Stock Buy Signals

Here is part 2 about stock entry strategy or the buying process.   The previous article talked about stock screening, which is the background investigation to select a pool of candidate stocks to buy when the time is right.   The trigger or market timing signal is the topic of this article.   

 Why You Need to Time Your Entry

Once you have a universe of candidates, you need an entry signal or trigger.  Stocks can sit around looking good enough to buy for a long time, and you need a discrete event to say “Buy Now”.  Hard experience has taught me that “when I have time to complete research” and “when I feel excited about stocks” are not the best entry conditions.    In retrospect, it was usually a price extreme that got me pumped enough to research stocks and hit the buying point.   I’ve found that exercising the judgement to pick a better entry point can be more financially rewarding than just jumping in.     Personally, I suspect that even a random entry point would be better than emotion-driven buying, and backtesting can help identify strategies that do better than random.

 How To Time Your Entry

I see three broad categories that can be used as in entry signal: news events, clock or calendar events, and price events, especially as indicated by objective technical analysis.   Let’s compare them.

 News Events

If you’re new to the stock market, reacting to news events may seem the most natural thing in the world.  However, a little experience shows that the market anticipates and prices in news before it happens.  This is called discounting.  As an example, remember the recent situation with Steve Jobs and Apple.   It follows the saying, “Buy the rumor, sell the news”, only in reverse because bad news is what moves the market lately.   Here’s what happened:  Amid rumors of Jobs’ recurring illness, the price of AAPL declined, all the while Apple insisted Jobs was healthy.   Then Jobs announced that he was taking a medical leave of absence.   If the rumor of illness prompted a decline, then one might think that the news of his departure would tank the stock – he has had an unquestionable impact on the company, after all.    What actually happened, though, is that AAPL traded down to a new 52 week low in after-hours trading on January 14, the day of Jobs’ departure.  The following day, the price opened low, but regained most of it to close at near the high of the day.  Price bounced around the lows for 3 days, and then began an ascent that ended 3 weeks and 30% later.   The market had already priced in the news and the reaction went in the opposite direction, as it often does.    The upshot of this example is that it is difficult, if not impossible, to form an objective strategy around the news because the news may be priced into the market and always must be subjectively interpreted.

 Calendar Events

The second type of entry signals, clock and calendar events, are more objective than the news, but that’s not saying they’re 100% reliable.   Some of the people who use this category of signals are

  • day-traders who never hold overnight
  • pro traders who only hold overnight
  • investors following the adage to “sell in May and go away”
  • small-cap investors who show up in December
  • commodity traders following the seasonal fundamentals
  • and those folks who mine the charts looking for the dates when a stock almost always seems to go a certain way

Some of the calendar-driven moves truly are driven by the calendar. Others are due to coincidence, while still others are illusion.  Backtesting – either automatically or by manually checking the charts – can weed out the pretenders by determining which have been profitable in the past, and that is a useful first step.    I think you owe it to yourself to take it one step further and look for a plausible cause for the move rather than betting good money on a pattern that came about by chance.

Technical Indicator Signals

 The same can be said of technical indicator signals – you need to understand why they work — plus you need to make sure they are objective.   Aronson’s book makes a good case for using objective indicators rather than relying on subjective information for trading decisions.   A signal is objective if there is no “wiggle room” in describing it, if any two people always see it the same way (not like pattern recognition) and/or you could program it into a computer.  Elder’s first book gives good descriptions of technical indicators grounded in crowd behavior.  

 You can also think through the implications of the strategy.   For example, consider the trend-following strategy of buying when price hits a new high.   A new high doesn’t guarantee that the price will keep going, but all runaway stocks had to make new highs along the way.   A good thing to know is how many stocks making new highs go on to make a profit for investors holding for, say, one year.   Backtesting is one good way to estimate this info.   Sign up for email alerts to find out when new highs will be featured in BackTesting Report.             

Backtesting can also help us overcome our human tendency to become overconfident in a signal because we can easily spot on a chart the times that the signals worked and all too easily overlook the false signals.   A false signal is where the signal comes but the stock price doesn’t go in the expected direction long enough for the trader to profit.  It’s expensive to learn about false signals and our little foibles of human cognition in live trading.

The previous article used the example of price above the moving average to illustrate a potential stock screen.  A corresponding signal using moving averages is price crossing the moving average, or moving averages crossing each other.    They offer objective, discrete events to replace emotional guesswork with rational decision-making.  To find out more, check out the BackTesting Report MA Buy Signal package.

Updated on 3/17/09 to add: (BacktestingBlog is an Amazon Associate. )

Updated on 3/19/09 to add: (Author has a position in stocks mentioned in this article. )

Stock Screens and Signals

With a rally coming together over the past week, I want to review two distinct and important elements of the buying process.   Before I jump in, let me say that I don’t claim to know if this is The Time to buy or not.  I do want to give you two steps to consider when making that decision for yourself.   They are:

  • Screening for candidate stocks
  • Signaling the time to buy (and sell)

This first, stock screens, is more time invariant – a fancy way of saying the list doesn’t change much day to day. In fact, you may not want to change you stock list much year to year as there is a lot to be said for getting to know a handful of stocks inside and out.   If you’re like me, you itch to scan a huge number of stocks to see offer up the best opportunities.   Of course, you can do both.  I have my screeners delivering new stocks every day and I also have my favorites that I’ve gone back to so many times over the years that I am part of the reason support and resistance works because I know from memory what is a low buying price and when to take the money and run.    On the other hand, a decidedly Bad Idea is obsessively returning to a stock on which you lost thinking that it “owes you”.  This is where an objective plan can really save you.

Sit down at a quiet time and think through the things you want in your candidate stocks.    I consider three categories:  practical matters, fundamentals, and technical screens.   Other folks might want to consider social values, or what their friends say, or worldwide demographics.    I have a hard time making the last three objective myself.

On the bare-bones practical side:

  •             Volume is a very measurable criterion that is almost pointless to test.   You need enough volume to get in and out.  Period.  I like to see at least 500,000 shares traded per day.
  •             Price is another area where it’s very easy to be objective – at least at the extremes.   If you want to be a penny stock trader – great!  Go be the best.   But most people choose $1, $5, or $10 and say it’s as low as they go.  
  •             Your risk limits drive a price/volatility limit.   If you risk only 2% of your account per trade (and that’s being generous), you can’t get into any stock with an average true range bigger than that amount.

Do fundamentals matter or is the sum total of available information reflected in the price?   You will have to make your own decision on that, dear reader, because the fundamental data I had at my disposal last I looked was not clean enough to make a good determination.    Even so, I do use fundamentals as a tie-breaker for the times when I get too many signals at once.   Then I’ll take the signals on the stocks with fundamentals (and story) to my liking.  A better way is to refine the objective rules to come up with just the right number of stocks to fit your account.

Technical stock screens are an important component of your plan.  They can and should be tested thoroughly.   First define what you want, say stocks in an uptrend, or beaten down stocks, or stocks trading in a nice range, whichever.  Then figure out which tool from technical analysis delivers the best candidates for your needs.  This means know how well the various technical analysis tools have performed.  This applies whether you are picking the short list of stocks you will grow with for the next couple years, or setting up a daily screen.   If it’s done right, your technical stock screener can give a solid list of candidates.   Remember, the point is not to go out and buy all of these right away, but instead to stalk them for the right time to make your move.

 For example, a moving average can function as a stock screener, where stocks above the moving average are said to be in an up-trend and stocks below the moving average are said to be in a downtrend.   Many experts recommend buying only stocks which are above their moving average, although some will say you can capture more of the move by getting in well below the averages.  Of course the advice varies on which length of moving average and what you use may depend on whether you have a short- or long-term outlook.    Click here to order your copy of the BackTesting Report on moving average stock screens and find out which moving averages have potential and which have not proven out as a stock screener.

 This post talks about screens stocks to build a candidate list that is bigger than you can use at any one time.   The examples — price, volume, above/below moving averages — showed objective, testable tactics that can identify out a candidate list.  But the stock screener doesn’t pinpoint the time to buy.   For that we need a more precise entry signal which I’ll discuss in the next article.