FINDING THE BEST FISH IN THE STOCK
Choosing which stocks to trade is as critical to profitable trading as the methodology or strategy you apply or understanding market dynamics. In my experience, what happens before a trade contributes to success as much as what happens during a trade. Trading success depends as much, if not more, on which stocks you're in as it does on being able to call short-term market direction. Simply, as a short-term trader, I need to be in stocks that are moving. A major reason my Hit-and-Run strategies work is that I use them on the correct stocks.
Below, I'll describe some of the characteristics I look for in stocks. This is how I focus on a relatively small number of names among the thousands of possible stocks to trade.
ABCs Of Stock Selection
I've created an easy-to-remember acronym that will allow you to establish a process for focusing on high-potential stocks.
Each letter stands for a criterion I use in stock selection.
"O" stands for observation. Speculation is largely observation--pure and simple. First, I've observed that higher-priced stocks make larger moves on a daily basis than lower-priced stocks. As a short-term trader, I'm not interested in percentage moves but in point moves. A 5% move in a $100 stock is much bigger than a 10% move in a $22 stock.
Second, look for situations in which you can put pieces together, whether multiple signals or recognizing how a long-term pattern has combined with a short-term pattern to create a higher-than-average likelihood for trend continuation.
One of the most important criteria in assembling a hit list is to observe which stocks outperform the rest --which stocks have high relative strength over the intermediate term.
Two shorter-term relative strength methods I developed for identifying the right stocks to trade are intra-day relative strength and day-over-day relative strength. For example, stocks in an uptrend that stay strong as the market falls in the morning are excellent long-side candidates when the market stops going down. If market dynamics reverse, the stock may explode. Also, stocks that remain resilient despite a strong overall market decline are interesting long candidates the following day.
Another observation to make is whether a stocks shows persistence or not. A stock closing near the top of its range benefits the short-term trader, as stocks in fast moves tend to close at or near the high (or low, for downtrending stocks) of the day. Also, the propensity of a stock to have periods of great velocity--that is, to move a large distance over a short period of time--is vital. Short-term traders need to be in stocks that have shown they can move--and move big. Ninety percent of the time, I trade in the direction of the trend because surprises happen in the direction of strong underlying trends.
Finally, if a stock consistently trades above its rising 50-day moving average, this is often a good tip-off to a developing strong uptrend.
"C" stands for capitalization. As I mentioned before, I create two hit lists. One is for smaller capitalization stocks that typically have an average daily volume of under 300,000 to 400,000 shares.
Note! When I wrote Hit and Run Trading, I found that stocks that traded with an average daily volume of under 200,000 shares best fit the bill for small-cap stocks; however, as the market has grown and the number of players has expanded, I have noticed that stocks that trade up to 400,000 shares behave similarly to those that trade lighter volume.
These small-cap, less-liquid stocks often make explosive moves, as once an institution makes a commitment to accumulate a position (or exit a position), their presence becomes quite evident on the tape. Once an institution decides to get involved, it's not worth their while unless they accumulate a meaningful position. This means size to buy (size bids) on the tape. Stalking small-cap stocks for size bids (and offers) is one of my bread and butter strategies. Size to buy in trending small caps is one of the best trading edges available, but you have to be watching a manageable list of strongly trending names to see what's going on.
"E" stands for expansion of range. Often large moves and new legs begin with an expansion in a stock's daily range, where buyers overwhelm sellers (or vice versa). Further, since the nature of trends is to thrust, pause, and thrust back in the direction of the underlying trend, I'm looking for expansions out of pullbacks or consolidations.
"A" stands for ADX. The Average Directional Movement Index (ADX) is an indicator that measures trend strength (but not direction). Not all trends are created equal. Since the nature of strong trends is to persist, high ADX readings are a valuable tool to help identify which trends may turn into runaways. Pullbacks in runaways usually last no more than a few days. Although those momentum stocks may be very volatile intra-day, for the agile, disciplined trader, this volatility offers opportunity. Since momentum begets momentum, I stalk the highest-momentum names for signs of continuation.
"N"Stands for new highs/new lows. Although many investors are cautious about buying new highs (or shorting new lows), believing the name of the game is to buy low and sell high, momentum players must be willing to buy high and sell higher. A stock must make a new high before a series of new highs is scored. Scanning new multi-month highs and lows will provide many good candidates.
To find stocks that meet these requirements, I begin by filtering those stocks that have made new 52-week highs (and lows) through my data service, and then I filter those stocks with high ADX readings, and then look for the types of price patterns I've described here (and the others I discuss in my daily "Momentum Stocks Insight" commentary).
Starting out with a sound foundation of stocks to trade is essential to any trading approach. Selecting stocks that meet the criteria outlined above allows you to focus on a small number of high-potential stocks out of the universe of tradable stocks