Where to Speculate
Stockscores.com Perspectives for the week ending December 5, 2004
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In this week's issue:
Do you want to be a speculator? You are not sure what you want to speculate on, but the idea that you can make a living through the process of buying and selling is attractive. Where do you start?
First, you have to decide what to speculate on. Stocks, bonds, real estate, foreign currencies, futures, wine, hockey cards … the list is endless. Where do you have the best chance for success?
The first thing to consider in answering that question is liquidity. You want to be able to move in and out of the asset quickly and easily. This criteria will shorten the list a lot. Real estate may be strong, but you would rather hold positions in hours rather than months or years. Wine has appeal because you enjoy it, but you don't have the physical space to store it. Hockey cards remind you of your misspent youth, but you no longer have the passion to pursue the hobby.
If liquidity is a factor, you are bound to turn to one of four vehicles; stocks, bonds, currencies or futures. Each of these is readily available for speculation, and it is possible to move in and out of positions in seconds. They have the benefit of liquidity.
Now, where will you find success? The downside of liquidity is that the markets for stocks, bonds, currencies and futures are also efficient. That means that it is difficult to consistently beat the market because there are so many people trading them that opportunities are quickly priced in. If interest rates go up in the US, the market reacts almost instantly and prices in the fundamental event in the currency and bond markets. A Florida hurricane is priced in to the Orange Juice futures before you can say Jeb Bush.
The reason most people can not consistently beat any liquid market is because of market efficiency. Important financial information is valued in to any market that has enough people playing in it. This means that success in the market is random, since we can not predict new information with certainty.
However, there are situations where market efficiency breaks down. The efficiency of any market assumes that investors will act rationally, and it assumes that the dissemination of fundamental information is fair. However, as many market speculators have found, there are instances where some market participants are trading on better information than the rest of us. There are also many instances where the emotion of market participants has an effect on price. Consider how fear and greed that have gripped the oil market of late.
To beat a market we have to focus on investment vehicles that are demonstrating a flaw in market efficiency. We have to focus on investments that are trading on private information, or that are trading with emotion. Typically, both come together.
The key to finding these opportunities is a focus on abnormal activity. If a stock normally trades a million shares a day around the $10 price mark, but then one day trades 5 million shares and jumps to $12, then it has behaved abnormally. Now, ask yourself what would cause this stock to trade so much more volume and show so much more price volatility than normal? It does not take a tremendous leap of faith to determine that there may be a significant change in the fundamentals of the business behind the abnormal activity. Not surprisingly, with abnormal trading comes emotion, as speculators are attracted to the stock by price volatility and liquidity.
This means that we should focus on abnormal behavior in whatever we wish to speculate on. The implied breakdown in market efficiency presents an opportunity to improve the probability of profitable speculation, and the abnormal volatility increases the potential profitability of the trade.
So, where does that leave us? To focus on abnormal behavior, we have to find abnormal behavior. If we are considering the foreign exchange market, then we have a small handful of currencies that trade actively enough to consider. What is the chance that one of these currencies will trade abnormally each day? At best, it is maybe one in 30.
Now, consider the futures market. There are about a dozen actively traded futures that we can follow in our search for abnormal behavior. What is the chance that one of these futures will trade abnormally each day? Perhaps one in 10?
The bond market has far more issues to trade, but nothing comes close to the variety of the stock market. Each day, roughly 15,000 stocks trade on the North America markets. With that many to choose from, how many will behave abnormally each day?
I have found that each day, there are typically 20 - 50 stocks that are trading with statistically significant abnormal behavior. That means there are 20 - 50 different stocks that are demonstrating a break down in market efficiency. 20 - 50 chances to beat the market by exploiting a weakness in the market.
Speculation can be extremely rewarding financially. Access to the major financial markets has made speculation in stocks, bonds, currencies and futures a more common pursuit than any time in the past. However, many people fail in their pursuit because they fail to recognize that most markets are efficient most of the time. Opportunities come when efficiency breaks down, and abnormal activity is the best indicator of the breakdown. By the power of its variety, the stock market holds the best potential for market beating opportunities.
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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.
The Stockscores Simple Market Scan is available to Stockscores Advanced Members, and seeks out stock with good Stockscores and potentially good chart patterns. I ran this market scan on Friday's trading data, and found two stocks that I think are worth considering. My comments on them can be found below:Back To Top
1. FORG
FORG is breaking through resistance that goes back to March of last year. With an increase in volume, it appears that some investors are excited about something in their business. The stock has the potential to move up toward resistance at $2.75 and has support at $1.60.
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2. CERS
CERS is breaking out from an optimistic ascending triangle pattern with good volume support and appears likely to move up toward the $4 resistance level. With support at $2.50, this provides good reward potential for the risk.
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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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