Champions aren’t made in the gyms. Champions are made from
something deep inside them—a desire, a dream, a vision.
—Muhammad Ali, three-time world heavyweight boxing champion
Success requires opportunity. The stock market provides incredible
opportunity on a daily basis. New companies are constantly emerging as market leaders in every field from high-tech medical equipment to retail stores and restaurants right in your own neighborhood. To spot them and take advantage of their success you must have the know-how and the discipline to apply the proper investment techniques.
Impossible is just a big word thrown around by small men who find
it easier to live in the world they’ve been given than to explore the
power they have to change it.
—Laila Ali
Dedication and a desire to succeed are definitely requirements to achieve superperformance in stocks. What is not required is conventional wisdom or a college education.
“Optimists are right. So are pessimists. It’s up to you to choose which you will be.”
—Harvey Mackay
When you make an unshakable commitment to a way of life, you put yourself way ahead of most others in the race for success. Why? Because most people have a natural tendency to overestimate
what they can achieve in the short run and underestimate what they can accomplish over the long haul. They think they’ve made a commitment, but when they run into difficulty, they lose steam or quit.
The difference between interest and commitment is the will not to give up. When you truly commit to something, you have no alternative but success.
Getting interested will get you started, but commitment gets you to
the finish line. The first and best investment you can make is an investment in yourself, a commitment to do what it takes and to persist. Persistence is more important than knowledge. You must persevere if you wish to succeed in anything. Knowledge and skill can be acquired through study and practice, but nothing great comes to those who quit.
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.
For me, the greatest success came when I finally decided to forget about the money and concentrate on being the best trader I could be. Then the money followed.
You don’t have to be great to get started, but you have to get started
to be great.
—Les Brown
Robert Schuller said, “It’s better to do something imperfectly than to do nothing flawlessly.” An ounce of action is worth pounds of theory. In the stock market, you can make excuses or you can make money, but you can’t do both.
It’s not enough to have knowledge, a dream, or passion; it’s what you do with what you know that counts. Even if you don’t become wealthy, by doing what you’re passionate about, you will at least be happy. The best chance you have to succeed in life is to do what you enjoy and give it everything you’ve got. When you get up each morning and do what you love, you never work a day in your life. Those days can begin today. The best time to begin is right now!
If you cannot—in the long run—tell everyone what you have been
doing, your doing has been worthless.
—Erwin Schrödinger
To realize profits from investing in stocks, you must make three correct decisions: what to buy, when to buy, and when to sell.
There isn’t a person anywhere who isn’t capable of doing more than he thinks he can.
—Henry Ford
The more I practice, the luckier I get.
—Gary Player
Success in the stock market has little to do with luck. On the contrary, the more you work a sound plan, the luckier you will become.
A new idea is delicate. It can be killed by a sneer or a yawn; it can
be stabbed to death by a quip and worried to death by a frown on
the right man’s brow.
—Charles Brower
Remember, people who say something can’t be done never did it themselves. Surround yourself with people who encourage you and
don’t let the naysayers knock you off track.
On the basis of 30 years of personal experience and historical analysis of every market cycle going back to the early 1900s, I can assure you that nothing has changed very much. In fact, history repeats itself over and over.
The world is full of people looking for a secret formula for success.
They do not want to think on their own; they just want a recipe to
follow. They are attracted to the idea of strategy for that very reason.
—Robert Greene
If you aren’t prepared to invest a good portion of your time before you invest your money, you’re just throwing darts. At some point, you will surely be taken to the cleaners.
Do the work, own your failures, and you will own your success.
No one is going to make you rich except you.
It wasn’t until I suffered enough big losses that I made the decision that turned my performance from mediocre to stellar: I decided it was time to make money and stop stressing about my ego.
trading is not about picking highs and lows or proving how smart you are; trading is about making money. If you want to reap big gains in the market, make up your mind right now that you
are going to separate trading from your ego. It’s more important to make money than it is to be right.
Any pattern of action repeated continuously will eventually become habit. Therefore, practice does not make perfect; practice only makes habitual.
“Practice does not make perfect. Only perfect
practice makes perfect.”
—Vince Lombardi
Do the thing and you will have the power.
—Ralph Waldo Emerson
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.
The amateur investor has many built in advantages that could result
in outperforming the experts. Rule #1 is to stop listening to the
professionals.
—Peter Lynch
if you want mutual fund–like results, invest like a fund manager. If you want superperformance results, you must invest like a superperformance investor.
In my experience, attaining superperformance in stocks comes from
doing things that are different from what is obvious or popular. This is often misinterpreted as risky.
If you want to be the best, you have to do things that other people
are unwilling to do.
—Michael Phelps,
Ask yourself, What are my goals? Even if you haven’t thought out a life plan,probably a few aspirations come to mind right away. Now ask yourself, What would I give up to achieve those goals? That’s another story, isn’t it? The choice to sacrifice is difficult, but it is one of the most important decisions you will make in the pursuit of success. Sacrifice means prioritizing, which could result in giving up certain activities to have the time to pursue trading.
Admittedly, this is a tough step to take, but no champion has a completely balanced life when he or she is going for a gold medal. Champions are laser-focused on their goal; they understand the power of a narrow focus. This comes at a price; it’s called sacrifice.
I fear not the man that has practiced 10,000 kicks once, but I fear
the man that has practiced one kick 10,000 times.
—Bruce Lee
To become great at anything, you must be focused and must specialize.
Many of life’s failures are people who did not realize how close they were to success when they gave up.
—Thomas Edison
Remember, if you choose not to take risks, to play it safe, you will never know what it feels like to accomplish your dreams. Go boldly after what you want and expect some setbacks, some disappointments, and some rotten days. Embrace them all as a valuable part of the process and learn to say, “Thank you, teacher.” Be happy, feel appreciative, and celebrate when you win. Don’t look back with regrets at failures. The past cannot be changed, only learned from. Most important, never let rotten days make you give up.
In 1991, the 40 top-performing stocks (starting at above $12 a share) began the year with an average P/E of 29, and by year end their P/E ratios had expanded to 83.
I execute a trade only at the point of alignment across the spectrum with regard to company fundamentals, stock price, and volume activity as well as overall market conditions.
Over the years, I’ve concluded that most superperformance stocks have common identifiable characteristics. In the majority of cases, decent earnings were already on the table. In fact, the majority of superperformance stocks already had periods of outperformance in terms of fundamentals as well as technical action before they made their biggest gains. More than 90 percent of superperformance stocks began their phenomenal price surges as the general market came out of a correction or bear market. Interestingly, very few stocks had superperformance phases during a bear market.
Look for candidates with a relatively small total market capitalization and amount of shares outstanding. All things being equal, a smallcap company will have the potential to appreciate more than a large-cap, based on the supply of stock available. It will take far less demand to move the stock of a small company with a comparatively small share float than a large-cap candidate.
Generally speaking, though, if a large-cap company advances rapidly in a short period, I’m inclined to take profits on it more quickly than I would with a smaller, faster-growing company that may have the potential to double or even triple in a number of months.
A stock trading strategy is like a marriage; if you’re not faithful, you probably won’t have a good outcome. It takes time and dedication, but your objective should be to become a specialist in your approach to the market.
A trader who really knows the strengths and weaknesses of his or her strategy can do significantly better than someone who knows only a little about a superior strategy.
It’s far better to buy a wonderful company at a fair price than a fair
company at a wonderful price.
—Warren Buffett
Buying a cheap stock is like a trap hand in poker; it’s hard to get away from. When you buy a stock solely because it’s cheap, it’s difficult to sell if it moves against you because then it’s even cheaper, which is the reason you bought it in the first place. The cheaper it gets, the more attractive it becomes based on the “it’s cheap” rationale. This is the type of thinking that gets investors in
big trouble. Most investors look for bargains instead of looking for leaders, and more often than not they get what they pay for.
If you avoid stocks just because the P/E or share price seems too high, you will miss out on many of the biggest market movers. The really exciting, fast-growing companies with big potential are
not going to be found in the bargain bin. You don’t find top-notch merchandise at the dollar store. As a matter of fact, the really great companies are almost always going to appear expensive, and that’s precisely why most investors miss out.
The top 100 best-performing small- and mid-cap stocks of 1996 and 1997 had an average P/E of 40. Their P/Es grew further to an average of 87 and a median of 65. Relatively speaking, their initially “expensive” P/Es turned out to be extremely cheap. These top stocks averaged a gain of 421 percent from buy point to peak. The P/E of the S&P 500 ranged from 18 to 20 during that period.
Value doesn’t move stock prices; people do by placing buy orders. Value is only part of the equation. Ultimately, you need demand.
One of the worst trades I ever made was Bethlehem Steel trading at
2x earnings. I said “How low can it go?” It went to zero.
—Jim Cramer
I don’t set trends. I just find out what they are and exploit them.
—Dick Clark
I identify these four stages on the basis of what is happening with the stock in terms of price action:
1. Stage 1—Neglect phase: consolidation
2. Stage 2—Advancing phase: accumulation
3. Stage 3—Topping phase: distribution
4. Stage 4—Declining phase: capitulation
What I found through my study of the biggest price performers was that virtually every superperformance stock made its big gain while in stage 2 of its price cycle.
You should avoid buying during stage 1 no matter how tempting it may be; even if the company’s fundamentals look appealing, wait and buy only in stage 2.
To compound capital at a rapid rate and achieve superperformance,
it is vital that you avoid stage 1 and learn to spot where momentum
is strong during stage 2.
I can tell you from experience that attempting to bottom fish—trying to buy a stock at or near its bottom—will prove to be a frustrating and fruitless endeavor. Even if you are fortunate enough to pick the exact bottom, making significant headway usually requires sitting without much progress for months and in some cases years, because when you buy a stock near its bottom, it is in stage 4 or stage 1 and therefore by definition lacks upside
momentum.
My goal is not to buy at the lowest or cheapest price but at the “right” price, just as the stock is ready to move significantly higher. Trying to pick a bottom is unnecessary and a waste of time; it misses the whole point.
A stage 2 advance may begin with little or no warning; there are no major announcements or news. One thing is certain, however: a proper stage 2 will show significant volume as the stock is in strong demand on big up days and up weeks, and volume will be relatively light during pullbacks. There should always be a previous rally with an escalation in price of at least 25 to 30 percent
off the 52-week low before you conclude that a stage 2 advance is under way and consider buying.
Transition Criteria of stage 2
1. The stock price is above both the 150-day and the 200-day moving average.
2. The 150-day moving average is above the 200-day.
3. The 200-day moving average has turned up.
4. A series of higher highs and higher lows has occurred.
5. Large up weeks on volume spikes are contrasted by low-volume
pullbacks.
6. There are more up weeks on volume than down weeks on volume.
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. These signs of accumulation
should appear during every stage 2 advance.
Stage 2 Characteristics
1. The stock price is above its 200-day (40-week) moving average.
2. The 200-day moving average itself is in an uptrend.
3. The 150-day (30-week) moving average is above the 200-day
(40-week) moving average.
4. The stock price is in a clear uptrend, defined by higher highs and
higher lows in a staircase pattern.
5. Short-term moving averages are above long-term moving averages (e.g., the 50-day moving average is above the 150-day moving average).
6. Volume spikes on big up days and big up weeks are contrasted by volume contractions during normal price pullbacks.
7. There are more up days and up weeks on above-average volume
than down days and down weeks on above-average volume.
During stage 3, the stock is no longer under extreme accumulation;
instead, it is changing hands from strong buyers to weaker ones. Smart money that bought early when the stock emerged onto the scene is now taking profits, selling into final signs of price strength. As that occurs, buyers on the other side of the transaction are weaker players who know about the stock because it has made such a dramatic run and captured headlines. In other words, the long trade in the stock has become crowded and too obvious.
This distribution phase exhibits a topping pattern. Volatility increases markedly, and the stock becomes visibly more erratic relative to its previous stage 2 trading pattern.
Stage 3 Characteristics
1. 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.
2. 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.
3. The stock price may undercut its 200-day moving average. Price
volatility around the 200-day (40-week) moving average line is
common as many stocks in stage 3 bounce below and above the
200-day average several times while topping out.
4. The 200-day moving average will lose upside momentum, flatten
out, and then roll over into a downtrend.
Stage 4 Characteristics
1. The vast majority of the price action is below the 200-day (40-week) moving average.
2. The 200-day moving average, which was flat or turning downward in stage 3, is now in a definite downtrend.
3. The stock price is near or hitting 52-week new lows
4. The stock price pattern is characterized as a series of lower lows
and lower highs, stair-stepping downward.
5. Short-term moving averages are below long-term moving
averages.
6. Volume spikes on big down days and big down weeks are
contrasted by low-volume rallies.
7. There are more down days and weeks on above-average volume
than up days and up weeks on above-average volume
How to Pinpoint Stage 2
I apply the Trend Template criteria (see below) to every single stock I’m considering. The Trend Template is a qualifier. If a stock doesn’t meet the Trend Template criteria, I don’t consider it. Even if the fundamentals are compelling, the stock must be in a long-term uptrend—as defined by the Trend Template—for me to consider it as a candidate. Without identifying a stock’s trend, investors are at risk of going long when a stock is in a dangerous
downtrend, going short during an explosive uptrend, or tying up capital in a stock lost in a sideways neglect phase. It’s important to point out that a stock must meet all eight of the Trend Template criteria to be considered in a confirmed stage 2 uptrend.
Trend Template
1. The current stock price is above both the 150-day (30-week) and the 200-day (40-week) moving average price lines.
2. The 150-day moving average is above the 200-day moving average.
3. The 200-day moving average line is trending up for at least 1 month (preferably 4–5 months minimum in most cases).
4. The 50-day (10-week) moving average is above both the 150-day and 200-day moving averages.
5. The current stock price is trading above the 50-day moving average.
6. The current stock price is at least 30 percent above its 52-week low. (Many of the best selections will be 100 percent, 300 percent, or greater above their 52-week low before they emerge from a solid consolidation period and mount a large scale advance.)
7. The current stock price is within at least 25 percent of its 52-week high (the closer to a new high the better).
8. The 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.
My favorite type of stock to invest in—the area where I have made most of my money trading—is the market leader. These companies are able to grow their earnings the fastest. An industry’s strongest players are usually number one, two, or three in sales and earnings and are gaining market share.
A company that is taking market share in a slow-growth industry
can also grow its earnings quite nicely. What’s most important is that the company can make substantial profits. A good balance sheet, expanding margins, high return on equity, and reasonable debt are all signs of good management.
The main questions should be: What is the company’s competitive
advantage? and Is the business model scalable? Then it’s a matter of whether management is executing successfully and delivering the goods, namely, earnings.
You should concentrate on the top two or three stocks in a group: the leaders in terms of earnings, sales, margins, and relative price strength. This is especially true if the industry group is a leading sector during a bull market.
Buying a cyclical after several years of record earnings and when the P/E ratio has hit a low point is a proven method for losing half your money in a short period of time.
—Peter Lynch
At the bottom of a cyclical swing, the following things happen:
1. Earnings are falling.
2. Dividends may be cut or omitted.3. The P/E ratio is high.
4. News is generally bad.
At the top of a cyclical swing:
1. Earnings are moving up.
2. Dividends are being raised.
3. The P/E ratio is low.
4. News is generally good.
Stay Away from the 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. These stocks can have periods of decent performance, usually brief ones, as they try to catch up with the true leaders near the end of a cycle or during times when a sector is red hot and the real leader has run up rapidly.Laggards usually appear to be relatively cheaper than market leaders, and that attracts unskilled investors. Don’t be tempted by a stock with a relatively low P/E or one that hasn’t appreciated as much as has the leader
in its industry.
When you see a growing number of names in a particular
industry making new 52-week highs (especially coming off a market low), this could be an indication that a group advance is under way.
I have found that more often than not, the best stocks in the leading groups advance before it’s obvious that the group or sector is hot. Therefore, I focus on stocks and let them point me to the group.
I look at the strongest stocks first: the ones that have the best earnings and sales, are closest to a new high, and show the greatest relative price strength versus the market. This is where you find the real market leaders.
History shows that big winning stocks tend to favor certain industry
groups. The groups that have produced the largest number of superperformance
stocks include the following:
1. Consumer/retail
2. Technology, computer, software, and related
3. Drugs, medical, and biotech
4. Leisure/entertainment
Just as leading stocks can at times foretell a powerful group advance, keeping an eye on the top two or three companies in an industry group could provide a tip-off to when the group may be headed for trouble. It’s important to keep your eye on important leading names in the top-performing sectors. Often you’ll see an important stock in a group break badly, and the whole group will suffer.If one or more important stocks in an industry group top, that could be a warning that the whole group will soon run into trouble. Even stocks that are outside the group, such as suppliers and customers, may share in the suffering. Historically, more than 60 percent of superperformance stocks were part of an industry group advance.
The fact is, no matter how big or prestigious a company is, when
fundamentals deteriorate—namely, earnings—you never know how far the stock will fall.
The stock market cares little about the past, including the status of a company. What it cares about is the future, namely, growth. Keep in mind that our goal is to uncover superperformance stocks: shares that will far outpace the rest of the pack. These stocks are the ones with the strongest potential, and they seldom are found in the bargain bin. They are going strong because of a powerful force behind them: growth—real growth—in earnings and sales. Why buy damaged merchandise?
Regardless of a company’s size, status, or reputation, there is no intelligent reason for an investor to settle for an inferior track record in a marketplace filled with companies with outstanding
fundamentals.
In real estate, the mantra goes “location, location, location.” In the stock market, it’s earnings, earnings, earnings; after all, it’s the bottom line that counts. How much money can a company earn and for how long? This leads to three basic questions every investor should ask when it comes to earnings: How much? How long? and How certain? Profitability, sustainability, and visibility represent the most influential factors that move stock prices.
When a company reports quarterly results that are meaningfully better than expected, analysts who follow the stock must reexamine and revise their earnings estimates upward.
Stocks move for two basic reasons: anticipation and surprise. Every price movement is rooted in one of these two elements: anticipation of news, an event, an important business change, or reaction to an unexpected event and a surprise, whether positive or negative.
Be on the lookout for companies that are beating
earnings estimates; the bigger the earnings surprise, the better.
They call it the cockroach effect because as with cockroaches, if you see one, you can bet there are others. The same thinking applies to companies reporting earnings surprises. If a company has posted very good quarterly results that are much better than were anticipated by analysts, there are probably more good quarters ahead. If a company is performing well with earnings surprises, other companies in the same industry or sector may post some upside surprises as well.
Because earnings surprises have a lingering effect, we want to focus on companies that beat estimates and avoid firms that have negative earnings surprises.
Look for companies for which analysts are raising estimates.
Quarterly as well as current fiscal year estimates should be trending
higher; the bigger the estimate revisions, the better.
In order to find your next superperformer, look for stocks that are in stage 2 with strong earnings, positive surprises, and upward revised estimates.
Sometimes a company with a rocketing stock price may not be making much money, but the rising price means that investors are hoping that it will be profitable in the future. However, 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 two or three quarters also show good gains.
Really successful companies generally report earnings increases of 30 to 40 percent or more during their superperformance phase.
If you demand that your stock selections not only show strong earnings but also show strong sales, you will increase your chances of latching on to a superperformer.
Strong quarterly results should translate into strong annual results. Just one or two quarters of good earning isn’t going to be enough to drive a stock’s price significantly higher for an extended period.
institutions like to see the following:
1. Earnings surprises
2. Accelerating earnings per share (EPS) and revenues
3. Expanding margins
5. Strong annual EPS change
6. Signs that acceleration will continue
Management may also choose to shift earnings so that a hit can be
absorbed in a single disappointing quarter. By shifting earnings to have one big down quarter, the company can beat estimates in the next quarter because the previous report prompted analysts to lower their estimates, making it easier for the company to beat the Street. You want to see earnings coming from robust top-line sales, not from accounting tricks and gimmicks.
A company can increase profits by cutting jobs, closing plants, or shedding its losing operations. However, these measures have a limited life span.
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. That’s a winning combination.
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.
When strong earnings are reported, check the story behind the results to make sure the good news is not due to a one-time event but is the product of conditions that probably will continue. Your questions should include the following:
1. Are there any new products or services or positive industry changes?
2. Is the company gaining market share? A market is ultimately
dominated by just a few companies.
3. What is the company doing to increase revenue and expand
margins?
4. What is the company doing to decrease costs and increase
productivity?
Net margin is based on a company’s net income divided by sales and reflects all the variables that influence profitability. A falling net margin indicates that the company is making a smaller profit on its sales.
For a true superperformer, there should definitely not be a huge sell-off that breaks the whole leg of the stock’s upward move.
When obliged to fess up to bad news, a publicly traded company will often try to spin the message. It may announce a stock buyback or some other “positive” news at the same time it reports a disappointing quarter in an effort to soften the blow and offset any potential negative effects. This generally doesn’t work.
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. If they say, “Business conditions will be tough this year, but we see improvement coming next year,” that’s not positive guidance. That’s spin.
When inventory grows much faster than sales, it can indicate weakening sales, misjudgment by management of future demand, or both.
When a company says one thing in one document and something quite different in another, you have differential disclosure.
If a company is reporting great earnings but is not paying much in taxes, be skeptical.
Look for what I call a Code 33 situation, three quarters of acceleration in earnings, sales, and profit margins. That’s a potent recipe. If a company has Earnings per share, sales, and margins accelerating for three consecutive quarters.
Most of the big money made in bull markets comes in the
early stages, during the first 12 to 18 months. However, by the
time a big advance asserts itself in the broad market indexes, many of the best stocks may have been running up for weeks in advance. The question then becomes how you know when to jump on board before an emerging rally gets away from you and the very best stocks leave you in the dust. The answer: follow the leaders.
More than 90 percent of superperformance stocks emerge from bear markets and general market corrections. The key is to do your homework while the market is down; then you will be prepared to make big profits when it turns up.
If the major market indexes ignore an extremely overbought condition after a bear market decline and your list of leaders
expands, this should be viewed as a sign of strength.
The true market leaders will show strong relative price strength before they advance. Such stocks have low correlation with the general market averages and very often act as lone wolves during their biggest advancing stage. The search for these stocks runs contrary to the thinking of most investors, who often take a top-down approach, examining first the economy and the stock market, then market sectors, and finally companies in a specific industry group. As I’ll show you in several examples in this chapter,
many of the very best leading stocks tend to bottom and top ahead of their respective sectors, whereas specific industry groups can lead a general market turn. 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.
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.
It’s important to study carefully the price action of individual companies with new positive developments and strong earnings
per share during major market declines. Many of the most strongly
rebounding stocks and the ones that hold up the best are likely to become the next up cycle’s superperformers.
A growing number of stocks displaying positive, divergent price
behavior during a general market decline can tip you off to where the next group of market leaders may emerge or what stocks are likely to blast off first when the market starts to rally. When you see this type of price action, it’s time to tune out the media and the gurus and concentrate on the facts: price, volume, earnings, sales, profit margins, new products, and positive industry changes.
Let the strength of the market tell you where to put your money, not
your personal opinion, which rarely is a good substitute for the wisdom of the market. Ultimately, opinions mean nothing compared with the verdict of the market. The stocks that emerge first in the early stage of a new bull market with the greatest power are generally the best candidates for superperformance.
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.
Just as the leaders lead on the upside, they also lead on the downside. Why? 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. When the leading names in leading industry groups start to falter after an extended market run, this is a danger signal that should heighten your attention to the more specific signs of market trouble or possible trouble in a particular sector.
History shows that one-third of superpeformers
give back all or more of their entire advance. On average, their subsequent price declines are 50 to 70 percent, depending on the period measured.
In the later stage of the general market’s advance, the same leaders will alert you to weakness in their underlying sectors as well as potential upcoming weakness in the broader market. Your portfolio will be your best barometer.
As a general rule, I buy strength, not weakness. True market leaders will always show improving relative strength, in particular during a market correction.
At this point, 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 stages 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 percent) of a new 52-week high. Conversely, every day there is a list of stocks to avoid printed in the financial newspapers: the 52-week-low list. I suggest that you stay away from this list and all of its components.
Generally, the correction for a healthy stock from peak to low will be contained within 25 to 35 percent and during severe bear market declines could be as much as 50 percent, but the less, the better. A correction of more than 50 percent is generally too much, and a
stock could fail as it reaches or slightly surpasses a new high.
The leaders of the past bull market rarely lead the next rally, so expect to see unfamiliar names. Fewer than 25 percent of market leaders in one cycle generally lead the next cycle.
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.
—Mark Weinstein
Charts enable us to see what’s going on in a particular stock as buyers and sellers come together in an auction marketplace. They distill the clash for emotional, logical, and even manipulative
decisions into a clear visual display; the verdict of supply and demand.
My own trading relies on charting to the extent that I would never bet on my fundamental ideas alone without confirmation
from the actual price action of the underlying stock.
The third group consists of techno-fundamentalists. As the name suggests, these traders exploit both technical analysis and fundamental analysis. If I had to pick, I would put myself in this group. I rely on price and volume as well as fundamentals. In making the decision whether to purchase a stock, there are important characteristics to consider, both fundamental and technical. A healthy hybrid approach exploits charts as well as fundamentals to increase the trader’s odds of success.
Chart patterns are not the cause; they’re the effect. The supply and demand picture does not dictate to the market; human behavior does, and human behavior hasn’t changed and isn’t likely to change much in the future.
The key is not knowing for sure what a stock is going to do next but knowing what it should do. Then it’s a matter of determining whether the proverbial train is on schedule.
When one identifies the proper characteristics for a superperformance candidate, the risks become unambiguous. If a stock doesn’t act as expected, that’s a major red flag. After all, the stock has already met very elite criteria and has been deemed a strong prospect. If such a stock behaves poorly, that suggests a problem. Learning what to expect allows you to detect when a
stock is acting correctly or incorrectly in the prevailing conditions. Because you know how something is supposed to perform, when it doesn’t perform that way, it makes the exit decision much easier.
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.
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.
If the long-term trend is not up, the stock simply doesn’t qualify as a candidate for purchase. Therefore, don’t forget the big picture.
As the saying goes, the trend is your friend. If you try to trade against it, the trend becomes your worst enemy. To increase your odds of success, stick to stocks moving in a definite uptrend. If a stock’s price is in a long-term downtrend, don’t even consider buying it.
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. I use the volatility contraction pattern
(VCP) concept to illustrate this.
The immediate distinguishing features of the VCP will be
the number of contractions that are formed (typically between two and four), their relative depths throughout the base, and the level of trading volume associated with specific points within the structure. Because I track hundreds of names each week, I created a quick way to capture a visual of a stock by quickly reviewing my nightly notes and each stock’s footprint abbreviation.
This quick reference is made up of three components:
1. Time. How many days or weeks have passed since the base started?
2. Price. How deep was the largest correction, and how narrow was
the smallest pullback at the very right of the price base?
3. Symmetry. How many contractions (Ts) did the stock go through
during the basing process?
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. 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. This is a very positive development, especially if it takes place after a period of correction and consolidation, and is a telltale sign that the amount of stock coming to market has diminished. 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.
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.
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.
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.
A stock making a new 52-week high during the early stages of a fresh bull market could be a stellar performer in its infancy. In contrast, a stock near its 52-week low at best has overhead supply to work through and lacks upside momentum; worse still, such a stock may be headed for a series of lower lows. A stock hitting a new high has no overhead supply to contend with. The stock is saying, “Hey, I have something going on here, and people are
taking notice,” whereas a stock hitting a new low is clearly a laggard that lacks investor interest or is being dumped in size by institutions.
When a stock reaches a new high in a confirmed stage 2 uptrend supported by big volume clues, it has been propelled upward by institutions taking positions because they believe that the fundamentals are solid and the prospects for the future are even better.
The only way a stock can become a superperformer, moving from, say, $20 to $80, is for that stock to make a series of new highs repeatedly, all the way up. The same thing applies to a stock that’s at $50 and doubles to $100 on its way to $300.
When a stock declines precipitously, it is likely that there is a serious problem in the company, its industry, or perhaps a bear market is unfolding. You shouldn’t conclude that a stock is a bargain just because it’s trading down 50 or 60 percent off its high. First, such a decline could indicate that a serious fundamental problem is undermining the share price. Second, even if the
fundamentals are not problematic yet, a stock that has experienced a deep sell-off must contend with a large amount of overhead supply: the more a stock drops, the more it is burdened by trapped buyers. Finally, the more a stock declines, the more potential profit takers will be waiting to sell if the stock rallies and intersects overhead supply; the larger the profit is, the more likely it is that bottom feeders will sell.
I rarely buy a stock that has corrected 60 percent or more; a stock that is down that much often signals a serious problem. Most constructive setups correct between 10 percent and 35 percent.
Time Compression
If a stock advances too quickly up the right side, this forms a hazardous time compression, and in most cases the stock should be avoided, at least temporarily. Time compression will show up as V-shaped price action or the absence of proper right-side development. Constructive price consolidations tend to have a degree of symmetry; a buildup of supply takes time to digest and work through. 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. You want to give your stock enough time to undergo a constructive consolidation period, which will allow it to continue its primary advance unencumbered by the chains of immediate sellers.
Always include in your thinking that whatever you’re seeing in the marketplace is also visible to everyone else.
To improve your odds, you want to see one or more price shakeouts
at certain key points during the base-building period. This will also allow for the elimination of weak holders and allow a sustained move higher. Remember, as a disciplined stock trader using stop losses to control risk, you, too, are a weak holder. In other words, you will sell during a relatively minor price pullback to protect yourself against the possibility of a larger loss. This is not to delegitimize your stop-loss discipline. A stop-loss regime
is essential. Inevitably, however, good stop-loss practice will shake you out of some winning stocks. 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.
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.
A stock may experience big price spikes in the form of gaps. A price gap occurs when the share price prints at a wide increment above or below the previous print; this is most easily observable at the open, but in thinly traded stocks it can also occur intraday. Gaps often occur on big volume. Upward price gaps may result from positive news such as better than expected earnings, a favorable industry development, or a brokerage house upgrade. Ideally, the gap will result from a fundamental change that creates a positive
shift in perception and generates buying demand. In many cases, a price gap will show up on a weekly graph as well. What you’re trying to determine is whether the stock is under accumulation by large institutional buyers.
A big price spike on a surge of volume indicates that institutions are buying in size. At the same time, 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. Avoid a stock that follows a big demand day with even bigger down days on volume. Large up days and weeks on increased overall volume, contrasted with lower-volume pullbacks, are another constructive sign that the stock you are considering is under institutional accumulation. Look for these traits before you buy.
Price 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. Cirrus Logic raised its earnings guidance by forecasting better than expected numbers for the upcoming quarter. This caused the stock to shoot up dramatically. Within days of the price spike, the overall market started correcting. This put temporary pressure on Cirrus’s stock price, causing it to correct 23 percent off its high, which was an acceptable 2.3 times the market correction. Once the market bottomed, the stock price moved up the right side and set up constructively. Cirrus advanced +162 percent in just four months from the point at which it made a new 52-week high.
The Pivot Point
A proper pivot point represents the completion of a stock’s consolidation and the cusp of its next advance. In other words, after a base pattern has been established, the pivot point is where the stock establishes a price level that will act as the trigger to enter that trade. Now the stock has moved into position for purchase. As the stock’s price trades above the high of the pivot, this often represents the start of the next advancing phase. A pivot point is
a “call to action” price level. It is often referred to as the optimal buy point. A pivot point can occur in connection with a stock breaking into new high territory or below the stock’s high.
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.
The next chart shows Mercadolibre (MELI), which has a technical
footprint of 6W 32/6 3T, meaning that the basing period occurred over six weeks, with corrections that began at 32 percent and concluded at 6 percent at the pivot. In November, the stock underwent a price shakeout and proceeded to tighten up in a constructive fashion. Notice, too, how the last contraction
was accompanied with little volume as a dearth of stock changed
Volume 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 one or two 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 up to a trickle; viewed as a lack of liquidity, this worries many investors. However, this is precisely what occurs right before a stock is ready to make a big move. Why? Because the decreased volume means that stock has stopped coming to market. With very little supply of stock in the market from sellers, even a small amount of buying can move the price up very rapidly.
Extrapolating Volume Intraday
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. Let’s say that a stock normally trades 1 million shares. Two hours into the trading day, 500,000 shares—half the usual volume—has already exchanged hands and the stock is moving up. You still have four and a half hours to go. Therefore, you can comfortably extrapolate that on the basis of the intraday volume thus far, the volume for the day could easily be 300 to
400 percent (or more) of the average daily volume. Now, when the price goes through the pivot point, you can place your trade.
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. Let the stock break above the pivot and prove itself.
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.
Of course, if the reversal is large enough to trigger my stop, I sell. If the reversal 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.
How Do You Know a Breakout Has Failed?
Once a stock breaks out of its pivot area, watch for signs of failure; a failed breakout can quickly lead to a base failure. 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. The pattern should not get wider (meaning up and down movements). Up is good, but wild swings back and forth are not. Although the price may pull back or even squat, don’t automatically conclude that the trade is going to fail. You want to give the stock a
chance to recover. 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.
Dealing with an Early Day Reversal
Another rule of thumb regarding a reversal on the breakout day is the early day reversal. This occurs when a stock moves up in the morning and then comes back down to the breakout before noon or 1:00 p.m. Try to give the stock until the end of the day unless the reversal is so severe that it triggers your protective stop. You should not panic and conclude that the breakout has failed just because the early morning rally lost steam and the stock pulled in. This often happens. The stock may even undercut your purchase price. 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.
Putting It All Together
In March 1995, I purchased Kenneth Cole Productions (KCP) because of characteristics that were classic in every sense: a perfect VCP setup. Kenneth Cole attracted my attention when it displayed healthy earnings and sales. The price and volume action looked great, and the market was starting to recover after a period of correction. Note how volatility contracts from left to right; the stock corrects and progressively tightens within ranges of 32 percent, 14 percent, 7 percent, and 3 percent. The VCP leads right to an entry point and a successful breakout. This provides an excellent example of constructive volatility contraction. The stock emerged and advanced more than 100 percent in just eight months.
something deep inside them—a desire, a dream, a vision.
—Muhammad Ali, three-time world heavyweight boxing champion
Success requires opportunity. The stock market provides incredible
opportunity on a daily basis. New companies are constantly emerging as market leaders in every field from high-tech medical equipment to retail stores and restaurants right in your own neighborhood. To spot them and take advantage of their success you must have the know-how and the discipline to apply the proper investment techniques.
Impossible is just a big word thrown around by small men who find
it easier to live in the world they’ve been given than to explore the
power they have to change it.
—Laila Ali
Dedication and a desire to succeed are definitely requirements to achieve superperformance in stocks. What is not required is conventional wisdom or a college education.
“Optimists are right. So are pessimists. It’s up to you to choose which you will be.”
—Harvey Mackay
When you make an unshakable commitment to a way of life, you put yourself way ahead of most others in the race for success. Why? Because most people have a natural tendency to overestimate
what they can achieve in the short run and underestimate what they can accomplish over the long haul. They think they’ve made a commitment, but when they run into difficulty, they lose steam or quit.
The difference between interest and commitment is the will not to give up. When you truly commit to something, you have no alternative but success.
Getting interested will get you started, but commitment gets you to
the finish line. The first and best investment you can make is an investment in yourself, a commitment to do what it takes and to persist. Persistence is more important than knowledge. You must persevere if you wish to succeed in anything. Knowledge and skill can be acquired through study and practice, but nothing great comes to those who quit.
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.
For me, the greatest success came when I finally decided to forget about the money and concentrate on being the best trader I could be. Then the money followed.
You don’t have to be great to get started, but you have to get started
to be great.
—Les Brown
Robert Schuller said, “It’s better to do something imperfectly than to do nothing flawlessly.” An ounce of action is worth pounds of theory. In the stock market, you can make excuses or you can make money, but you can’t do both.
It’s not enough to have knowledge, a dream, or passion; it’s what you do with what you know that counts. Even if you don’t become wealthy, by doing what you’re passionate about, you will at least be happy. The best chance you have to succeed in life is to do what you enjoy and give it everything you’ve got. When you get up each morning and do what you love, you never work a day in your life. Those days can begin today. The best time to begin is right now!
If you cannot—in the long run—tell everyone what you have been
doing, your doing has been worthless.
—Erwin Schrödinger
To realize profits from investing in stocks, you must make three correct decisions: what to buy, when to buy, and when to sell.
There isn’t a person anywhere who isn’t capable of doing more than he thinks he can.
—Henry Ford
The more I practice, the luckier I get.
—Gary Player
Success in the stock market has little to do with luck. On the contrary, the more you work a sound plan, the luckier you will become.
A new idea is delicate. It can be killed by a sneer or a yawn; it can
be stabbed to death by a quip and worried to death by a frown on
the right man’s brow.
—Charles Brower
Remember, people who say something can’t be done never did it themselves. Surround yourself with people who encourage you and
don’t let the naysayers knock you off track.
On the basis of 30 years of personal experience and historical analysis of every market cycle going back to the early 1900s, I can assure you that nothing has changed very much. In fact, history repeats itself over and over.
The world is full of people looking for a secret formula for success.
They do not want to think on their own; they just want a recipe to
follow. They are attracted to the idea of strategy for that very reason.
—Robert Greene
If you aren’t prepared to invest a good portion of your time before you invest your money, you’re just throwing darts. At some point, you will surely be taken to the cleaners.
Do the work, own your failures, and you will own your success.
No one is going to make you rich except you.
It wasn’t until I suffered enough big losses that I made the decision that turned my performance from mediocre to stellar: I decided it was time to make money and stop stressing about my ego.
trading is not about picking highs and lows or proving how smart you are; trading is about making money. If you want to reap big gains in the market, make up your mind right now that you
are going to separate trading from your ego. It’s more important to make money than it is to be right.
Any pattern of action repeated continuously will eventually become habit. Therefore, practice does not make perfect; practice only makes habitual.
“Practice does not make perfect. Only perfect
practice makes perfect.”
—Vince Lombardi
Do the thing and you will have the power.
—Ralph Waldo Emerson
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.
The amateur investor has many built in advantages that could result
in outperforming the experts. Rule #1 is to stop listening to the
professionals.
—Peter Lynch
if you want mutual fund–like results, invest like a fund manager. If you want superperformance results, you must invest like a superperformance investor.
In my experience, attaining superperformance in stocks comes from
doing things that are different from what is obvious or popular. This is often misinterpreted as risky.
If you want to be the best, you have to do things that other people
are unwilling to do.
—Michael Phelps,
Ask yourself, What are my goals? Even if you haven’t thought out a life plan,probably a few aspirations come to mind right away. Now ask yourself, What would I give up to achieve those goals? That’s another story, isn’t it? The choice to sacrifice is difficult, but it is one of the most important decisions you will make in the pursuit of success. Sacrifice means prioritizing, which could result in giving up certain activities to have the time to pursue trading.
Admittedly, this is a tough step to take, but no champion has a completely balanced life when he or she is going for a gold medal. Champions are laser-focused on their goal; they understand the power of a narrow focus. This comes at a price; it’s called sacrifice.
I fear not the man that has practiced 10,000 kicks once, but I fear
the man that has practiced one kick 10,000 times.
—Bruce Lee
To become great at anything, you must be focused and must specialize.
Many of life’s failures are people who did not realize how close they were to success when they gave up.
—Thomas Edison
Remember, if you choose not to take risks, to play it safe, you will never know what it feels like to accomplish your dreams. Go boldly after what you want and expect some setbacks, some disappointments, and some rotten days. Embrace them all as a valuable part of the process and learn to say, “Thank you, teacher.” Be happy, feel appreciative, and celebrate when you win. Don’t look back with regrets at failures. The past cannot be changed, only learned from. Most important, never let rotten days make you give up.
In 1991, the 40 top-performing stocks (starting at above $12 a share) began the year with an average P/E of 29, and by year end their P/E ratios had expanded to 83.
I execute a trade only at the point of alignment across the spectrum with regard to company fundamentals, stock price, and volume activity as well as overall market conditions.
Over the years, I’ve concluded that most superperformance stocks have common identifiable characteristics. In the majority of cases, decent earnings were already on the table. In fact, the majority of superperformance stocks already had periods of outperformance in terms of fundamentals as well as technical action before they made their biggest gains. More than 90 percent of superperformance stocks began their phenomenal price surges as the general market came out of a correction or bear market. Interestingly, very few stocks had superperformance phases during a bear market.
Look for candidates with a relatively small total market capitalization and amount of shares outstanding. All things being equal, a smallcap company will have the potential to appreciate more than a large-cap, based on the supply of stock available. It will take far less demand to move the stock of a small company with a comparatively small share float than a large-cap candidate.
Generally speaking, though, if a large-cap company advances rapidly in a short period, I’m inclined to take profits on it more quickly than I would with a smaller, faster-growing company that may have the potential to double or even triple in a number of months.
A stock trading strategy is like a marriage; if you’re not faithful, you probably won’t have a good outcome. It takes time and dedication, but your objective should be to become a specialist in your approach to the market.
A trader who really knows the strengths and weaknesses of his or her strategy can do significantly better than someone who knows only a little about a superior strategy.
It’s far better to buy a wonderful company at a fair price than a fair
company at a wonderful price.
—Warren Buffett
Buying a cheap stock is like a trap hand in poker; it’s hard to get away from. When you buy a stock solely because it’s cheap, it’s difficult to sell if it moves against you because then it’s even cheaper, which is the reason you bought it in the first place. The cheaper it gets, the more attractive it becomes based on the “it’s cheap” rationale. This is the type of thinking that gets investors in
big trouble. Most investors look for bargains instead of looking for leaders, and more often than not they get what they pay for.
If you avoid stocks just because the P/E or share price seems too high, you will miss out on many of the biggest market movers. The really exciting, fast-growing companies with big potential are
not going to be found in the bargain bin. You don’t find top-notch merchandise at the dollar store. As a matter of fact, the really great companies are almost always going to appear expensive, and that’s precisely why most investors miss out.
The top 100 best-performing small- and mid-cap stocks of 1996 and 1997 had an average P/E of 40. Their P/Es grew further to an average of 87 and a median of 65. Relatively speaking, their initially “expensive” P/Es turned out to be extremely cheap. These top stocks averaged a gain of 421 percent from buy point to peak. The P/E of the S&P 500 ranged from 18 to 20 during that period.
Value doesn’t move stock prices; people do by placing buy orders. Value is only part of the equation. Ultimately, you need demand.
One of the worst trades I ever made was Bethlehem Steel trading at
2x earnings. I said “How low can it go?” It went to zero.
—Jim Cramer
I don’t set trends. I just find out what they are and exploit them.
—Dick Clark
I identify these four stages on the basis of what is happening with the stock in terms of price action:
1. Stage 1—Neglect phase: consolidation
2. Stage 2—Advancing phase: accumulation
3. Stage 3—Topping phase: distribution
4. Stage 4—Declining phase: capitulation
What I found through my study of the biggest price performers was that virtually every superperformance stock made its big gain while in stage 2 of its price cycle.
You should avoid buying during stage 1 no matter how tempting it may be; even if the company’s fundamentals look appealing, wait and buy only in stage 2.
To compound capital at a rapid rate and achieve superperformance,
it is vital that you avoid stage 1 and learn to spot where momentum
is strong during stage 2.
I can tell you from experience that attempting to bottom fish—trying to buy a stock at or near its bottom—will prove to be a frustrating and fruitless endeavor. Even if you are fortunate enough to pick the exact bottom, making significant headway usually requires sitting without much progress for months and in some cases years, because when you buy a stock near its bottom, it is in stage 4 or stage 1 and therefore by definition lacks upside
momentum.
My goal is not to buy at the lowest or cheapest price but at the “right” price, just as the stock is ready to move significantly higher. Trying to pick a bottom is unnecessary and a waste of time; it misses the whole point.
A stage 2 advance may begin with little or no warning; there are no major announcements or news. One thing is certain, however: a proper stage 2 will show significant volume as the stock is in strong demand on big up days and up weeks, and volume will be relatively light during pullbacks. There should always be a previous rally with an escalation in price of at least 25 to 30 percent
off the 52-week low before you conclude that a stage 2 advance is under way and consider buying.
Transition Criteria of stage 2
1. The stock price is above both the 150-day and the 200-day moving average.
2. The 150-day moving average is above the 200-day.
3. The 200-day moving average has turned up.
4. A series of higher highs and higher lows has occurred.
5. Large up weeks on volume spikes are contrasted by low-volume
pullbacks.
6. There are more up weeks on volume than down weeks on volume.
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. These signs of accumulation
should appear during every stage 2 advance.
Stage 2 Characteristics
1. The stock price is above its 200-day (40-week) moving average.
2. The 200-day moving average itself is in an uptrend.
3. The 150-day (30-week) moving average is above the 200-day
(40-week) moving average.
4. The stock price is in a clear uptrend, defined by higher highs and
higher lows in a staircase pattern.
5. Short-term moving averages are above long-term moving averages (e.g., the 50-day moving average is above the 150-day moving average).
6. Volume spikes on big up days and big up weeks are contrasted by volume contractions during normal price pullbacks.
7. There are more up days and up weeks on above-average volume
than down days and down weeks on above-average volume.
During stage 3, the stock is no longer under extreme accumulation;
instead, it is changing hands from strong buyers to weaker ones. Smart money that bought early when the stock emerged onto the scene is now taking profits, selling into final signs of price strength. As that occurs, buyers on the other side of the transaction are weaker players who know about the stock because it has made such a dramatic run and captured headlines. In other words, the long trade in the stock has become crowded and too obvious.
This distribution phase exhibits a topping pattern. Volatility increases markedly, and the stock becomes visibly more erratic relative to its previous stage 2 trading pattern.
Stage 3 Characteristics
1. 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.
2. 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.
3. The stock price may undercut its 200-day moving average. Price
volatility around the 200-day (40-week) moving average line is
common as many stocks in stage 3 bounce below and above the
200-day average several times while topping out.
4. The 200-day moving average will lose upside momentum, flatten
out, and then roll over into a downtrend.
Stage 4 Characteristics
1. The vast majority of the price action is below the 200-day (40-week) moving average.
2. The 200-day moving average, which was flat or turning downward in stage 3, is now in a definite downtrend.
3. The stock price is near or hitting 52-week new lows
4. The stock price pattern is characterized as a series of lower lows
and lower highs, stair-stepping downward.
5. Short-term moving averages are below long-term moving
averages.
6. Volume spikes on big down days and big down weeks are
contrasted by low-volume rallies.
7. There are more down days and weeks on above-average volume
than up days and up weeks on above-average volume
How to Pinpoint Stage 2
I apply the Trend Template criteria (see below) to every single stock I’m considering. The Trend Template is a qualifier. If a stock doesn’t meet the Trend Template criteria, I don’t consider it. Even if the fundamentals are compelling, the stock must be in a long-term uptrend—as defined by the Trend Template—for me to consider it as a candidate. Without identifying a stock’s trend, investors are at risk of going long when a stock is in a dangerous
downtrend, going short during an explosive uptrend, or tying up capital in a stock lost in a sideways neglect phase. It’s important to point out that a stock must meet all eight of the Trend Template criteria to be considered in a confirmed stage 2 uptrend.
Trend Template
1. The current stock price is above both the 150-day (30-week) and the 200-day (40-week) moving average price lines.
2. The 150-day moving average is above the 200-day moving average.
3. The 200-day moving average line is trending up for at least 1 month (preferably 4–5 months minimum in most cases).
4. The 50-day (10-week) moving average is above both the 150-day and 200-day moving averages.
5. The current stock price is trading above the 50-day moving average.
6. The current stock price is at least 30 percent above its 52-week low. (Many of the best selections will be 100 percent, 300 percent, or greater above their 52-week low before they emerge from a solid consolidation period and mount a large scale advance.)
7. The current stock price is within at least 25 percent of its 52-week high (the closer to a new high the better).
8. The 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.
My favorite type of stock to invest in—the area where I have made most of my money trading—is the market leader. These companies are able to grow their earnings the fastest. An industry’s strongest players are usually number one, two, or three in sales and earnings and are gaining market share.
A company that is taking market share in a slow-growth industry
can also grow its earnings quite nicely. What’s most important is that the company can make substantial profits. A good balance sheet, expanding margins, high return on equity, and reasonable debt are all signs of good management.
The main questions should be: What is the company’s competitive
advantage? and Is the business model scalable? Then it’s a matter of whether management is executing successfully and delivering the goods, namely, earnings.
You should concentrate on the top two or three stocks in a group: the leaders in terms of earnings, sales, margins, and relative price strength. This is especially true if the industry group is a leading sector during a bull market.
Buying a cyclical after several years of record earnings and when the P/E ratio has hit a low point is a proven method for losing half your money in a short period of time.
—Peter Lynch
At the bottom of a cyclical swing, the following things happen:
1. Earnings are falling.
2. Dividends may be cut or omitted.3. The P/E ratio is high.
4. News is generally bad.
At the top of a cyclical swing:
1. Earnings are moving up.
2. Dividends are being raised.
3. The P/E ratio is low.
4. News is generally good.
Stay Away from the 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. These stocks can have periods of decent performance, usually brief ones, as they try to catch up with the true leaders near the end of a cycle or during times when a sector is red hot and the real leader has run up rapidly.Laggards usually appear to be relatively cheaper than market leaders, and that attracts unskilled investors. Don’t be tempted by a stock with a relatively low P/E or one that hasn’t appreciated as much as has the leader
in its industry.
When you see a growing number of names in a particular
industry making new 52-week highs (especially coming off a market low), this could be an indication that a group advance is under way.
I have found that more often than not, the best stocks in the leading groups advance before it’s obvious that the group or sector is hot. Therefore, I focus on stocks and let them point me to the group.
I look at the strongest stocks first: the ones that have the best earnings and sales, are closest to a new high, and show the greatest relative price strength versus the market. This is where you find the real market leaders.
History shows that big winning stocks tend to favor certain industry
groups. The groups that have produced the largest number of superperformance
stocks include the following:
1. Consumer/retail
2. Technology, computer, software, and related
3. Drugs, medical, and biotech
4. Leisure/entertainment
Just as leading stocks can at times foretell a powerful group advance, keeping an eye on the top two or three companies in an industry group could provide a tip-off to when the group may be headed for trouble. It’s important to keep your eye on important leading names in the top-performing sectors. Often you’ll see an important stock in a group break badly, and the whole group will suffer.If one or more important stocks in an industry group top, that could be a warning that the whole group will soon run into trouble. Even stocks that are outside the group, such as suppliers and customers, may share in the suffering. Historically, more than 60 percent of superperformance stocks were part of an industry group advance.
The fact is, no matter how big or prestigious a company is, when
fundamentals deteriorate—namely, earnings—you never know how far the stock will fall.
The stock market cares little about the past, including the status of a company. What it cares about is the future, namely, growth. Keep in mind that our goal is to uncover superperformance stocks: shares that will far outpace the rest of the pack. These stocks are the ones with the strongest potential, and they seldom are found in the bargain bin. They are going strong because of a powerful force behind them: growth—real growth—in earnings and sales. Why buy damaged merchandise?
Regardless of a company’s size, status, or reputation, there is no intelligent reason for an investor to settle for an inferior track record in a marketplace filled with companies with outstanding
fundamentals.
In real estate, the mantra goes “location, location, location.” In the stock market, it’s earnings, earnings, earnings; after all, it’s the bottom line that counts. How much money can a company earn and for how long? This leads to three basic questions every investor should ask when it comes to earnings: How much? How long? and How certain? Profitability, sustainability, and visibility represent the most influential factors that move stock prices.
When a company reports quarterly results that are meaningfully better than expected, analysts who follow the stock must reexamine and revise their earnings estimates upward.
Stocks move for two basic reasons: anticipation and surprise. Every price movement is rooted in one of these two elements: anticipation of news, an event, an important business change, or reaction to an unexpected event and a surprise, whether positive or negative.
Be on the lookout for companies that are beating
earnings estimates; the bigger the earnings surprise, the better.
They call it the cockroach effect because as with cockroaches, if you see one, you can bet there are others. The same thinking applies to companies reporting earnings surprises. If a company has posted very good quarterly results that are much better than were anticipated by analysts, there are probably more good quarters ahead. If a company is performing well with earnings surprises, other companies in the same industry or sector may post some upside surprises as well.
Because earnings surprises have a lingering effect, we want to focus on companies that beat estimates and avoid firms that have negative earnings surprises.
Look for companies for which analysts are raising estimates.
Quarterly as well as current fiscal year estimates should be trending
higher; the bigger the estimate revisions, the better.
In order to find your next superperformer, look for stocks that are in stage 2 with strong earnings, positive surprises, and upward revised estimates.
Sometimes a company with a rocketing stock price may not be making much money, but the rising price means that investors are hoping that it will be profitable in the future. However, 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 two or three quarters also show good gains.
Really successful companies generally report earnings increases of 30 to 40 percent or more during their superperformance phase.
If you demand that your stock selections not only show strong earnings but also show strong sales, you will increase your chances of latching on to a superperformer.
Strong quarterly results should translate into strong annual results. Just one or two quarters of good earning isn’t going to be enough to drive a stock’s price significantly higher for an extended period.
institutions like to see the following:
1. Earnings surprises
2. Accelerating earnings per share (EPS) and revenues
3. Expanding margins
5. Strong annual EPS change
6. Signs that acceleration will continue
Management may also choose to shift earnings so that a hit can be
absorbed in a single disappointing quarter. By shifting earnings to have one big down quarter, the company can beat estimates in the next quarter because the previous report prompted analysts to lower their estimates, making it easier for the company to beat the Street. You want to see earnings coming from robust top-line sales, not from accounting tricks and gimmicks.
A company can increase profits by cutting jobs, closing plants, or shedding its losing operations. However, these measures have a limited life span.
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. That’s a winning combination.
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.
When strong earnings are reported, check the story behind the results to make sure the good news is not due to a one-time event but is the product of conditions that probably will continue. Your questions should include the following:
1. Are there any new products or services or positive industry changes?
2. Is the company gaining market share? A market is ultimately
dominated by just a few companies.
3. What is the company doing to increase revenue and expand
margins?
4. What is the company doing to decrease costs and increase
productivity?
Net margin is based on a company’s net income divided by sales and reflects all the variables that influence profitability. A falling net margin indicates that the company is making a smaller profit on its sales.
For a true superperformer, there should definitely not be a huge sell-off that breaks the whole leg of the stock’s upward move.
When obliged to fess up to bad news, a publicly traded company will often try to spin the message. It may announce a stock buyback or some other “positive” news at the same time it reports a disappointing quarter in an effort to soften the blow and offset any potential negative effects. This generally doesn’t work.
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. If they say, “Business conditions will be tough this year, but we see improvement coming next year,” that’s not positive guidance. That’s spin.
When inventory grows much faster than sales, it can indicate weakening sales, misjudgment by management of future demand, or both.
When a company says one thing in one document and something quite different in another, you have differential disclosure.
If a company is reporting great earnings but is not paying much in taxes, be skeptical.
Look for what I call a Code 33 situation, three quarters of acceleration in earnings, sales, and profit margins. That’s a potent recipe. If a company has Earnings per share, sales, and margins accelerating for three consecutive quarters.
Most of the big money made in bull markets comes in the
early stages, during the first 12 to 18 months. However, by the
time a big advance asserts itself in the broad market indexes, many of the best stocks may have been running up for weeks in advance. The question then becomes how you know when to jump on board before an emerging rally gets away from you and the very best stocks leave you in the dust. The answer: follow the leaders.
More than 90 percent of superperformance stocks emerge from bear markets and general market corrections. The key is to do your homework while the market is down; then you will be prepared to make big profits when it turns up.
If the major market indexes ignore an extremely overbought condition after a bear market decline and your list of leaders
expands, this should be viewed as a sign of strength.
The true market leaders will show strong relative price strength before they advance. Such stocks have low correlation with the general market averages and very often act as lone wolves during their biggest advancing stage. The search for these stocks runs contrary to the thinking of most investors, who often take a top-down approach, examining first the economy and the stock market, then market sectors, and finally companies in a specific industry group. As I’ll show you in several examples in this chapter,
many of the very best leading stocks tend to bottom and top ahead of their respective sectors, whereas specific industry groups can lead a general market turn. 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.
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.
It’s important to study carefully the price action of individual companies with new positive developments and strong earnings
per share during major market declines. Many of the most strongly
rebounding stocks and the ones that hold up the best are likely to become the next up cycle’s superperformers.
A growing number of stocks displaying positive, divergent price
behavior during a general market decline can tip you off to where the next group of market leaders may emerge or what stocks are likely to blast off first when the market starts to rally. When you see this type of price action, it’s time to tune out the media and the gurus and concentrate on the facts: price, volume, earnings, sales, profit margins, new products, and positive industry changes.
Let the strength of the market tell you where to put your money, not
your personal opinion, which rarely is a good substitute for the wisdom of the market. Ultimately, opinions mean nothing compared with the verdict of the market. The stocks that emerge first in the early stage of a new bull market with the greatest power are generally the best candidates for superperformance.
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.
Just as the leaders lead on the upside, they also lead on the downside. Why? 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. When the leading names in leading industry groups start to falter after an extended market run, this is a danger signal that should heighten your attention to the more specific signs of market trouble or possible trouble in a particular sector.
History shows that one-third of superpeformers
give back all or more of their entire advance. On average, their subsequent price declines are 50 to 70 percent, depending on the period measured.
In the later stage of the general market’s advance, the same leaders will alert you to weakness in their underlying sectors as well as potential upcoming weakness in the broader market. Your portfolio will be your best barometer.
As a general rule, I buy strength, not weakness. True market leaders will always show improving relative strength, in particular during a market correction.
At this point, 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 stages 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 percent) of a new 52-week high. Conversely, every day there is a list of stocks to avoid printed in the financial newspapers: the 52-week-low list. I suggest that you stay away from this list and all of its components.
Generally, the correction for a healthy stock from peak to low will be contained within 25 to 35 percent and during severe bear market declines could be as much as 50 percent, but the less, the better. A correction of more than 50 percent is generally too much, and a
stock could fail as it reaches or slightly surpasses a new high.
The leaders of the past bull market rarely lead the next rally, so expect to see unfamiliar names. Fewer than 25 percent of market leaders in one cycle generally lead the next cycle.
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.
—Mark Weinstein
Charts enable us to see what’s going on in a particular stock as buyers and sellers come together in an auction marketplace. They distill the clash for emotional, logical, and even manipulative
decisions into a clear visual display; the verdict of supply and demand.
My own trading relies on charting to the extent that I would never bet on my fundamental ideas alone without confirmation
from the actual price action of the underlying stock.
The third group consists of techno-fundamentalists. As the name suggests, these traders exploit both technical analysis and fundamental analysis. If I had to pick, I would put myself in this group. I rely on price and volume as well as fundamentals. In making the decision whether to purchase a stock, there are important characteristics to consider, both fundamental and technical. A healthy hybrid approach exploits charts as well as fundamentals to increase the trader’s odds of success.
Chart patterns are not the cause; they’re the effect. The supply and demand picture does not dictate to the market; human behavior does, and human behavior hasn’t changed and isn’t likely to change much in the future.
The key is not knowing for sure what a stock is going to do next but knowing what it should do. Then it’s a matter of determining whether the proverbial train is on schedule.
When one identifies the proper characteristics for a superperformance candidate, the risks become unambiguous. If a stock doesn’t act as expected, that’s a major red flag. After all, the stock has already met very elite criteria and has been deemed a strong prospect. If such a stock behaves poorly, that suggests a problem. Learning what to expect allows you to detect when a
stock is acting correctly or incorrectly in the prevailing conditions. Because you know how something is supposed to perform, when it doesn’t perform that way, it makes the exit decision much easier.
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.
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.
If the long-term trend is not up, the stock simply doesn’t qualify as a candidate for purchase. Therefore, don’t forget the big picture.
As the saying goes, the trend is your friend. If you try to trade against it, the trend becomes your worst enemy. To increase your odds of success, stick to stocks moving in a definite uptrend. If a stock’s price is in a long-term downtrend, don’t even consider buying it.
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. I use the volatility contraction pattern
(VCP) concept to illustrate this.
The immediate distinguishing features of the VCP will be
the number of contractions that are formed (typically between two and four), their relative depths throughout the base, and the level of trading volume associated with specific points within the structure. Because I track hundreds of names each week, I created a quick way to capture a visual of a stock by quickly reviewing my nightly notes and each stock’s footprint abbreviation.
This quick reference is made up of three components:
1. Time. How many days or weeks have passed since the base started?
2. Price. How deep was the largest correction, and how narrow was
the smallest pullback at the very right of the price base?
3. Symmetry. How many contractions (Ts) did the stock go through
during the basing process?
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. 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. This is a very positive development, especially if it takes place after a period of correction and consolidation, and is a telltale sign that the amount of stock coming to market has diminished. 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.
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.
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.
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.
A stock making a new 52-week high during the early stages of a fresh bull market could be a stellar performer in its infancy. In contrast, a stock near its 52-week low at best has overhead supply to work through and lacks upside momentum; worse still, such a stock may be headed for a series of lower lows. A stock hitting a new high has no overhead supply to contend with. The stock is saying, “Hey, I have something going on here, and people are
taking notice,” whereas a stock hitting a new low is clearly a laggard that lacks investor interest or is being dumped in size by institutions.
When a stock reaches a new high in a confirmed stage 2 uptrend supported by big volume clues, it has been propelled upward by institutions taking positions because they believe that the fundamentals are solid and the prospects for the future are even better.
The only way a stock can become a superperformer, moving from, say, $20 to $80, is for that stock to make a series of new highs repeatedly, all the way up. The same thing applies to a stock that’s at $50 and doubles to $100 on its way to $300.
When a stock declines precipitously, it is likely that there is a serious problem in the company, its industry, or perhaps a bear market is unfolding. You shouldn’t conclude that a stock is a bargain just because it’s trading down 50 or 60 percent off its high. First, such a decline could indicate that a serious fundamental problem is undermining the share price. Second, even if the
fundamentals are not problematic yet, a stock that has experienced a deep sell-off must contend with a large amount of overhead supply: the more a stock drops, the more it is burdened by trapped buyers. Finally, the more a stock declines, the more potential profit takers will be waiting to sell if the stock rallies and intersects overhead supply; the larger the profit is, the more likely it is that bottom feeders will sell.
I rarely buy a stock that has corrected 60 percent or more; a stock that is down that much often signals a serious problem. Most constructive setups correct between 10 percent and 35 percent.
Time Compression
If a stock advances too quickly up the right side, this forms a hazardous time compression, and in most cases the stock should be avoided, at least temporarily. Time compression will show up as V-shaped price action or the absence of proper right-side development. Constructive price consolidations tend to have a degree of symmetry; a buildup of supply takes time to digest and work through. 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. You want to give your stock enough time to undergo a constructive consolidation period, which will allow it to continue its primary advance unencumbered by the chains of immediate sellers.
Always include in your thinking that whatever you’re seeing in the marketplace is also visible to everyone else.
To improve your odds, you want to see one or more price shakeouts
at certain key points during the base-building period. This will also allow for the elimination of weak holders and allow a sustained move higher. Remember, as a disciplined stock trader using stop losses to control risk, you, too, are a weak holder. In other words, you will sell during a relatively minor price pullback to protect yourself against the possibility of a larger loss. This is not to delegitimize your stop-loss discipline. A stop-loss regime
is essential. Inevitably, however, good stop-loss practice will shake you out of some winning stocks. 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.
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.
A stock may experience big price spikes in the form of gaps. A price gap occurs when the share price prints at a wide increment above or below the previous print; this is most easily observable at the open, but in thinly traded stocks it can also occur intraday. Gaps often occur on big volume. Upward price gaps may result from positive news such as better than expected earnings, a favorable industry development, or a brokerage house upgrade. Ideally, the gap will result from a fundamental change that creates a positive
shift in perception and generates buying demand. In many cases, a price gap will show up on a weekly graph as well. What you’re trying to determine is whether the stock is under accumulation by large institutional buyers.
A big price spike on a surge of volume indicates that institutions are buying in size. At the same time, 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. Avoid a stock that follows a big demand day with even bigger down days on volume. Large up days and weeks on increased overall volume, contrasted with lower-volume pullbacks, are another constructive sign that the stock you are considering is under institutional accumulation. Look for these traits before you buy.
Price 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. Cirrus Logic raised its earnings guidance by forecasting better than expected numbers for the upcoming quarter. This caused the stock to shoot up dramatically. Within days of the price spike, the overall market started correcting. This put temporary pressure on Cirrus’s stock price, causing it to correct 23 percent off its high, which was an acceptable 2.3 times the market correction. Once the market bottomed, the stock price moved up the right side and set up constructively. Cirrus advanced +162 percent in just four months from the point at which it made a new 52-week high.
The Pivot Point
A proper pivot point represents the completion of a stock’s consolidation and the cusp of its next advance. In other words, after a base pattern has been established, the pivot point is where the stock establishes a price level that will act as the trigger to enter that trade. Now the stock has moved into position for purchase. As the stock’s price trades above the high of the pivot, this often represents the start of the next advancing phase. A pivot point is
a “call to action” price level. It is often referred to as the optimal buy point. A pivot point can occur in connection with a stock breaking into new high territory or below the stock’s high.
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.
The next chart shows Mercadolibre (MELI), which has a technical
footprint of 6W 32/6 3T, meaning that the basing period occurred over six weeks, with corrections that began at 32 percent and concluded at 6 percent at the pivot. In November, the stock underwent a price shakeout and proceeded to tighten up in a constructive fashion. Notice, too, how the last contraction
was accompanied with little volume as a dearth of stock changed
Volume 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 one or two 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 up to a trickle; viewed as a lack of liquidity, this worries many investors. However, this is precisely what occurs right before a stock is ready to make a big move. Why? Because the decreased volume means that stock has stopped coming to market. With very little supply of stock in the market from sellers, even a small amount of buying can move the price up very rapidly.
Extrapolating Volume Intraday
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. Let’s say that a stock normally trades 1 million shares. Two hours into the trading day, 500,000 shares—half the usual volume—has already exchanged hands and the stock is moving up. You still have four and a half hours to go. Therefore, you can comfortably extrapolate that on the basis of the intraday volume thus far, the volume for the day could easily be 300 to
400 percent (or more) of the average daily volume. Now, when the price goes through the pivot point, you can place your trade.
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. Let the stock break above the pivot and prove itself.
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.
Of course, if the reversal is large enough to trigger my stop, I sell. If the reversal 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.
How Do You Know a Breakout Has Failed?
Once a stock breaks out of its pivot area, watch for signs of failure; a failed breakout can quickly lead to a base failure. 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. The pattern should not get wider (meaning up and down movements). Up is good, but wild swings back and forth are not. Although the price may pull back or even squat, don’t automatically conclude that the trade is going to fail. You want to give the stock a
chance to recover. 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.
Dealing with an Early Day Reversal
Another rule of thumb regarding a reversal on the breakout day is the early day reversal. This occurs when a stock moves up in the morning and then comes back down to the breakout before noon or 1:00 p.m. Try to give the stock until the end of the day unless the reversal is so severe that it triggers your protective stop. You should not panic and conclude that the breakout has failed just because the early morning rally lost steam and the stock pulled in. This often happens. The stock may even undercut your purchase price. 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.
Putting It All Together
In March 1995, I purchased Kenneth Cole Productions (KCP) because of characteristics that were classic in every sense: a perfect VCP setup. Kenneth Cole attracted my attention when it displayed healthy earnings and sales. The price and volume action looked great, and the market was starting to recover after a period of correction. Note how volatility contracts from left to right; the stock corrects and progressively tightens within ranges of 32 percent, 14 percent, 7 percent, and 3 percent. The VCP leads right to an entry point and a successful breakout. This provides an excellent example of constructive volatility contraction. The stock emerged and advanced more than 100 percent in just eight months.
Netflix illustrates a successful breakout coming out of a 27W 27/7 3T VCP setup. You can see the pullbacks are five and seven days, respectively, and the stock subsequently moves right back into new high ground. Volume expanded dramatically on the initial breakout and on the subsequent rally after the first normal reaction. 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. Volume should contract during
the pullback and then expand as the stock moves back into new highs. There should not be much volatility during the initial rally phase and during the first one or two normal reactions. Minor reactions or pullbacks in price are natural and are bound to occur as the advance runs its course. The best stocks rebound quickly. This is how you know you’re on to something worth holding.
Once you have bought a stock emerging from a VCP, look for the
following signs:
1. At the beginning of the move, volume should expand over a
number of days.
2. Prices generally should move upward for a few days with little
resistance.
3. A normal reaction will occur: volume should decrease compared
with the volumes observed during the initial trend, and the price
may move against the trend somewhat.
4. Within a few days or perhaps a week or two of the normal
reaction, volume should increase again and the price trend should
be resumed.
Saucer with Platform
In the 1960s, William L. Jiler wrote a book titled How Charts Can Help You in the Stock Market. In my opinion, Jiler’s work on chart patterns was way ahead of its time and to this day still has valuable findings. I would put it on the must-read list for anyone interested in using charts to improve his or her performance in the stock market. Jiler was the first to highlight the saucer-with-platform pattern, which later became popularized as the
cup-with-handle pattern. This pattern without a doubt is the most repeatable and reliable price structure among all the variations that superperformance stocks trace out before they advance dramatically in price. Jiler refers to the saucer pattern as a “dream pattern,” citing its ease of recognition and reliability. Although I agree with Jiler, the pattern is prone to misinterpretation. The VCP concept and some education about volume and certain specific nuances to look for can quickly clear up poor analysis and lead you to find the next big superperformer. As was mentioned above,
volatility contraction is a key characteristic of constructive price behavior within all patterns.
The 3C Pattern
The cup completion cheat, or 3C, is a continuation pattern; it is the earliest point at which you should attempt to buy a stock. Some stocks form a low cheat, and some form the cheat area, near the middle of the cup or saucer that precedes it. 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. The cheat trade gives you an actionable pivot point to time a stock’s upturn while increasing your odds of success. When a handle forms, it usually occurs in the upper third of the cup. If it forms in the middle third of the cup or just below the halfway point, you
could get more than one buy point.
The most dangerous time to trade is when a stock is trying to bottom. This tends to be a very volatile period for stocks. When a stock is searching for a bottom, it can whip back and forth violently. Trying to pick a low can be very frustrating and costly.
The Livermore System
The legendary trader Jesse Livermore had a system of buying and selling when a stock changed direction, but only if the stock followed through. Livermore only took positions in the direction of his trade. 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. This was
Livermore’s version of the turn. Livermore used this technique to make more money than any other trader ever.
The Power Play
One of the most important setups you can learn to distinguish is the power play, which is also referred to as a high tight flag. This is without a doubt the most misinterpreted price setup among all the technical patterns. However, it is also one of the most profitable. The power play is what I call a velocity pattern for two reasons. First, it takes a great deal of momentum to qualify; in fact, the first requirement is a sharp price thrust upward. Second, these setups can move the fastest in the shortest period of time; velocity begets
more velocity. This pattern often signals a dramatic shift in the prospects of a company. The rapid price run-up could be induced by a major news development such as an FDA drug approval, litigation resolution, a new product or service announcement, or even an earnings report; it can also occur on no news at all. Some of the best trades from this setup can develop as unexplained strength. Therefore, this is the only situation I will enter with a
dearth of fundamentals. It doesn’t mean that improving fundamentals don’t exist; very often they do. However, 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. The stock is discounting something major. Although I don’t demand that a power play have fundamentals on the table, I do require it to display VCP characteristics just as I do with all the other setups. Even the power play must go through a proper digestion of supply and demand.
To qualify as a power play, the following criteria must be met:
1. An explosive price move commences on huge volume that shoots the stock price up 100 percent or more in less than eight weeks. This generally occurs after a period of relative dormancy.
2. The stock price then moves sideways in a relatively tight range, not correcting more than 20 to 25 percent over a period of three to six weeks (some can emerge after only 12 days).
3. There is very tight price action that doesn’t correct the stock more than 10 percent, or the stock must display VCP characteristics.
Fundamentally Sound versus Price-Ready
The fact that a company has met all of your fundamental criteria does not mean that you should necessarily run out and buy it right away. Even if your fundamental analysis of the company is spot on, to make big money, your analysis of investor perception also needs to be accurate and timed correctly. Often a company will deliver one or two great quarterly earnings reports while the stock is still in a correction or consolidation. The stock price may have already run up in anticipation, and it simply needs time to digest the advance while earnings catch up, or perhaps the overall market is in a correction, holding it back. Be patient. Keep the stock on your radar and wait for its price and volume characteristics to set up properly. The key to making big money in stocks is to align supporting fundamentals with constructive price action during a healthy overall market environment.
A good company is not always a good stock. It’s important that you learn to differentiate between the two. It doesn’t really matter what you think about a stock. 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.
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. —Jesse Livermore, 1930
Just as styles in women’s gowns and hats and costume jewelry are
forever changing with time, the old leaders of the stock market are
dropped and new ones rise up to take their places. In the course
of time new leaders will come to the front: some of the old leaders
will be dropped. It will always be that way as long as there is a stock market. Keep mentally flexible. Remember the leaders of today may not be the leaders two years from now.
—Jesse Livermore
If there’s one thing I’ve learned over the years, it’s that risk management is the most important building block for achieving consistent success in the stock market. Notice that I said “consistent.”
It’s Your Money Only as Long as You Protect It
Whether you are dealing in millions or in thousands the same
principle lesson applies. It is your money. It will remain with you
just so long as you guard it. Faulty speculation is one of the most
certain ways of losing it. —Jesse L. Livermore
To achieve consistent profitability, you must protect your profits and principal. As a matter of fact, I don’t differentiate between the two. A big mistake I see many traders make is to consider trading profits as house money, acting as if that money somehow were less their own to lose than their original starting capital is. If you have fallen into this mental habit, you need to change your perception immediately to achieve superperformance. Let’s say I make $5,000 on Monday. I don’t consider myself $5,000 “ahead of the game,” free to risk that amount shooting for the moon. My account simply has a new starting balance, subject to the same set of rules as before. Once I make a profit, that money belongs to me. Yesterday’s profit is part of today’s principal.
My biggest losses have always come after I have had a great period
and I started to think that I knew something. —Paul Tudor Jones
The last thing you want to do is put yourself in a position of losing
when your account is large and a position of gaining when it’s small; this will accomplish little. By keeping your losses small, you preserve your hardearned capital for future investments. The lesson here is never to permit yourself to lose an amount of money that would jeopardize your account. The larger the loss is, the more difficult it is to recover from it.
The definition of a great investor is someone who starts by
understanding the downside. —Sam Zell
Good trading is a peculiar balance between the conviction to follow
your ideas and the flexibility to recognize when you have made a
mistake. —Michael Steinhardt
Regardless of your methodology or approach to stock investing, there is only one way to protect your portfolio from a large loss, and that is to sell when you have a small loss before it snowballs
into a huge one. In three decades of trading, I have not found a better way. Amazingly, no matter how many successful investors advocate this commonsense approach, this advice is followed only by an extremely small group of people even among professionals. Consequently, only a very small number of investors (including pros) achieve outstanding results in the stock market. Without a doubt, the hardest discipline for investors to follow consistently is to cut their losses short because it involves admitting that one’s original purchase was a mistake, and no one likes to be wrong.
Avoid the Big Errors
The study highlights several interesting conclusions:
1. Investors are more likely to allow a stock to reach a large loss than they are to allow a stock to attain a large gain; they hold losers too long and sell winners too quickly.
2. The probability of buying additional shares is greater for shares
that have lost value than it is for shares that have gained value;
investors may readily double down on their bets when stocks
decline in value.
3. Investors are more likely to take a small gain than a small loss.
Avoiding large losses is the single most important factor for winning big as a speculator. You can’t control how much a stock rises, but in most cases, whether you take a small loss or a big loss is entirely your choice. There is one thing I can guarantee:
if you can’t learn to accept small losses, sooner or later you will take big losses. It’s inevitable.
Every major correction begins as a minor reaction. You can’t tell
when a 10 percent decline is the beginning of a 50 percent decline until after the fact, when it’s too late.
Every dollar saved is a dollar earned, and every dollar saved is more money that can be compounded when you latch
on to your next big winner. Don’t become an involuntary investor.
It would be simple to run down the list of hundreds of stocks which, in my time, have been considered gilt-edge investments, and which today are worth little or nothing. Thus, great investments tumble, and with them the fortunes of so-called conservative investors in the continuous distribution of wealth.
—Jesse Livermore
Some investors feel they don’t need to trade with a stop loss because they buy only quality stocks. There’s no such thing as a safe stock. Many “conservative investors” have gone broke owning and holding on to so-called blue chip companies for a long-term investment with the philosophy that patience is prudence by way of quality. If this is your strategy, I’m afraid you will eventually be in for an unpleasant surprise. This is simply a lazy person’s
strategy, or lack of strategy.
No stock can be held forever. Few stocks can be held unattended
for even a few months without risk. Good companies can be terrible stock investments if they are bought at the wrong time.
Consistent winners raise their bet as their position strengthens,
and they exit the game when the odds are against them, while
consistent losers hang on until the bitter end of every expensive pot, hoping for miracles and enjoying the thrill of defeat. In stud poker and on Wall Street, miracles happen just often enough to keep the losers losing. —Peter Lynch, One Up on Wall Street
If you regard each trade as just one out of a million over time, it becomes much easier to take a small loss and move on to the next
trade.
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.
The difference between successful investors and unsuccessful
investors is how they react to being invested in a losing stock.
There is absolutely no reason to allow a mistake to become an ego
shattering experience. Being wrong is not the problem. Making
a mistake is not the problem. The problem is being unwilling to
accept the mistake. The problem is staying wrong.
—Dan Sullivan
No matter how smart you think you are, I guarantee you will make an abundance of mistakes over time. We all do. Many of your failed trades may not even be mistakes on your part, just changes in circumstances that were impossible to forecast. The real mistake comes when you refuse to make an adjustment after things change. No one will ever be so good that he or she will never take a loss. Being wrong is unavoidable, but staying wrong is a choice. Staying wrong can be deadly; it can take both a physical and a psychological toll on your health. When you deny reality, you are no longer trading: you’ve sacrificed your principal to the fates. stress and effects such as heart disease and ulcers are well known. To protect your health, your confidence, and your money, you must learn to release a bad hand and move on.
If You’re Not Feeling Stupid, You’re Not Managing Risk
Sometimes after you sell a stock to cut short a loss, the stock will turn around and move up in price. This has happened to me thousands of times. Do I feel dumb or get angry? No. Investing and trading stocks is a business of playing probabilities so that the profit from winners outweighs the losses over time. It is completely unrealistic to think you’re going to be right all the time or think that you can hold losses and they will never leave you broke. Making
you feel stupid is the market’s way of pressuring you to act foolish. Don’t succumb. Remain disciplined and cut your losses. The alternative to managing risk is not managing risk, and that never turns out well.
stock market is no place for someone who is easily discouraged by mistakes. Mistakes are lessons, in other words, opportunities to improve. These experiences are the greatest part of the learning process. Although cutting your losses won’t guarantee that
you will win in the stock market, it will help ensure your survival.
To have lasting success in the stock market, you must decide once and for all that it’s more important to make money than to be right. Your ego must take a backseat.
Most investors fall into psychological traps. Feelings of hope and greed confuse their decisions to sell their stock holdings at a loss or, for that matter, at a profit. They find it difficult to sell, and so they rationalize a losing position. They convince themselves that they haven’t taken the loss until they sell it. Losses are a part of trading and investing; if you are not prepared to deal with them, then prepare to eventually lose a lot of money.
Individual stocks are not like mutual funds, they don’t have a manager and they don’t manage themselves; you’re the manager. When investing in stocks, everything is not necessarily
going to be “OK” if you just hang in there and wait it out. For a speculator, small losses are simply the cost of doing business, just as marked-down merchandise is to a retail store operator. A good retail merchant doesn’t hang on to dead merchandise, hoping a particular style or product will come back in vogue a year later. If he’s smart, he marks it down, gets it off the shelf as quickly as possible, and then looks to restock the shelves with something
that everyone wants to buy.
I have two basic rules about winning in trading as well as in life:
(1) If you don’t bet, you can’t win. (2) If you lose all your chips, you can’t bet. —Larry Hite
Risk is the possibility of loss. When you own a stock, there is always the possibility of a price decline; as long as you are invested in the stock market, you are at risk. The goal with stock trading is to make money consistently by taking trades that have more reward potential than risk. The problem for most investors, however, is that they focus too much on the reward side and not enough on the risk side. Simple as this sounds, few will follow the advice I’m about to impart to you.
The difference between mediocrity and greatness lies in the fundamental belief that discipline is not merely a principle of trading but a principle of greatness. Managing risk requires discipline. Sticking to your strategy requires discipline. Even if you have a sensible plan, if you lack discipline, emotions will creep into your trading and wreak havoc. Discipline leads to habit. They can be good habits or bad ones; it’s a matter of what you discipline
yourself to do over time.
Good trading is boring; bad trading is exciting and makes the hair on the back of your neck stand up. You can be a bored rich trader or a thrill-seeking gambler. It’s entirely your choice.
Your goal is not risk avoidance but risk management: to mitigate risk and have a significant degree of control over the possibility and amount of loss.
The Initial Stop-Loss
Before buying a stock, I establish in advance a maximum stop loss: the price at which I will exit the position if it moves against me. The moment the price hits the stop loss, I sell the position without hesitation. Once I’m out of the stock, I can evaluate the situation with a clear head. The initial stop loss is most relevant in the early stages of a position. Once a stock advances, the sell point should be raised to protect your profit with the use of a trailing stop or back stop.
You shouldn’t assume that a stock will reset if it moves against you.
You should always protect yourself and cut your loss. However, if a stock knocks you out of your position, don’t automatically discard it as a future buy candidate. 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 two or even three tries to catch a big winner. This is a trait of professional traders. Amateurs are scared of positions that stop them out once or twice or just weary of the struggle; professionals are objective and dispassionate.
Some believe that selling a stock and then reentering the same stock soon afterward is amateurish. I believe missing opportunity because of emotion is as amateurish.
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. For instance, let’s say your stop loss is set at 7 percent. If you have a 20 percent gain in a stock, you shouldn’t allow that position to give up all that profit and produce a loss. To guard against that, you could move up your stop loss to breakeven or trail a stop to lock in the majority of the gain. You may feel foolish breaking even on a position that was previously a decent gain; however, you will
feel even worse if you let a nice gain turn into a loss.
The importance contingency planning plays is that it enables you to
make good decisions when you’re under fire, when you need it the most. To survive in the stock market over the long term, I run my portfolio as if something really bad were going to happen every day. I am always prepared for the worst-case scenario.
Speculation is nothing more than anticipating coming movements.
In order to anticipate correctly, one must have a definite basis for
that anticipation. —Jesse Livermore
You have no control over how much a stock goes up, but you can, however, control the amount you lose on each trade. You should base that amount of loss on the average mortality of your gains.
To make money consistently, you need a positive mathematical expectation for return; you need an edge. That is, your reward/risk ratio must be greater than one to one (net of costs). To achieve this, your losses obviously need to be contained on average to a level lower than that of your gains.
Imagine: being wrong just as often as being right allowed me to amass a fortune. This is because I follow a very important rule: always keep your risk at a level that is less than that of your average gain.
A rule of thumb could be to cut your losses at a level of one-half of your average gain.
Avoid the Trader’s Cardinal Sin
Allowing your loss on a trade to exceed your average gain is what I call the trader’s cardinal sin. You must make more on your winners than you lose on your losers, remember? How can you possibly make money over time unless your winners return more dollars than your losers lose? The fact is that most traders don’t even know what their average gain is. When setting a stop loss, I have a rule of thumb that the amount of loss should be no more than one-half the amount of expected gain based on one’s real-life trading results. For example, if your winning trades produce a gain of 15 percent on average, you should sell any declining stock at no more than 7.5 percent off the purchase price. If you buy a stock at $30 a share, you would set your initial stop loss at $27.75.
The best thing you can do is to keep your losses small in relation to your gains. With more experience, you will become a more effective trader. You’ll realize larger gains on average and have more money to reinvest. Improved trading skills will compound your trading account, but only if you keep your losses small and avoid the trader’s cardinal sin. Never let a loss grow larger than your average gain.
expect the best and plan for the worst.
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 your gains get squeezed during difficult periods.
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. It’s a concept that I call building in failure. My goal is to maintain at least a 2:1 win/loss ratio with an absolute maximum stop loss of no more than10 percent. I shoot for 3:1, and I’m elated if I can attain this ratio with even a 50 percent batting average. This means I’m making money three times faster on my wins than I’m losing when I’m wrong. At a 2:1 ratio, I can be right only one-third of
the time and still not get into real trouble. At a 3:1 ratio, even a 40 percent batting average could yield a fortune. If I’m able to be profitable with such a low percentage of winning trades, I’ve built a lot of failure into the system.
Always Determine Your Risk in Advance
The time to think most clearly about where you will exit a position is before you get in. By the time you purchase a stock, the price at which you will sell at a loss should already be determined. When a stock drops to your defensive sell line, there is no time for vacillating or second-guessing. There is no decision to be made; it’s been decided ahead of time. You just carry out your plan; you should write down your sell price before you buy each stock. Put it on a Post-it and attach it to your computer screen. If you don’t
write it down, it’s very likely that you will forget about it or start rationalizing why you should hold on. Not defining and committing to a predetermined level of risk cost traders and investors more money than any other mistake.
Honor Thy Stop
Letting losses run out of control is the most common and fatal mistake made by virtually every investor, including professionals. Trading without a stop loss is like driving a car without brakes, it’s just a matter of time before you crash. As far as I’m concerned, if you aren’t willing to cut losses, you should not be managing your investments or anyone else’s. Most investors can’t stand to take losses. Unfortunately, as a result, they suffer much bigger losses that do lasting damage to their portfolios. This is ironic; they won’t take a small loss because their egos won’t let them accept that they have made a mistake, but in the long run they take larger losses. 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. I suggest that you make that same commitment right now.
Your predetermined stop-loss point should be used as an absolute maximum. Once the stock has declined to your stop, sell it immediately without exception or hesitation. Nothing must prevent you from getting out of the position. Unfortunately, most investors don’t have a stop, even fewer write it down, and many do not sell when the stop is triggered. Typically, a stock declines and the investor says, “On the next rally I’ll get out.” Then one of
two things happens. The stock rallies and in many cases these investors still don’t sell because they feel comfortable that the stock is fine again, or the stock never rallies but keeps falling and becomes even more difficult to sell.
If you want to achieve superperformance in stocks, praying and hoping for a stock to recover from a loss has no place in your psychology.
Concentrate on your plan and stick to your rules; the money will come as a result of sticking to your discipline and maintaining a positive reward/risk ratio.
Handling Stop-Loss Slippage
At the time you purchase a stock, the price at which you expect to sell at a loss should be written down and then executed as soon as the stock tradesat that price. At this decisive moment, you execute the trade as quickly as you can. Sooner or later, however, one of your stocks will dive under your sell 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.
Stop-loss protection is about protecting yourself from a major setback or, worse, devastation. It has nothing to do with being right all the time or getting the high or low price. Success in the stock market has nothing to do with hope or luck. Winning stock traders
have rules and a well-thought-out plan. Conversely, losers lack rules, and if they have rules, they don’t stick to them for very long; they deviate. The old adage holds true: your first loss is your best loss.
How to Handle a Losing Streak
A losing streak usually means it’s time for an assessment. 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 are flawed.
2. The general market environment is hostile.
If you’re experiencing a heavy number of losses in a strong market,
maybe your timing is off. Perhaps your stock-selection criteria are missing a key factor. If you experience an abnormal losing streak, first scale down your exposure. Don’t try to trade larger to recoup your losses fast; that can lead to much bigger losses. Instead, cut down your position sizes; for example, if you normally trade 5,000-share lots, trade 2,000 shares. If you continue to have trouble, cut back again, maybe to 1,000 shares. If it continues, cut back again. When your trading plan is working well, do the opposite and pyramid back up.
It would be bad enough to sit and watch your wealth disappear and do nothing to protect yourself by not using a stop loss, but it is even worse to put more money into a losing investment. Throwing good money after bad is one of the quickest ways to the poorhouse. This is called averaging down.
Brokers often talk their clients into buying more shares of a stock that shows a loss in an effort to sell more stock or rationalize the poor recommendations they made in the first place. They tell the client that it will lower their cost basis. If you liked it at $50, you’re going to love it at $40, right? Double up at $40 and your average price is now $45. Wow, what a deal! You now own twice the amount of stock, and you’ve doubled your risk. Your loss is still the same; you didn’t gain anything except maybe a double-size loss if the stock keeps sliding. How about buying at $30, then $20, and then $10? How ridiculous! There is no shame in losing money on a stock trade, but to hold on to a loss and let it get bigger and bigger or, even worse, to buy more is amateurish and self destructive.
For many investors, it’s tempting to buy a pullback because you feel you’re getting a bargain compared with where the stock was trading previously. However, averaging down is for losers, plain and simple. If this is the type of advice you’re getting, I suggest you get a new broker or advisor. This is simply the worst possible advice you can receive. Remember that only losers average losers.
If your trading is causing you difficulty or stress, something is wrong with your criteria or timing or you’re trading too large. To trade with ease, you must learn to wait patiently until the wind is at your back. If you were going sailing, you wouldn’t go out on a dead calm and sit there floating in the water all day waiting for the wind to pick up. Why not just wait for a breezy day to set sail?
I view the objectives in trading as a three-tiered hierarchy. First
and foremost is the preservation of capital. When I first look at a
trade, I don’t ask, “What is the potential profit I can realize?” but
rather, “What is the potential loss I could suffer?” Second, I strive
for consistent profitability by balancing my risk relative to the
accumulated profits or losses. Consistency is far more important
than making lots of money. Third, insofar as I’m successful in
the first two goals, I attempt to achieve superior returns. I do this
by increasing my bet size after, and only after, periods of high
profitability. In other words, if I have had a particularly profitable
recent period, I may try to pyramid my gains by placing a larger bet
size assuming, of course, the right situation presents itself. The key
to building wealth is to preserve capital and wait patiently for the
right opportunity to make extraordinary gains.
—Victor Sperandeo
Prudence is the order of the day here. 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. This toe-in-the-water approach helps keep you out of trouble and building on your successes. If you’re not profitable at 25 percent or 50 percent invested, why move up to 75 percent or 100 percent invested or use margin? 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. There’s no intelligent reason to increase your trading size if your positions are showing losses. By pyramiding up when you’re trading well and tapering off when you’re trading poorly, you trade your largest when trading your best and trade your smallest when trading your worst. This is how you make big money as well as protect yourself from disaster. Before stepping up my exposure aggressively, I look to my portfolio for confirmation. 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. Be incremental in your decision-making process. Build on success. Subtract on setbacks. Let your portfolio guide you.
Scaling In versus Averaging Down
A key difference between professionals and amateurs is that professionals scale into positions whereas amateurs average down. What do I mean by this? Let’s assume that both the professional and the amateur decide to risk 5 percent of their capital on a trade. The pro may scale in with 2 percent on the first buy, 2 percent on the second, and maybe an additional 1 percent on the third. He then might put his stop at 10 percent from the average cost of his three buys, risking 0.50 percent of the total account capital. The amateur buys his position, usually at one price, and if the trade goes against him, he may decide to average down, doubling up on a losing
position. Often amateurs double up several times. Do this three times and you’ve gone from what started out as a 5 percent position to a 20 percent position. If the stock keeps sinking, it becomes even more difficult to sell because you kept committing to the stock with additional buys. In my trading, I try to buy or add to a position in the direction of the trade only after it has shown me a profit; even if I’m buying a pullback, I generally wait for the stock to turn up before going long. The lesson: never trust the first price unless the position shows you a profit.
When to Move Up Your Stop
I have some basic general guidelines: Any stock that rises to a multiple of my stop loss should never be allowed to go into the loss column. When the price of a stock I own rises by three times 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 percent on the trade ($47.50 stop loss for a $2.50 risk). If the
stock advances to $57.50 (3 $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 down my profit. If I get stopped out at breakeven, I still have my capital; nothing gained but nothing lost. You may feel dumb breaking even on a trade that was once at a profit; however, you’ll feel a lot worse if you turn a good-size gain into a loser. Move your stop up when your stock rises by two or three times your risk, especially if that number is above your historical average gain. This will help guard you against losses and protect your profits and your confidence.
Not All Ratios Are Created Equal
Once your batting average drops below 50 percent, 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. If your winning trades were to more than double from 20 percent to 42 percent and you maintained a 2:1 gain/loss ratio by cutting your losses at 21 percent instead of 10 percent, you would actually lose money. You’re still
maintaining the same ratio, so how could you be losing? This is the dangerous nature of losses; they work geometrically against you. At a 50 percent batting average, if you made 100 percent on your winners and lost 50 percent on your losers, you would do nothing but break even; you would make more money taking profits at 4 percent and cutting your losses at 2 percent. Not surprisingly, as your batting average drops, it gets much worse. At a 30 percent batting average, profiting 100 percent on your winners and giving back 50 percent on your losers, you would have a whopping 93 percent loss in just 10 trades.
I’ve always felt that if I was enthusiastic about an industry or a
company, then I would concentrate in it. It causes commentators to
consider me risky. I never thought that was risk; I thought that was
opportunity. —Kenneth Heebner
You will never achieve superperformance if you overly diversify and rely on diversification for protection. During a bear market, almost all stocks will go down. By having your money spread all over the place, you accomplish three things:
1. Inability to follow each company closely and know everything you should know about the investments
2. Inability to reduce your portfolio exposure quickly when needed
3. A smoothing effect that will ensure average results
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 will provide sufficient diversification but not too much. You should not hold more than 20 positions, which would represent a 5 percent position size if they were equally weighted.
“Risk comes from not knowing what you’re doing.” - Warren Buffet
DIVERSIFICATION DOES NOT PROTECT YOU FROM LOSSES
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