How to Make Money Picking And Trading Stocks That Are Undervalued

Why Stocks?

The last few years have succeeded in scaring many people away from the stock market. But the fact is, stocks still represent the single best return for most investors. Historically the stock market returned 10% per year over its life.

For example, a $1 investment in the stock market in 1802 compounded (reinvested all earnings) to $7.47 million by the end of 1997. I have purposely left out the gigantic explosive up years of 1998, 1999, and early 2000, as well as the subsequent down market of the next 3 years to give you a more accurate historical picture. Keep in mind though, that this time period does factor in the stock market crash of 1929 and the subsequent Great Depression.

One of the first questions I hear when I relate these returns though, is what about inflation. Those of us who were in our prime earning years in the last 1970s when inflation hit double digit levels for an extended time were jaded by the experience. But it is a legitimate question. After all, governments historically resort to inflation when the populace rises up against confiscatory tax rates.

But even adjusting this for inflation still shows that that $1 grew to $558,945. To put this in perspective for you, a $1 investment in gold in 1802 and held through 1997 and adjusted for inflation would be worth only $0.84!

Gary Smith in his wonderful How I Trade for a Living relates the story of Anne Scheiber who worked as an IRS auditor. Her peak earning year was $3,100. In 1944 she opened an account with Merrill Lynch with $5,000. When she passed away in 1995, her $5,000 had compounded to more than $20,000,000.

Using the Rule of 72 you can easily calculate how long it would take earnings the market’s historic annual 10% to double your money. Divide 72 by the percentage return, in this case 10. If you earn 10% per year and reinvest those earnings (compounding your investment) your money will double in 7.2 years. Now that is not bad in anyone’s book.

Incidentally you can use the Rule of 72 in reverse as well. Say that you have a 6% loan that you are not making payments on as you defer payments. Your debt will double in 12 years. In other words, if you started owing $5,000, in only 12 years you would owe $10,000! Now you understand why your 30 year mortgage actually winds up costing you about 2 to 3 times the value of your house by the time the mortgage is paid off!

A 10% annual return is the best sustained return that any liquid (meaning you can cash out immediately and use the funds) investment earned in our modern history. The market historically goes up as the U.S. economy historically grows. This is not to say that there are not times when the market falls. Just as there are periodic economic recessions, there are periodic time periods when the stock market goes down.

But experienced professional investors who make their living in stocks, know that the long term trend is higher. While nobody likes to see the price of their stocks go down, if you understand the long term picture, you can profit steadily while the average Mary or Joe perpetually buys at the top when the euphoria is high, and then sells at the bottom when everyone is discouraged.

The pros do just the opposite. They know that eventually the stock market will reverse and march steadily higher. Unless you believe that the United States economy is doomed, the U.S. is finished as the greatest freest most productive country in history, then one of the safest bets you can make is on stocks.

And we’ll leave you with this tidbit, the technological revolution of recent years means increasing productivity for businesses. All that means is that each person is able to produce far more than a person 20 years ago. That productivity is reflected in a number of ways: less expensive goods (who would have ever thought that the price of TVs, computers, and other electronic goods would drop into the average consumer’s price range), a better standard of living for all, and let’s not forget, a steadily rising stock market.

In fact, the stock market in the 1980s and the 1990s earned nearly 20% per year, rather then the historic 10%. Of course, the excesses of the late 1990s market, when any company could raise hundreds of millions of dollars simply by added "dot com" to their name, proved to be a speculative bubble that burst quickly and dramatically. Those dot com companies, which were all concept and no substance, fell to wayside and unfortunately many investors caught up in the fervor lost money investing in them.

But investors who knew the difference between fluff and substance, were not hurt as badly and in fact were in position to be buyers when the market once again hit bottom in early 2003. Many of these investors made back their small losses, and are once again rising their investment portfolios to greater and greater profits.

When seeking out the best investment avenues, a cardinal rule is to stick with those investments where you have an edge. The historic upward tendency of the stock market is one such hedge. There is no such long term tendency in gold, corn, soybeans, currencies, sugar, cattle, or pinwheels.

There are no huge edges in the investment world. If there were someone would have recognized and acted on them years ago. By now they would have earned all the money in the world, and would merely divvy it up among the rest of us at their leisure.

A small edge worked intelligently is the secret to long term success. Unfortunately we cannot promise you the "Holy Grail" of perpetual profits and no losses. Such a thing does not exist. But if you take a realistic view of the investment world, a small reliable edge is all you need to outperform the vast majority of investors who chase the latest fads and hottest gurus only to find disaster at the end.

Buy and Hold

By now you may be thinking that you have heard how to take advantage of this long term upward tendency of the stock market. There are many investment "gurus" pundits hawking their wares on TV, the radio, in newspapers, and especially on the Internet. All you need do is "buy and hold" good quality stocks.

You know the litany: "No one can time stocks, so the best strategy is to simply buy good quality stocks and hold on through thick and thin."

The problem with this philosophy is that it is wrong. Other than that we don’t see any problems with it! Seriously, just looking at a chart of the last 5 years will demonstrate the problem here. The highly touted "new economy" stocks are best represented by an index known as the NASDAQ Composite. When you check out stock prices in the Wall Street Journal or on the Internet, it is one of the three most widely mentioned measures of the stock market as a whole.

The single most widely used index is the Dow Jones Industrial Average (DJIA) a composite of 30 leading companies in the U.S. When you hear that the stock market is up 25 or down 8 points, they are usually referring to the DJIA.

But in the high flying 1990s, the index most representative of what the stock market was doing was the NASDAQ. Most of the leading high technology companies like Microsoft (MSFT), Intel (INTC), Cisco (CSCO), Sun Micro Systems (SUNW), and Oracle (ORCL) are traded over-the-counter (i.e., not on the New York, American Stock or other stock Exchanges), and are included in the NASDAQ Composite. The composite is an index of about 5,000 of the leading over-the-counter (OTC) stocks. Since the "action" in the 1990s was in those stocks, the NASDAQ was the index to watch.

The NASDAQ went from a low of 330 in October 1990 to a high of 5132 in March 2002. That was a 1455% return in 10 years. Not too shabby assuming you bought at the low (few did) and sold at the top (even fewer did that). It then dropped all the way to 1108 in October 2002. That was a drop of 78%. That pales in comparison to the gain, until you realize that to get back to even if you bought at the high 5132 and held to the low, the market must still go up 363%. A mere pittance compared to its previous up leg, but still a daunting project.

Interestingly enough during most of that downfall, major brokerage firms kept reiterating their buy advice for those "quality" stocks they were recommending at the stock market highs. A fat lot of good that did anyone.

Keep in mind that most major brokerage firms make the majority of their money from underwriting fees. These fees are paid by companies selling stock to the public for the first time, or by existing companies selling additional stock to raise money for the company, or in secondary offerings, for select shareholders. This is a glaring conflict of interest. Their bread and butter depends on their underwriting fees, and those fees depend on their underwriting clients happy. What brokerage firm will issue sell advice on an underwriting client that is paying it millions and millions of dollars?

Where would you be, even after the strong 2003 market, if you were buying as stocks fell and holding them through the bear market of recent years? If you are like most investors, you are still in a very big hole. This is because the natural tendency, and it is encouraged by major brokers, is to buy more stock as it goes higher. That raises the average buying price, so that when it turn down, it does not take much of a fall to erase your profits and put you in a losing position.

But guess what? The real pros, the most successful stock traders, those that make their living trading stocks as opposed to selling their advice or managing funds for which they receive sizable fees regardless of how well their managed funds do, were buying when the NASDAQ was under 500 and selling as it approached 5,000. In technical parlance, this is known as "accumulation" when they are buying, and "distribution" when they are selling. These are the true "big boys" whose action you want to emulate.

In the pages that follow we detail for you the exact strategies and tactics used by the most successful investors in the world. Don’t expect to find some secret formula or complicated technique. We will tell you exactly how to recognize when "accumulation" occurs and when "distribution" occurs. When these wizards act, they are disciplined, consistent, confident, and above all patient. We highly recommend Jack Schwager’s three classic books of interviews with the best of the best traders: Market Wizards, the New Market Wizards, and Stock Market Wizards.

What these wizards will tell you is that buy and hold is for suckers. You buy a stock, hold it till it drops 50%, then it has to go up 100% just to get you back to even. Not many stocks move 100% with any regularity. It is hard enough to find a stock that goes up 10-20%, say nothing of 100%. But consider this, many stocks have the potential to earn far more than 100% if you buy and sell their short term swings.

Swing Trading

Successful traders need to be flexible and change with the times. In the 1960s and 70s the proven approach was "Buy and Hold." Even though there are many advisors even today who recommend "buy and hold." But that style of investing requires you to sit through losses of as much as 50% - 60% or even 70% when markets fall. It is not surprising that the elite traders changed their approach.

In the 1980s and ‘90s the most successful trading approach was "momentum" trading. Momentum traders simply waited for stock to demonstrate strong upside price action. Momentum traders bought stock when they made new highs and then quickly spun out of those positions. You may have read about the rise "day traders" during this time. With the spread of computer technology, many people suddenly felt they could day trade with the pros. It turned out to be easier said than done. Day trading requires full time attention to the market. Most people have neither the time nor the money to devote to full time trading.

The debacle of the technology and Internet stocks that led to a 75% plunge in the NASDAQ composite and similar collapses in other leading market indices like the Dow Jones Industrial Average and the S&P 500 led traders to develop yet another trading strategy. Swing trading is designed to pick out stocks with characteristics for short term price moves of two to five days. Swing traders focus on low risk high potential positions that can be held for days rather than hours. This eliminates the need to follow every tick of every stock.

A swing trade can be a short as two or three days, or as long as a month or two. Swing traders generally do not hold positions longer than that though. The idea is to be in when the getting is good, but be out when normal market fluctuations chop up the average investor. Studies show that stocks only trend about 33% of the time. That means that 66% of the time is a difficult choppy action that quickly takes back profit previously earned.

A swing trader focuses on short term tradable trends and foregoes the pain and suffering that goes with Buy and Hold, or the ever suffering Momentum Traders of the last three years. Momentum traders make money only when the market puts in a strong trend. Swing traders only need a quick turnaround because they will be gone by the time the trend reverses.

For example, on April 11, 2003 Microsoft (MSFT) closed at 24.20. On December 26, 2003 it closed at 27.21. That is a 3 point gain or 12.4% in only 9 months. Not bad, but certainly not something you’d be dancing in the street about.

However, if you employed the same easy to recognize timing signals that the pros use, you’re average holding period would be measured in days rather than months. The shorter time period reduces your risk off overnight disasters. In that same time period there were six fairly well defined up and down waves that totaled about 20 points. Even if you were only able to capture half those waves, you would have earned 10 points, or 3 times more than the buy and hold strategy. If fact, even if you were able to only capture 1/3^rd of those 20 points, you would still more than double your buy and hold profits.

Swing traders identify high potential lower risk short-term trades. The typical holding duration is typically only 2 to 5 trading days. Swing traders are targeting profits of 2 to 5 points per trade with the idea that they are perfectly willing to re-enter and re-enter pullbacks on trending stocks to accumulate even more profit than the buy and hold investor.

Contrary to conventional wisdom, you do not have to be a full time trader to take advantage of these techniques. You should be able to spend 10-15 minutes per day reviewing your "watch list" of 10-15 stocks, and as many as 5 open positions. But if you have access to the Internet, this is easily done in less than 1o minute by checking prices at a free website such as www.pcquote.com, or www.financial.yahoo.com, among dozens of other sites. Your own broker will also offer free price quotes.

If you do not have access to the Internet don’t despair. Most major newspapers and the national Wall Street Journal and Investor’s Business Daily, carry price quotes for the cost actively traded stocks.

Getting Started

First you will need to open an account with a stock broker. A stock broker will buy and sell your stock for a commission. Commission rates are very low today compared to rates only 5 or 10 years ago.

Some nationwide discount brokerage firms you might want to consider:

Scottrade caters to individual investors through its 198 branch offices as well as its state-of-the-art online services. Scottrade offers steep discount commissions along with a wide variety of customer services including price quotes, access to independent research, and the ability to execute your orders quickly, efficiently, and low commission rates starting at only $7 per trade. Minimum accounts are only $500. Call 1-800-691-SAVE or go to www.scottrade.com for more information.

TD Waterhouse provides investors and financial advisors with a broad range of brokerage, mutual fund, banking and other consumer financial products on an integrated basis. Worldwide, TD Waterhouse currently services 3.3 million active customer accounts. TD Waterhouse was ranked #1 among brokerage firms serving the do-it-yourself investor by SmartMoney magazine in their 2002 survey. Offering commission rates as low as $9.95 for qualified investors, TD Waterhouse has over 150 branch offices. Call 1-800-934-4448 or go direct to www.tdwaterhouse.com.

There are literally dozens more offering discount commissions and brick and mortar buildings and facilities where you can visit your broker in person. If you are comfortable with your computer and placing orders over the Internet, you likely can save money on your commissions. For starters check out:

Ameritrade is one of the longest established online brokerage firms offering a full range of services including stock and option trading. Commission rates are among the best and Ameritrade offers a full range of services including real time price quotes and charts. Ameritrade prides itself on efficient services. It took over Datek, one of our favorite online brokerage firms and has done a very good job of incorporating its speedy trade execution process. Check out www.ameritrade.com for more information on services and commissions.

E*Trade provides online discount brokerage services, including automated order placement, portfolio tracking, and related market information, news, and services 24 hours a day, seven days a week. This well known and well established firms features services worldwide. It offers competitive commission rates, a full range of services to suit novice to professional traders. Check it out at www.etrade.com for more information.

There are literally dozens of well qualified Internet brokers competing for your business. If you would like to see more, go to a good search engine like www.google.com and type in "discount brokers." It will bring up hundreds of companies. If you prefer to talk to a broker, 800-numbers are listed for those willing to speak to clients. Keep in mind that some brokers do all their business over the Internet and don’t frankly want to talk to you or anyone else. If you are not comfortable with that, go to a different broker.

All brokers will send you an account packet. To open an account you will need to fill out account forms detailing name, address, identification data (address, social security number, etc), provide identification proof, and finally, make a deposit of at least $500 in most cases. Once you open an account you are ready for the next step: placing orders.

Working With Your Broker

When working with your broker, you will place orders based upon the list of recommended picks you are working with. The recommended list tells you the stock name and the symbol, and often a suggested buying level.

Whether you place your orders with you broker over the phone or by computer over the Internet, the procedure is the same. You will need to identify the stock you wish to buy (or sell) (XYZ, SCMR, IBM or whatever), the number of shares you want to buy (100, 200, 1,000, or whatever you can afford for this particular trade), the type of order you are using (market, limit, stop, stop limit as we detail below), and the length of time you want to order to be in effect. For example, a "day" order is cancelled if it is not filled or executed by the end of the day. But a "GTC" (good till cancel) order stays on the books until you cancel it, or until your broker’s policy cancels it (typically brokers cancel all open order on the books at the end of each month). Your broker should notify you if your GTC order is cancelled.

Say you call your broker and tell him to buy 100 shares of XYZ at $3 (a limit order). If XYZ trades at $3 or less, your broker will be able to buy the 100 shares for you. This is called "filling" the order.

Once your order is filled (executed) the brokerage firm must notify you. This is always done in writing, either by email on the Internet, or my snail mail through the post office, or often, both methods. If you have a live broker as opposed to a computer taking your orders, that broker will likely call you back telling you your order is filled.

Once you buy a stock it is your decision when to sell. If you buy XYZ stock at $3 a share and you bought 100 shares (a round lot), your account is debited $300 plus the commission charged by your broker. If the stock goes to $5, and you sell your account is credited with the $500 minus the commission charged. Your profit will be $200 minus the total of commissions. You can take that money out of your account or leave it in to buy more stock and thereby compound your gains.

For example, if you make $200 on the above trade and you started with $500 when you opened your account, your account now has $700. You can buy 100 shares of a $4 stock AND 100 shares of a $3 stock (not counting commissions). Being able to buy two stocks lowers your risk through diversification. As you make money, you will be able to buy 3, 4 or more stocks each time, diversifying your risk. The advantage of diversification is that you do not have all your eggs in one basket, just in case that basket crashes. To put that in perspective, keep Enron in mind!

Types of Orders

There are two main types of trade entry orders for stocks: market and limit. A market order is an order to buy the stock immediately at the best price available. This will typically be the "ask" of the bid and ask spread that your broker should be able to provide you at the time of order entry.

A market order is a high risk order in a thinly traded stock market. If there is a wide spread between the bid and ask when you get a price quote, do not use a market order. For example, if the quote for XYZ stock is $3 by $3.50 the spread is 50 cents per share. If you buy 1000 shares of XYZ at market you will pay $500 (the 50 cents X 1000) more than you could get if you were to turn around and sell it immediately after buying. You would pay $3500 but could only sell it on a market order for $3000 (the bid price). In other words you pay the ask price but receive only the bid price.

Active floor traders or traders with sophisticated quote equipment on their desks who trade is very liquid stocks with high volume often trade very successfully with market orders because the spread between the bid and ask is very small.

But you are trading less liquid stocks (less than 300,000 shares per day) be very careful with market orders. A ¼ point difference is $250 on a 1,000 share order. A market order guarantees you immediate execution of the trade, but the price may come as a surprise.

A limit order specifies a certain price at which to buy or sell the shares. For example, in the example above you may think that 50 cents is much too wide a spread. You think correctly because once you buy the stock you are immediately at a 17% loss. It is tough enough to make money consistently as a trader without putting yourself behind 17% at the beginning of your trade.

However, you may decide to "split the spread." In this case, you would enter a limit order to buy 500 shares of XYZ stock at $3.25. The limit order means that you are ONLY willing to buy the stock at the specified limit (in this case $3.25) or lower. You will not pay any more than $3.25 per share. However, remember you will only be able to buy the stock if someone steps up who is willing to drop their sell price to $3.25 or lower.

It works the same way for a sell order. Let’s say you bought XYZ stock at $2.50. You are now considering selling it. The current bid/ask is $3.00 to $3.50. The big of $3.00 is what you would get if you place a market order to sell. Remember a market order says to execute a the best price currently available. In this case, that would be the bid of $3.00.

You may want to try to get a bit more though by placing a sell limit order at $3.25. This specifies that you will not take less than $3.25 per share for your stock. If you have 1000 shares, the difference between a limit order of $3.25 and a market order that would be filled at $3 is $250. That is a lot of money to leave on the table.

However, be aware of a very important drawback of limit orders. You are not guaranteed an execution (or a fill in broker lingo). If no one is willing to come down and sell you 1,000 shares at $3.25 per share, you will not be able to sell any shares of XYZ at your limit price.

With a market order you are guaranteed an execution if the stock is available. With a limit order there is no guarantee of execution unless there is stock available at the price you want to pay or sell.

With a limit order also, you are not guaranteed an execution of your whole order if it is more than 100 shares at a single price. For example, you may want to buy 1,000 shares of XYZ at $3.25, but only be able to get 500 shares because there are no other sellers at $3.25. This is called a "partial" fill.

The same works on the sell side. Unless someone is willing to pay the $3.25 you specify in your limit order, you will not be able to sell all or even any of your shares.

If you feel you must buy or as is more often the case you MUST sell, then use market orders.

One other order that you should be very familiar with is the stop order. A stop order is an order most commonly used to protect you from devastating price reversals. You will often see it described as a "protective stop order."

A stop order is a two part order. You use sell stop order to protect buy or long positions. Once you buy a stock, you would place a sell stop order BELOW the current price of the stock to protect yourself in case the price collapsed.

For example, let’s say you bought XYZ at 15. You anticipate a potential profit of 9 points or a move to 24. The best rule of thumb is that your average profit should be at least 3 times your average loss. If you expect to make 9 points, then you should not risk more than 3 points. In this case, you would place a sell stop order at 12, or 3 points below your purchase price.

If the price drops to 12, your sell stop order is triggered and becomes a market order to sell as quickly as possible. It is important that you keep this two part distinction in mind. The sell stop order does not sell at 12, it is merely triggered at 12. That trigger then puts into place a market order to sell at the NEXT price available.

If you are selling short, and naturally you would want to protect yourself in case the stock went shooting higher, you would place a buy stop order ABOVE the current price of the stock.

For example lets say you shorted IBM at 90. You expect it to drop all the way to 75. That is a 15 point drop. You would place a protective buy stop order at 95 (5 points or 1/3^rd your anticipated profit potential). If instead of dropping 15 points, the dastardly stock actually went up, your stop loss order would be triggered if it hit 95, making it a market buy order to buy (or close out your short sale position) at the next trade. That trade may be at 95, or more likely at 95 1/8 or even 95 ¼. But either way, the stop loss would have performed its job of getting you out of a position that was going opposite of your expectations.

Day or GTC Orders

When you place a limit order you need to decide how long you want that order to sit on the books. With a limit order there is no guarantee of execution. You would place a "Day" order if you want the order cancelled at the end of the trading day.

If you want the order to stay on the books for a few days, use a GTC (Good Till Cancel) order. Different brokerage firms have different terms for GTC. Some will cancel all GTC orders at the end of every month. Others cancel the orders after 30 days. Some firms allow you to place a GTC order to the end of the week.

But the important point is that a GTC order stays on the books and does not have to be renewed everyday like a Day order.

If you use GTC orders, be sure to have a good record keeping system. You don't want to forget about an old order on the books that may get filled when you are committed fully elsewhere.

A Sample Buy Order

Buy 1000 shares of SCMR at $4.00 per share, day order.

This order is a limit buy order. It specifies that you want to buy 1000 shares of SCMR (Sycamore Networks) at $4.00 or lower. You will not pay more than $4.00 per share. If the order is not filled immediately it will stay on the books until the close of business the day the order is entered. It will be cancelled at the close of business of not filled.

There are a only a few things which can happen with this order. If no one steps up willing to sell SCMR for $4.00 or lower nothing will be done. You will not buy any stock and the order will expire at the end of the day. No commission will be charged if the order is not filled, though there may be an order charge by your broker.

Someone may be willing to sell some SCMR at $4.00 but not 1000 shares. So you may wind up buying fewer shares than you ordered with your limit order. A seller can always fill part of your order unless you specify the rarely used condition "AON" (all or none) and your brokerage firm allows you to use an AON order. You will be charged a commission for the stock you buy. If the order is partially, say 300 shares, you will pay a commission for that amount.

Finally, you may buy the full 1000 shares at $4.00 or lower. Naturally you will pay a commission for the stock.

A Sample Sell Order

Sell 1500 shares of SCMR at the market.

First be sure that you have 1500 shares of SCMR in your account! This order will be filled (all 1,000 shares sold) immediately when it hits the pit at the best price available when the order hits the floor. A market order WILL be filled.

The fill price may be all 1500 shares at a single price. However, there may also be 2 or more sellers to filling your whole order at two or more prices. You may get $4 for 1000 shares, $3.75 per share for 300 shares and $3.50 per share for the remaining 200 shares. With a market order there is no guarantee of a specific price, though there is a guarantee of an execution.

At any one time, there are typically a number of buy and sell orders of different quantities of stocks that are outstanding for the various market makers for your stock. That is why a market order may not be filled all at once or even with just one market maker. That is also why the fills on market orders may cover a wide range, not just a single price.

Remember what we told you above. The more market makers there are for OTC stocks the better more true the price is. Listed stocks are traded and at least theoretically kept liquid by Specialists. A single market maker can really take advantage of a sizable market order by scaling down the prices it is willing to pay or scaling up quickly the prices it is willing to sell for.

Unfilled and Partial Fills

As we explain above, limit orders may not be filled at all. If no one is willing to pay (or sell) what at the price you want for your stock (the limit price), the order will not be filled. In very thinly traded stocks, low volume issues, there may be few trades on any one day.

Sometimes you may only get part of your order filled, because there was no one willing to meet your full quantity with the price you wanted in your limit order.

You can always adjust your order during the market day or before trading begins the next day. Simply cancel the exiting order, and replace it with a new order specifying new limit prices.

The Keys to Buying and Selling: Watch volume for tip offs.

Volume is a great lead indicator. It is watched closely by professional traders for early tip-offs to coming price action. Try to avoid low volume stocks that trade below 100,000 shares per day. Before buying any stock get a chart or observe it for some time but look not only at price action but at volume activity as well. One obvious advantage of higher volume issues is that the bid/ask spread tends to be much smaller.

Volume is a vital tool for assessing potential turning points. We mentioned above the very important concepts of "accumulation" and "distribution." Volume is the key to understanding these critical concepts.

The general rule of thumb is that you look for volume to confirm the trend. In other words, if the stock price is rising, and volume is also increasing, that is a sign of "accumulation." It simply means that new money is coming into the stock at higher prices, a sign that the big money folks are accumulating the stock. If they are willing to pay higher prices they obviously see something of real value in the stock.

However, if a stock is rising but the volume is falling, that is called "distribution" and is a warning signal that the upside move is running out of gas. It means that the big boys and girls are "distributing the stock" to the public. The only ones dense enough to continue buying it at continually higher prices is the public. That is shown by the lower volume. The big traders trade in much bigger volume. It is true that the big or institutional investors leave tracks despite their best efforts to hide what they are doing.

Volume is the most obvious of those tracks. If you are familiar with the volume pattern of a particular stock you will recognize when unusual volume activity takes place. Often volume will increase prior to a big move as insiders and other people in the know move in to take advantage of the low priced stock before it explodes. One of the key indicators to watch for volume activity is if it crosses above its 50 day moving average. If the stock price is rising and volume moves above its 50 day moving average – bingo! – you have a very promising situations. That is accumulation with an capital "A."

On the other hand, if the price is declining, and you notice that volume is increasing above its 50 day moving average, then it is a very bearish or negative signal. You should look to sell any of that stock you may own, and even consider looking to go short if your other indicators are also negative.

Volume is a good lead indicator to price. Watch it carefully. Try to focus on stocks with a good daily volume that will enable you to move 1,000 to 2,000 or more shares easily. The good volume indicates a consistent underlying interest in the company. If that interest gets stoked by a news development the volume will increase. The heightened liquidity will prove useful for trading.

A support level is a price zone at which buying historically comes into a stock. When looking at a chart, note areas where 4,5 or more closing prices are close together. If that level is below the current price of the stock it is called a "support" level. If you plan to buy the stock due to your research or the advice of your advisory service, buying at support levels when the price dips is a prudent strategy. Volume is a great tip off at both of these levels. If prices have dropped to what is historically a support zone take a close look at volume If the volume fell and is lower than usual at it nears the support zone you can buy with greater confidence.

A resistance level is a price zone where selling historically arises. Just as with support levels review your charts to identify levels at which there are an accumulation of closing prices in close proximity. If this level is ABOVE the current price of the stock, it is considered a resistance level. You would expect sell to come in at resistance levels. Remember, many of those people who bought at that level, as evidenced by the series of closing prices, will be anxious to sell out when the price gets there once again. They are anxious to "get out even", the mantra of the losing trader.

Resistance levels arrest or at least slow upward price moves. If volume drops as prices rise to a resistance zone, then it confirms your signal to sell.

Understanding accumulation and distribution, and how volume helps to define support and resistance levels are among the most important keys to long term investment success.

Timing Signals: The Final Key to Entry of Successful Trades

Proper understanding of entry or timing signals give you the final trigger to enter the trade. A big advantage of a properly understood timing signal is that is carries with an identifiable stop loss point, so you know what your probable risk is BEFORE taking the trade.

Reversal timing signals are fairly easy to spot. A buy reversal occurs when the day’s low is BELOW the previous day’s low, the close is ABOVE the previous day’s close and today’s open, AND it closes in the upper half, and preferably upper third of today’s price range (today’s low to high).

A sell reversal (for selling short or exiting previously purchased longs) occurs when today’s high is ABOVE yesterday’s high, and today’s close is BELOW yesterday’s close and today’s opening price, and the close is in the lower half (preferably lower third) of the day’s range.

That is the classic definition. However, you can look at charts all day and see variations that would be of value. Rather than dismiss these variations, vary your position size based on the type of timing signal you get. For example, we consider gaps and outside days strong timing signals and would take larger trading positions with them than we would with simple reversals.

Reversals

Reversals come in a variety of forms. In the charts on this page we show three common variations on reversals. If you are an aggressive well-capitalized trader who uses a variety of technical tools, then the weaker formation may still provide you with a signal you may want to act on.

For example, say that today the low was lower than yesterday’s low (part one of the definition) AND it closed in the upper third of the day’s range above the previous day’s close (the third part of the definition) but not necessarily above today’s opening.

If your other indicators (e.g., advisor’s recommendations or volume indications) are suggesting a buy, then even though this would qualify as a weak reversal, you may want to act on it. If you normally trade 1,000 shares, then perhaps with the weaker signal you would consider trading 200 shares. With a standard reversal perhaps you would buy or sell 400 or 600 shares. If you get a very strong reversal signal (everything falls into place) you may want to buy or sell your full position of 1,000 shares.

Note that the primary difference between the various signals is the relative position of the closing price to the previous day’s close and the previous day’s high or low. If the closing price is in the upper half of the days range (or lower half for a sell) then you have a signal. However, it is a "weak" signal. It would be stronger if it closed in the upper or lower third of the day’s range.

The strongest signal occurs when the closing price of the signal day closes above not only the close but the HIGH of the prior day (or below the LOW of the prior day for sell signals).

Be careful of being tripped into acting on what looks like a reversal, but the closing price is not above the prior day’s closing price (or below the prior day’s closing price for a sell signal). The close for a buy must be above the prior day’s close.

If the close is above the prior day’s high or below the prior day’s low, it is a stronger signal than if the closing price is simply above or below the prior day’s close.

There are a couple other considerations as well. A stronger signal is made when the day’s range is wider than normal. A volume surge, especially above the 50 day moving average, on the signal day should also be viewed as a confirming sign for the signal.

It sounds confusing, but if you take the time to review charts regularly, these formations will quickly become second nature. And remember, they are only important when you have other reasons to be watching for a signal such as volume or a trusted advisor’s recommendation.

You should never take action based upon any of the timing signals we teach, whether a gap, outside day, reversal, or 3High/3Low, or High/Low itself without having outside confirmation for taking such a trade. Trade entry should be made with a timing signal trigger ONLY when there are sufficient supporting reasons (e.g., volume indications or advisory recommendations).

3H and 3L Timing Signals

A favorite timing signal of successful professionals, that you will not see discussed very much elsewhere is the 3H & 3L. This timing signal, unlike most of the other signals which occur over only two days, occurs over 4 days.

A 3H buy signal (for buying or exiting previous short sale positions) occurs when today’s closing price is higher than the closing prices of all three preceding days. Your protective sell stop order would be placed one or two ticks below the low of the signal day.

A 3L timing signal (for selling short or exiting buys) is triggered when today’s closing price is below the closing prices of the three previous trading days. That triggers a short sell (or exit sell) order. Your protective stop would be placed one or two ticks above the high of the signal day.

It is possible to get 3H or 3L signals when the market is stuck in a tight narrow trading range. The wider the range Signals are more valid when the range is wider. Be careful of acting on signals that occur on narrow range days.

A buy reversal requires that the low today goes below yesterday’s low and closes higher. The problem is that sometimes important trend changes occur without that drop below the prior low (or rise above the prior day’s high) that defines a reversal pattern.

In other words, the market will do what is necessary to make it difficult for most traders most of the time. Rather than waiting for a textbook reversal, the Low/High (L/H), or High/Low (H/L) is another signal that you may see.

A Low/High (L/H) occurs on two consecutive trading days. On the first day, the closing price of the day is no more than 10% of the day’s range from low of the day. [For example, if the day’s range between high and low is $1.00, 10% would be 10 cents. If the closing price is within 10 cents of the low, that confirms the first day’s signal].

On the second day, the range is approximately the same or wider than the first day, but the closing price is within 10% of the high of the day. That confirms a Low/High (L/H) buy signal just as though it was a buy reversal.

Both the Low/High, High/Low and the 3H & 3L timing signals can be refined just like the reversal timing signals we have covered before. For example, if the 3H close is higher than not only the last 3 closes, but the last 4, 5, or 6 days, the stronger the signal. The more days "reversed" by the strong close, the stronger the signal.

It works the same way for the 3L. If today’s close is lower than the previous 4,5, or 6 days , it is stronger than simply reversing the last 3 days’ closes. Watch Low/Highs as well for relationship to previous closes.

Also the day’s high to low range is important. A signal occurring on a wider range day (the range from high to low is larger than usual) the stronger the signal.

Another very useful timing signal, which occurs more rarely than either reversal or 3H signals the chart gap. Professionals will tell you that Gaps are one of the most valuable chart formations for a technician.

An upside gap occurs when the low of a day’s range is higher than the previous day’s high. A downside gap occurs when the high of a day’s range is lower than the previous day’s low. In other words, a gap is an empty spot on the chart.

When Gaps form on charts they indicate overwhelming buying or selling pressures. They reflect a strong change in psychology that occurred overnight or over a weekend when trading was halted. While gaps occur most commonly on daily charts, their appearance on weekly and monthly charts are even stronger signals of intense buying or selling pressure. A gap represents graphically the anxiety of buyers or sellers to enter the market even if it means trading outside recent price ranges. Gaps are used to spot the beginning of a trend, measuring the extent of the succeeding trend, or signal the end of a trend.

There are four types of gaps and it is important that you understand the difference among them. "Common" gaps occur in low volume narrow trading range markets. Typically they are quickly filled with price action in the following few days. Once a gap is filled it is no longer of any value. Common gaps have little predictive value.

"Breakaway" gaps are the most important type. A breakaway gap occurs when prices gap over important trend lines, or over key moving averages such as the 50 DMA or the 200 DMA or out of developing chart formations such as head and shoulders, or consolidation patterns. A breakaway gap indicates that the next significant price move will be in the direction of the gap. For example, if prices gap up over a declining trend line it signals a reversal of the downtrend. If a head and shoulders top formation has developed and the price gaps down below the neckline (the lower level of the formation) it signals a completion of the bearish top formation and a reversal of the up or sideways trend to the downside.

Breakaway gaps are also important support or resistance areas. The gap itself is evidence of intense demand and offers a good point for risk management stops. If you are looking to go long (buy) in a market that has been trending down, a gap over the trend line would be a good signal of the reversal of trend. Place your stop below the gap for a relatively low risk entry.

Once a trend is underway another gap may occur on the chart. This is a "measuring" gap. A measuring gap is used to project the ultimate duration of the trend. Another name for measuring gaps is "midpoint" gap. They are used to project the ultimate duration of the trend. For example, if IBM moves from 60 to 80, then prices gap to 82, the measuring gap would project a move to 102 (the 20 points of the first leg added to the top of the first leg). Measuring gaps like breakaway gaps occur in both bull and bear trends.

Finally, as a trend matures you may see yet another gap near the end of the trend: the "exhaustion" gap. Just as the name implies, an exhaustion gap occurs when the buying or selling pressure has nearly exhausted itself. When you see a gap late in a trend it is a warning of an imminent reversal of trend.

One rule of thumb is that gaps will be filled. What this means is that a genuine gap offers good support or resistance for subsequent retracements or price swings. If a chart gap remains unfilled for a long period it becomes a price objective when the dominant trend finally reverses.

Gaps are very useful timing signals. They offer very visible evidence of supply/demand imbalances and when properly understood can be used to enter or exit markets with less risk. When there is a breakaway price gap up, it is a timing signal to buy. Your protective sell stop would be placed just below the closing price of the prior day.

For example, say that the price of XYZ gapped up today and close at 20. The low today was 18 and the high yesterday was 17½. That leaves a ½ point gap. If the close yesterday was 17, then you would place a sell stop at a tick below 17, say 16¾.

The same would go if the gap was down. Today ZYX closed at 23. The high was 24, and the prior day’s low was 25, and close was 26. That leaves a one point down side gap. You would sell short on the close. Your protective BUY stop would be a tick above yesterday’s close at 26¼.

Finally, you should be familiar with outside days. An outside day buy occurs when the entire price range exceeds the previous day’s price range, and today’s closing price is above yesterday’s close. A stronger buy signal is given when today’s closing price is higher than yesterday’s high. Your protective sell stop on an outside day buy would be one tick below the signal day’s low.

For example, yesterday the range on ZYX was 34 Low, 36 High, and a close of 35. Today the high was 37, the low was 33 and the close was 36. That is a good outside buy signal, but not extra strong because the close was equal to the high, but not above it. Your protective SELL stop would be 32¾.

An outside day sell signal occurs when today’s entire price range is outside yesterday’s price range AND today’s closing price is below yesterday’s close. A stronger sell or short sell signal occurs when today’s closing price is below yesterday’s low. The wider the range the more valid the signal. Your protective stop would be placed one tick above the signal day’s high.

For example, yesterday the range on XYZ was 24 high, 21 low, and a close of 22. Today the high was 25, the low was 19½ and the close was 20. That is a pretty strong sell signal because today’s close is below yesterday’s low. You would go short at the close: 20. Your protective BUY stop would be 25¼.

An outside day is a more meaningful indicator of minor swing direction. The end of extended trends often end with outside days.

A few years ago an advisor tested a simple short term trading system based solely on outside days. Entry was made in the direction of the close on the outside day. A close on the outside day above previous day’s high triggered a buy. A close on the outside day that was below the previous day’s low triggered a short. Protective stops were placed one tick beyond the opposite extreme. This shot term trend system was tested on a number of different markets. Virtually all showed profits for the tested 1 to 5 day holding periods. The most profitable strategy was to exit on the third day. How’s that for an example of a pure chartist’s system?

Summing Up: KISS

A professional floor trader once observed to me that he thought it very funny how trading systems were becoming more and more complex with the advent of computers. Today it is not unusual to see systems with as many as 20 check points to take a trade. He said you will notice that floor traders do not lug huge computers around with them to make a series of complex mathematical calculations. In fact the very idea is absurd.

What he told me changed my whole perspective on trading for the better. He pointed out that the most successful traders in the world are floor traders. They run their business by that age old adage: KISS, Keep It Simple Sam!

In the few pages above we have outlined the components of what makes very successful traders successful. They look at very few things, volume being among the most important. They then act on very few actual price activated signals, the handful of timing signals we detail above.

The secret to success? Be disciplined enough to act when you get a timing signal confirmed buy volume. But most importantly be disciplined enough to cut your losses aggressively. Refusal to face facts and cut losses is the difference between long term success and the usual failure that most traders experience.

Be patient. Be disciplined. Let your profits run. Cut your losses aggressively. And you too will be one of the winners of the very tough, very exciting, and very profitable trading business.

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