Our Trading Process
General Criteria for Stock Selection
Here is a basic outline of how I break down a market and what I look for when hunting for a stock.
Top Down Approach
I believe that general market conditions determine in large part to whether a stock is likely to move up or down. Is the market in Bull mode? Choppy? bifurcated? Bear mode? I ask myself, "Am I a buyer or seller of this market?" From there I drill down into Sector and Industry Group relative performance.
MARKET >>> Sector >>>> Industry Group >>>> Stock
For example, let's assume we're in bull mode and I have determined that Consumer Discretionary is a leading sector within the bull ,market. Here is how the stock narrowing decision process might look
I look for compelling long set ups within the top 3 sectors and short set ups with the bottom 3 sectors.
Option Chain Characteristics
I am looking for a highly liquid option chain with narrow bid / ask spreads. In general, the more activity there is in a particular option chain, the narrower the bid / ask spread. The spread represents the potential slippage that will occur when you try to exit the trade. Low volume option chains are "Roach Motels".....easy to get in; hard to get out. I try to avoid these traps.
Option Chain Criteria
Trading Style
At my core, I am a swing / trend trader but with enough flexibility to implement other trading styles when specific situations or market conditions dictate.
Top Down Approach
I believe that general market conditions determine in large part to whether a stock is likely to move up or down. Is the market in Bull mode? Choppy? bifurcated? Bear mode? I ask myself, "Am I a buyer or seller of this market?" From there I drill down into Sector and Industry Group relative performance.
MARKET >>> Sector >>>> Industry Group >>>> Stock
For example, let's assume we're in bull mode and I have determined that Consumer Discretionary is a leading sector within the bull ,market. Here is how the stock narrowing decision process might look
- Bull Market >>> $XLY Outperforming broad market >>>> Restaurant Group leading $XLY >>> $BWLD strong stock within group
- I'd also be carefully looking at other restaurants within the group for strong set ups
I look for compelling long set ups within the top 3 sectors and short set ups with the bottom 3 sectors.
Option Chain Characteristics
I am looking for a highly liquid option chain with narrow bid / ask spreads. In general, the more activity there is in a particular option chain, the narrower the bid / ask spread. The spread represents the potential slippage that will occur when you try to exit the trade. Low volume option chains are "Roach Motels".....easy to get in; hard to get out. I try to avoid these traps.
Option Chain Criteria
- No Chain - Stock eliminated from consideration unless the stock is under $10
- Option Chain Volume - I like to see a a stock that trades at least 1500 contracts a day; not a hard and fast rule
- Bid / Ask Spread - The lower the better; I think long and hard when the spread is greater than 50 cents
Trading Style
At my core, I am a swing / trend trader but with enough flexibility to implement other trading styles when specific situations or market conditions dictate.
- Earnings: I do not participate in many earnings related trades except in certain circumstances. When I do participate it is with lunch money that I am fully prepared to lose.
- Binary Events: Again, not really my thing. Lunch money only.
Elements of a Successful Trade
After the broad market, leading / lagging sectors, and industry group performance has been determined, I take a look at these factors when down at the stock picking level.
- Fundamental Factors
- Technical Indicators
- Institutional Activity in the Options Market
Fundamental Factors
Fundamental Analysis
In my view, the stock market is neither efficient nor rational. Apple trades at a P/E of 10 while Amazon's is 1000. Gilead Sciences has proven products that generate phenomenal cash flow but is regarded by many as a "melting ice cube" and trades at a P/E of 10. Meanwhile other biotech stocks with no drugs or earnings but many dreams trade at ridiculous valuations. Sometimes Stocks with "bad" fundamentals race higher while those with "great " fundamentals sink lower. Why? The examples of these dislocations are endless. The herd mentality is a strong force within the marketplace. Stories are created; stories fall apart.
For these reasons, fundamentals don't play a huge role in my process. I believe price reveals all and at the end of the day price is the only thing that pays. That said, I don't simply ignore fundamentals.
Here are the things I look for....
- Is the macro landscape changing in a way that could pop story stocks or cause turnarounds in beaten up sectors?
- Are analysts behind the curve on earnings projections? Analysts are notorious for being late to the party. Upgrading after huge runs; downgrading after a stock craters. Nothing better than already being in a stock when upgrades start cascading as analysts catch up to a a stock who's earnings power has been growing but not yet recognized by the street.
- Is there a hidden or misunderstood catalyst out there that most participants are not aware of?
- Relative Valuation; High valuation stocks can go higher; low valuation stocks can go lower
- Most traditional measures of fundamental value like FCF, P/E, PEG etc
Technical Set up and Indicators
Charts and the patterns within them provide footprints in the sand showing us where market participants have been. Through this study, we can make assumptions and predictions for where price will go. Easier said than done but I look for set ups that put the odds on our side and entry points where we'll clearly know when we're wrong if the stock goes the wrong way.
Here are the main technical indicators I use.
When I present a chart to you, I will highlight all the relative points of interest from a technical standpoint such as support / resistance, trend lines, and relative positioning of key indicators. Supplemental information regarding fundamentals or option order flow is also provided. If the stock is set up for a trade, entry and exit zones are marked along with a stop when clearly the trade was wrong.
Here are the main technical indicators I use.
- RSI
- Relative strength vs Sector and market
- Momentum with MACD / PPO / Stochastics
- Bollinger Bands and Bollinger band width
- Support and Resistance levels / Volume over Price Bars
- Volume Accumulation / Distribution profiles
- Candlestick Pattern Awareness
When I present a chart to you, I will highlight all the relative points of interest from a technical standpoint such as support / resistance, trend lines, and relative positioning of key indicators. Supplemental information regarding fundamentals or option order flow is also provided. If the stock is set up for a trade, entry and exit zones are marked along with a stop when clearly the trade was wrong.
Institutional Option Order Flow - Follow the Money
Let me ask you a question. Let's say through your process, you determine that you want to be long $XYZ stock. Would you feel better or worse about your decision if you discovered institutional traders were betting heavily that $XYZ was going to go down over the next 60 days rather than up?? Yeah, I thought so.
There is a saying out there that goes like this... "somebody always knows". Simply put, there are no secrets in the market place. Somebody knows when a company is going to be taken out. Somebody always knows if a company will beat or miss earnings before the print. Somebody knows when stocks will get upgraded or downgraded. Rightly or wrongly, institutions hold most of the strong cards. They have both the connections and resources at their disposal to make more informed wagers than we do. I don't think there is much argument about that. Rather than complain about it or ignore it, how can we take advantage of it?
Institutions, with billions of dollars in their coffers, are the driving force behind stock moves. The way we take advantage is to follow institutional order flow. Where is the big money flowing? What sectors? What stocks? Where are the bazookas aimed? Institutional sized option orders are like breadcrumbs. They lead us down a path and give us strong hints about what is going to happen.
Here are several of the things I look for when analyzing order flow.
It's important to treat order flow as important breadcrumbs, but nothing more. Here are a few things you should know about order flow.
There is a saying out there that goes like this... "somebody always knows". Simply put, there are no secrets in the market place. Somebody knows when a company is going to be taken out. Somebody always knows if a company will beat or miss earnings before the print. Somebody knows when stocks will get upgraded or downgraded. Rightly or wrongly, institutions hold most of the strong cards. They have both the connections and resources at their disposal to make more informed wagers than we do. I don't think there is much argument about that. Rather than complain about it or ignore it, how can we take advantage of it?
Institutions, with billions of dollars in their coffers, are the driving force behind stock moves. The way we take advantage is to follow institutional order flow. Where is the big money flowing? What sectors? What stocks? Where are the bazookas aimed? Institutional sized option orders are like breadcrumbs. They lead us down a path and give us strong hints about what is going to happen.
Here are several of the things I look for when analyzing order flow.
- Are they buying short term, medium term, or long term positions?
- Am I seeing repeated, consistent flow across several days or weeks or was it a one -time thing?
- Is it obvious the traders are targeting a known catalyst like earnings or drug approval decision?
- Do the orders seem unusual? Example: A stock trades on average 79 contracts a day but here comes someone buying a 5000 contract block paying above the ask. I sit a little taller in my chair and lean forward when i see stuff like that.
- When did the contract execute? These guys get sneaky at times. You'd be surprised by the amount of important orders that go off in the last 5 minutes of trading when they think no one is looking.
It's important to treat order flow as important breadcrumbs, but nothing more. Here are a few things you should know about order flow.
- It is truly amazing to see "sharp Money Traders" nail call after call, but these institutional traders are not perfect. Lots of examples of belly flops where they got it 100% wrong. Something to keep in mind.
- Its easy to be impressed with a $5M bet; don't be. That trader's account may be $500M. $5M to him is like a $20 bill to people like us. If he loses, he simply shrugs his shoulders and is on to the next trade.
- One never really knows the motivation behind a given trade. You see a huge order for puts. You assume its a big bearish bet, but in fact, it's a hedge / protection on an even larger bullish position in common stock.
