An Open Letter To A New Intermediate-Term Trader
The principles of intermediate-term
trading are precise and well-documented. The problem is the trader must apply
many
principles correctly, all at the same time.
The practitioner must screen stocks
for the proper mix of fundamentals and technicals, then manually inspect the
fundamentals and chart patterns. The trader must ascertain how to act within the
general market environment. The trader must enter a trade at
precisely the right time. And finally, the trader must practice ironclad money management for the life of
the trade.
Naturally, it takes a great
deal of study, trading experience and patience for it all to gel in the mind of
the trader.
Earlier this week, I received a letter
from Matt Maciejewski, an officer in the U.S. Navy and one of our TradingMarkets
members. Matt has worked hard at mastering intermediate-term
momentum trading, but he has encountered a number of problems.
Matt’s frustrations are not unique. I find variations on the same
themes
among many new intermediate-term momentum traders as they work their way up the
learning curve. Most dedicated beginners understand how to screen for high-growth, high relative strength stocks. Like Matt, most traders take
more time
learning to recognize proper chart patterns and to adapt to general market
conditions. Matt’s in good company. I encountered the same stumbling blocks
myself, as did just about every successful trader I know. So with Matt’s kind
permission, I’m sharing with you his letter, and my answer.
Dear TradingMarkets,
As an aspiring and developing “Intermediate-Term Trader” for 2 1/2 years now, I have to state that the
time frame from 1 September until this week has been very frustrating. I have been in cash and
continue to do my charting. However, it just seems as if my timing is off, or the scores of movers and shakers with all of the right stuff have not come to the party yet. Lately over the last three weeks, individual names such as Sketchers (SKX), Americredit (ACF), Christopher and Banks (CHBS) and Lehman Bros. (LEH) are issues that are 90/90, accelerating earnings, good basing patterns, but for one reason or another have been elusive to catch.
I started to look closely at the
CHBS chart last Tuesday, 1/23 and with upside resistance at 40, felt it would pause before launching; guess what? It decided not to pause and took off today to 42 1/4! I will not chase 5% past the pivot or feel that it is getting away from
me. However it just seems that the homework I do every night and over the weekend currently is not paying off (monetarily).
I know that I am doing something right because the leaders and the ones breaking out, I have been following and
charting. The cash position I am sitting on has not deteriorated by choosing beaten-down issues, and I have continued to do
a lot of reading (Justin Mamis, John Murphy, Martin Pring, William O’Neil, etc.) to continue to keep
focus. However, lately due to my hectic sked at times, I have been unable to place an order and with the market as it has been lately, felt that patience will be rewarded as time goes on. For an intermediate-term player, has one ever experienced this atmosphere, and if so, what was the way to continue to power through it in face of some good stocks breaking out?
Thanks for your time,
Matt Maciejewski
P.S. I remember Greg Kuhn stating that it took him approx. 4 years before he started making real
money. Is this attributed to the “learning curve” and the experience that has built up charting and watching the markets?
Dear Matt,
First off, hang in there! I’m not overly concerned that you haven’t made
“real money” in 2 1/2 years. As you noted, Greg Kuhn — in my view,
one of the best money managers in the country — traded through a learning curve in his early years. The same can be said of just about every consistently successful trader. We all have to pay our
tuition to Mr. Market.
On the other hand, I am delighted that you appear to be
playing good defense. Many people who fail to master a strategy fail for one of two reasons: They trade without proper money management and blow up, or they just give up too soon.
It sounds like you’re not in the first category. You appear to have avoided a
knockout punch in 2 1/2 years of trading. I’d rather that you slog through two years
without severe losses rather than getting lucky and making a lot of money in a bull market without mastering money management. So congratulate yourself on that score!
Rule No. 1 is preservation of capital.
That means using initial price stops on every trade and proper position sizing, techniques introduced in my lesson,
Risky Business.
I’m going to assume that you are using
a real-time streaming-quote service. You cannot fly blind. To trade the
intermediate-term, you don’t have to keep your eye glued to the screen throughout the regular
trading session. You can rely on your quote service alert to notify you when a
stock hits your pivot or your stop, although it’s generally a good idea to keep
an eye on your stocks during the first and last hours of the regular market. There
are a number of good quote services. I like Quote.com’s QCharts product. Kevin
Haggerty likes A-T Financial. I mention other services in my lesson, I
Need Those Quotes Yesterday!. Some brokerages provide streaming quotes
as part of their overall package.
Now let’s address your two biggest
problems: general market interpretation and entry timing.
General
Market Interpretation:
The market was in a downtrend from Sept. 1 through early January.
During such a downtrend, you can try to trade long in small positions in the strongest sectors, but your
stop-out rate will be higher since you are trading against the general market trend.
You can also short in downtrends. Intermediate-term momentum traders who don’t short are well advised to wait out downtrends largely or entirely in
cash.
The market appears to be bottoming
now, and we’ve got the Fed on our
side. (I’m writing this on Jan. 30, 2001.) However, the trading action is still whippy.
The breakouts from sound
bases are not coming fast and furious. They’re isolated, and a lot of them are backing and filling rather than taking off for nice runs.
Intermediate-term traders should
realize that just because a market has bottomed does not mean that high
strength stocks will immediately come alive. Remember the market bottom in October 1990. It was not until January 1991 when the high-earnings growth, high relative strength stocks rallied en masse. No one can predict when our kind of stocks will come alive, but by doing what you’re doing, coming up with buy
candidates every night, watching for the breakout after every day’s open, you’ll be poised to pounce.
When D-Day comes, it will be obvious.
The high RS breakouts will come in large numbers, and more high RS stocks will
set up behind them and break out as well. And you’ll notice that an increasing
number of these stocks follow-through to the upside rather than whipping around
and stopping you out.
Your nightly stock screening will help
you notice this shift. Like many traders, each night you screen the market for
stocks meeting your combination of technical and fundamental values. However, many new
traders get tunnel vision. They duly scrutinize the chart of each stock for a
promising setup, but they lose sight of the overall picture. As you go through
the charts, ask yourself two questions: Are you seeing lots of high RS stocks
completing sound bases and/or breaking out of sound bases? Or is it hard to find
such sound setups because most high RS stocks have either broken down, or look
extended, or have wide-loose chart patterns? The former suggests a healthy
market favorable to the medium-term momentum trader. The latter suggests the
contrary.
Entry Timing
Your stock selection seems sound. Your stock picks have good technicals and
fundamentals. Finding such stocks is relatively easy. The computer does most of
the work for you. But as you note yourself, your timing is off. Timing boils
down the pattern recognition, a subtle skill that one acquires over years of
looking at multitudes of stock charts.
By the way, congratulate yourself.
Self-diagnosis is the key to being a successful trader. At least you figured out that
your problem lay in your timing rather than your stock selection.
Let’s look at your example of
Christopher & Banks
(
CHBS |
Quote |
Chart |
News |
PowerRating). The stock actually formed a cup-with-handle
pattern, a bullish continuation pattern popularized by the legendary William
O’Neil. Anyone interested in the cup-with-handle base should read O’Neil’s rules
for the pattern as elaborated in his modern classic, How to Make Money in
Stocks (McGraw-Hill, 1988), and his more recent volume, 24
Essential Lessons for Investment Success (McGraw-Hill, 2000).
Christopher & Banks shares
actually formed a handle and broke out a little earlier than you recognized in
your letter. The high of the handle was 37 15/16 on Jan. 23 (see Point a in the following chart). Using O’Neil rules, you would buy once the stock rose 1/8 point above that high and not chase more than 5% beyond that point. Remember that 5% is a maximum.
You ought to catch most breakouts within 2% or 3% of the high of the handle.
The handle breakout came on Jan. 26 with robust volume
(Point b). It’s true that this was still within the overall base, but it came above the mid-level and above the stock’s 50-day
and 200-day moving averages. So it’s tradable.
Note the confirming move by the relative strength line into new high ground.
Admittedly, there is one problem with
this handle breakout. The breakout occurred underneath resistance at 40 a
share, a fact that you duly identified. If that puts you off the stock, you could wait for the stock to break above that resistance, which it did on Jan. 29
(Point c), then wait for a new handle to form.
You may or may not get one. That’s up to Mr. Market. If the stock escapes you,
no regrets. Look for other stocks setting up. No stock is worth violating your
methodology.
The top field of all charts in this
lesson uses a logarithmic price scale and displays a 50-day price average in red
and a 200-day price average in black. In the second field, a
blue relative strength line represents the displayed security’s price
performance relative to the S&P 500. The third field displays vertical daily
volume bars in black with a 50-day moving average in blue for volume.
Let me expand a bit on my earlier
statement. “No stock is worth violating your methodology.” Over time,
as successful traders gain experience, they learn to depart slightly from the
classic patterns that they traded. For instance, I might disregard some
imperfections in a stock’s pattern if other features — such as outstanding
accumulation, uptrend, relative strength — combined to convey a strong overall
picture. I cannot sum up when to make such exceptions in a neatly wrapped set of
rules. It’s something a trader gains with experience.
Let me define a term that I mentioned earlier:
Mid-level. For long trades, I want a stock to be above its simple 50-day and 200-day moving averages, assuming the stock has been around long enough to generate a 200-day. I also want it to be above its mid-level before the breakout. You find the mid-level by adding the pre-correction peak
(Point d in the above
chart) to the trough (Point e) and then dividing that sum by 2. All three tests — moving averages and mid-level — are intended to avoid stocks with heavy overhead resistance posed by shareholders with paper losses in the stock. Such shareholders tend to sell into rallies.
You should be aware that not all correction-recovery patterns put in a
pause, handle or platform before advancing into new high ground. Some shoot
straight out of their bases. These structures are more prone to failure than
correction-recovery patterns that put in a little handle or platform before
breaking out.
You can ignore these handle-less
breakouts, or you can try to trade them as they make the new high. If you get stopped out, you get stopped out. Move on to the next trade. PeopleSoft
(
PSFT |
Quote |
Chart |
News |
PowerRating)
is an example. The stock shot out of a correction-recovery formation on Jan. 11
(Point a in following chart). Note that the
breakout came on the stock’s fourth straight up day, making it vulnerable to
profit-taking. Most intermediate-term traders cut their losses at 5% to 8% of cost. Assuming you got in as soon as the stock cleared its Nov. 7 high of 50, you probably would have been stopped out on Jan.
26 (Point b).
The ideal cup-with-handle breakout forms a handle just below the old high. Then you buy as the stock simultaneously clears the high of the handle and prints a new high. However, some valid handles form lower in the base. As a result, you can get a buy signal as the stock clears the high of the handle without simultaneously printing a new high. This is a perfectly tradable situation, but certainly the closer the handle forms to the old high, the better. You definitely want the handle to form in the upper half of the base, as defined by the mid-level, and above the 50- and 200-day moving averages.
Lehman Brothers
(
LEH |
Quote |
Chart |
News |
PowerRating), which you mentioned, did so on Jan. 3. For a chart of that breakout,
see my Jan. 3
commentary in “Trading The News.”
For further reading that should help
your chart analysis, I recommend you check out two
lessons in particular: Using Volume: The Key to Price & Liquidity
and The
Psychology of Chart Patterns.
Fundamental
Considerations:
It’s relatively easy to screen for
stocks that, on the surface, have displayed strong earnings growth. However,
just screening for a stock with high relative strength does not ensure it will
be forming a proper base, screening for stocks with high-earnings scores does
not ensure they are fundamentally sound companies. Once you’ve narrowed down
your list of stocks with high-earnings scores, high relative strength scores and
sound chart patterns, dig into the fundamentals of the individual companies. For
instance, if you use Greg Kuhn’s Earnings Matrix, which is described in the Kuhn/Marder
course, dig into each company’s annual and quarterly earnings to make
sure the performance is up to snuff for each stock added to your buy list.
Just glancing over your stock picks, they look pretty sound on a
fundamental basis. For instance, CHBS has a track record of powerful past quarterly
and annual growth. Fundamental criteria vary among traders, but CHBS’ fundamentals would pass muster for many of us. I would note that analysts foresee a deceleration in
annual earnings growth in the future.
At the time I’m writing this lesson,
Zacks’ analyst estimates for the current fiscal year earnings averaged $2.12 a
share for CHBS. That would represent a 94% increase over prior year earnings of
$1.09, a figure which I got from the company’s press release. Analysts estimate
CHBS will earn $2.64 in the next fiscal year, a 25% increase over the current
year estimate of $2.12. Going from 94% projected growth to 25% could be a
meaningful deceleration with bearish implications for the stock.
You still might have traded the stock
anyway, given its sound base breakout, strong past growth history and high
relative strength scores (at this point in time, on TradingMarkets’ StockScanner,
the stock has RS values in the 90s for the past 12 months and six months) and
strong relative strength line. I will sometimes disregard lackluster past or
forecast fundamentals if a stock has exceptionaly high RS values. In such cases,
the market is obviously discounting something powerful and positive ahead of the
stock.
Whether earnings deceleration occurred
in the past or is forecast for the future, it’s something to take into account. In
the case of CHBS, if the stock’s RS scores were down in the 80s or low 90s,
either the projected deceleration or the apparent overhead resistance at 40
might well have kept me sidelined if I had been watching the stock break out of
its handle on Jan. 26.
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