A Stockscores user highlighted an article that I wrote back in 2009, saying it was one of his favorites and that I should send it out again. So, here it is, from February 21 2009:
In recent months I have devoted many of the weekly newsletters to discussion of trading psychology, risk management and trading strategies. But Stockscores was created in 1999 to simplify the market for investors. I created the Stockscores indicators to help investors quickly determine whether a stock is worth considering or not. This week, I would like to review how we use the Stockscores indicators and what they are based on.
I can remember the weekend that I built the Stockscores indicator model. The summer of 1999, I took my computer to a sunny beach town with a plan to relax and try to make an indicator out of the chart pattern recognition techniques that I had been trading with for about 10 years. Concepts like rising bottoms and falling tops, price consolidations, abnormal price and volume activity, price momentum, emotional buying and selling and market index correlation were important to my ability to pick winning stocks and avoid losers. While these concepts by themselves are easy to understand, using them in relation to one another requires some experience. I wanted to make an indicator that would simplify the art of chart reading.
And so, I decided to assign points to chart pattern criteria and make the point system conditional on different elements. For example, I had found that abnormal price gains with abnormal volume was (and still is) an important indication of future trend, but the abnormal action is most predictive when breaking from low volatility sideways trading patterns. So, the model gives more points to stocks trading abnormally if they are doing so from a period of sideways trading.
The Stockscores model is composed of over a dozen criteria, each with a set of rules that determine points. We start out giving every stock 50 points and add and take away points based on the many criteria that exist in the model. Statistically significant abnormal price and volume activity is the most important element in the model and is really the thing that differentiates what I do from conventional technical analysis.
How I came to focus on abnormal activity is an interesting story. It was probably 1995 that I found myself in a Finance class at the University of Calgary. That class was focused on Mergers and Acquisitions which was quite topical at the time because the market had just come out of "Merger Mania" where Investment Bankers were the king of the financial world based on the deals they did to combine big companies. Kohlberg Kravis and Roberts, Solomon Brothers and many other Wall Street firms were the big money makers of the 80's and even inspired an Oscar winning movie, Wall Street.
One of the topics of this class was an investigation of whether news of an impending merger was leaked to the market and whether some people profited from trading on inside information. This was a theme of the movie Wall Street as the lead, Gordon Gecko, hired a young and enthusiastic broker named Bud Fox to uncover the next big deal before it was announced.
Now, when Gecko and Fox would uncover inside information on a stock, they would go in and buy that stock aggressively ahead of the news, reaping large profits which were then promptly spent on art, beach houses, nice cars and girlfriends - The American Dream.
Think about what happens when a real life Gordon Gecko begins to trade on information that is not already priced in. They create abnormal activity in the trading of the stock and it was this that we sought to prove in the Finance class on Mergers and Acquisitions.
And it was proven, for many of the major Wall Street deals that saw big price jumps in the stock of acquired companies had statistically significant abnormal price and volume activity in the weeks leading up to the deal. This phenomenon still exists today.
Right now, I am reading a book called Outliers, The Story of Success by Malcolm Gladwell. That book discusses how very simple things that happen in people's lives can have dramatic effects on what they become later in life and that many of these things are neither purposeful or necessarily in the control of the people that benefit from them. Much of what determines your path in life is based on simple things like the month or year you were born and your cultural background.
Jumping ahead to sitting by the pool with a lap top in 1999 and building the Stockscores model, I harkened back to that one element of my Mergers and Acquisitions class that focused on measuring the statistical significance of abnormal price and volume action. It has become the core of all of my trading techniques and has been key to making my living from the stock market.
So, how do we use the Stockscores indicators? For the longer term trader, what I call a Position trader, the rules are as follows:
1. Sentiment Stockscore should be 60 or higher
This measure determines whether the buyers are in control of the stock. We don't want to buy anything until the buyers are in control.
2. Signal Stockscore should be 80 or higher
The Signal Stockscore looks for abnormal market activity, breakouts, gaps etc and assigns a score to them. I like the Signal Stockscore to jump up above 80 because it Signals to us that something may be going on with the stock. This indicator does not need to stay above 80, it is just a trade trigger that tells us to check out the stock
3. A predictive chart pattern must exist
I don't want to trust indicators to pick stocks so the final rule requires that we look at the chart and decide if the stock is breaking from a period of sideways trading and has enough reward potential to justify the risk.
Now, these are not the only ways to use the Stockscores indicators, over the years I have found other ways to combine rules to come up with different strategies. But this was the initial way that the Stockscores model was developed and it remains the core Position Trading Strategy of the Stockscores Approach, referred to in our course material as the Stockscores Simple strategy.
Does it always work? Absolutely not, no trading strategy does and it is important to understand that trading is about a lot more than just picking the right stock. But try applying just rule number 1 to all of the losing stocks in your portfolio that you wish you did not have. How many of them have a Sentiment Stockscore of 60 or more? How many of the stocks that have been falling over the past 6 or 8 months have passed rule number 1?
I expect that the answer will be very few or none. Rule number one will keep you out of bad stocks.
Now, go look at some stocks in the Precious Metals sector. This group of stocks has been the one area where we have seen consistent winners. In fact, the top performing stock on the TSX right now is Eldorado Gold (T.ELD). What is its Sentiment Stockscore and when did it cross above 60?
Those are the basics for using the Stockscores indicators and a little bit of background on how they came to be. I am often asked about why I teach people about the market and why I spend so much time traveling around talking about stocks. My answer has always been that I enjoy it and that it is a way for me to get out from behind my trading computer, but reading this book brought back a memory that I think has more to do with that choice than anything else.
I was in Grade 1 and we were getting ready to join the other classes in the school for an assembly. A tradition at our school was that each assembly would begin with a group participation of "Going on a Lion Hunt". Those familiar with this game know that one person leads the others in a series of animated actions demonstrating the process of hunting lions.
For some reason, my Grade 1 teacher asked if I would like to lead the school through this event at the assembly and, not yet knowing a fear of public speaking, I willingly said yes. I can imagine that the teachers thought it was cute or funny to see a 6 year old telling a few hundred other students the actions they must do to hunt the lion and so it became tradition. I led Going on a Lion Hunt for every assembly and so my career as a public speaker was born.
What does this have to do with trading and making money in the market? Simply this; every trend starts with a well defined seed that drives fear or greed and understanding what that seed is will determine the path that the stock follows. The Stockscores Indicators are a way to identify future trends which can be combined with the many other skills necessary to succeed in the market.
STRATEGY OF THE WEEK
A pretty simple Market Scan this week, looking for stocks that are up more than 5% over the past 10 days with a Sentiment Stockscore of 50 or higher. The most important part is the inspection of the chart, looking for breaks from predictive chart patterns on the 3 year weekly time frame. Almost all of the good looking stocks that I see right now are from the Energy sector as money looks to be rotating out of the high flying stocks and in to the comeback sector. Here are three stocks that are good position trade candidates:
STOCKS THAT MEET THAT FEATURED STRATEGY
The three year weekly chart shows T.CTA breaking out from a very lengthy pennant pattern, making a good long term entry signal for a position trade. Support at $3.20.
Look at a daily chart of T.CR and it hard to want to buy it because the stock has been going up day after day for three months. But, in the context of the three year weekly charts, you can see that this stock still has a lot of lost ground to make up and is breaking through some long term resistance at $8. Support at $8.10.
CRK has recently broken through resistance at $20 and looks like it has good potential to go to $32 in the months ahead. Support at $19.
Stockscores Market Minutes Video
In this week's Market Minutes video, I discuss Strategy Development. It is a time consuming process but one of my favorite parts of trading. Learn more about what it takes to create a new trading strategy. Watch the video by clicking here.
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This is not an investment advisory, and should not be used to make investment decisions. Information in Stockscores Perspectives is often opinionated and should be considered for information purposes only. No stock exchange anywhere has approved or disapproved of the information contained herein. There is no express or implied solicitation to buy or sell securities. The writers and editors of Perspectives may have positions in the stocks discussed above and may trade in the stocks mentioned. Don't consider buying or selling any stock without conducting your own due diligence.