Having a robust trade idea funnel may not enable you to “shoot fish in a barrel” but it can get you close to fishing in a stocked pond. This post gives you a methodology to follow to build a robust trade idea funnel of your own.
The Problem
Finding trade ideas is pretty easy; finding excellent, high probability trades is a little harder. Most good traders follow a methodology that distills the universe of possibilities down to a manageable number of trade possibilities that can be used for further study.
For this process, I use the analogy of a funnel as shown below.
Why building a Robust Trade Idea Funnel is important
Knowing where to “fish” for good trade ideas makes all the difference on how successful you will be. You’ve likely heard the phrase ” a rising tide lifts all boats”. It’s true because the broad market determines between 55%-60% of a stock’s performance. Sector performance accounts for about 15% – 20% while the Industry group accounts for another 10% or so. The individual stock only accounts for about 10%. These facts highlight why understanding sector rotation is so important. There are times when the stocks of great companies simply do not perform because their sector / industry group is out of favor. Clearly, we want to avoid those fishing holes and find more productive ones.
Step 1: Pick your Pond
Although U.S. Equities have been outperforming the rest of the world and other asset classes for quite some time, that won’t always be the case. Make sure you determine that you are fishing from the best pond by considering all the possibilities and not simply assuming a particular asset class is performing well.
– US Equities / Emerging Markets / Europe / Bonds / Commodities / etc
To do the comparison, you can graph the relative performance of one asset class against the other. For example. To compare US Equities vs Emerging Markets, you could plot $SPY vs $EEM. If the graph is going up, $SPY is outperforming. Currently, SPY is outperforming everything so we’ll set the S&P 500 as our Broad Market / Universe; the pond where we’ll be fishing.
Step 2: Determine which Sectors within $SPY are outperforming
In this step we start working our way down the funnel by comparing recent performance between the various SPDR sectors ( XLY, XLK etc ). At this point its important to understand the these sectors are cap weighted. For example, $XOM and $CVX comprise over 40% weighting of the $XLE. $AMZN comprises about 25% of the $XLY. If that distinction is important to you, you could easily use the equal weight versions of the sectors for your analysis.
At this point I use Performance graphs and Relative Rotation Graphs on the Stockcharts.com FREE TOOLS web page. HERE I selected the relative rotation graph and input the SPDR symbols. I set the look back period to 6 weeks.
Here is the graph.
And the accompanying table
From the graph and table we can see the defensive sectors XLV, XLU, and XLRE are leading the market over the look back period. Consumer Staples XLP is coming on strong. You can also see the weakening and lagging sectors.
The relative rotation graph suggests we look in these outperforming and improving sectors for bullish trade ideas. Those in the lagging quadrant might be fertile ground for a short idea but with the market at all-time highs, lets be bullish.
Does the above mean you cant find winning trades in Technology or Consumer Discretionary? Of course not. There are winning trades everywhere. The idea behind this process is that you can’t look everywhere all the time. This simply points you in a direction. For the purpose of this example, lets focus on Healthcare XLV.
Step 3: What industry groups within Healthcare are outperforming
Each SPDR is divided up into pertinent industry groups. A fancy way of saying similar companies doing similar things within a sector. Within Healthcare there are 5 industry groups. To see them, go back to the Stockcharts.com FREE TOOLS webpage. HERE Look in the right hand column. Look for Summary Pages. Click on “Industry Summary” scroll down to Healthcare. See the 5 groups? $DJUSHP, $DJUSMS, $DJUSAM, $DJUSPR, $DJUSBT. Now, enter this list into the Relative Rotation Graph. Here is what i got.
From the graph we see Pharma moving fast ( long tail ) into the leading quadrant and Biotech improving quickly. Health Care Providers are showing steady outperformance. Conversely, the Medical Supply group is quickly dropping.
Step 4: Determine which stocks to look at.
Within the market summary page on Stockcharts.com, if you click on the industry group name it will expand and show you all the stocks within the group. If we drilled down into the Health Care Provider group we’d see Centene, Wellcare, HCA, Cigna and a whole host of names. You can easily sort the list by Cap size or other parameters. For me, I look for names with liquid, higher volume option chains. Then I will put those names into an RRG chart to look for the outperformers. You can use whatever sorting criteria that is important to you.
Step 5: Trade Selection
Now, with a pool of outperforming stocks to choose from, its up to you to look for the set ups that you like to trade. Some could be poised for another breakout or be pulling back to a nice uptrend line. Whatever criteria is important to you.
Getting back to the rising tide lifting all boats idea, keep an open mind toward stocks within the group that may be underperforming peers. The rising tide of group leaders may pull them along and offer some good trading opportunities.
Pulling it all together
Are you still with me? This was a long post. Believe me, its harder to explain this than to actually do it. Sure it takes time to build a robust trade selection funnel, but in my experience, its time well spent. Fishing in a stocked pond isn’t all that challenging, but in the market we need every edge we can find. The trade selection funnel keeps us fishing in the good sectors and industry groups. Our chances of catching winners is greatly improved.
Thank you for reading; hope you found the information useful.
Happy Hunting and Good trading!!
For further Study
All about Relative Rotation Charts HERE
