Choices

As I work with the price-channel breakout style of trading, I keep running into feast-or-famine problems.

When I started out, the markets were churning and there were few breakouts and few prospects for trading. Then we went into a broad decline, and the bear watchlist grew enormously. Then we swung into a broad rise in the markets, and the bull watchlist grew while the bear list shrank.

So, a method for deciding what to trade out of all the possibilities is still an open question. I'm working with two methods, and inclining a bit toward Method 2, which has a more rigorous basing in technical analysis.

My full set of trading rules is set out in "How I Trade".


Choices: Method 1

Initially, I do triage on the universe of possible trades, sorting the potentials into three bins:

Top Prospects are issues upon which I would consider opening a new position because they have met these criteria: 1) The average directional index is 20 or above and rising. 2) The price has touched the boundary of the 55-day price channel, in the direction of the trade, at least once within the two most recent trading days (not including breakout day). 3) The price-channel boundary in the direction of the trade has moved in that direction within the past 10 days. 4) The position is no longer subject to the two-day rule (Exit 2).

Not Top plays are issues that are tradeable under my rules but fail to meet the criteria for Top Picks. It's not against my rules to trade these stocks, but their condition on the chart leaves me unenthusiastic about opening a new position.

Out of Play issues aren’t prospects for new positions under my rules because the parabolic sar phase doesn’t match the price-channel phase.

I next turn away from the charts toward the company finances.

For bull positions, I'm looking for companies with a return on equity of 20% or more and debt that is one-tenth of equity or less (debt-equity ratio of 0.1x or less). For bear positions, ROE of 10% or less and debt equal to or greater than equity (debt-equity ration of 1.0x or greater).

For all plays, I prefer to see institutions owning 70% or more of outstanding shares.

I also take a look at the scores on a screening service I suscribe to, InvesTools, which I find to be quite useful.

Also, I look at the growth (or shrinkage) trends for the ROE, sales/revenues and earnings. I agree with Warren Buffet: Past consistency is an important indicator of future results.

None of the financials are deal-killers, but they're important.

And finally, when decision time comes, I look at the chart and trust my instincts. Sometimes a chart just looks right. Sometimes it doesn't. I've been studying charts for 30 years, and I've found the queasy feeling in my stomach can be a pretty good market analyst.

Choices: Method 2

In a trending market, on any given day, there are always more good trends that I'm capable of covering. Opportunities always outnumber the dollars.

So, how to choose?

I'm a fact based trader, so I make my choices based on the math.

1) I choose trades that are new breakouts. That means I'll have a chance to ride more of the trend than would otherwise be the case.

2) From among the new breakouts, I throw out any that will be announcing earnings prior to the next expiration date for options that can be traded under my rules (20 to 50 days out). Earnings plays can be interesting, but that's not what this trading system is about.

3) I then score the remaining potentials by creating the LTV Index for the stock. The initials stand for Liquidity, Trendiness and Volatility. That is, I'm looking for strongly trending stocks with large price changes and the narrow spreads produced by high volume.

4) The LTV Index is calculated by taking the most recent day's volume rounded to the nearest thousand, multiplying that by the 14-day Average Directional Index (ADX) divided by 100, and multiplying the result by the 14-day Average True Range (ATR) as a percentage of price. It's a rough-and-ready way of estimating which stocks best meet my criteria.

5) I then sort the stocks by the LTV Index, in descending order, giving priority to those at the top of the list. I tend to size my trades so that I can't lose more than 1 percent of my trading capital on any single position, so that means I can carry lots of positions at any given time.

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That's it. Method 1 tends to look for established trends. Method 2 looks to get in earlier. I think that Method 2 will produce more failed trades than Method 1 does, the Method 2 profits on good trades will be higher.