Market Methods

Every market method is a combination of:

1) Equity selection rules

2) Entry criteria

3) Exit and position sizing rules

On this page I feature a few equity selection approaches that I use to come up with investing/trading ideas and I explain the underlying logic behind each of them. The goal of equity selection is to save time when searching for potential ideas with high probability of success. It is the essential first step – a necessary, but not sufficient condition for consistent profits. The secret behind success in any field is to chose your battles. Fight only worthwhile battles that you can win.

Catalyst driven Range expansion

Long-term price trends are based on social trends, which just don’t end overnight. At the beginning of every major price trend there is a fundamental catalyst. It is always earnings related. If it is not based on actual earnings (as is often the case), it is based on expectations for future earnings.

The stock market is a forward looking mechanism that constantly tries to discount collective expectations and perceptions about the future.  Prices change when expectations and perceptions change. The latter two change under the pressure of external factors, which I call catalysts.

The major type of catalysts that have the potential to start a process of major re-pricing (new trend or continuation of an existing trend) can be grouped in the following categories:

1) Earnings surprises that are well beyond the consensus estimate

2) Earnings guidance and pre-announcements that are far above the current expectations

3) New contract

4) New regulation

I am looking for high volume, price expansion:

- high volume (at least 3 times the 20-day average daily volume)

- price expansion (at least 2 times the average true range for the last 20 days or a minimum of 5% move)

Such combination of price and volume action guarantees institutions’ involvement. My logic is simple – when institutions buy, they leave traces. They are heavy, slow buyers; therefore I have enough time to enter and exit as they build their position.

In addition to already described conditions, I am looking for stock that is:

-  at new 6 months high;

- breaking out of long sideways range (the longer the better)

No setup works all the time. The success rate of any setup is a derivative of the current market environment. During severe market corrections most upside breakouts fail. Participants sell first and ask later.

I have very simple philosophy – I want to be aggressively long when there is clear evidence that institutions are buying across the board. I want to be in cash or net short when there is evidence that institutions are selling.

I terms of actual earnings’ catalysts, I seek the following characteristics in a stock:

1) Positive earnings’ and sales surprise. The announced results beat handily the consensus estimate by a wide margin.

2) Substantial Earnings’ growth on a Q/Q basis – something in the high double digit numbers and higher. Strong earnings’ growth leads to strong price growth. Sales and margin growth is a big plus. I prefer to see that the reason behind EPS growth is strong demand for the company’s products and services, not  an accounting magic.

3) Price trend before earnings. If the stock price was substantially bid up in anticipation of earnings then most likely the reported surprise was expected by the market and it is already discounted in the stock’s price. This might turn into a typical buy the rumor, sell the news event. I prefer to see stock that is trending in a tight range before earnings or is even declining.

4) Positive market reaction to earnings. This is the essential confirmation. If the market doesn’t react favorably to the earnings’ announcement, forget about this stock. Something is wrong with it. Even if it reports humongous earnings and sales growth that crash every analyst’s estimate, I won’t buy If I don’t see that the market catches up and starts bidding up the price. I need the essential buying power of institutions, which is going to support  the stock price in the future. The reaction to news is more important than the news itself.

5) Management’ guidance for future earnings. Wall Street trades on expectations for future earnings. If the management only mentions that it expects some difficulties ahead, the stock might tank disregarding outstanding current quarter results.

6) Float, price, daily price range and average volume. The smaller, the better. Many people are afraid to even look at stocks with low average volume. They don’t understand that catalyst driven price momentum precedes volume momentum.

7) Sector’s Relative Strength. How popular is the sector, where the stock belongs. A combination of strong earnings’ growth and hot sector might lead to 20-200% moves in a month. Interestingly, often the strong earnings’ report of one company attracts the attention to the whole industry and as a result other related stocks benefit.

8)This method works best in bullish market environment or after prolonged periods of market decline, which has led to very low earnings’ expectations. The purpose is to catch the first or second major earnings acceleration of a neglected stock. A substantial earnings surprise after long period of neglect, is a powerful catalyst that should work in any market environment, but sentiment is important. It defines the size and the duration of the move and the probability of success. As a general rule, I strive not to be long stocks, when there is no risk appetite in the markets.

I usually buy at the day of the catalyst driven, high volume, price expansion. If I miss the move of a worthy stock I might enter later on a bounce from a rising moving average (5, 10 or 20). I risk 1% of my capital for each position I open.  My stop is usually 2-3% below the breakout gap. Once my position start to move in my direction and shows healthy price action, I usually add to my position and raise my stop to protect unrealized profits.

I apply partial  exit strategy where I sell 1/3 to 1/2 of my position at a time, depending on the price action and other market opportunities.

Buying All Time highs

1) Buying stocks that reach all time highs. If a stock closes at all time high today it becomes part of  my high Relative strength watchlist and I might consider adding it after a slight pullback. The most important factor in my decision making process is sector’s belonging. Stocks tend to move in groups.

2) 65 days growth is less than 25%. I don’t want to buy overextended stocks. Emerging from a long sideways consolidation usually provides best results. Such major shift in supply and demand are usually caused by earnings related events, which include earnings surprises, new contracts, regulatory changes, FDA approval for drug companies.

3) Risk 1% of the available trading capital.

4) Exit when my stop loss or profit protection stop is hit.

This method works best in bullish market environment. When market is in downtrend, stocks at all time highs are often targets for aggressive short sellers. In bear markets all stocks, all industry groups are taken down, sooner or later. Such behavior is a simple reflection of investors’ confidence – the most powerful factor, moving markets in short-term perspective.  In neutral periods, using the all time highs method is very useful equity selection tool, since it reveals which industries will lead the new bull market.

Leverage with options

Occasionally I decide to utilize options when trading any of the above mentioned methods. Options are used for three main reasons:

- leverage:

- better risk control;

- flexibility;

Carefully picked option has the potential to multiply significantly profits. It might bring several hundred and even thousand percent return. Something that a stock very rarely could achieve in a short time frame.

I know exactly how much I can afford to lose. (the maximum loss is the entire option’s premium). Every time when I purchase ATM or slightly OTM option or spread, I assume than if I am wrong I will lose the whole option’s premium. I never risk more than 1% of my capital for any trading idea.

Some of the things I pay special attention to when trading options include:

- liquidity;

- Implied Volatility.

Some options issues are traded in extremely low volume which begets huge bid/ask spread. I try to avoid low liquid options as the bid/ask spread significantly harms the risk/reward ratio of the trade. I avoid options of low priced stocks for the same reason.

I always pay attention to the IV of the option I consider to buy. The IV reflects market’s participants expectation about future price fluctuations of the underlying asset. It reflects the current supply and demand for an option’s contract. IV tends to reverse to its mean on a regular basis. When that happens, the premium of the option declines quickly. Remember, if the IV starts working against your position, even a 10% one week rise in the underlying asset might not be enough to save you from losses.

As a general rule, I am long premium when I expect huge move in the underlying stock. Rising IV is also important consideration, but it is not a priority.

Usually 10-15 trading days before an earnings announcement, the IV of options tends to increase substantially. In the cases I am long premium, I make sure to exit before the earnings announcement, as it is always followed by volatility crash.

Also in general, the IV of options tend to increase as the underlying asset declines.

I am short premium, when I expect the IV to decrease. I never sell naked calls or puts. The potential risk involved in being short gamma are tremendous. When I sell premium, I do it via credit spreads.