My Trading Method (Part 1)

My purpose of writing this series of posts is to lay out my method of operating in the stock market. This process outlined here is by no mean an original creation of my own. Rather, it is a synthesis of many different ideas which I have learnt from other great investors in the past, after many painful years of trial and error. For this reason, I have decided to release the information contained herein for free.

[Disclaimer: all the information in this series of articles is for educational purposes only. The author do not claim or guarantee that the readers may benefit from the information provided.]

Introduction

There are many ways of making money in the stock market, and my method is by no mean the only way that works. I am not a traditional buy-and-hold investor, so I am not interested in finding undervalued companies and hold onto them forever. My method rather aims to catch the big moves in the market which only happened once or twice in a decade.

I have a habit of keeping things simple, so I only pay attention to the most important things and disregard the rest. I base my decisions on price and volume alone, and nothing else. Even though I take note of a plethora of other things like current earnings, cash flows, return on equity and so on, such things do not carry much weight in my method. In other words, I solely use technical analysis and do not pay as much attention to the fundamentals. While this is not an approach with which everyone agrees, it is working for me, and I have no reason to discontinue what is working.

The sceptical readers may question the motive of sharing my own system. If it is doing so well, why would I want to make it public, and risk the chance of losing its profitability after everyone knows about it? If one needs an effective method, he does not need to read this post. Many successful investors have written about their systems, and their works are publicly available in the investing literature. A lot of people have read about them, but few have ever made a fortune in the market. The reason is the same as why there are so many people know about how to build a healthy body, yet so few of them are physically fit. It is the consistency and discipline that count.

And this brings me to the very reason for writing this post.  Even though I have a set of rules and I know about the importance of following them, I am only human and I must continually remind myself not to deviate from them. As I believe that the best way to enforce discipline is to write the rules down and keep referring to them, this post is the logical solution.

Selection

Picking the best securities from the lesser ones is an important part of stock market success. With thousands of possible choices in the exchange, one must have a way to filter out the bad ones efficiently and only focus on those which are ready for an incredible run. There are three simple rules which I employ to screen for such companies.

Firstly, the trading history of the shares must be less than fifteen years. If the shareholders have already listed a corporation for a long time, a significant portion of its shares are already in the hands of the public, and it will be hard for the large investors to drive up the price in a short time. The newer the company is, the more concentrated the allocation finds, and the easier the large investors can pump up the price.

Secondly, the price must have made a new three-year high within the last six months, and it must be at least twice of the lowest price in the recent year. For example, the price of a company has been moving between $20 and $35 for one year. One day, it suddenly breaks above $35 and reaches a new three-year high of $42. Since $42 is more than twice of $20, this candidate qualifies the selection.

Thirdly, after breaking out to a new three-year high, the price cannot dive below the original level of the breakout again. Consider the above example again. After going beyond $35 and touching a new high at $42, the price shall never fall too far below $35 afterwards. An occasional retest of the $35 level is acceptable as long as it bounces back above it within days. What usually happens is that the price goes quietly sideways and range-bound between $35 and $42. This sturdy platform of consolidation is a good sign because it shows that the large investors are willing to drive the price higher without the intention of unloading the shares soon.

One may consider the example of Taser International (TASR) in late 2003. Ever since going public in May 2001, the equity price has been moving in a range between $0.25 and $1.80 for about two years. In March 2003, it suddenly showed significant energy and jumped from $0.30 to $2.20 in half a year, breaking into a new all-time high since its initial offering. However, after that, it fell back and kept dancing around the old high of $1.80, so the breakout was not as “clean” as one wished. In September 2003, it broke to a new high again to $2.70 and immediately retested the old $2.10-$2.20 resistance, but it soon bounces back and approaches the $2.70 peak again. It is precisely the sort of momentum that investors of my kind prefer to see.

A very similar example could be seen in Tesla Motors (TSLA) almost ten years later. Since the IPO in June 2010, the equity price has been moving in a range between $17.00 and $40.00 for about two years. In April 2003, it suddenly broke above $40.00 and shot up to $46.00. Selling pressure pushed the price back, but it never touches the old high of $40.00, and the price soon bounces back and approaches the $46.00 peak again.

Summary

In summary, below is a list of my selection criteria:

1. Trading history is below fifteen years.
2. The twelve-month high is at least one time and a half of the twelve-month low.
3. It has made a new three-year high (or all-time high if trading history less than three years) within the last six months.
4. The breakout mentioned in the last point is “clean”, meaning that the retest of the old resistance level shall be minimal or even none.

Part 2 is available here.