The Stockscores Approach First Pillar - When to Enter
Stockscores.com Perspectives for the week ending December 22, 2007
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In this week's issue:
This week's newsletter begins the series looking at the four pillars of the Stockscores Approach. I want to outline the most important principles of knowing when to enter a trade, how to manage risk, when to exit the trade and how to manage emotions. This week I begin the series with the most obvious step in the trade, the entry.
The entry is what most people focus on; we are each obsessed with what to buy or what to short. Stock tips, analyst reports, media features and technical trading strategies usually put the sole focus on what stock to consider. Despite this concerted effort to pick the right stock, I think most investors don't realize how futile their efforts are. Let me begin by explaining why.
For the most part, the stock market is efficient. This idea is the backbone of financial theory; all information is priced in to stocks and, therefore, the success of investors large or small will be random. The results prove this fact, the vast majority of professional money managers fail to consistently beat the market. The same can be said for individual investors who tend to underperform the market averages over the long term.
It is important to understand what is meant by market efficiency. Ask yourself, what is the value of publicly available information? If a gold mining stock is trading at $10 a share before announcing that they have made a large discovery of gold, what do we expect to happen to the price of their stock after the news? Since a new discovery of gold improves the value of the company, we of course expect their stock price to go up. And the reality is, it does not take very long for this process to happen. The market is very efficient at pricing in new information.
Now, consider the investor who reads the news release after the rest of the market has had a chance to digest it. Is there any value in what the news release says? It may make the investor feel good about owning the stock, but since the information in the news release is already priced in to the stock, the value in reading that news release is close to zero.
This definition of market efficiency assumes that stock prices will change immediately after news is released to the public, but the stock market is actually even more efficient than that. Stocks tend to move before the news because some investors have access to better information than others and anticipate the news. Have you ever seen a stock move before a major news announcement?
The fact that we have all seen stocks anticipate news is the basis for one of the core principles of the Stockscores Approach; the stock market is not fair! Some people get information before the masses and with that better information they can make trades that give them abnormal profits. The Stockscores principle on entering stocks is to exploit a breakdown in the efficiency of the stock market by learning to find opportunities that the market tells us about. Market activity provides the message.
The simplest requirement when looking for stocks to enter is abnormal trading activity. Abnormal price movement and abnormal volume are signals that someone is trading with new information. I have looked at the stock charts of thousands of stocks that have had periods where their trends were moving much faster than the overall market and the great majority of those trends started with abnormal trading activity.
Unfortunately there is a lot of noise in market activity, distorting the message that abnormal activity brings. It is not enough to just look for abnormal market activity, we must add in some other rules to improve the probability of success and the profitability of the trade.
These "other rules" are as follows:
1. Prior to the abnormal market activity, the stock has to have been directionless, trading sideways with little price volatility. The chart should demonstrate that buyers and sellers had come to consensus on the value of the company prior to the abnormal break. We want to find stocks that are starting a trend with this abnormality out of a period of relative quiet activity.
2. Prior to the abnormal market activity, the stock should have been in the control of the group that causes the abnormal activity. For an abnormal breakout to the upside, this means that the buyers were in control. If there are rising bottoms on the stock chart, the buyers are in control. If the tops are falling, the sellers are in control.
3. The abnormal break should take the stock through resistance or support, out of its previous trading range. Resistance is a ceiling price that has been defined by the market in the past, the point where the stock has stopped going up and started to go down. The more often resistance is touched, the more important it is. Support is the opposite of resistance; a floor price that shows where the sellers lost control to the buyers.
4. The trade needs to have a risk reward ratio of at least 2 to 1. This will be explained in next week's newsletter.
So, buyers need a stock that is breaking through resistance with abnormal price and volume action. The break should come from sideways, low volatility trading with rising bottoms leading in to the breakout. Short sellers need an abnormal break to the downside from sideways, low volatility trading with falling tops leading in to the breakdown.
The stock is showing life where previously the market was not too interested in it. Something has motivated the people who know the most about the company to take a position and create the abnormal market activity. Don't take my word for it; look at the charts of stocks that have done really well and study the stock's trading activity when the trend was just getting started.
The Stockscores Indicators were designed to find these sort of chart pattern situations. A major component of the Stockscore is abnormal activity; the Signal Stockscore will spike upward for positive price gains that are abnormal and downward for abnormal price losses. The Sentiment Stockscore shows us who is in control of the market, a move above 60 is an indication that the buyers are stronger than the sellers.
We use the Market Scan tool on Stockscores to filter the market for opportunities. There are preset strategies which seek out different trading opportunities. A person looking for a position trade buy should use the Stockscores Simple market scan, it fits with what I have discussed here.
It is important to realize that we should never make a trade because of what the Stockscores or any other indicator. Indicators are tools to help us make decisions, but ultimately the chart pattern tells us if there is a good opportunity. Next week, I will look at how to evaluate and manage the risk of a trade, an often overlooked part of the trading equation.
The strategy of the week below demonstrates the analysis for entry on a stock that I featured in the newsletter a few months ago, it should help to emphasize the points below.
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OK, talk is cheap, let's know look at a chart as it was a few months ago so you can see the rules that I have described above. The stock is Auxilium Pharmaceuticals (AUXL) and on July 31 it broke out of the ideal pattern as you can see below. Notice the abnormal price movement and abnormal volume that traded on July 31. You should also see how the stock was in a sideways trading range for the previous four months with a ceiling price at $17. Over that time, each move up to $17 was met with selling pressure and the buyers lost control to the sellers. But, the bottoms were rising and the price volatility was diminishing over time. This pattern is called an ascending triangle and it is a very good indicator of a future upward trend when there is a break out of it provided the break has abnormal price and volume behind it.Back To Top
1. AUXL
AUXL broke from ascending triangle pattern on July 31, 2007. Abnormal volume supported the abnormal price move.
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2. AUXL
Here is how AUXL looks now, notice that the abnormal break at the end of July was the start of this orderly upward trend that is approaching a 100% return in only five months!
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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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