as before.
- Once a stock moves up a decent amount from my purchase price, I usually give it less room on the downside. I go into a profit-protection mode. At the very least, I protect my breakeven point. I’m certainly not going to let a good gain turn into a loss.
- I’m not suggesting that you not allow a stock to go through a normal reaction or pullback in price if you believe the stock can go much higher. Of course, you should give stocks some room to fluctuate, but that leeway has little to do with your past gain. Evaluate your stocks on the basis of the return you expect from them in the future versus what you’re risking. Each day, a stock must justify your confidence in holding it for a greater profit.
Set a Maximum Downside Loss Limit
- Set an absolute maximum line in the sand of no more than 10% on the downside.
- Your average loss should be much less, maybe 6 or 7%.
- If you can’t be correct on your purchase with a 10% cushion for normal price fluctuation, you have a different problem to address. Either your selection criteria and timing are flawed or the overall market is hostile and you should be out of stocks.
Try a Loss Adjustment Exercise
- Adjust all of your past losses to an arbitrary level of 10% to see what the effect of capping the downside would be. This included adjusting the losses that were smaller up to 10% as well as adjusting the ones that were larger down.
- Capping the losses would have knocked me out of a few of my winners; however this consequence was overwhelmed by the loss-cutting effect… Instead of having a double-digit percentage loss in my portfolio, I would have had a gain of more than 70%.
- From that point on, I grew very risk averse, and my results improved dramatically.
When the Stock Goes Down, You Know You’re Wrong
- When a stock you have bought falls below your purchase price, it is telling you have made an error — at a minimum in timing. Make no mistake, whether you’re a short-term trader or a long-term investor, timing is everything. Just as much money is lost on great companies bought at the wrong time as on investments that were poor choices in the first place.
Only One Way to Prevent a Large Loss
- Sell when you have a small loss before it snowballs into a huge one.
- My trading results went from mediocre to outstanding once I finally made the decision to draw a line in the sand and vowed never again to let a loss get out of control.
Be an Exacting Opportunist
- In the stock market, you have the luxury of being able to stay on the sidelines, free of charge, observing and waiting for the most opportune moment to wager. You get to see the market’s “cards” before you bet, free of charge. This is a wonderful advantage, yet few exploit it.
- Be selective and pick your entry spots very carefully. Wait until the probabilities are stacked in your favor before you act.
- With patience and discipline, you can profit from market opponents who are less disciplined and less capable than you are. While you do nothing, less skilled opponents are laying the groundwork for your success, and you get to wait and watch for free.
Develop Contingency Plans that Handle Virtually Every Situation
- Before I invest, I have already worked out in advance responses to virtually any conceivable development that may take place.
- Before the open of each trading day, mentally rehearse how you will handle each position based on whatever could potentially unfold during that day. Then, when the market opens for trading, there will be no surprises; you already know how you will respond.
Four Basic Contingency Plans
- Initialstop loss
- Establish in advance a maximum stop loss.
- The moment the price hits the stop loss, I sell the position without hesitation.
- When the market experiences general weakness or high volatility, your stock can undergo a correction or sharp pullback that stops you out. However, a stock with strong fundamentals can reset after such a correction or pullback, forming a new base or a proper setup… Often, the second setup is stronger than the first. The stock has fought its way back and along the way shaken out another batch of weak holders. If it breaks out of the second base on high volume, it can really take off.
- If the stock still has all the characteristics of a potential winner, look for a reentry point. Your timing may have been off. It could take 2 or even 3 tries to catch a big winner.
- Selling at a profit
- Once a stock amasses a percentage gain that is a multiple of your stop loss, you should rarely allow that position to turn into a loss (e.g. stop loss of 7%, if you have 20% gain, move stop to breakeven or trail stop to lock in majority of the gain).
- When you have to close out a trade, selling into strength is a learned practice of professional traders. It’s important to recognize when a stock is running up rapidly and may be exhausting itself. Or you can sell into the first signs of weakness immediately after such a price run has broken down.
- Disaster plan
- Plan what to do if your Internet goes down, or power fails, or your stock gaps down, company investigated by SEC, CEO embezzled funds.
Determine Your Cut Loss Level Based on Your Average Gain
- Calculate the average gain from your actual trades. Assume that a trader is profitable on 50% of his trades. A rule of thumb could be to cut your losses at a level of one-half of your average gain.
- Over time your average gain will improve as you learn how to trade more effectively. You should monitor your average gain on a regular basis and make adjustments to your stop loss accordingly.
- During my 30 years trading tens of thousands of stocks, I have been correct on winning trades only about 50% of the time; the dollar amounts of the profitable trades have been much larger than the losses on average.
- Allowing your loss on a trade to exceed your average gain is what I call the trader’s cardinal sin.
Build in Failure with a Low Batting Average Strategy
- If a trader has to be right on 70 or 80% of his trades and that’s his edge, what happens if he’s right only 40 or 50% of the time during a difficult period?
- The problem with relying on a high percentage of profitable trades is that no adjustment can be made; you can’t control the number of wins and losses. What you can control is your stop loss; you can tighten it up as you get squeezed during difficult periods.
- My goal is to maintain at least a 2:1 win/loss ratio with an absolute maximum stop loss of no more than 10%. I like to keep my risk/reward ratio intact so that I can have a relatively low batting average and still not get into serious trouble.
Get Out Immediately When Your Stop Slips
- Sooner or later, one of your stocks will dive under your sell [stop] price before you can react; this is called slippage. My advice is to get out immediately. Take whatever the next bid price is. Such a hard-falling stock is sending a warning.
- Sure, there are going to be many times when you sell a stock that’s down and it comes right back up. So what! Stop-loss protection is about protecting yourself from a major setback or, worse, devastation.
Handling a Losing Streak
- If you find yourself getting stopped out of your positions over and over, there can only be two things wrong: (1) your stock selection criteria is flawed, (ii) the general market environment is hostile.
- Leading stocks often break down before the general market decline. If you’re using sound criteria with regard to fundamentals and timing your stock picks should work for you, but if the market is entering a correction or a bear market, even good selection criteria can show poor results. It’s not time to buy; it’s time to sell or even possibly go short.
- Scale down your exposure, if it continues, cut back on your position sizes again and again.
Ease In When Coming Out of a Bear Market
- Find the theme
- When I come out of a 100% cash position, generally after a bear market or intermediate-term correction, I rarely jump right in with both feet…. I take it slow with my main focus on avoiding major errors and finding the market’s theme.
- Themes can come in the form of how prices are acting in general, industry group leadership, overall market tone, and economic and political influences… Once I find a theme and establish my trading rhythm, then and only then do I step up my exposure significantly… When the opportunity presents itself with the least chance of loss, I’m ready to strike. Patience is the key.
- Ease in
- As emerging stocks multiply on your watch list and the market tries to rally off its apparent lows, the time will come to test the water with real money.
- You should start off with “pilot buys” by initiating smaller positions than normal; if they work out, larger positions should be added to the portfolio soon thereafter… Wait for confirmation and require that at least a few trades work out before getting more aggressive…. Conversely, if your trades are not working as expected, cut back.
- If the market is indeed healthy, I should be experiencing success with my trading. in addition, you should see additional stocks setting up behind the first wave of emerging leaders…. Let your portfolio guide you.
Scale In, Not Average Down
- Say the professional decides to risk 5% of their capital on a trade (my note: i.e., position size is 5% of capital). The pro may scale in with 2% on the first buy, 2% on the second, and maybe an additional 1% on the third. He then might put his stop at 10% from the average cost of his 3 buys, risking 0.5% of the total account capital.
Trail Your Stop to Breakeven When Profit = 3x Risk
- When the price of a stock I own rises by 3x my risk, I almost always move my stop up to at least breakeven. Suppose I buy a stock at $50 and decide that I’m willing to risk 5% on the trade ($47.50 stop loss for a $2.50 risk). If the stock advances to $57.50 (3 x $2.50), I move my stop to at least $50.
- If the stock continues to rise, I start to look for an opportunity to sell on the way up and nail my profit.
- Move your stop up when your stock rises by 2 or 3 times your risk, especially if that number is above your historical average gain.
Handling Difficult Market Environments
- You may have heard that in setting a stop loss you should allow more room for volatile price action; you should widen your stops on the basis of the volatility of the underlying stock. I strongly disagree.
- Most often, high volatility is experienced during a tough market environment. During difficult periods, your gains will be smaller than normal and your percentage of profitable trades (your batting average) will definitely be lower than usual, and so your losses must be cut shorter to compensate. It would be fair to assume that in difficult trading periods your batting average is likely to fall below 50%. Once your batting average drops below 50%, increasing your risk proportionately to compensate for a higher expected gain based on higher volatility will eventually cause you to hit negative expectancy; the more your batting average drops, the sooner negative expectancy will be achieved.
- In addition, losses will be larger, downside gaps will be more common, and you will most likely experience greater slippage.
- The smart way to handle this is to do the following
- Tighten up stop losses. If you normally cut losses at 7 to 8%, cut them to 5 to 6%.
- Settle for smaller profits. If you normally take profits of 15 to 20% on average, take profits at 10 to 12%.
- If you’re trading with the use of leverage, get off margin immediately.
- Reduce your exposure with regard to your position sizes as well as your overall capital commitment.
- Once you see your batting average and risk/reward profile improve, you can start to extend your parameters gradually back to normal levels.
You Will Never Achieve Superformance If You Overly Diversify
- Depending on the size of your portfolio and your risk tolerance, you should typically have between 4 and 6 stocks, and for large portfolios maybe as many as 10 or 12 stocks. This should provide sufficient diversification but not too much.
- You should not hold more than 20 positions, which would represent a 5% position size if they were equally weighted.
- If you’re a true 2:1 trader, mathematically your optimal position size should be 25% (four stocks divided equally). As a result, a stock that is a big winner will make a real contribution to your portfolio.
- Concentrate your capital in the very best stocks — a relatively small group — that have exciting things going on. Watch your stocks carefully and be prepared to move if things take a turn for the worse.
- In my career, I have had many periods in which I put my entire account in just four names. This of course corresponds with some of my most profitable periods.
Categorize Your Stocks Into Six Categories
- Market leaders
- #1, #2, or #3 in sales and earnings in their industry and gaining market share.
- EPS growth of 20% or higher.
- These companies grow so fast that Wall Street can’t value them very accurately, leaving the stock inefficiently priced and providing a big opportunity.
- One type of market leaders are category killers, or companies whose brand and market position are so strong that it would be difficult to compete against it even if you had unlimited capital (e.g. Disney, Walmart, Apple).
- Another type are cookie cutters, where a firm produces a successful formula in one store and then replicates it over and over. You want to see same-store sales increasing each quarter. High-single-digit to moderate-double-digit same-store sales growth is high enough to be considered robust but not so high that it’s unsustainable (25 to 30% or more same-store sales growth is definitely unsustainable over the long term). Other key metrics include comparing sales per square foot, and sales per dollar of capital invested per unit with other companies in the same business.
- Top competitors
- A top competitor may not be the superior company in an industry group, rather, it’s in the right place at the right time. These “competitor” companies can also produce high rates of earnings growth and enjoy large-scale price advances. The #2 company in an industry can eventually take market share from the leader and in some cases take over the #1 spot.
- Always track the top 2 of 3 stocks in an industry group.
- Institutional favorites
- Mature companies with a good track record of consistent sales and dividend growth. Earnings growth is generally in the low to mid teens.
- Turnaround situations
- Look for at least 2 quarters of strong earnings increases or 1 quarter that is up enough to move the trailing 12-month earnings per share to near or above its old peak.
- Look for acceleration in the growth rate in the most recent couple of quarters compared with the three- and five-year growth rate, which often is negative or reflects very slow growth.
- You want to see the stock acting well in the market and the fundamentals coming in strong.
- Cyclical stocks
- Cyclical stocks have an inverse P/E cycle, meaning they generally have a high P/E ratio when they are poised to rally and a low P/E near the end of their cycle.
- With cyclical stocks, the trick is to figure out whether the next cycle turn is going to happen earlier or later than usual. Inventories and supply and demand are important variables in analyzing the dynamics of cyclical stocks.
- At the bottom of a cyclical swing, earnings are falling, dividends may be cut or omitted, P/E is high, news is generally bad.
- At the top of a cyclical swing, earnings are moving up, dividends are being raised, P/E is low, news is generally good.
- Past leaders and laggards
- A laggard is a stock that belongs to the same group as the market leader but has inferior price performance and in most cases inferior earnings and sales growth. Stay away from laggards.
Plan Your Trades Without Distractions
- Planning your trades in advance allows you to conduct research when there are no distractions such as level II systems or blinking quote screens. I conduct my research at around the same time each evening. By the time the opening bell rings at 9:30 a.m., I already know which stocks show the most potential and at what price level.
- Watch list shorthand notation
- Underline – Shows potential
- pb – Stock is setting up in such a way that I would be interested on a pullback
- Asterisk – Stock has formed a pivot point
- Circled Asterisk – Pivot point is immediately buyable
- Circled – Really like a stock
- Trading screen organization
- Buy ready – Circled + Asterisks
- Buy alert – Underlined
- Watch – pb + others
- Les Brown
- You don’t have to be great to get started, but you have to get started to be great.
- Vince Lombardi
- Practice does not make perfect. Only perfect practice makes perfect.
- Mark Weinstein
- I also don’t lose much on my trades, because I wait for the exact right moment. Most people will not wait for the environment to tip itself off. They will walk into the forest when it is still dark, while I wait until it gets light. Although the cheetah is the fastest animal in the world and can catch any animal on the plains, it will wait until it is absolutely sure it can catch its prey. It may hide in the bush for a week, waiting for just the right moment. It will wait for a baby antelope, and not just any baby antelope, but preferably one that is also sick or lame. Only then, when there is no chance it can lose its prey, does it attack. That, to me, is the epitome of professional trading.
- Jesse Livermore
- Let us say that a new stock has been listed in the last two or three years and its high was 20, or any other figure, and that such a price was made two or three years ago. If something favorable happens in connection with the company, and the stock starts upward, usually it is a safe play to buy the minute it touches a brand new high.
- I’ve always felt that smart people learn from their mistakes but really smart people learn from other people’s mistakes.
- Richard Love – Superperformance Stocks (Chapter 7)
- Marc R. Reinganum – “The Anatomy of a Stock Market Winner” (March-April 1988 issue of Financial Analyst Journal)
- Robert A. Levy – The Relative Strength Concept of Common Stock Price
- Edward S. Jensen – Stock Market Blueprints (1967)
- Richard Donchian – Various articles
- William L. Jiler – How Charts Can Help You in the Stock Market
- Jesse Livermore – How to Trade in Stocks
- Stan Weinstein – Secrets for Profiting in Bull and Bear Markets