The Stockscores Approach
Stockscores.com Perspectives for the week ending January 2, 2006
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In this week's issue:
I thought that the start of a new year would be a good time to summarize the Stockscores Approach to trading the stock market. This will include an overview of the theory behind the Stockscores indicators, the key components of a good stock and what to do after you enter the trade.
Here are some disturbing facts for those who aspire to make money in the stock market. Most people, including most professional money managers, fail to consistently beat the stock market. Of those that try to make a living trading the stock market, I would guess that 90% fail.
The Efficient Market Hypothesis is at the root of this poor performance. This most basic of financial theories states that the stock market is efficient at pricing in new information and therefore, no investor can consistently outperform the market average. That is a nice textbook definition but what does it really mean?
Consider what would happen if you were to drop a $100 bill in a crowded shopping mall. Would it stay on the ground for long, or would someone quickly pick it up? The answer is obvious; almost anyone who spots a $100 bill on the ground would pick it up and put it in their pocket.
The same can be said for the stock market. The market quickly adjusts the price of a stock when the company announces a significant advancement in their business. Announce a cure for Avian Bird Flu and your stock will go up in price almost instantly.
That means that using publicly available information to make an investment decision is a futile pursuit. The market takes every bit of fundamental information pertaining to each individual company and prices it in through the buying and selling of that stock in the open market. The buying and selling is essentially the result of an argument between buyers and sellers about the true value of the company.
This argument for market efficiency is the reason most financial theorists suggest the simple purchase of a market index when investing in stocks. That way, your performance closely mirrors the long term performance of the stock market, which historically, has been better than any other class of investments.
So why bother trying to beat the market? Because, there are some holes in the theory of market efficiency that can be exploited
The theory has two critical assumptions. First, investors are assumed to be rational in their deduction of the value of information. Second, it is assumed that the spread of new information is fair and that all investors learn of new information at the same time.
If you have been investing in the stock market, you will likely laugh at these assumptions. Have you ever bought a stock with an irrational feeling of greed? Have you ever sold a stock out of fear?
Do you think that there are some investors who get new information before the broader market? Have you ever watched a stock move up in price before a big news announcement?
The truth is, some investors are trading on private information that is not yet widely disseminated. This is referred to as information asymmetries in the market. And, for some reason, we humans are prone to making emotional investment decisions.
This is good news, because it opens some holes in the theory of market efficiency that savvy traders can exploit. These breakdowns are the basis for the Stockscores Approach.
The Sentiment Stockscore is a measure of investor psychology. By looking at the general patterns of trading in the stock market, we can gauge whether the buyers or sellers are in control of the market. If the Sentiment Stockscore is above 60 we suggest that investors are optimistic. When investors are optimistic, they will tend to judge fundamentals favorably.
The Signal Stockscore is a much rougher line that looks for abnormal trading behavior as a clue that some investors may be trading on new information that is not widely disseminated. If a stock jumps up in price with heavy volume, expect the Signal Stockscore to jump above 80.
This leads to the three rules for picking a stock using the Stockscores Approach. First, make sure the Sentiment Stockscore is above 60. Next, check that the Signal Stockscore is spiking up above 80. The final rule is to check the chart to see if the is making a good chart pattern.
This is where some skill is necessary since good chart patterns are a matter of judgment. At this point, it is important to stress that we never buy a stock because it has good Stockscores. We stocks when the chart patterns suggest that the probability of the stock going up are in our favor.
So, what makes a good chart pattern? For purchasing a stock, there are four factors to consider:
is the stock breaking through a price ceiling or level of resistance?
is the stock showing optimism (have there been rising bottoms on the chart leading in to the breakout)?
is the stock behaving abnormally?
was the stock trading with very little volatility (sideways and not in a trend) before the break?
These are the basic elements of a good buying chart pattern but only the beginning of the successful trade.
Suppose you are a very good stock picker, you can spot good chart patterns and find winning stocks 70% of the time? Are you guaranteed to make money in the market? Sadly, the answer is no.
The next key component to trading the Stockscores Approach is Risk Management. Since picking stocks is really just a probability game, we have to be able to control our losses when we are inevitably wrong. That requires planning our losses and letting the plan determine our position size. If the stock chart tells you that a break below $9 will prove your decision to buy the stock at $10 wrong, then you have to plan to sell on a move below $9. That means you have $1 per share in risk, and if you don't want to lose more than $500 on any one trade, you should not buy more than 500 shares. This is a simplification of the Risk Management concept but hopefully you get the idea.
Reward potential is also important in the risk management calculation. There has to be enough upside potential to justify the downside risk. The expected value of the trade has to be positive or the trade is not worth taking.
Is good stock picking and effective risk management all there is? Sorry to disappoint you, but no, there is more.
Once the market has proven your decision to enter a trade correct (by a show of profit on the trade) it is smart to add to that position, a practice called scaling in. Buying more of a winner is good because the probability of success is greater when your trading decision has already been proven successful.
Finally, and most importantly, the ability to have emotional control is necessary to beat the performance of the market. This requires that you do not make decisions based on fear or greed, that you follow proven and rational rules of trading. This is what makes trading the stock market difficult.
Most people have an emotional attachment to money. They are afraid of losing it and get excited at the prospect of making it. As a result, they tend to sell their winners too early and exit their losers too late. They tend to take risks in the pursuit of pleasure and avoidance of pain. If you are a normal human being, you are predisposed to fail in the stock market.
I can teach most people the basic rules of the Stockscores Approach through our StockSchool Pro course in a relatively short period of time. However, trading is not so easy to learn in a weekend. That is why the StockSchool Pro course is a six month mentoring process. If you are looking to learn how to trade the stock market, don't expect the instant solutions offered by some companies to work. Learning to trade will take at least a couple of months, but typically longer.
So, we must ask the question again, why bother? Here are some other things to consider:
with the power of compounding, an improvement in the annual return of your retirement portfolio can have a dramatic effect on when you retire. Would you put in an hour of effort a week to retire 10 years earlier?
making a career out of trading the stock market can be very lucrative and give you a kind of freedom that few other choices offer. I have seen my students make more in a day than the average person makes in an entire year. I have sat on a beach chair in Hawaii with my feet in the Pacific while trading the market with a lap top computer. Trading is a lot of fun.
I expect 2006 to be a good year for the stock market and hopefully this overview of the Stockscores Approach serves as a good primer for everyone to exploit the opportunities that the stock market delivers every day.
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Since the markets have been mostly closed or slow this past week, there are no feature stocks.Back To Top
References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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