There is a right time and a wrong time to buy any stock. The company with the best earnings growth rate, the best book value relative to price, the best management, and the best sales outlook, can be a catastrophe for a portfolio if it is bought at the wrong time, and a company with a poor profile can give a portfolio a real boost if it is bought at the right time. Therefore, top traders and investors create “Watch Lists” of stocks they believe are nearly “ready” to be bought because they are developing a pattern known as a “setup.”
As a stock’s price rises and falls, so does its PE ratio. An investor who focuses on fundamentals may want to buy a stock that typically has a high PE ratio, but puts it on his watch list so he can monitor it and buy it when its PE ratio is relatively low. Another example would be a technical trader who wants to buy a stock that is currently just below a band of resistance (a price at which sellers enter the market and depress the stock’s price or keep it from rising). He may put the stock on his watch list to monitor it so that he can buy it quickly if it gets enough investor interest to push its way through all the overhead resistance (a breakout).
In general, the most quickly profitable “watch list” stocks are those in a technical “setup” configuration (the kind we target). A “Setup” is a stock price configuration that usually occurs just before a price surge. An example of a technical “Setup” configuration is when a stock declines to its rapidly rising 50-day moving average. If the 50-day moving average of a stock is rising rapidly, the stock usually trades above that average. However, it will occasionally decline to the average, rebound off it, and then climb away from it again. It does this because institutional investors consider a 50-day moving average to be a region of support, especially if it is rising rapidly. That means if a stock has declined to a point very near the 50-day moving average, it is a low-risk investment. A stop loss can be placed just below the average so that, if it is triggered, the loss will be minimal (since the purchase price is just above the moving average). If the moving average (where there is significant support) cannot stop the decline, you have a rationale for selling the stock. For high-performance investors, when a stock falls right through support (this should not happen to a stock that will soon be profitable), they see it as a clear sell signal. However, the strength of the rising average means there is considerable momentum in the move and a high probability that the stock will continue its rising trend by rebounding off its average. That is why institutional investors like to buy such setups. When they buy, the stock rises in response. That “bounce” off of support is the “trigger event” (the signal to buy). If the Stock does not rebound off the average, there is no “trigger event,” and the investor does not buy.
“Setups” may take a few days to mature. Stocks that are not ready to move at the beginning of a week may be ready sometime before the end of the week or during the following week. A watch list of a few stocks may be good for a few days before needing to be updated, but long lists can provide buy candidates for up to several weeks. The most successful traders and investors do not want to wait 6 months to find out whether a stock will perform as hoped. That’s why they focus on “setups.” When they see that a “setup” has failed to deliver or if it begins to break down, they sell. The expected surge in price normally begins within about two weeks. Knowing that, expert traders/investors do not have to wait 6 months to see if their investment will be profitable. This comes down to the time-management of money..
Once a stock is put on a “watch list,” the investor waits for the “trigger event.” Let’s look again at the 50-day moving average example described above. First, as the stock nears its rapidly rising 50-day moving average, it is put on a “watch list.” Then, a “trigger event” occurs if the stock touches its 50-day moving average and reverses direction. The “trigger event” (bounce) occurs because (institutional investors tend to be buyers when a stock declines to its rapidly rising 50-day moving average). The “watch list” tells us “here are stocks that bear watching.” The “trigger event” says ” if there is no reason to avoid acting, act now!”
Top performing investors use “watch lists” because time is money. To achieve a maximum return on his money, the trader wants to keep his portfolio fully invested in profit-making positions. Any time a portfolio has a non-performing position, that portion of the portfolio exerts a drag on the performance of all the positive work being done by the performing positions. Let’s assume a trader (or investor) likes to maintain 10 positions in his portfolio. Each position occupies a “slot” or “basket.” So, when a stock is sold, a slot or basket is emptied and becomes non-performing. If our trader averages 7 positions over the year, then the 3 empty baskets will have dragged down the performance of the other 7. Instead of averaging 40% for the year (assuming each position gained 40%), the portfolio will gain only 28% (assuming no interest is accumulated in the empty slots). If the trader has a “watch list” by which he can monitor a large number of stocks in “setup” configurations, then when the portfolio sells a position, it won’t take long to find a replacement for that empty “basket.”
Why buy a stock just because it has a “good story” and then wait for 6 months to see if it rises or falls, when a “watch list” system can provide you with lists of stocks that currently show a high probability of a coming surge in price (probably within two weeks). By using “watch lists,” you can dramatically cut your wait time for performance. Traders at Stock Disciplines generally wait no more than 2 weeks for the expected move. If it doesn’t occur, they know that the setup failed, and that it is time to look elsewhere. They can then switch to another stock that is about to have a “trigger event.” The Valuator has a persistent strength column. Highly ranked stock in that column already have strong positive momentum. Simply selecting the stocks ranked 90% or above will provide a good watch-list of 100 stocks. There are other watch-lists that can be constructed by selecting stocks highly ranked under the column headings “10-Day Mom,” “RSI,” or “CCI.” Our own preference is to use stocks under “Strength Rank%” That column is percentile ranked, so if we select all those with a rank of 90% or higher we will have a list of 105 stocks. That should be enough to satisfy us until the next issue of The Valuator is available. The stocks that are in that column are already in a setup configuration by virtue of their strength and momentum. Some of those may also have an additional setup configuration worthy of being monitored. We like to focus on our “strength stocks” because they often have within their pattern other setup patterns, but even without those, having a list of 105 strong stocks gives us the ability of quickly replace a stock that has been sold. That is, we can keep a portfolio nearly 100% invested in some of the strongest stocks on the market.
For information on “Setups” see “Setups.” This page has Illustrations of some setups.
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