Month: August 2012

The Power of Relative Strength or How to Spot Future Winners

Today, $PCYC reached another multi-year high, which brought its YTD gain to a little over 300%. Its impressive performance is not what matters here. What is more important is that it left plenty of clues along the way that it was a major winner in the making.

While $SPY and $QQQ were in a free fall in mid-May; while almost every single stock was obliterated, $PCYC stood firm. Not only it stood firm, but on May 16/17 it was literally the only stock that broke out to new 10-year highs on above the average volume. It takes a lot of buying power and conviction to move a stock to major new highs when the indexes are down 2% for the day and the protection of capital is everyone’s main priority. What happened after the market turned back up in June and July? $PCYC doubled.

Another example. On May 3rd, $ELLI broke out to new all-time high after reporting strong earnings. At exactly the same time, the market was rolling over and it went into a 10% deep monthly correction. What did $ELLI do in the meantime? It went sideways, quietly being accumulated while almost everything around it was falling apart. True market leaders form bases during market corrections. Once the market snapped back, $ELLI resumed its upward gallop and went up another 65% in a couple months.

This equity selection method works even better when a whole group of stocks from the same industry exhibit relative strength. For example, take look at the price action in fertilizer stocks near the end of June – the time when the whole country was hit by a record heat and it became clear that the drought will substantially reduce this year’s grain crop. The market, which is a forward looking mechanism most of time, quickly discounted the drought by bidding up fertilizer stocks. Most notable was the relative strength on June 25, Monday: $SPY gaped down and finished the day lower. Fertilizer stocks ($CF, $MOS, $POT…) gaped up and finished the day above their opening print. Most of them went up 15-20% from there.

The above mentioned examples are not isolated cases. They happen all the time, several times a year. Only this summer, we saw similar group price patters in newspapers and refiners stocks. Relative strength is one of the most reliable equity selection methods.

Top 20 Best Performing Liquid Stocks in 2012

What are some of the common features that this year’s current best performers share:

1) 18 had market cap of under $3 billion at the beginning of the year. Don’t be afraid to look beyond the popular names that everyone knows and follows and therefore no one has an edge at.

2) 11 had under 50 million shares in their float. Small float is a huge asset for a stock under accumulation and a huge liability for a stock under distribution as it is a defining element of supply and demand dynamics.

3) 16 of them reached new 52-week high before they had the bulk of their gain.

P.S. By liquid stocks I mean:
– min current volume of 200k shares a day (that doesn’t mean that the daily volume wasn’t lower at the beginning of the year);
– min current price of $10;

How Useful Are Stops in Today’s “Algos Gone Wild” World

I have friends who gave up on the stock market after the flash crash event on May 6th, 2010. They were like: “I had my money in trends I understood and stocks that I liked, I had my stops in place just like I was taught and bam, on May 6th I was stopped out of all my positions at prices below my stops. I am not going back, ever” (I know, using market stop loss order is not bright)

And I understand them completely.

We have all heard it a thousand times:
– The basic premise of consistently profitable market engagement is cutting your losses short and letting your winners run;
– If you can’t take a small loss, sooner or later you will take the mother of all losses;
– As a position moves in our favor, we are supposed to move our stops to protect some of the profits;
– Discipline should always trump conviction;
– Never say never and Never fall in love in anything that can’t love you back…

Sounds reasonable, sounds wise, but when algos go wild, it might turn against you.

I saw a lot of frustrated people on the StockTwits’ streams today due to the multiple mini flash crashes and decided to follow up with a few suggestions how to deal with this issue:

1) Most long-term trend followers use closing prices for their entries and exit signals. In the words of a legendary trend follower Ed Seykota: “Having a quote machine is like having a slot machine at your desk – you end up feeding it all day long. I get my price data after the close each day.” Occasionally staying away from your screen has its benefits… If you are an intraday trader, days like today are called an opportunity.

2) Limit your market exposure during noisy market periods. Safety is derived from the timing of your market engagement and position sizing. Proper timing doesn’t consider only the technical characteristics of the setup, but also the overall market environment at the time. Market is healthy two to three times a year and this is when the majority of money is made. Trading during the rest of the time will only frustrate you. For example, I made the bulk of my profits in the first 4 months of the year. After that, I have little to show. A lot of chop, a lot of efforts and basically a little better than breakeven since May.

3) Use option spreads to limit your risk. Of course this is applicable only to liquid stocks.