THINK AND TRADE LIKE A CHAMPION
A TALE OF TWO WOLVES
There are two types of traders inside you and me and everyone. One I call the builder—disciplined and process-driven. The builder is focused on procedure and perfecting the method. The builder trusts that the results will come if he gets the process right. Mistakes are viewed as teachers, constantly providing valuable lessons in a continuous feedback loop. When the builder makes a mistake, it’s taken as encouragement: That’s one I won’t make again. Ever optimistic, the builder looks forward to the day when results are achieved— good or bad—because the process is constantly being improved.
The other trader is what I call the wrecking ball. Ego-driven, the wrecking ball is fixated on results; if they don’t come right away, he gets discouraged. If a mistake is made, the wrecking ball beats up on himself or looks for someone or something else to blame. If a strategy doesn’t produce winning results quickly or it goes through a difficult period, the wrecking ball tosses it aside and looks for a new strategy, never really committing to the process. A
wrecking ball, as you might guess, has tons of excuses and rarely takes ownership of the outcome—and as a result, never builds anything lasting or wonderful.
The one that wins will be the one I choose to feed.’
It’s not just putting in the hours that will make you successful; it’s the persistent intention to improve by examining your results, tweaking your approach, and making incremental progress. In his book The Talent Code, Daniel Coyle refers to this process as “deep practice”—not just doing the same thing over and over, but using feedback to make adjustments and making practice more meaningful.
If you spread yourself too thin, you won’t succeed big at anything and will never experience anything fully. Specialists get paid well, while those who know a little about many things make good conversation at parties.
Mastery requires sacrifices; therefore, something must come first. Make a list, prioritize, and pursue accordingly: Focus, achieve, and then move to the next big goal.
Through those challenging years, though, I stuck with my strategy. I didn’t jump from one approach to another as if there were some magic formula out there and the secret was finding it. As stated earlier, I decided on a strategy
that made sense to me and then concentrated on improving my ability to execute it. I stayed the course, remained steadfastly disciplined, and stuck to the rules. Persistence is more important than knowledge, and victory comes to those who persist, as long as you are learning from your experiences.
The first thing I would like to see after a breakout from a base is multiple days of follow- through action, the more the better. The best trades emerge and rally for several days on increased volume. This is how you differentiate institutional buying from retail buying.
Stocks under strong institutional accumulation almost always find support during the first few pullbacks over the course of several days to a couple of weeks after emerging from a sound structure.
The best stocks usually rebound the fastest. Once I buy a stock, if it meets my upside expectations very quickly and displays tennis ball action, I will probably hold it longer.
trade is working out as planned is more up days than down days during the first week or two of a rally. I simply count the days up and the days down; the more up days the better. I want to see three up days out of four, or six up days out of eight —ideally seven or eight up days in a row. Stocks under institutional accumulation almost always display this type of price action, which is evidence that institutions are establishing big positions that can’t be filled in only one day.
Big winning stocks will display the following characteristics:
Follow-through price action after a breakout
More up days than down days and more up weeks than down weeks Tennis ball action—resilient price snapback after a pullback
Strong volume on up days and up weeks compared to down days and down weeks
More good closes than bad closes.
IF THINGS DON’T GO AS PLANNED
WATCH THE 20-DAY LINE SOON AFTER A BASE BREAKOUT
Once a stock breaks out of a proper base and starts moving up, it should hold above its 20-day moving average; I don’t want to see the price close below its 20-day line soon after a breakout. If that happens, it’s a negative.
Three lower lows on increased volume is a red flag
Sometimes it takes four lower lows. The rule of thumb, however, is every consecutive lower low after the third becomes more and more ominous, and even much more so if volume is high.
LOW VOLUME OUT, HIGH VOLUME IN IS A BIG WARNING
If a stock breaks out on low volume and then comes right back in on high volume on subsequent days, that’s a real reason for concern
Depending upon how many violations occur and how severe they are, I’ll either reduce my position or get out entirely. Of course, if my stop-loss is hit, then I’m out regardless!
Violations Soon After a Breakout
Low volume out of a base—high volume back in Three or four lower lows without supportive action More down days than up days
More bad closes than good closes
A close below the 20-day moving average
A close below the 50-day moving average on heavy volume Full retracement of a good-size gain.
After you make a purchase, try to give the stock a week or two and enough room to fluctuate normally—within the confines of your stop level, of course. If the stock squats, don’t panic; as long as your stop is not triggered and no major violations occur, wait to see if the stock can stage a reversal recovery.
You go in with a plan and execute it. Then, after the trade is completed, you evaluate the results, troubleshoot your approach, and come back in with a new plan of attack.
With each buy order I enter, I know the exact price where I am going to sell at a loss if things don’t work out as expected. I define this price level before I get in.
My stop-loss is actually an important part of my selection process. I may set my sights on a particular name, but I’m not going to buy a stock unless it offers me a low-risk entry point. You don’t control risk when you sell, you control it when you buy;
Buying breakouts and setting stops based on a percentage drop is a good start and will likely put you ahead of most traders.
The goal for optimal stop-loss placement is to set it at a level that will allow the stock price enough room for normal fluctuation, but close enough to the danger point that’s not too much risk mathematically.
always go in with a plan and approach every trade risk-first.
In order to set an appropriate stop-loss, you need to know your average gain, not just what you hope to make on each individual trade, but a number you can reasonably expect to occur over time on average.
My way of governing the areas that I don’t directly control is not to rely on them too heavily. My edge is maintained by keeping my losses at a fraction of my gains. The smaller I keep my losses in relation to my gains, the more batting average risk I can tolerate, which means the more times I can be wrong and still make money.
If you’re trading poorly and your batting average falls below the 50 percent level, the last thing you want to do is increase the room you give your stocks on the downside.
My results went from average to stellar when I finally made the choice that I was going to make every trade an intelligent risk/reward decision. The following formula is the only holy grail I know of:
PWT (percentage of winning trades)*AG (average gain) / PLT (percentage of losing trades)*AL (average loss) = Expectancy
Any stock that rises to a multiple of my stop-loss and is above my average gain should never be allowed to go into the loss column. When the price of a stock I own rises by three times my risk and my gain is higher than my average, I almost always move my stop up to at least breakeven.
Move your stop up when your stock rises by two or three times your risk, particularly if that number is above your historical average gain
three legs of the trading triangle (Figure 4- 1) are:
Your average win size: how much do you win, on a percentage basis, across all your winning trades?
Your average loss size: how much do you lose, on a percentage basis, across all your losing trades?
Your ratio of wins to losses: your percentage of winning trades, or what is referred to as your “batting average.”
The next relevant numbers are the largest gain and loss in any one month and the number of days my gains and losses are held. I call them the “Stubborn Trader” indicators. Don’t pay much attention to any one month, but when you look at the average over a 6- to 12-month period, the net result should be positive. For example, if your largest gainers are smaller than your largest losers on average, this means you’re stubbornly holding losses and only taking small profits, the exact opposite of what you should be doing. If your average hold time on your gainers is less than the amount of time you hold your losers, again, it’s an indication that you hold onto losses and sell winners too quickly.
If you’re turning your portfolio over very rapidly, you can have smaller gains and losses and a lower win/loss ratio than if you’re turning it over less. You’re getting the benefit of your “edge” more often. This is the same concept as a retailer who sells a low-priced or low- margin
Remember, trading is not about buying at the absolute low and selling at the all-time high. It’s about buying lower than you sell, making profits that are larger than your losses, and doing it over and over again.
Using this example, if you sell half your position at 20 percent, compared to your average gain of 10 percent, it’s very difficult to lose on the trade. Half of your trade is booked at a 20 percent profit. Even if you only break even on the remaining half, you will still make 10 percent (right in line with your
average gain), and you’ll still be ahead of the game. In fact, you could suffer a 10 percent loss on the remaining position and still be okay with no loss on the trade.
One word of caution—selling half does not work on the downside when you’re at a loss. When your stop is hit, you get out! You shouldn’t sell half on the downside and gamble with the rest of your position, hoping the stock will turn around. When a position moves against you and hits your defensive sell line, there is no wiggle room—only disciplined, decisive action.
a secular market leader puts in a major top, there’s a 50 percent chance that it will decline by 80 percent—and an 80 percent chance it will decline by 50 percent.
Every major decline starts as a minor pullback. If you have the discipline to heed sound trading rules, you will limit your losses while they’re small and you will not throw good money after bad.
Pros play the percentages; they’re consistent, and they avoid the big errors. Most of all, they avoid risking money on low probability plays. They bet when the odds are in their favor and fold when they’re not.
- Protect myself from a large loss with an initial stop
- Protect my principal once the stock moves up
- Protect my profit once I’m at a decent gain
I have some general guidelines: Any stock that rises to a multiple of my stop-loss and above my average gain should never be allowed to go into the loss column. When the price of a stock I own rises by three times my risk, I almost always move my stop up, especially if that number is above my historical average gain. If a stock rises to twice my average gain, I always move my stop up to at least breakeven, and in most cases I back stop the position equal to my average gain.
My general rule of thumb is never hold a large position going into a major report unless I have a reasonable profit cushion.
Regardless of how well you know the company, holding into earnings is always a crapshoot.
One of my major rules is never force trades.
TREND TEMPLATE CRITERIA
A stock must meet all eight criteria to be deemed in a confirmed Stage 2 uptrend.
- Stock price is above both the 150-day (30-week) and the 200-day (40- week) moving average price lines.
- The 150-day moving average is above the 200-day moving average.
- The 200-day moving average line is trending up for at least 1-month
(preferably 4 to 5 months or longer). - The 50-day (10-week moving average) is above both the 150-day and
the 200-day moving averages. - The current stock price is at least 25 percent above its 52-week low.
(Many of the best selections will be 100 percent, 300 percent, or more above their 52-week low before they emerge from a healthy
consolidation period and mount a large-scale advance).
6. The current stock price is within at least 25 percent of its 52-week high
(the closer to a new high the better).
7. The relative strength (RS) ranking (as reported in Investor’s Business
Daily) is no less than 70, but preferably in the 90s, which will generally be the case with the better selections. (Note: The RS line should not be in a strong downtrend. I like to see the RS line in an uptrend for at least 6 weeks, preferably 13 weeks or more.)
8. Current price is trading above the 50-day moving average as the stock is coming out of a base.
As the stock transitions from Stage 1 to Stage 2, you should see a meaningful pickup in volume—a sign of institutional support.
VOLATILITY CONTRACTION PATTERN
Once I determine a stock is in a confirmed Stage 2 uptrend—it meets all eight of my Trend Template criteria—I look at the current chart pattern.
The most common characteristic shared by constructive price structures (stocks that are under accumulation) is a contraction of volatility accompanied by specific areas in the base where volume recedes noticeably.
During a VCP, you will generally see a sequence of anywhere from two to six price contractions. This progressive reduction in price volatility, which is always accompanied by a reduction in volume at specific points, signifies that the base has been completed.
As a rule of thumb, each successive contraction is generally contained to about half (plus or minus a reasonable amount) of the previous pullback or contraction. Volatility, measured from high to low, will be greatest when sellers rush to take profits.
Typically, most VCP setups will be formed by two to four contractions, although sometimes there can be as many as five or six. This action will produce a pattern, which also reveals the symmetry of the contractions being formed. I refer to each of these contractions as a “T.”
A stock that is under accumulation will almost always show these characteristics (price tightness with contacting volume).
You can tell supply has stopped coming to market by the significant contraction in trading volume and significantly quieter price action as the right side of the base develops. Demanding that your stock meet these criteria before you buy improves the likelihood that your stock is off the public’s radar,
It’s important to keep in mind that the VCP occurs within the confines of an uptrend. The VCP is going to happen at higher levels, after the stock has already moved up 30, 40, 50 percent or even much more, because the VCP is a continuation pattern as part of a much larger upward move. A stock that is under accumulation will almost always show VCP characteristics. This is what you want to see before you initiate your purchase on the right side of the base, which forms what we call the pivot buy point.
see volume contracting significantly during the tightest section of the consolidation (the pivot point).
How and When to Buy Stocks—Part 2
Most constructive setups correct between 10 percent and 35 percent, some as much as 40 percent. Very deep correction patterns, however, are failure prone.
A stock that has corrected 60 percent or more is off my radar, especially because a decline of that magnitude often signals a serious problem. Under most conditions, stocks that correct more than two and a half or three times the decline of the general market should be avoided.
If the major market indexes ignore an extremely overbought condition after a bear market decline or correction, and your list of leaders expands, this should be viewed as a sign of strength. To determine if the rally is real, up days should be accompanied by increased volume, whereas down days should be on lower overall market volume.
THE 3-C PATTERN
The cup completion cheat, or 3-C, is a continuation pattern. It’s called a “cheat” because at one time I considered it to be an earlier entry than the optimal buy point,
The cheat trade gives you an actionable pivot point to time a stock’s upturn while increasing your odds of success.
qualify, the stock should have already moved up by at least 25 to 100 percent —and in some cases by 200 or 300 percent—during the previous 3 to 36 months of trading. The stock also should be trading above its upwardly trending 200-day moving average
THE “CHEAT” EXPLAINED
Following are the four steps to a stock turning up through the cheat area (see Figures 7-11 through 7-13):
-
Downtrend. The stock will experience an intermediate-term price correction that takes place within the context of a longer-term Stage 2 uptrend.
-
Uptrend. The price will attempt to rally and break its downtrend.
-
Pause. The stock will pause over a number of days or weeks and form a plateau area (the cheat), which should be contained within 5 percent to 10 percent from high point to low point.
-
Breakout. As the stock rallies above the high of the plateau area, you place your buy order.
THE “LOW CHEAT”
The low cheat forms in the lower third of the base. It’s riskier to buy in the lower third of the base than in the middle third (the classic cheat area) or the upper third (from the handle).
The best power plays are stocks that were quiet in Stage 1 and then suddenly explode.
Following the explosive move, the stock price moves sideways in a relatively tight range, not correcting more than 20 percent (some lower- priced stocks can correct as much as 25 percent) over a period of three to six weeks (some can emerge after only 10 or 12 days).
Instead of arbitrarily picking a number, your maximum risk should be no more than 1.25 to 2.5 percent of your equity on any one trade.
I usually will hold 25 to 50 percent of my original position for a larger move in these strong leaders.
Use the math of your results as a tool, and hone your edge by calculating the amount of risk you should be taking based on your own performance.
High-volume reversals
Elevated volume without much price progress—“churning”
If your stock experiences its largest daily and/or weekly price decline since the beginning of a Stage 2 advance, this is almost always an outright sell signal.
Often before a fundamental problem becomes evident, there will be significant change in price behavior. That change should always be respected even if you don’t see any reason for the sudden shift in sentiment. Earnings may still look good; the story may still be intact. However, in most cases, you’ll be far better off getting out and asking questions later than waiting to learn the reason why, which often doesn’t become apparent until the stock has suffered a large decline.
The 50-day line becomes a trailing stop to protect your profits. This is why we call the rule breakeven or better.
Included in the Section 1 discussion was David Ryan’s MVP indicator; when 12 of 15 days up signaled breakout strength that suggests you should hold for a larger move. It may sound confusing that now I’m telling you essentially the opposite: to sell when you have 70 percent more up days than down days. That’s because now we’re talking about a late-stage exhaustion move versus an early-stage breakout move.
What looks like exhaustion in buying activity in the late stage, giving you rationale to sell a stock, is actually a bullish sign early on and would compel you to keep holding on.
I never buy a falling stock. I always trade directionally. This applies to all time frames, from long-term investing to swing trading and even day trading. Allowing the market to guide you puts you in sync with it, which increases your chances of making a profit and limiting losses.
Subscribe To Our Free Newsletter |