Tuesday, December 17, 2013

My General Method for approaching Stocks:

In any trading system, its good to have a method that you go back to and repeat with every new trade.  Think of it as a pre-shot routine in pool, or the way you practice your swing a few times before you actually try to hit a golf ball.  Here is the general outline of what I do before, during and after an investment.

1) Identify if it's a bull or bear market. Sounds simple, but can be difficult. I've designed a few spreadsheets/indicators that help me gauge this but are in no way fool proof. My main indicators are as follows:
  • A moving avg of New Highs vs. New Lows
  • Yield Curve Slope (Libor vs. 10yr US Treasuries)
  • Investor Sentiment (I use AAII's Bull vs. Bear reading - Contrary Indicator)
  • Equal Weighted S&P returns/levels; Transports & Utility indexes
  • The Earnings Yield on the S&P 500 vs. 10yr US Treasuries
  • Insider buying and selling
  • Large weekly moves up/down... big reversals? Breakouts of the major indices? etc
Each of these factors is pretty much eyeballed to see the current state of the markets. I'd like to make this more programatic, but it's a work in progress.

2) Find your Investment Instrument: OK, if the answer to question 1 is bull market -- Start looking for investment candidates. Now this could just mean buying the index (SPY, QQQ, IWM, etc) or it could mean looking for individual stocks that you think will outperform. The goals is to find stocks that will go up or are already going up. To do this I scan through charts on freestockcharts.com and finviz.com. Here you can get creative and come up with screeners that widdle down the investable universe to a handful of stocks...i.e. I only want to see stocks above X avg trading volume with a PE Ratio below X, with no debt and positive earnings growth, that are trading 10% above their 50-day Moving avg....blah blah blah.  It makes no difference how you find the stocks/bonds/futures, but you need a way to narrow the field a bit.  There are literally 1,000s of instruments you can buy/sell...the goal is to find the best one for your particular purpose.

3) Check the Financials: Once you've identified a nice looking chart, if this is going to be a long-term trade, make sure the company's books check out (if you're not into this, skip to the next step). From Finviz, you can click on "Company Financials", on the right hand side of the table of data, which takes you over to Google finance. Keep it simple here -- Lot of cash? Good. Lot of Debt? Bad. Revenues Growing? Are Earnings growing like crazy but Revenues only going up a little bit?  This can be a major red flag.  Is the earnings growth sustainable into the future?  Entire books have been written (by people far more qualified than I) on these topics, so I won't belabor the point, but do your homework if you want.

4) Set your Level: Where will you buy it? Are you early and waiting for a breakout or late and waiting for a pull back? Assuming you like the chart and like the company, set your level. By this I mean set up the price you want to buy the stock at.  I (personally) have been using a free service called zignals.com. Your broker may have something that can do this for you also. Once the alert is triggered, it sends a text or an email to alert you that the stock is hitting your level. I prefer this method to using Buy Stop/Sell Stop orders because then you can fall victim to a "flash crash" that puts you into/gets you out of a stock at a bad level (can talk more about this later).

5) Execute: Once the text message comes through that your stock is ready to buy...buy it! From here you can start looking at your minute/intraday charts to fine-tune your entry. The important thing to note is that the time that expires between step 4 and step 5 is generally a few days/weeks/even months.  Patience is one thing that I've learned the hard way in stock trading.  You rush i nto something you will get burned.  Some people are great at whipping things around...  unfortunately I'm not one of them.  Slow and steady.  

Execution also involved position sizing.  Everyone has what makes them comfortable so this part is different for everyone.  For me, generally to size my position I'll take my Stop Loss, minus my entry price and divide that number into 1% of my account size.  If the trade/investment moves against me, I've risked 1%... Enough to hurt, but not enough to break the bank.

6) Set your Stop: This step is important... Once you've executed your trade, head back over to zignals (or whatever signal provider you've chosen) and delete your old alert and create a new alert with your stop-loss level! This way you're given a heads up when it's time to close out your trade. Again, you can use a stop loss, but I prefer doing it this way so my broker doesn't know my take-out level...

7) Monitor your positions. As your stock heads higher (hopefully) go back to zignals and update your stop loss levels. Sometimes you'll get to a point where the risk reward looks just as good and you have opportunities to add-on.  Other times, if a stock has run away from you, you'll just have too much money at risk.  Generally this last part is a good thing -- you've made so much you're at risk of losing a good portion of it on a pull back. 

8) Go back to step one. Is it still a bull market. It's critical to make sure that the general market isn't turning on you... AAPL went from $200 to <$80 during the crisis before heading to $700... So even the best stocks can lose $ when the general market is getting pummeled.  Also You need to repeat steps 2-7 for every new stock you buy.

And it goes without saying the same method applies to short selling, just in reverse.

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