6 Steps to Profitable Swing Trading

Part 3: Go Where the Oil Is

TLDR: Trade stocks with relative strength, momentum, trend, volatility, strong fundamentals, and low float/capitalization

J. Paul Getty once said, "The best way to find oil is to go where other people are finding it." This might seem like a “no shit” kind of statement, but you’d be amazed at how many people ignore the simplicity of this wisdom from one of the greatest oil tycoons and richest men in history.

When I trade, I'm always trying to isolate positive trading environments, identify the strongest trends, sectors, and themes, and focus on the stocks with the most potential to go up the fastest and furthest in that positive backdrop. In other words, the starting point of finding good stocks is to Go where the oil is. Go where the fish are biting.

I isolate the best trading opportunities when a whole host of factors converge. I never limit myself to one particular sector or theme because there is always a rotation between what is hot and what is out of favor. Today Internet-related stocks are. Tomorrow it might well be oil stocks. Or it might be gold or currencies. Though, I will note the VAST majority of the biggest winning stocks have come from three main sectors: Technology, Consumer, and Healthcare.

The foundation of my approach to trading is to spend most of my time assessing market conditions and looking for the strong stocks with the most potential to buy. Only after I have done these two things - wait for a positive market environment and isolate the strongest stocks to trade - do I look for low-risk, high-reward patterns that justify an actual trade.

Most novice traders look for mechanical trading systems, holy grail indicator settings, or market timing theories to predict major market tops or bottoms. Technical analysis offers many valuable tools that help you to anticipate future market action and I use some of them myself. But the real key is to wait for the right market environment and the strongest stocks to trade in the first place so that you already have the home-court advantage when you apply your arsenal of trading tools. This is where the bulk of profits come from.

Step 3: How do I find the fastest stocks with the most potential?

A study by Hendrik Bessembinder, a finance professor at Arizona State University, found that most of the stock market's gains over the long run have come from a small number of outlier stocks. In fact, just 4% of stocks accounted for all of the market's gains between 1926 and 2016. These stocks are often referred to as "super stocks."

Finding these outliers - these “super stocks" - is our goal. However, we don’t do this by guessing which stock will be the next big leader. Even if you found the next Apple or Cisco, your 200 shares will do little to increase the stock price. It takes persistent buying for weeks and months by institutions with big pockets and teams of analysts. Since the institutions won’t be calling us up anytime soon and telling us which stocks they’re interested in, how do we find these leading stocks?

Relative Strength

Leading up to writing his book “How to Make Money in Stocks”, William O’Neil conducted an extensive study of the biggest winning stocks in history, where he tried to uncover the common characteristics of these big winners. He states:

“From the early 1950s through 2008, the average RS of the best stocks before their major run-ups was 87. In other words, the best stocks were already doing better than nearly 9 out of 10 others when they started out on their most explosive advance yet.”

Studies from Standford Ph.D. Tom Johnson found that Relative Strength was the most consistent, reliable, and robust variable contributing to portfolio performance. It single-handedly improved profit better than anything else tested.

To further drive home this point, Marc Boucher of Hedgefund Edge uses a simple example:

One day, two fictitious traders, who I'll call Mr. Timing and Mr. Selection, decide to engage in a trading contest. Each has their own speical talent:

• Mr. Timing is able to buy an index fund just prior to every market rally of 10% or more and exits right at the top just before the onset of the next decline.

• Mr. Selection invests 100 percent of his funds in the top-performing sector fund each year. He does not employ any market timing strategies whatsoever, so he is in the sector fund whether it is going up or down.

Who do you think will win this competition?

For the sake of argument, let's pretend that index funds and sector funds have actually existed for many decades. If we do this:

• From 1940 to 1973, Mr. Selection made over 30 times as much money as Mr. Timing.

• From 1980 to 1992, Mr. Selection's bottom line results still beats Mr. Timing's by 4 to 1.

While this story was fictional, the data is not - selecting the strongest markets leads to the strongest outcomes.

Another way to use relative strength is not by the value or RS number, but by the RS line - looking at the slope. In the Kuhn-Marder Intermediate-Term Momentum Course, Kevin Marder wrote:

“Specifically, I look for a stock to show a rising RS line over the past eight to 13 weeks. This tells me that the market—which is all that really matters—likes a stock more than it does the average stock.”

Hedgefund Manager Gregory Kuhn further explains his method:

“Basically, a stock’s relative strength line, the line that measures a stock’s performance against the S&P 500, should either lead a stock into new high ground or accompany it into new high ground as the stock breaks out of a basing pattern.”

Nearly every top winning momentum trader that I’ve ever studied, whether we’re talking Zanger, Kell, Kacher, Morales, O’Neil, Minervini, Qullamaggie, Darvas, Livermore, Boucher, and many others, all used some form of relative strength as a basis of finding the biggest winning stocks. We don’t just go out and randomly buy these stocks - there’s obviously more to it than that. However, RS is a great starting point for finding the stocks with the most potential.

Momentum

Another important but less talked about aspect of winning stocks is momentum. The momentum effect refers to the tendency of stocks that have performed well in the recent past to continue to perform well in the future. A study by Narasimhan Jegadeesh and Sheridan Titman found that a momentum-based investment strategy that buys past winners and sells past losers generated significant abnormal returns over a long period of time. There is a tendency for momentum to beget more momentum. This is the basis of nearly all continuation pattern strategies.

There is often confusion between relative strength and momentum, as many assume they are referring to the same thing. However, there are clear differences.

• Relative strength measures one asset’s performance vs other assets.

• Momentum measures the magnitude or speed of an asset over a certain time period.

In other words, a stock with momentum almost always has high relative strength, whereas a stock with relative strength doesn’t always have momentum. Let me explain:

During corrections or downtrends, most stocks will follow suit. However, some stocks will drop less than others and will actually hold above key moving averages while their peers perform far worse. This is a sign of relative strength or relative outperformance. However, this isn’t momentum - the stock isn’t moving up quickly - it is merely moving down less quickly.

In fact, some of the stocks with the best “relative strength” during corrections and downtrends are low-beta defensive names that are perceived to be “safe” investments to store capital. Oftentimes, these slower, larger stocks, which are not traditionally seen as RS or momentum stocks, can outperform growth by large margins.

The best way to gauge momentum is not by comparing stocks when the market is correcting, but by comparing them once the correction has lifted. Which horses race out of the gate the fastest once the race starts? Look for the stocks with the greatest magnitude of gains in the first 2-4 weeks of a new rally.

While this means you’ll have to miss that initial leg up, it also means you won’t be wasting time sitting on laggard stocks that you “hope” move, even though they’ve really proven nothing. The stocks that make the biggest first legs often go on to make the biggest overall moves. A stock with a 50% first leg, after a few weeks of break, can go on to make hundreds or thousands of percent gains through the life of the move.

This is the basis behind famed trader Kristjan Kullamaggie’s flag setup. He wants a “big move higher sometime in the past 1-3 months. This move can be anywhere from 30-100%+ and usually lasts a few days to a few weeks.” This shows the stock has momentum and power before it formed its consolidation pattern. If the reasons still exist for the initial leg up, the stock can follow through significantly.

Trend

Trend-following is an investment strategy that involves identifying and following the direction of an asset’s trend. The goal is to buy an asset when its price is upward and sell it when the trend reverses, and the price begins to fall.

This type of trading is based on the idea that markets tend to move in trends that can persist for a significant amount of time and that these trends can be identified using technical analysis. Trend-following traders use indicators such as moving averages and trendlines to identify and confirm trends.

Some of the most famous trend-following money managers are:

1. David Harding: Founder of Winton Capital Management, which manages over $30 billion in assets. Harding is widely considered one of the pioneers of trend following and his firm has consistently delivered strong returns.

2. Ed Seykota: A legendary trader who is known for his pioneering work in computerized trading systems. Seykota's trend-following strategies have been highly successful over the years.

3. Bill Dunn: Founder of Dunn Capital Management, which has been managing trend-following strategies since the 1970s. The firm has consistently delivered strong returns over the years, even during periods of market turmoil.

4. John Henry: Founder of John W. Henry & Company, which manages over $2.5 billion in assets. Henry is also the owner of the Boston Red Sox and Liverpool FC. His firm's trend-following strategies have been highly successful over the years.

5. Richard Dennis: Founder of C&D Commodities, which was one of the most successful commodity trading firms of the 1980s. Dennis was known for his trend-following strategies and his ability to identify profitable trades.

While trend-following long-term isn’t for the faint of heart, the sustained success and outperformance by these giants of the industry point to the value of finding and sticking with big trends once they’re in motion.

Another popular perspective on trend trading is the use of stage analysis. Stan Weinstein's stage analysis analyzes stocks and other financial instruments by dividing their price movements into four stages: basing, advancing, topping, and declining. The method is based on the idea that stocks go through predictable patterns of behavior, and by identifying which stage a stock is in, traders can make more informed decisions about when to buy, hold, or sell.

1. Basing Stage: In Stage 1, the stock price is consolidating after a significant decline. This is typically marked by a period of sideways trading and low volume. Traders may look for signs of accumulation during this stage, such as higher lows or an increase in volume.

2. Advancing Stage: In Stage 2, the stock price starts to break out of the basing stage and shows an upward trend. Traders may look for signs of strength during this stage, such as higher highs or increased volume.

3. Topping Stage: In Stage 3, the stock price reaches a peak and starts to show signs of weakness. Traders may look for signs of distribution during this stage, such as lower highs or decreasing volume.

4. Declining Stage: In Stage 4, the stock price falls sharply, often breaking below key support levels. Traders may look for signs of panic selling or capitulation during this stage.

By using trend-following and stage analysis strategies, traders can identify when a stock is in a strong trend and when it may be ready to reverse course. This can help traders make more informed decisions about when to enter or exit a position, and can also help them manage risk by setting stop-loss orders at key support levels.

As famed trader Ed Seykota once quipped, “The trend is your friend until it ends.”

Volatility

Stock volatility is the degree of variation of a stock's price over time. It measures the degree of uncertainty or risk associated with an investment in a particular stock. Volatility is often expressed as a percentage and can be calculated using various methods, including standard deviation or beta coefficient.

High stock volatility means that the stock's price fluctuates significantly, indicating a higher degree of risk and uncertainty associated with the stock. Conversely, low stock volatility indicates that the stock's price is relatively stable and less subject to sudden price swings. Uncertainty isn’t necessarily bad - in an “efficient market”, we WANT inefficiency and uncertainty - that’s where big price moves come from.

Investors and traders use volatility as an important indicator when making investment decisions. Some investors may prefer stocks with lower volatility, as they tend to provide more stable returns over time. Others may prefer high-volatility stocks, as they offer the potential for greater profits but carry higher risk.

Dan Zanger attributed much of his success to finding and trading "frisky" stocks, which have a lot of volatility and potential for big moves in a short period. By the same measure, Kristjan Kullamaggie advises only trading stocks with an average daily range of at least 5%, usually, higher, for traders with smaller accounts. This is because these “frisky” stocks can make the biggest moves in the shortest amount of time, allowing smaller accounts to compound their money faster.

Volatility is a subject worthy of intense study - in fact, all of my chart patterns in the next part of the series are tied in some way to the concepts of volatility expansion and contraction. For now, know that more volatility means more risk and more potential for reward. If you want to get to the finish line faster, we want the fastest car and the fastest horse. Riding these stocks properly requires a great deal of skill, but that’s for future conversations.

Fundamentals

This is the one section where I had the most trouble, to be honest. While many of the greatest traders in the world swear by fundamentals, other great traders dismiss them. Ed Seykota said:

“Fundamentals that you read about are typically useless as the market has already discounted the price, and I call them ‘funny-mentals’. However, if you catch on early, before others believe, you might have valuable “surprise-a-mentals”.

Stan Weistein echos this sentiment in his book Secrets to Profiting in Bull and Bear Markets, where he points out numerous examples of stocks with strong, growing earnings that dropped precipitously. This gets into a far deeper discussion regarding PE multiple expansion, explained by Mark Boucher in Hedgefund Edge. Still, many great traders disregard fundamentals either outright or partially.

So what is the big deal with fundamentals?

The reason fundamentals matter on some level is basic supply and demand - with huge demand coming from institutions. Imagine Cisco, Microsoft, Apple or Tesla in their early days, when their fundamentals where growing like crazy - before they became large-cap stocks that everyone knows about and before their growth rates slowed considerably. Now imagine you’re a fund manager responsible for finding the best growth names out there for the next 5-10 years. Think Cathy Wood, but with better risk management.

There are hundreds of growth-oriented funds that MUST invest in these hot growth companies - in the cut-throat world of finance, where performance matters, getting into these stocks at an early stage could mean the difference between being a superstar or a super dud. This leads to demand for those shares for quarters, possibly years or decades - as the company continues to grow and post big numbers and projections, these funds accumulate more shares.

So it isn’t necessary to believe in “funny-mentals” but because these fund managers do, and their analyst projections are based on a company's current and future growth, it is important to consider them as an important fuel for sustained price appreciation.

Ultimately, it’s not who you think will win the beauty pageant but who you think the judges will pick. It is the coat-tails of the deep-pocketed institution that we want to ride.

This gets us into the slippery, subjective slope of which judges, which criteria they might use, and how they might judge certain aspects over others. Do I use current growth or future growth? How much growth? Oh, that’s too much growth - is it sustainable? ROI vs ROE? Sales - no wait, Price to Sales because we don’t want to pay too much for those sales. And on and on it goes ad naseum. This dizzying onslaught of “important” fundamentals - emphasized by analysts who have never made a dime trading in most cases - becomes an endless circle jerk.

Use fundamentals at your own discretion - there are countless articles and books out there on what “growth” means. I, personally, have never found much value in them and take almost a purely technical approach. The ONLY time I use fundamentals is when I’m trying to, perhaps, whittle my 20 stock watchlist down to 5 or 6 - then I might use a simplistic question of “Which one of these stocks has SOME kind of noteworthy fundamentals?”

Maybe the stock has strong current growth or strong projections, or if they have no earnings, they have strong sales growth. Something - I need to be able to point to something noteworthy in their fundamental picture quickly. Not that I think it matters much, honestly, but maybe it makes me feel better about kicking certain stocks out of my watchlist.

Float and Capitalization

In his article “Revisiting Float”, Stockbee discussed the importance of float and why it matters to finding big winners. He said in studying the biggest winning stocks year after year:

“Essentially there are four types of stocks which make sharp moves in short time frames.

1. Stock with high earnings or sales

2. Volatile or high beta stocks like biotechnology and technology stocks

3. Neglected and beaten down stocks

4. Low float stocks

After analyzing the 50% and 100% list for years, I have found these are the four main characteristics that increase the probability of a stock making a big move in short time frames. In all the 3 factors mentioned above, if there is low float, there is further move accentuation.”

Top traders like Dan Zanger realized the importance of low float early. Zanger commented in an interview, “I combine these patterns with stocks that have unusually higher rates of growth and low number of shares that float. For the average stock I list, growth rates must be up at least 40% for both earnings and revenues growth for their most recent quarters and most stocks that I list have growth rates up 80, 90, 100 and sometimes up 200% and more. It's these high growth rates combined with stocks that have low number of shares that float that make them so explosive.”

Similarly, Nicolas Darvas, the famed Hungarian dancer turned stock trader millionaire, would seek out new, young stocks with low capitalization and float in growing industries with strong growth rates. As Zanger noted, it’s the combination of low float/capitalization and strong growth that propels these stocks to staggering heights.

Why is that? It goes back to supply and demand. Remember back to the section on fundamentals. Imagine all of these funds accumulating shares of these young hot stocks, but there’s only so much supply to go around. The small float and small capitalization combined with the strong demand for shares drive these stocks higher and higher, leading to these massive price appreciation trends.

Practical Application

So in a nutshell, when looking for stocks with the most potential for the biggest moves, you want to focus on the following:

1. High Relative Strength - the higher to better, but most top traders focus on a minimum of top 20%, while others, like KK, use top 2%.

2. Strong Momentum - you not only want strong RS, but a strong momentum move that proceeds the base or flag you’re trading. You want a strong first leg up of at least 30-50%, followed by a base or consolidation.

3. High Volatility - low volatility stocks are more stable, but they also don’t move very fast. Focus on stocks with at least an average volatility of 3%, preferably 4-5%+

4. Strong Growth - this one is more subjective, but if you use fundamentals, at a minimum find stocks with strong current growth - say, 25% YoY growth in the last few quarters. Or use future growth projections of at least 25% in the next two FYs. The higher the better. This is the minimum - look for triple digit or high double digit growth numbers, showing strong growth trends. Preferrably, you want sales to be just as strong, indicating a strong top-line growth. You can inflate earnings with accounting tricks, but you can’t really inflate sales.

5. Low Float and/or Capitalization - most studies indicate that less than 25 million float and small/mid-cap stocks are the fertile grounds where big moves are found. Some float studies indicate that less than 100 million is the best. Whatever metric you use, avoid stocks with hundreds of million in float or more - they are almost impossible to move in a meaningful way, short of some significant change to their business model - think Apple.

In Part 3 of this 6 part series, I discussed the criteria that make for the fastest moving stocks in the market, based on history and research/experience of some of the top traders in the world. Ideally, you want stocks with high relative strength, strong momentum, solid fundamentals, a lot of “friskiness”, and a small supply. That doesn’t mean you just go out and buy anything that comes through your scans. You need a low-risk platform, pattern, or base from which to initiate your purchase.

In Part 4, we will discuss the specific setups and patterns that top traders use to isolate the highest reward opportunities the market has to offer.

Stay Tuned!!