Placing the bet
17 July 2009. There are endless debates about how to pick stocks to bet on (that is, hope to make money), generally falling into two camps focusing on either fundamentals or technical analysis.
I long ago gave up on the idea of picking stocks based on fundamentals. There are just too many stocks out there to analyze and there is just too much to know about a company, its sector, and its competitors for the ordinary trader to make sensible decisions. I'll leave that to the professional managers with their cadre of researchers, insider-access, and massive databases.
For me, technical analysis is more manageable; it basically looks for patterns in a stock's trading history and uses those patterns and relationships to make decisions about when to jump in or out of a stock. It's more manageable, but that doesn't necessarily mean simpler: there are a gazillion technical indicators based on arcane calculations that only a statistician could love.
I'm interested — in my Trader Paul account — in something quite simple: the intellectual challenge of figuring out better how the market works and banking enough gains to pay for vacations, special projects, or big purchases.
As a rule, I focus on stocks that meet several criteria:
- Closing price between $5 and $10
Stocks below $5 are often quite risky (there's a reason the price is so low) and, in any case, they're generally not marginable. Stocks above $10 require too much capital to buy a decent number of shares. For lots of 500 shares, this keeps the exposure between $2500 and $5000.
- Average daily volume of at least 50,000 shares
The more heavily traded a stock is, the easier it is to get in or out. Lightly traded stocks are too illiquid — you can lose your shirt if you can't get in or out when you want to.
- At the beginning of an up- or down-cycle of a clear trend
The idea is to ride a stock up (or down) and then jump off until it starts another up (or down) cycle. Since the cycles are sometimes quite short, timing is everything.
The hard part of this list is the last item: timing the beginning and end of cycles. Many indicators are lagging indicators; they give clear signals after the fact. What's needed is something predictive. By painful and costly experience, I've found the PPO a pretty good indicator for judging the turns in the cycle (see 2008 strategy).
PPO Percentage Price Oscillator. A price oscillator uses the difference between two moving averages, one covering a shorter period than the other, and turns that difference into a percentage so it can be compared across stocks at different prices. At StockCharts.com, which I use for stock charting, the default periods for daily charts are 12-days and 26-days. The 9-day average is used as the signal line.
What I noticed in looking at many charts for my trades, is that a new up- or down-cycle often corresponds to times when the PPO line crosses over the signal line and diverges sharply from it (see ARAY chart, right). The cross-over is essentially a shift from bullish to bearish sentiment (or vice-versa). That's the science of using the PPO indicator.
The art of using the PPO indicator is when the signal is decisive enough to bet on. Jump too soon (as I did with this lot of PRFT) and sentiment might still reverse; jump too late, and leave money on the table or miss the cycle entirely (see ALLI).