The full title of this book is In the Trading Cockpit with the O’Neil Disciples: Strategies that Made Us 18,000% in the Stock Market by Gil Morales and Dr. Chris Kacher (2013).
Gil Morales and Chris Kacher were both portfolio managers who worked for William O’Neil (of Investor’s Business Daily fame). They had great success trading the dot-com boom, and had published another book Trade Like an O’Neil Disciple: How We Made 18,000% in the Stock Market in 2010.
This book goes through a few topics:
- Summary of the O’Neil method
- Summary of their new techniques
- Pocket pivot
- Buyable gap-up
- Seven-week sell rule
- Review of their trading in some instruments in 2011
- Many examples of pocket pivots
- Many examples of buyable gap-ups
- A FAQ towards the end of the book
One thing I particularly liked about the book is its emphasis that the key to making the big money is in understanding the market environment (i.e. macroeconomics, sector behavior, price/volume action of leaders, etc.) to identify and exploit investment themes. This is more like what Jesse Livermore advocated, and is somewhat different from the standard O’Neil style which is more like: wait for a bull market and trade the leaders.
I also liked the two chapters in the book where many examples were given of pocket pivots and buyable gap-ups, to help readers really get a better understanding of what they look like. However I felt that almost all the examples shown were positive examples, and would really like to have seen a lot more examples where the setup fails. This is especially so when the authors wrote that the success rate is around 50% during a good market environment, so there should be a lot more examples of the setups failing. In fact, those might be more educational as they help to prepare readers for what they would more realistically see when they apply the techniques in their own trading.
One thing to note here is that the trading style of the authors is very discretionary. Even though there seem to be rules, those are not hard and fast mechanical rules and they are not meant to be so. For example, the authors admit there are no hard and fast rules on when to buy gap-ups. Many of the answers in the FAQ section at the back of the book are in the form of “it depends, you can do this, that, or that”. One of the chapters showed a number of trades the authors took in 2011, and you can see that they would enter one day, re-think and sell the next day, re-think and buy the following day, and perhaps sell again a few days later. The authors also repeatedly highlight that they had tried to systematize various aspects but their conclusion is that it is virtually impossible. Hence because of that, it is also difficult to do any form of backtesting.
Finally, I noticed that there were a number of mistakes in the charts. Many of the charts have arrows pointing to the price bar and the volume bar to show where actions (e.g. buy, sell) are taken. A few of the charts have price arrows and volume arrows that are out-of-sync, and in some portions, the text do not gel with what you see on the associated chart. It happened in more than a few places, so the editorial review could have been improved.
- Buy a leading stock on a new-high base breakout (volume generally needs to be 150% of average daily volume for a valid base-breakout) and then adding to the position as it moves up 2% from the initial buy point.
Stop Loss Rule
- O’Neil studies showed that a future winning stock will rarely fall more than 7-8% below their precise buy point on the base breakout.
- According to O’Neil’s rules, you can buy a pivot point up to 5% past the actual pivot point buy price. Hence you could be required to sit through as much as 13% of downside.
- Livermore abided by a strict stop-loss rule of 10%.
Types of O’Neil-style Bases
- Ascending base (i.e. more than 2)
- Double bottom
Follow-Through Days Are Not Reliable, And That’s Fine
- Investors who follow the O’Neil methodology often reveal a psychological need to see a follow-through day as if it were the starting gate at the racetrack.
- The reality is that most follow-through days fail, and in 2011, every single follow-through day (6 in total) during that year failed.
- While the Market Direction Model (MDM) is an improvement over relying on follow-through days alone, it does not provide any clear or high levels of reliability, and it only serves as a directional pointer.
- The need to predict the “99.9 percent reliable follow-through day” is a waste of time and energy, and it reflects a need to approach the market in a rigidly deterministic manner. Using historical statistical analysis to generate such an indicator also runs the risk of overfitting the data, so that it becomes useless in the context of often anomalous action that characterizes a market that always seeks to fool most of the people most of the time.
- Finding opportunities where big money can be made is not dependent on the reliability of follow-through days… The follow-through day is [merely] a contextual tool in determining when the market may be changing direction from bear to bull… Understanding the [broader] circumstances and market context surround a follow-through day is critical.
Key to Making Money is to Understand Context, Identify Themes, and Execute based on Price/Volume
- Market history often rhymes, but it rarely replicates, and in practice we find that all bull and bear phases have their own particular contexts, in the sense that the 1990s were characterized by the rise of the Internet as a massive new paradigm and enabling technology, the early 2000s by the brutal bear market and recovery following the terrorist attacks of 9/11, or the period of 2008-2011 by the levitating effects of the reactionary financial engineering phenomenon and central bank policy tool of quantitative easing, popularly known as QE.
- Being able to sift through the context to find investment themes that can drive strong price moves in individual stocks is paramount to making money in the markets over the long term…. Taking into account critical bits of information like what other stocks in the same or similar group may be doing must always be accounted for when interpreting chart patterns.
- Making money in 2011 meant understanding that QE would debase the dollar and other fiat currencies being printed at the time. Such currency debasement can result in only one thing: rising commodities prices, particularly in precious metals that are seen as alternative currencies that offer a hedge against such currency debasement… it was only a matter of having the iShares Silver Trust (SLV) confirm this theme by showing up on our stock screens as it was emerging from a base consolidation in mid-February 2011.
- What is critical is being able to implement some judgment with respect to understanding the current market context, deriving some potential investment themes from such analysis. From there, one then identifies potential opportunities by screening for objective price/volume action in any environment, and then implementing clear, concrete buying, selling, and pyramiding rules based on the same objective price/volume action.
POCKET PIVOT BUY POINTS
- Should be within a base, where the stock is quieting down and it begins to move relatively tightly sideways as volume begins to dry up.
- Generally stock begins to act tightly around a moving average such as the 10-day or 50-day SMA.
- Avoid noisy, choppy, and volatile chart formations.
- Stock’s fundamentals should be strong (i.e. excellent earnings, sales, pretax margins, ROE, strong leader in its space, etc.)
- Stock comes up and off, or up and through the 10-day or 50-day SMA.
- Volume on the day of the pocket pivot must be higher than any down-volume day over the prior 10 trading days.
- Most all pocket pivots should be bought at or above the 50-day SMA. Exceptions are when the market has had a massive correction.
- Prices within the range of a prior pocket pivot is buyable (e.g. prices might overlap the following day).
- Use the seven-week rule (see below).
- If you bought your initial position on a continuation pocket pivot, use the violation of the 10-day SMA as your sell guide.
Types of Pocket Pivots
- Standard Pocket Pivot
- Occurs as an early buy point within a stock’s base or consolidation.
- Continuation Pocket Pivot
- Occurs as a movement up and off, or up and through the 10-day or 50-day SMA after the stock has already broken out and trended higher, becoming extended from the initial base-breakout buy point.
- Stock should act constructively around its 10-day SMA.
- Bottom-fishing pocket pivots
- Bottom-fishing pockets should only be explored when the market has been trendless or in a downtrend that has lasted for at least several weeks if not months. Should generally be avoided in uptrending markets.
- Pocket pivot coincides with a base breakout or gap-up.
- Pocket pivot coincides with an upside reversal (i.e. price had gone down, but it recovered and closed strongly) off the 10-day / 50-day SMA
- Stock bounced off the 10-day or 50-day SMA after a
- constructive tight sideways consolidation in price on low volume
- rounding out of the base
- tight price consolidation off its lows
- lengthy basing pattern
- tight range-bound trading
- prior gap-up
- Stock that is well under its 50-day SMA but getting support near the 200-day SMA can be bought if the base is constructive.
- Too extended from the 10-day SMA
- Prices closed below the 50-day or 200-day SMA
- Pocket pivot coming right after a sharp decline in the stock (‘V formation’), or after a down-trending formation before the base has had a chance to round itself out. It is best to wait for the rounding part of the base to form before buying a stock that had experienced a multi-month (5 months or longer) downtrend.
- Pocket pivot occurred within a slow-moving pattern with low relative strength.
- Pocket pivot occurred after a wedging pattern.
- When stock closes in the lower half of its trading range on the day of pocket pivot
- When there is sloppy / choppy price action
- When pocket pivot occurred after a V-shaped pattern
- In an uptrending market, about half of high quality stocks showing pocket pivots will work. In the 1990s, this was roughly equivalent to the success rate of standard base-breakouts during uptrending markets. The difference is that with pocket pivots the losses are often contained to within 5% or less.
- Bulls have decisively won the argument over the bears.
- Tends to work most likely because the crowd is too timid to buy.
- Buyable gap-up technique offers a way to buy an otherwise extended (from the breakout point) standard base-breakout.
- Gap-up is at least 0.75 times the 40-day AT.
- Volume is 1.5 times the 50-day SMA of daily trading volume.
- Gap-up should be bought at least in part at the open to avoid getting left behind in a situation where the price continues higher during the remainder of the day, and closes at its high.
- Intraday low of the gap-up day plus 2-3% more on the downside to allow the stock to dip below the intraday low.
- 1 to 2% below the intraday low of the gap-up day is the standard allowable amount of porosity.
- If the stock has moved higher for a few days and then retrace back to the low of its gap-up day while the general market has been strong, then you can sell when the stock undercuts the low of its gap-up day.
- Maximum risk of 7-8% has to be adhered to.
- Decisive action is always necessary, but many times, if you fail to buy a stock on the actual gap-up day, the stock will often give you a second entry point either by constructively pulling back on low volume following the gap-up day, or by issuing a pocket pivot in subsequent days.
- Gap-up occurs coming out of a well-formed consolidation
- where the stock’s price/volume action has tightened up
- after a constructive rounding out of the base
- after price has rounded out the lows of a new base before working its way up the right side of the base structure,
- where it is also a standard base-breakout
- after a tight price sideways consolidation
- after the base rounds out on the right side and tightens up along the 50-day moving average
- Gap ups that occur
- after a sharp uptrend can be an exhaustion gap move (climax top)
- near to a prior gap up are too obvious to work
- after a reasonably sharp downtrend, without a sideways basing pattern or constructive uptrend
- after a prior leader has massively crashed down
- Stocks will show a tendency to “obey” either their 10-day or 50-day SMA.
- A stock “obeys” its 10-day SMA if it is able to hold above its 10-day SMA for at least 7 weeks following a buy point without ever violating the MA.
- A stock might follow its 20-day SMA and 65-day EMA, but it is more often the exception
- Selling rule
- For a profitable position, if a stock “obeys” its 10-day SMA, use the 10-day SMA as a selling guide, such that a violation of the MA would cause you to sell your position, or at least some portion of it. If a stock does not “obey” its 10-day SMA, use the 50-day SMA as your selling guide.
- For a non-profitable position, if the stock violates its 10-day SMA, decide whether to sell depending on the stock quality and general market strength.
- What it means to violate an MA
- Need to allow for porosity around the MA, i.e. the tendency for price to briefly move beyond a moving average before returning back above it.
- To be considered a violation of an MA, price must close below the MA, and then on next day or over the next few days the stock must move below the intraday low of the first day it closed beneath the MA.
- If a stock violates a MA, but is doing so within a tight, narrow price channel, wait to sell only if the stock undercuts the low of the price channel.
- Counting details
- A buyable gap-up (but not another pocket pivot) will reset the seven-week clock back to zero.
- If the stock has been obeying the 10-day SMA prior to the pivot point, the count begins there.
- If the stock has been basing, the count begins on the day of the pivot buy point (e.g. pocket pivot, standard base-breakout, buyable gap-up, etc.)
Accounting for Volatile Stocks
- To account for the inherent greater volatility in an IPO stock, one way is to (1) wait for a close below the intraday low of the first day it closed beneath the MA, or (2) wait to see if the stock undercuts a nearby support level.
Don’t Exit Just Because of General Market Action
- Leading stocks can often buck a general market top and continue to go higher for several weeks and sometimes months beyond the actual market peak.
- Operate according to the Seven-Week Rule in order to keep from selling one’s position prematurely by becoming scared out by the general market action alone.
Dump on Major Gap Down
- When there is a massive gap-down on huge downside volume, sell everything right at the open. At best, volatility is likely, and further selling action is likely.
Leaders Can Rest While the Market Catches Up
- In order to make big money, one must focus on what one perceives as the biggest potential leaders once the market gets going in a new rally or bull phase.
- Since leading stock often move up on days when the general market may be flat or even down, one should not be surprised if such leaders rest on a day when the market is up. As long as the stock is resting and acting normally, there is nothing to do (i.e. no need to sell off).
Dealing with Slow Moving Stock After Entering
- If your stock is not moving higher because of a temporarily weak market, you might hold the position.
- If your stock doesn’t move higher within a week or two in the face of an up-trending market, you might sell it out for another stock flashing a pocket pivot buy point.
How to Handle Stock Positions Going into Earnings
- Investors can only think in terms of risk and reward and decide what to do, based on the profit cushion they have, and the position of that stock within its overall price move. Investors complicate the investing process by wasting time and energy trying to find ways to eliminate uncertainty, but uncertainty can never be eliminated in the markets.
- Assess the various scenarios and the potential amount that could be lost in percentage terms as a result of the position size. Assess just how much of an outright loss — if they have little profit cushion in the position — they are willing to tolerate, or how much profit they are willing to give up in a stock they might be up 50% or more on.
- Given a huge profit cushion in the stock, one might be willing to tolerate a 5-10% hit to the overall portfolio. Given only a small profit cushion of 1-2%, one might not be willing to tolerate much more than a 2-5% total hit to the overall portfolio.
Dump on Serious Gap Downs
- If a stock suffered a major gap-down of greater than 15%, statistical studies have shown that such stocks should be sold, usually at the opening of the day of the gap-down. If you can’t get yourself to sell the stock on that first gap-down day, then you should sell it if, in subsequent trading days, it breaks the low of the gap-down day.
- The risk of a stock gapping-down is one reason why you might want to build a position in a stock more slowly.
Prior Leaders Are The Best Candidates
- The best candidates for selling short in a bear market are precisely those stocks that were going up in the immediately prior bull market phase.
- The stocks that institutional investors drove higher as they piled in, gobbling up shares all the way, are the same stocks institutional investors will pile out of once the stocks have topped for good.
- Generally use 3 to 5% stops on short-sale positions, or use some area of overhead resistance provided it is not too far above your entry price.
- Since timing of your short-sale is always critical, you can also use a very tight stop such as the intraday high on the day you are taking the short position.
- Another way is to use a major moving average such as the 50-day or 200-day SMA as expected areas of upside resistance, give or take 2-3%.
Size Up When Market and Stocks Are Aligned
- If we think the market is starting a leg down and this is coinciding with stocks starting to break down from bona fide topping formations, then we may size up very quickly on the short side.
- Anyone who is new to short-selling should only use about 10-20% of their total account value.
Look for Voodoo Days
- A voodoo day is an up day at the end of a wedging rally where volume dries up sharply, usually 45% below average or more. Comes from the term “volume dry-up” or “VDU”.
- Volume drying up at the end of a rally indicates buying interest is diminishing, so the rally may likely give way to the downside and the macro-trend will resume.
- You may be able to short into a wedging rally just as it is about to run out of steam.
Layer In Your Position
- Because we frequently short into rallies, we may break up our initial position into three or more pieces that we will execute as the stock rallies into a potential area of resistance.
Beware the Rule of Three
- After something has occurred in the stock market twice, conditioning the crowd to expect it, the third time ends up fooling the crowd by doing the opposite of what it did the first two times.
- E.g. while Molycorp (MCP) had two prior pocket pivot buy points coming up off the lows of its bases in December 2010 and March 2011, the third time in July 2011 was simply too obvious.
Most Indicators Are Useless for Trend Following
- We find that price and volume, along with three primary moving averages — the 10-day, 50-day, and 200-day simple moving averages — are sufficient to determine points of entry and exit when dealing with leading stocks as they are both initiating and extending any profitable price trend.
- What most indicators, particularly breadth indicators and overbought-oversold indicators do is scare the crowd… But for our own practical use, we find them utterly useless.
- In trendless, choppy environments, perhaps some of these indicators become useful since a trendless market goes from short-term overbought to short-term oversold and then back again. This might be good for those who think they can make big money by channeling stocks, but the O’Neil-Wyckoff-Livermore methodology is a trend following methodology, and short-term indicators do not aid in determining or optimizing one’s ride on the primary trend.
Use Intraday Charts Only for Short Sales and Fine Tuning
- The trends we seek to follow are those of at least more of an intermediate-term nature… one day is certainly not an intermediate-term trend, and it probably isn’t even a short-term trend.
- Little moves on the daily chart can seem like big moves on a five-minute chart, thus the exaggeration of the price/volume on such a short time frame also has a tendency to exaggerate the emotions of fear and greed, which in turn can lead to improper trading action.
- If we had to use intraday charts, we would likely favor a longer time frame such as 30 minutes of 60 minutes. Occasionally, when we are working a large position, say 50,000 or 100,000 shares of a stock, we want to be aware of the 30-minute or 60-minute short-term support or resistance levels to help work the order, but just as often we just go in and buy our shares once our buy alert goes off.
- We do use intraday charts for the purpose of timing short sales in former leading stocks during a bear market or market correction.
- Use calming colors
- Blue or aquamarine, for example, has been shown to have a calming effect. Use a color scheme that emphasizes cool colors (e.g. blue and green).
- Daily chart
- 10-day, 50-day, 200-day SMA
- 20-day SMA, 65-day EMA
- Weekly chart
- 10-week, 40-week SMA
- Screen for real-time pocket pivots
- Screen for pocket pivots during the day. If don’t have access to screening tools, go through your leader list every day to see which stocks are in position for possible pocket pivot moves, and then set volume alerts to go off if the stock trades the highest volume over the prior 10 days.
- Screen for buyable gap ups
- Run eSignal’s premarket screen 20-30 minutes before the open to get a list of stocks that are set to gap-up on the open based on their pre-open prices.