In previous posts, I discussed the influences on the development of my stock market trading strategy. These posts included discussions of the CANSLIM trading methodology, the Turtle Trading System, and the Darvas trading method.
Now, it’s time to tie it all together into the strategy I’ve developed for myself and which is employed in my newsletter, The Cole Stock Market Report.
If you’ve taken the time to read those previous posts, you’ll likely come to the conclusion that my strategy is a trend following approach, and you would be right. You’ll also likely conclude that there must be some discretion involved in the screening of the stock market for the right candidates for trading, and you’d be right again.
Stock Market Trading Strategy – Price and Volume Behavior
If you’ll recall, the CANSLIM method basically screened for stocks that exhibited strong relative strength compared to the rest of the market, and had strong earnings. My approach employs the former, but I don’t pay attention to fundamentals whatsoever.
The Darvas method paid more attention to price and volume action, and that is where I begin to build on my strategy.
While CANSLIM employed relative strength, it also required that a stock form a basing pattern over a certain period of at least seven weeks before jumping on board. I don’t hold to that particular standard.
Instead, I look for very strong momentum, as did Darvas. I also look for indications in the stock’s trading volume over the last year that suggest an increase in institutional interest.
In fact, one of my absolute favorite price and volume behaviors is a breakout from a base to a new 52 week high in price accompanied by a spike in volume on that trading day. Here’s an example…
In January, AAOI broke out to a new 52 week high, just a few days after the stock’s price closed under its 50 day moving average. This breakout was accompanied by a big spike in volume…the highest volume day in the previous six months by far.
This type of behavior tells me that there is strong interest in the stock for some reason. A move like this is often the result of an earnings report or some bit of important news about the company, such as positive results from a drug trial.
Once this pattern appears, it’s a matter of finding an appropriate place to enter a position. This can be a matter of personal preference. You can enter at the close of trading on the breakout day, the open the next day, above the high of the breakout day, or you can wait for the stock to consolidate its gains.
Stock Market Trading Strategy – Risk Management
As with any strategy, the ultimate success of a stock market trading strategy hinges on the risk management portion of the strategy. This is where my experience with Turtle Trading Strategy comes in. I like the idea of utilizing recent price action to determine an appropriate stop loss.
If you read my post on the Turtle Trading System, you’ll have learned a bit about the money management strategies employed by the Turtles. This involved the Average True Range (ATR) of a market over the past X number of days. In my case, I presently look at the 14 day Average True Range for potential use as a stop loss.
Like the Turtles, I like the idea of multiplying the 14 day Average True Range by 2, and then subtracting this figure from my entry price to arrive at my stop loss. So, if my entry price is $20, and the ATR is $1, then my stop loss will be $2 below the entry price (2 x $1), or $18.
I like this idea, as it gives the stock a little bit of wiggle room so we are not stopped out too quickly. If you recall, William O’Neil employed a stop loss of 7-8% of the stock’s price below his entry price as his stop loss. Darvas simply used a very tight stop loss, probably on the order of 5% of the stock’s price or less. Neither one of these ideas is based on actual price action though, which is why I prefer the Turtle strategy.
The Turtles also had a money management strategy that restricted their exposure in any single position to 4% of their account equity. This was after getting fully loaded into a position through pyramiding.
Nowadays, that figure is considered to be quite high, and most professional traders who manage customer money will risk no more than 1% of their equity on a position.
Ultimately, my research suggests you can still generate strong absolute returns, even if you risk no more than about 2.5% of your equity on a single position.
Stock Market Trading Strategy – Exiting Positions
Over a period of about three years, from 2013 through mid-2016 I conducted substantial research on developing a trend following program for use in the futures markets. I ultimately concluded that a multi-strategy approach was needed to achieve success in those markets.
This has carried over a bit to my stock market research. There is no one exit strategy that works best. While it is necessary to have some trading rules for exiting positions, it is ultimately the price action itself that is what determines the best exit strategy at a given time.
Again, my experience with the Turtle Trading System helped with this conclusion. While the Turtles were given mechanical rules for entering and exiting positions, they were also given discretionary criteria as well. This criteria was based upon both price action and market sentiment.
The benefit to trading stocks versus futures for the smaller trader is that in the stock market you are usually trading more than one share at a time. So, if you are trading 100 shares, you have the luxury of exiting a trade piecemeal.
In the futures markets, however, if you have a small trading account, you are often left to trading one contract at a time due to the amount of leverage involved in those markets. As a result, you are left with using just one exit signal.
The Turtle discretionary criteria placed emphasis on a market making a 10 day high or low, and a 20 day high or low, but it also emphasized opening and closing gaps, a market’s reaction to news, etc.
With this in mind, my exit strategies involve a number of indicators, including price channels, swing highs and lows, moving averages, daily price action, sentiment indicators, etc. The bottom line is that each stock is treated differently based upon its individual price behavior.
As we revisit AAOI, you will see that I’ve drawn a trend line from a February low through a March swing low. A break of that trend line is one potential exit signal, along with the break of the March swing low itself. You could also use a 20 day low, or even a close below the 50 day moving average, as depicted by the blue line in the chart (I use exponential moving averages).
My Stock Market Trading Strategy – Tying It All Together
My basic stock market trading strategy employs the use of breakouts for entries, a risk management strategy similar to that used in the Turtle Trading System most of the time, and multiple exit strategies.
I should note again that significant momentum accompanied by increasing volume is also a critical component of my overall strategy.
So there you have it! If you think you might be interested in learning more, consider signing up for the Cole Stock Market Report. I will work my ass off to help you make more money in the stock market, and hopefully teach you a thing or two about trading as well.
Thanks for reading!