Is the Trend Your Friend?
Stockscores.com Perspectives for the week ending March 25, 2006
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In this week's issue:
The trend is your friend. It is an overused cliché that can never be said enough. Trading with the direction of the market will have more of an effect on your stock picking ability than any analytical tool can. The trend can make neophyte buyers in a bull market look like all-star analysts but can also leave all-star analysts and their buy recommendations feeling stupid in a bear market.
One of the core rules for reading chart patterns is determining whether there is optimism or pessimism among investors. Most of the Stockscores Strategies buy when there is optimism and short when there is pessimism. We want to trade with the trend even when the fundamentals argue against it.
Trading with the trend often means buying stocks that have gone up a lot, stocks that appear expensive. Unfortunately, many investors transfer their skill at shopping for deals to shopping for stocks. They look for bargains, stocks that have fallen a lot and appear to be on sale. They buy stocks in down trends.
Blue light specials are not a great way to buy stocks. You may be right about the stock being on sale but if the market disagrees with your assessment you will lose money. Would you rather be right or be profitable?
Profitable trading requires buying stocks that investors like and are going to like more in the future.
That does not mean you can not bargain hunt. An inevitable part of all trends are counter trend pull backs that give you a chance to load up at prices that are off the high. Buying short term down trends is ok if the long term trend remains up.
This approach is all about being on the right team. Imagine if a professional athlete could get up and move to whatever team was at the top of the standings. Imagine if you could go work at what ever company was leading its industry. Imagine if you could hit 5 golf shots at every turn and take the best one.
In stock trading, you can load the deck in your favor. It is called trading with the trend.
Of course, there is more to success in the stock market than just buying stocks that are going up over time. We still have to apply good analytical methods to time our entry at the right point and use good risk management. We still have to work hard to control our emotions and follow our rules of trading.
But, if you apply good trading techniques to strong stocks in strong sectors, I am confident that you will do well.
Last weekend I highlighted my daily newsletter stock picks from December and the first half of January. There were some big winners on that list and they almost all came from the TSX and TSX Venture market. Why did these stocks outperform the US stock picks? Because these markets have been hot and the US markets have not.
The Stockscores Approach use the Sentiment Stockscore to help determine the trend. If the Sentiment Stockscore is above 60 then it is likely that optimism prevails among investors. That is why I don't like to buy stocks with a Sentiment Stockscore of anything less than 60.
So keep this in mind when you are analyzing stocks and looking for opportunities. Trade the sectors of the market that are strong and the focus on the strong stocks in those sectors. It is just one more weapon against the cruelty of the stock market.
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A common theme among Head and Shoulder Bottom, Ascending Triangles, Pennants and Rectangle Consolidation patterns is a break through resistance from low price volatility, usually with volume supporting the breakout. Rising price bottom formations in to the breakout point are common, but what market dynamic do these patterns really represent?
Rising bottoms are a sign of growing optimism among investors. As time passes, they demonstrate a weakening of selling force and increase power among buyers. As a stock moves up toward a resistance price point, the market is faced with the upper limit on what investors believe the company to be worth. We often see that stocks will go in to narrow trading ranges under resistance as investors come to a consensus on the value of the company. When stocks break out from this condition, they may be signaling significant new fundamental information at work in the market since resistance has been broken from strong consensus out of a period of optimism.
The Sentiment Stockscore is useful for finding optimism in the market, and the Signal Stockscore is heavily weighted on the abnormal market activity that comes with breakouts. By looking for stocks that have a Sentiment Stockscore of 60 or higher, and a Signal Stockscore of 80 or higher, we can consider charts that may have a good chart pattern set up. The Stockscores Simple Market Scan adds in some other technical filters to shorten the list of potential candidates further.
This strategy is not solely about finding stocks with good Stockscores. The most important step is visually inspecting the charts to ensure that the chart patterns are what we are looking for. A good chart pattern will have the following characteristics:
A break through resistance
Abnormal activity, in terms of price and volume activity
The break through resistance should be from a period of low price volatility. Low price volatility is characterized by the price range of trading on each day (how tall the trading range is on the chart) and by the range of trading over a number of days (are the trading days side by side on the chart, or is there a price trend?)
A show of optimism leading in to the break through resistance from low price volatility.
It is necessary to have all of these criteria, many traders forget to check whether the stock was trading with low price volatility before the breakout, or to make sure that the stock is truly breaking through resistance and will not encounter more selling pressure soon.
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1. LOOK
Look at LOOK and you will see a good example of a stock breaking through resistance, from optimism, with abnormal activity and out of a period of low price volatility. The pattern on this chart is called an Ascending Triangle and it is a good indicator that an uptrend is likely. Support is at $4.75, a close below that would void the bullish chart pattern set up.
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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.
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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