10 Essential Trading Elements
Stockscores.com Perspectives for the week ending January 20, 2006
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In this week's issue:
Successful trading of the stock market requires a lot more than knowing what to buy or sell. While most beginning traders focus their study on when to enter a position, traders who make money know that the money goes to those who do a lot of other things right. Here are ten things that every trader must know:
1. You can't take more risk than you are comfortable with - emotion is the enemy of the trader. Most of us are slaves to our emotion, which is why most traders fail despite the apparent simplicity of trading. To be successful, you have to manage emotion, and the first step toward emotional mastery is to not take more risk than you are comfortable with. If you can't sleep at night over the potential of losing more than $500 on a stock trade, then you should not risk more than $500 on a stock trade. The less you care about the outcome of a trade, the smarter you will execute it.
2. Stops loss orders must be used - one big loss can wipe out the gains of five winning trades. Success requires that you don't take big losses, so utilize stop loss orders. Once you are entered in a trade, enter a stop loss order and stick to it. If your brokerage does not provide the ability to execute stop loss orders, then change brokers.
3. No one cares more about your money than you - only you really care whether you make money or not. Therefore, do not depend on others to make you money; you have to take control and know what is going on. You can use the skills of others to help you make decisions, but ultimately, your success in the market will come down to what you do.
4. Losers react, winners predict - the market does not care about what happened in the past. If you are using publicly available information to make trading decisions, then you are using old information. The stock market moves on what it expects to happen in the future, and not on what has already happened. Use what has happened in the past to provide clues to what may happen in the future, but don't make decisions on information that is widely known.
5. The stock market is not fair - Within every stock, there are a small group of investors who know more than the general public. They have an advantage, because they can better predict what a company will do in the future. To be successful, we have to figure out what the investors with better information are doing, and then do the same.
6. Information is biased - the financial industry wants you to buy stocks. The brokerages that finance the companies, the newsletters that get paid to advertise company stories, the promoters that get paid to promote stocks, the media that sell more advertising in an up market and of course, the companies themselves all benefit when stock prices go higher. The more buyers, the higher prices go. Trust no one when making investment decisions, because everyone can have a bias. Only the market can not lie (although it can seem pretty stupid sometimes), therefore, trust what the market tells you.
7. Hard work does not make money in the market - you need to work hard to learn how the stock market works. You need to work hard to learn how to manage your emotions. You need to work hard to learn discipline. However, the most money is made in a market that is trending, one where there are lots of opportunities and it seems easy to make money. When the market is not trending, it is harder to find opportunities. Working harder when the going gets tough will cause you to take marginal trades. Take the obvious trades, they are more likely to work.
8. Black boxes don't work - there are a lot of companies selling trading systems that magically spit out buy and sell recommendations. The stock market is like a flu virus; just when you think you have it figured out, it changes in to something else. Therefore, systems too must evolve with the market. A system that worked in the past may not work in the future. However, what seems to always work is understanding how humans and crowds behave. Learn that, and you can begin to pick stocks in any market condition. More importantly, learn the art of trading well, knowing that you can not always be right, that you have to limit losses and let profits run and that you have to understand what motivates people to buy and sell. Systems, indicators, and computer programs are simply tools to help you make better decisions.
9. The stock market is usually efficient - actually, stock, futures, currencies and any other market that has enough people trading them are usually efficient. That means, most of the time you can not beat the markets. To do better than the masses, you have to identify situations where market efficiency is breaking down. That occurs when the crowd is emotional or when small groups of investors are trading on private information. Usually, that is most easily found when stocks are trading abnormally in terms of price and volume. Focus your attention on abnormal behavior when looking for trading opportunities.
10. Discipline is essential - you have to manage risk effectively, you have to use stops loss orders, you have to always be looking for high probability trading opportunities, you have to avoid taking too much risk and you have to let winning positions run. The laws of trading are nothing if you don't have the discipline to follow them.
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In my opinion, abnormal trading activity is the best indication of significant fundamental change. Abnormal activity can be measured using linear regression using some indicators that I have developed and that are at the core of the Stockscores calculation. This week, I thought I would look at the 2000 most active stocks on the Nasdaq stock market and see which ones made abnormal price moves for the week. From that list, I found that 60 made statistically significant abnormal price moves (either up or down). My final step is to inspect the weekly charts of each of these stocks to see which ones have good long term chart patterns. These become the stocks that I consider for a trade.
When I look at the chart patterns, I want to see if the stock broke from a period of low price volatility, through support or resistance, with abnormal volume (which is almost assured when there is abnormal price activity) and does not have price barriers that will impede its future movement (there needs to be enough reward potential in the stock before it hits the next area of past price consolidation).
Time and again I find that long term trends start with this set up of abnormal price activity out of a good chart pattern. Apple Computer is a great example as it made an abnormal price gain with abnormal volume the week of May 9, 2003, three weeks off of its low to close at $9.15. It hit a high this week of $86.38). For a more recent example, check out the chart of EDAP, which made its abnormal gain the week of Dec 16, 2005 and has been rising steadily since.
From the list of Abnormal Weekly Performers that I uncovered this week, here is a stock that I think has a good long term chart pattern and deserves consideration.
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1. AVGN
AVGN was a real high flier in 2000, hitting a high of 89.00. With the stock now at $4.12, you would not want to be the person who bought it back then and is still holding as it is unlikely that the stock will ever see those highs again. However, it does appear that some life is coming back to AVGN as it made some good gains this week on volume. If the stock can stay above $3.15 on a weekly close I think it has a good chance to move up toward the next resistance level of $7, giving it about a 1:3 risk-reward ratio.
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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.
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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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