Stocks

Stocks tend to move more slowly than futures, thus reducing risks for beginners, especially those who avoid margin. It is one of the mysteries of markets that cash traders are more likely to win, and margin traders to lose. Why? Interest rates on margin loans are a serious expense, raising a barrier to winning, but there's more. People who buy stocks for cash tend to feel more relaxed, buying as much or as little as they want. Margin traders are more likely to feel stressed. An anxious trader is a troubled trader. It is better to buy only what you can afford, polish your skills, and the money will follow.

The sheer number of stocks drives people to distraction. Beginners throw their arms in the air and beg for a list of stocks to follow. A disciplined trader makes several choices that help him concentrate. He begins by selecting an industry group or groups and then zeros in on individual stocks.

A beginner should start with one or two groups, an intermediate trader can go up to four or five, and an expert knows how many he can handle. Chances are, he sticks to the few groups he knows well. Begin by choosing a group that you think has a great future or one in which you have a personal interest. For example, you may decide to concentrate on biotechnology because of its promise or the hospitality industry because that's where you work.

Select a broad rather than a narrow group. For example, if you decide to track autos, look not just at car manufacturers, but also at companies that make auto parts, tires, etc. The disadvantage of focusing on a single group is that you miss spectacular moves in others, but there are several advantages. You learn which stocks tend to lead or follow. When leaders start to move, they give you an advance signal to trade the laggards. You can use relative strength, that is, buy the strongest stocks when the group moves up and short the weakest on the way down. You can create an index that includes all the stocks you follow in your industry group, and then analyze that index. This analytic tool is not available to any other trader. If you use fundamental analysis, then having your finger on the pulse of a single industry, such as software, puts you miles ahead of competitors who trade Microsoft today and McDonald's tomorrow.

A broadly defined industry group may include over a hundred stocks, but an intelligent beginner should not follow more than a dozen. We can divide all stocks into blue chips and speculative "cats and dogs." Blue chips are the stocks of large, well-established companies, held by many institutions and followed by many researchers. They have a fairly well-established consensus of value around which they more or less gently oscillate. If you design a system for catching their swings several times each year, the potential gains can be very attractive. Don't ignore the big Dow-type stocks. Their orderly swings from the moving average to the channel wall create good trading opportunities.

The so-called cats and dogs may spend months, if not years, flat at the bottom, in a speculative doghouse, until a fundamental change, or even a rumor of change, propels them to a breakout and a new uptrend. Other cats and dogs may go nowhere or expire. Those stocks offer much higher percentage gains than blue chips, but the risks are greater and you must spend a great deal of time waiting for them to move. It makes sense to trade a large portion of your account in blue chips, while keeping a smaller portion in longer-term speculative positions.

What if you've paid your dues, learned to trade a few stocks in a few groups, and now want to forage in wider pastures? After all, technical patterns and signals are not all that different in various markets. What if you want to scan a larger number of stocks for MACD divergences, Impulse breakouts, or other patterns that you learned to recognize, trust, and trade?

Go on the Internet and find a website that gives you the 100 most active stocks on the NASDAQ (and if you do not know how to find such a website, you haven't got what it takes to trade them). Keep an eye on any stock that floats by you. A newspaper article mentions several companies—look up their stocks. People at a party talk about stocks—jot them down, drop them into your system, and see how they look on your screen. Many tips call for an exercise of contrary thinking. In summer 2001, Lucent (LU) was in the news with another earnings disappointment, having slid from 80 to 6. The journalists were aghast, but that stock has completed its bear market, traced an attractive bullish divergence, and was poised for a rally. A rise from 6 to 9 is a 50% increase. Stocks that people tout at parties are often good candidates for shorting. By the time outsiders become interested, the rise tends to be over. The idea is to maintain your curiosity and use tips not on their face value but only as invitations to look at this or that stock. I find that my yield, the percentage of tips that I end up trading in either direction, is about 5%—I end up trading one out of 20. I have a friend, a brilliant trader, who often calls me asking to take a look at this or that stock. My yield on her tips is 10%—she is the best.

The Turnover Ratio The Turnover Ratio (TRO) predicts expected volatility of any stock by comparing its average daily volume with the available float. This formula was brought to my attention by Roger Perry of The RightLine Report (www.rightline.net):

I TRO = monthly volume divided by the available float

Volume for the past month is easy to calculate. The available float refers to the total float, or number of shares issued, minus the holdings of institutions and insiders. Those groups tend to hold positions more tightly than private traders, who are more likely to sell if the price is right. All of the above figures are widely available from financial databases.

You can calculate the average monthly volume by multiplying the daily volume by 22, the number of trading days in a month. Using the daily volume makes the TRO more responsive to changes in volume as a stock rolls into or out of favor with traders.

TRO shows how many times the float trades in a month. For example, if a stock's monthly volume is 200 million shares and its available float 100 million, its TRO is 2%. If monthly volume of another stock is also 200 million, but its available float is 50 million, its TRO is 4.

If the average volume is much lower than the float, that stock has a low turnover rate and an onrush of buyers is unlikely to move the price much. However, if the volume is high relative to the float, then a lot of people compete for few available shares, and a sudden rush of buyers can move the price dramatically.

High-TRO stocks tend to be more volatile. Whoever wants to buy them has to pay a premium to pry them out of the hands of relatively few holders. When a selling wave hits the markets, the stocks with high TROs tend to go down harder because they do not have a large pool of institutional holders looking to pick up extra shares at a discount. All other factors being equal, the stock with a higher TRO will make a bigger percentage move.

For example, at the time of this writing, the monthly volume in GE was 355.9 million, with the available float of 9,809 million, resulting in a turnover ratio of 4%. The figures for JNPR were 387.2 million, 155.6 million, and 249%. No wonder; GE is a slow-moving blue chip, whereas JNPR is a high-flyer. Check these numbers once a month, as they keep changing. Stock splits reduce TROs by increasing the float. One split too many in DELL has oversaturated the market to the point where the stock has become unattractive for day-traders.

Blue chips, such as General Electric and IBM, are widely held by institutions and individuals. Their daily volume, no matter how high, is but a tiny percentage of their float. New unseasoned stocks often have very small floats, but when they catch the public's eye, their daily volumes go sky-high, lifting the TRO.

You can keep close tabs on the TROs of stocks you track. Whenever the market is active and running, switch into high-TRO stocks. Whenever the market goes into a choppy stage, switch to low-TRO stocks and trade their swings. TRO can help you switch between aggressive and defensive positions.

Trading Swings or Trends Whenever you glance at a chart, your eye is immediately drawn to major rallies and declines. Big moves attract us with their promise of a killing. Exactly who gets killed is a question that seldom crosses beginners' minds. The trouble with major rallies and declines is that they are clearly visible in the middle of the chart, but the closer you get to the right edge, the murkier they become.

Big uptrends are punctuated by drops, while downtrends are interrupted by rallies. Emotionally, it is extremely hard to hold a position through a countertrend move. As profits melt away, we begin to wonder whether this is a temporary interruption or a full-blown reversal. There is a strong temptation to grab what little money is left and run. Shorter swings are easier to catch because price targets are closer and stops are tighter.

Should you trade long-term trends or short-term swings? Be sure to decide before you put on a trade; it is easier to be objective when no money is at risk. Different stocks have different personalities, which is why trend traders and swing traders tend to follow different stocks.

Traders have three choices. Trend traders identify major trends which run for months. Swing traders catch short-term swings between optimism and pessimism, which last from a few days to a few weeks. Day-traders enter and exit during the same trading session, with trades lasting only minutes or hours.

Successful trend trades that catch large moves bring in more money per trade. Other advantages include having more time to decide when to enter or exit, not being tied to the screen, and having the emotional satisfaction of calling major moves. Trend trading does, however, have its drawbacks. The stops are farther from the market—when they get hit, you lose more. Also, you have to sit through long periods of inactivity, which many people find hard to tolerate, and you miss many short-term trading opportunities.

Swing traders have more opportunities than trend traders, gaining more experience from frequent trades. The dollar risk is lower thanks to closer stops, and quick rewards provide emotional satisfaction. Swing trading also has its drawbacks. Expenses for commissions and slippage are higher, due to more frequent trading. You must work every day, actively managing trades. Also, you are likely to miss major moves—you can't catch big fish on a small hook.

Trend trading—buying and holding in a major bull market—works best with the type of stocks that Peter Lynch calls 10-baggers, those that go up by a factor of 10. They are usually newer, cheaper, less seasoned issues. An Internet or a biotech company with a hot new invention, a new patent, or a new idea is more likely to go up by a huge percentage than the stock of an old established firm. A small company may bet its future on a single idea or product, and its stock will soar if the public buys that bet or stay in the doghouse if it doesn't. Had a large multinational company come up with the same invention, its stock would have barely budged because one more product makes little difference for a huge firm.

The lure of big trends makes stocks of small companies in promising new industries attractive to trend traders. Swing traders should select their candidates from among the most actively traded stocks on major exchanges. Look for large-cap stocks which swing within broad, well-defined channels.

Once you choose a stock, don't assume it will continue to behave the same way forever. Companies change, and you must stay on top of your picks. For example, DELL, started by Michael Dell in his college dorm room, used to be a tiny public company, but grew into one of the largest computer firms in the world. A friend of mine bought $50,000 worth of Dell in the early 1990s and cashed out three years later at $2.3 million, but DELL's days of spiking through the roof and doubling twice a year are gone. Instead, this widely held stock has become a vehicle for swing traders, and not a very active one at that.

A beginning trader is better off learning to catch swings, because profit targets and stops are clearer, feedback comes faster, and money management is easier. The choice between trend trading and swing trading is partly objective and partly subjective. Should you trade trends or swings? My impression, after meeting thousands of traders and investors, is that the elite tend to trade the big moves and ride major trends, but people who can do it successfully are few and far between. There are many more traders who make money—sometimes very serious money—by trading swings. The principles of Triple Screen work for both, even though the entries and especially the exits are different.

Trend Trading Trend trading means holding your positions for a long time, sometimes for months. It requires holding while your stocks react against the main trend. Bull and bear markets are driven by shifts in the fundamentals, such as new technologies and discoveries in the case of stocks, weather patterns in the case of agricultural markets, political shifts in the case of currencies, and so on. Fundamental factors are behind bull and bear markets, but prices move only in response to actions by traders and investors. When your fundamental information forecasts a major move, you need to analyze the charts to see whether the technicals confirm the fundamentals.

A market doesn't send you an invitation before it takes off. When a trend first climbs out of the cellar, few people pay attention. Amateurs are fast asleep, while professionals monitor their markets and scan for breakouts and divergences. Active markets get into the news because the lows and especially the highs attract journalists. One of the key differences between the pros and the outsiders is that the pros always track their markets, while amateurs wake up and look at charts only after a market hits the news. By that time the train has already left the station. The ABC Rating System, described on page 255, can help you handle the challenge of tracking stocks through inactive periods.

A new breakout is easy to recognize but hard to trade and even harder to hold. As a trend speeds up, more and more people pray for a pullback. The stronger the trend, the less likely it is to accommodate bargain hunters. It takes a lot of patience and confidence to hold a position in a trend. Traders tend to be active men with the attitude of "don't just sit there, do something." Learning to be passive comes hard to them. One reason women tend to trade better is that they are more likely to be patient.

How can you teach yourself to trade trends? You may begin by studying historical charts, but remember, there is no substitute for experience. The idea is to learn by doing. Start by putting on positions so small that you can be relaxed and not tie your mind into a knot. Trade only a few hundred shares or a single futures contract while you're learning.

To apply Triple Screen to trend trading, monitor long-term charts for breakouts or look for well-established moves, identified by a weekly EMA. When the weeklies tell you to be bullish or bearish, return to the dailies and use oscillators to find entry points. Put on long positions in uptrends when prices touch their rising daily EMA and keep adding on pullbacks. You can also add when daily oscillators, such as MACD-Histogram or Force Index, give buy signals, especially when they coincide with pullbacks. Reverse the procedure in downtrends. When the weekly trend is down and daily oscillators rally and reach overbought levels, they signal to sell short, especially when they coincide with rallies to the EMA.

The idea is to position yourself in the direction of the market tide and use the waves that go against that tide to build up your initial position. As a beginner, learn to trade a single small position, but once you start making money, the size of your positions and the number of additions become a function of money management.

Once you recognize a new trend, get in! New trends, springing out of trading ranges, are notoriously fast, with few or no pullbacks. If you think you have identified a new trend, hop aboard. You can reduce your risk by trading a smaller size, but do not wait for a deep pullback. Those may come later, and you will be able to add to your position. Jumping aboard a new trend feels counterintuitive, but being in the market makes you more alert to its behavior. The great George Soros was only half-joking when he said, "Buy first, investigate later."

Place your initial stop at the breakout level, where the new trend erupted from the range. A rocket that takes off from its launching pad has no business sinking back to the ground. Do not hurry to move your initial stop. Wait for a reaction and then a new move before moving your stop to the bottom of that reaction. The SafeZone stops, which work so well for swings, are much too tight for big trends. While riding a tide, you must expect the waves to swing against you and still hold your position.

Trend trading means retaining your initial position through thick and thin. You are fishing for very big fish, and you need plenty of room. One of the reasons so few people make big money from big trends is that they become anxious and hyperactive and forget to hang on. Trends are unlike swings, where you must take profits and run fast. Stay with the trend unless weekly trend-following indicators go flat or reverse.

Amateurs often outsmart themselves by trying to pick the end of a trend—a notoriously hard task. As Peter Lynch aptly put it, trying to catch a bottom is like trying to catch a falling knife—you invariably grab it in the wrong spot. Trends tend to overshoot rational expectations. News, daily chart patterns, and other distractions try to throw you off the saddle. Hang on! Consider trading a core position and supplementary positions. You may put on a core position with a wide stop and no definite profit target, while swinging in and out of additional positions—buying on declines to the EMA or selling on rallies to the upper channel line. Consider using two different accounts for easier record keeping.

Swing Trading Markets spend most of their time going nowhere. They rally a few days, pause, decline a few days, and rally again. Small swings—weekly, daily, or hourly—are more common than big trends. By the end of the month the market may be higher or lower, but it has traveled up and down several times. Newcomers get shaken out, while professionals enjoy the short rides.

Markets' tendency to swing above and below value has been statistically confirmed by several researchers. Swing trading means buying normalcy and selling mania (buy near the rising moving average, sell near the upper channel line) or shorting normalcy and covering depression (sell short near the falling moving average and cover at the lower channel line). The best swing-trading candidates are among the most active stocks and blue chips that tend to rock, more or less regularly, within their channels. Cats and dogs are best left for trend trading. To draw a list of candidates, start with the 20 most active stocks and a handful of famous blue chips, and choose the ones with the widest channels and the most regular swings.

Be sure to select only those candidates whose daily channels are wide enough for a C-level trader to take at least a point out of a trade. A C trader is someone who normally takes 10% or more out of a channel. The only way you can prove you are a B or even an A trader is by trading at that level for at least six months. Even A traders are better off with broad channels because profits are fatter. Beginners have no choice but to use the "1 point for a C trader" rule. This translates into 10-point channels. Technical signals may look delicious, but if a channel is narrower than 10 points, click on to the next stock.

Some stocks give better technical signals than others. Look for a handful of regular performers; you need six or seven, certainly no more than 10. Tracking just a handful of issues allows you to keep up your daily homework without running ragged or falling behind. Learn the personalities of your stocks, rate yourself on every trade, and once you become a steady B trader, increase your trading size.

When the weekly trend is up, wait for daily oscillators to become oversold while prices decline toward the EMA. When the weekly trend is down, look for sell signals from daily oscillators while prices rally toward the EMA. If an oscillator falls to a new multi-month low while prices are moving toward the EMA, it shows that bears are extra strong and it is better to put off buying until the following bottom. The reverse applies to shorting.

In a weekly uptrend, the bottoms of daily charts tend to be very sharp affairs. The best time to buy is when the market stabs below its daily EMA. The best time to short is when the market stabs above it. To place an order near the EMA, estimate its level for tomorrow. The math is simple. You know where the EMA was yesterday and where it closed today. If it has risen, say, by half a point, expect tomorrow's rise also to be half a point and add that to today's EMA.

Take a look at how your stock has behaved since the latest trend began. If the trend is up, look at the previous declines. If the stock has returned to the EMA three times and penetrated it by an average of a point and a half, place a buy order approximately a point below the moving average, a little more shallow than the previous declines. Estimate the EMA for tomorrow and adjust your buy orders daily. Electronic brokers do not become irritated when you change orders each day!

Swing trading, like fishing, demands a great deal of attention and patience. You need to do your homework daily, calculate the estimated EMA for tomorrow, and place orders. You also must calculate your profit targets and stops.

After entering a swing trade, place a protective stop, using the SafeZone method. Swing trading is a high-wire act, requiring a safety net. Stops and money management are essential for your survival and success.

Take profits near the channel line. The exact level depends on the strength of the swing. If MACD-Histogram and Force Index are making new highs, the market is strong, and you can wait for the channel line to be hit. If they act weak, grab your first profit while it's still there. What if a strong swing overshoots the channel line? An experienced trader may shift his tactics and hold a little longer, perhaps until the day when the market fails to reach a new extreme. A beginner must train himself to take profits near the channel wall because he does not have the skills to switch on the fly. Being able to take a limited profit without kicking yourself for missing a big part of a move is a sign of emotional maturity. It is liberating to accept what you asked for and not worry about the rest. Profit targets help you create a structure in an unstructured environment. Measure your performance as the percentage of the channel width. You must grade yourself to know where you stand.

Early in your trading career, it is safer to concentrate on swings. As your level of expertise rises, allocate a portion of your capital to trading trends. Major trends offer spectacular profit opportunities—the big money is in big moves. You owe it to yourself to learn to trade them. Concentrate on quality, and money will follow.

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