My Latest Research On Stock Selection

As swing traders, we're looking to capture explosive short-term market moves. We don't have the luxury of waiting around for something to happen. Therefore, it's vitally important that we are trading in the stocks that show the most immediate potential. Below, we will look at how to weed though thousands of stocks to find those that show most promise.

My Friend, The Trend

"The trend is your friend" is truest of all stock market adages. As a momentum trader, it is one of the most important characteristics I look for when looking for stocks to trade. Trend can be measured by observing the stocks' behavior or through quantitative methods.

Trend Qualifiers

Trending markets leave behind clues. I have dubbed these "Trend Qualifiers." These include base breakouts, gaps, new highs (lows), strong closes, the slope of moving averages, and the order of moving averages to name a few. Notice below that Gilead Sciences (GILD | Quote | Chart | News | PowerRating)  exhibited many of these qualifiers during its recent trend. These included wide-range bars and strong closes (a),(c),(e),(f), positive slope in the moving averages (b) and moving averages in proper order (d) -- the faster moving averages (shorter period) are greater than the slower moving averages (longer periods). 

Quantitative Methods

ADX is a standardized measurement of trend developed by Wells Wilder. Its components, plus directional movement (+DMI) and minus directional movement (-DMI), are calculated based on what portion of today's range lies outside of yesterday's range. In general, ADX readings of 30 or higher and +DMI > -DMI suggests an uptrend and readings of 30 or higher and -DMI < +DMI suggests a downtrend. For more information on ADX, see my article "Finding The Strongest Trends With ADX".

Eyeballing

The truth is, there is no one perfect indicator when determining trend. The good news is it's not rocket science. One of the best ways to determine trend is to simply "eyeball" the chart. The trend should be obvious. My litmus test is to think about which direction a six-year old kid would say the stock is headed.

Sector

The old stock market adage "A rising tide lifts all boats" is as relevant to the individual sectors as it is to the major averages. In fact, because sectors can often outperform and even trade counter to the overall market, sector action is more important than the overall stock market. Therefore, look for stocks that are in the strongest (or weakest sectors for shorting) sectors.

Spread

In general, you should avoid stocks that have large spreads, as you will immediately have a loss as soon as you initiate a trade. Therefore, trade only in stocks that have reasonable spreads. Obviously, "reasonable" becomes a matter of discretion. For me, I like to see stocks with a spread no larger than a 1/2 point. Keep in mind that in trading, there are trade-offs. Sometimes stocks in fast moves will have large spreads as traders are reluctant to sell near the bid. In these cases, you'll have to decide whether or not the potential for gains outweighs the immediate loss.

Daily Range

The stock must exhibit the ability to make large moves over a short period of time. One of the easiest ways to recognize this potential is to look at the average range (high-low). As a general rule, this range should be 2 points or higher.

Volume/Liquidity

One advantage the small independent trader has over the institutions is that he/she can trade in smaller-cap issues. These stocks, being less efficient than their larger-cap counterparts, often have the ability to make much larger gains. However, the issues must be liquid enough to move in and out of with ease. Therefore, the 10-day average volume should be at least 100,000 shares.

Volatility

Volatility seems to be the most difficult and least understood market concept. However, it doesn't have to be a mystery. Volatility is simply how much prices fluctuate over time. Nothing more, nothing less. One of the best measurements of volatility is historical (statistical) volatility. The higher the HV numbers, the more the stock has fluctuated in the past. And based on past behavior, the more likely the stock will fluctuate in the future. In general, the HV reading should be 40% or higher.

See my articles on volatility under Trader's Lessons for more details here.

Price

As I've learned from Jeff Cooper, if you are going to trade stocks on a short-term basis, you need to focus on the higher-priced stocks. This is because these stocks have the potential to make a larger point gain over a short period of time. Therefore, I suggest only trading in stocks priced at least $20 and preferably $30 or higher.

Price Persistency

Persistency is a gauge of the consistency of a trend. Stocks that are price persistent tend to follow through from one day to the next. I believe it is one of the most important things to study when choosing which stocks to trade. In the past, I have experimented with complex formulas such as linear regression but have yet to find an accurate measurement of persistency. Therefore, and once again, your own eye may be the best judge here. Notice how the stock performs when coming out of a pattern. Does it follow through from one day to the next? Does it "persist" in the direction of the trend? A very simple technique of measuring persistency is to draw a line through a chart and see how many bars you can intersect.

Getting to Know You, Getting To Know All About You

One way to assure you are in the right stocks is to "get to know" a core group of stocks. You might pick a few from each of the representative sectors -- a few biotechs, a few semis and so on and so forth. Then observe and trade these core stocks. The more you watch and trade them, the better you get to know their personality. 

Q&A

Q. At last count, there were more than 10,000 stocks traded on the various exchanges. Do you think your above criteria will help to reduce this down to a more manageable number?

A. Absolutely. It becomes a "whittling" process. First, you eliminate the cheap stocks, that gets rid of a few thousand then you eliminate those that are too thin, then you might consider getting rid of those that are too thick, then you require the historical volatility to be at least 40% (possibly higher or lower depending on the market conditions) and so on and so forth. Then by focusing on those in the hottest (or poorest for shorts) sectors and combining those that are set up, you end up with a few stocks that are worth watching.

Q. You mention "quantitative measurement" of trend. Why bother using all the other methods to determine trend?

A. Because there are no perfect indicators for determining trend. ADX is fantastic for computer-based screening of thousands of stocks, but it does lag and have a left-over effect to it. Therefore, unless I'm running computer-based scans, I'd much rather "eyeball" a stock and look for Trend Qualifiers.

Q. Left-over effect?

A. Suppose you have a stock in a strong downtrend that begins to rally. The +DMI may cross the -DMI suggesting an uptrend and the high ADX reading may suggest that this trend is strong, but the truth is it's likely "left over" from the prior downtrend.

Q. You briefly mentioned linear regression as a measure of persistency. Can you explain linear regression and elaborate on this subject?

A. Sure. Linear regression finds a "best fit" line over a given period of time. This is done with complete hindsight, of course. Take Protein Design Labs (PDLI), a biotech, for example. It was in a strong uptrend like many of the other biotechs during May and early June of 2001. By plotting regression lines, of various periods (10-days, 15-days, 20-days, etc...) you can see that most of the lines ran together in an uptrend.

On the other hand, during the same time frame, many of the telecommunication stocks were going through a painful fundamental "shake out" of companies. Notice Ciena Corp. (CIEN) has chopped around during that period. By plotting the same regression lines, you'll see that they are in no specific order and they don't run in tandem.

Q. This seems like a useful indicator. Why not use it?

A. I occasionally still experiment with the indicator now and then. However, if you think about it, despite its complexities in its calculations, all it does is draw a line on the chart. This is essentially the same thing that a six-year would do in his/her analysis.

Q. Where can I find a good book on swing trading?

A. I thought you'd never ask.

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References and Additional Reading

Dave Landry On Swing Trading, by Dave Landry: Chapter 3 "Trend Qualifiers," Chapter 4 "Stock Selection."

Hit And Run Trading, by Jeff Cooper: Chapter 4 "Creating The Hit List."

Connors On Advanced Trading Strategies, Larry Connors: "Trading Where The Action Is."

The Hedge Fund Edge, by Mark Boucher: "Runaway Market Characteristics."

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