How Can I Pick Better Stocks?

Before getting into more interesting ways to increase your trading results, let's spend a bit more time on how to pick stocks appropriate for the style of trading you've selected.

Why focus on what seems a minor issue? Your stocks are your employees. You're asking them to do a job for you. Interview them. Don't take on ones who can't do the job. As with hiring your nephew Ernie, it could end up being costly.

Your needs as a short-term trader are much different than an investor's, a day-trader's, even a long-term trader's. Your watchlist must match your needs.

Reproducible Success

When picking stocks, think in terms of reproducible success. If you find a particular strategy is a good fit for trading a particular stock, you will likely be able to regularly duplicate that success over the long term (not 100% of the timeof course).

If you're an active short-term trader, you aren't likely interested in trading a $200 stock for a few percent return in sixty days or so. You would much rather aim for a 20+% return in a few weeks. (I'll get into whether this is a realistic goal in a future article. It can be, but you really have to do your homework and make minimal mistakes.)

Therefore, you should be focusing on stocks that have several characteristics, allowing you to implement the various option strategies you've been learning on Markettamer with increased odds of success.

Let's go over some characteristics your watchlist stocks should have on their résumé:

• Well known
  Your stock isn't going anywhere unless there are thousands of smaller traders, and at least a handful of big players (institutions), interested in buying or selling that stock. Pick stocks that are well known and mentioned frequently by analysts and media. How often is that stock highlighted in one of Investor's Business Daily's focus articles? The stock's price should be greater than $10, which is the minimum price level required by many institutions. Does the stock show up on lists of recent purchases by institutions? (they tend to accumulate a stock over time to avoid overpaying)If you are regularly hearing about XYZ, that it is in the right market at the right time and the fundamentals are strong, so are thousands of other investors and traders.

• Good volume
  A stock moves when buying interest overwhelms selling, or selling overwhelms buying. Good average volume, along with strong volume peaks on larger-move days, is a good sign that big players are actively participating in this stock.

• Regular movements
  With most trading strategies, you won't make money unless the stock moves, and you won't make money regularly unless it regularly moves. You don't want an erratic stock. You want stocks that seem to be guided by the forces of logic and reason – they either trend or cycle up and down most of the time. Stuff your watchlist with stocks that regularly give good movements of several percent.

• Liquid options
  You're not investigating advanced option strategies to make 2% a year. That means your active trading watchlist must contain stocks that have options traded on them. The individual options on those stocks, in the nearer expiration periods and strike prices, need to have good Open Interest levels, and the Bid/Ask spreads on those options need to be narrow. For instance, over the past two years, Allstate Insurance (ALL) has generally traded in the range of 27.5 to 35. While the Bid/Ask spreads are actually quite tight, ALL is currently at 31.24 here in early March, but the Oct 2012 31 Call has just 16 contracts open (the ‘Open Interest'). Even though ALL's Historical Volatility (HV) is at a year-low value, meaning the stock has been lifeless, the current Ask of the Oct 31 Call is2.29, which is 17% greater than the theoretical value of 1.953 for that option. Because there isn't much activity in ALL options, they must figure that if you want an ALL option, you must REALLY want it, so you can pay up for it. Exxon Mobil (XOM), currently at 86.33, has an Open Interest on the Oct 87.5 Call of 1,121 contracts. Exxon also currently has its lowest HV figure for the past year. With a 4.50 Ask, that option's theoretical value is 4.179, making it priced just 7% over. The odds for success with certain option strategies will be higher trading XOM options verses ALL options, because there is a lot more competition for XOM options – you'll start out your trade with better prices.

• Cyclical and/or seasonal tendencies
  Most stocks, at one time or another, fall into cyclical patterns. They don't stay that way forever. But it's not uncommon to find a stock that has been undulating up and down in regular cycles. You may be surprised to learn that most stocks getinto a 1-month cycle every now and then (on a weekly chart, you may often see a 3-month pattern). Once you've identified a cyclical pattern, you may be able to trade it for a few more cycles. Many stocks, even entire sectors, have seasonal tendencies, which are track records of rising or falling the same time each year. This makes sense, although few traders ever think about it. Any stock connected to seasonal sales patterns, agricultural,drilling, refining, retailing, and many other sectors, will likely show seasonal patterns over some period of the year. Even if you've never traded a wheat contract, you've likely heard the jokes about trading pork bellies and such. Well, John Deere, Monsanto, and Exxon Mobil all have seasonal tendencies at various times of the year. If you learn to line up your trades with seasonal tendencies, it's like getting an additional ‘tailwind' in your sails. To properly use seasonal information however, you must focus on stocks that have a lengthy history of trading. At Stockquirks.com, we regularly analyze about 500 stocks, and one of the requirements is each stock must have at least 12 years of trading history.

Building a good watchlist

You should have two watchlists. A larger one should be built up with several of the top stocks in a variety of sectors. A good start would be one or more of Investor's Business Daily's stock lists and screens available online, such as their CAN SLIM Select combined with the IBD Big Cap 20, and maybe their Top Fundamentals screen results. Each list can be exported to a text file or an Excel spreadsheet, allowing easy copy/pasting of symbols into your favorite charting tool.

Look back over the history of each stock. Remove the stocks that, over the years, traded in relatively narrow ranges, had few cycles or major trends, or often had wild, erratic moves.

Periodically re-evaluating your watchlist will get you familiar with every stock, and you will be refining the list into the stocks that are most likely to provide you with reproducible success.

Now, form your active trading watchlist. This should be only six to twelve stocks, each one in a different sector. These are the ones you should get to know as well as your kids. You will not change this list often. But there will be times it will make sense to remove one or more stocks because of either a sudden change in their fundamentals or an entire sector has gone out offavor.

For instance, back in the Lehman-inspired stock market crash of 2008, it was obvious that a liquidity crisis was causing stocks to dive. From past experience, I knew that Gold and gold stocks would likely dive, as traders liquidated even their “insurance” stocks to cover margin calls. But I also knew that gold stocks tend to recover faster than the overall market.

In November 2008 the overall market was setting lower lows. But the gold stocks on my larger watchlist started setting higher lows, with strong volume spikes on up-move days. I stopped trading all other stocks and moved a few of the best looking/past favorite gold stocks to my active list. I began making profit after profit, doing only conservative covered calls on those gold stocks. I recall making a 34% return on a Yamana Gold covered call over just a couple months(I was able to roll it up a couple times). I did very well on Goldcorp and Newmont covered calls as well, while the S&P 500 was threatening further downside.

After the overall market stabilized and gold stocks lost their upward momentum, I removed the gold stocks from my active watchlist and went back to my ‘regulars'.

Just recently, scanning through my larger watchlist, I noticed auto repair-related stocks were starting to show strength. Then, AutoZone announced good earnings. They need a pullback, but as soon as they do, I'll pick the best looking one, especially if I had success trading it in the past, and move it onto my active watchlist.

Becoming a chart reader extraordinaire

Around the body shop you work at, you may be known as Michelangelo for how you can feather bondo™ like no one else. But you didn't pick up that skill patching up justa few old Chevys. It took you years to acquire that skill.

Same thing with chart reading. Do you really want to increase your trade success rate and trade returns? Every night, go through the daily charts of all the stocks on your larger watchlist. Some you can skim over quickly, others will catch your attention as more and more chart patterns start to jump out at you. At least once a week, go through the weekly charts of all those stocks.

At the very least, you'll be the center of attention at family get-togethers when you start rambling through all the descending triangle setups you're seeing on the steels and the oil drillers. At best, your trade results will start ramping upwards and those dreams of summer getaways to the Jersey shore will become a reality.

An odds increasing direction?

Sounds odd, doesn't it? A short is merely the opposite of a long, and a Bull Call Spread is merely the opposite of a Bear Put Spread. Well, not really. Less experienced option traders will usually do better with just bullish-oriented trades. Even pros will occasionally admit their bullish trades have been the better performers overall.

This means there are times, perhaps weeks at a time, when you should just sit on the sidelines, out of all positions, to watch and learn! You can still make money. Get used to parking some of your short-term trading funds into more conservative vehicles. Even big-name, world dominating dividend-paying stocks may be resilient to overall market pullbacks. Consider parking a portion of your funds into them when the market is falling (if they are holding up well), collect dividend payments, and when the market starts recovering, sell covered calls on these stocks. As they get called away, you can take the original investments and profits and make more bullish-oriented trades.

Make sure your stocks CAN make money

Let's go back for a minute to the regular movements requirement. If your trading strategy requires the stock to move (most do), make sure the stock has shown a tendency to do that – on a regular basis.

For example, let's look at the recent cycles of Caterpillar:CAT cycles since 2009

It has lots of good tradable cycles. An average 14.5% gain on up-trends, and an average 9.1% stock price decrease on down-trends, and most movements were several percent or higher.

You will seldom catch the exact bottoms and tops, as our cycle analyzer did in these printouts. But, with appropriate option strategies, a trader could have done very well catching portions of these moves.

I mentioned Allstate (ALL) earlier. Let's look at ALL's moves since 2009: ALL cycles since 2009

You see a lot of the cycles were moves of only a couple percent. It was only a few big moves that brought the averages up to 9.1% and 7.7%, for up-trends and down-trends respectively.

Which stock would you rather trade with Bull Call and Bear Put spreads, which require certain minimum moves to end up profitable?

Back in 1992-1994 however, Caterpillar's cycles looked similar to Allstate's cycles now, and back in 2000, Allstate looked even better than Caterpillar now. This is why you need to constantly re-evaluate which stocks you are actively trading.

In my next article, I'll introduce you to an odds-increasing analysis that few traders think about, but has the potential to make a big difference in your results.

(previous article: How can you improve your trading results)

Article below submitted by Gregg Harris, of StockQuirks.com : a site dedicated to helping professional traders increase their odds of success.

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