I know, stock trading can be overwhelming.
You’ve got stuff like PE ratios, earnings forecasts, trendlines, price action, support and resistance etc.
How do you know which to focus on and which to ignore?
Well, I’ve got good news for you because it turns out that there are only 5 things to look for before you place a trade, and you can ignore everything else.
Do you want to learn more?
Then read on…
#1: The state of the overall market
The stock market index has the power to determine if stocks are likely to head higher or lower.
When the stock market index is bullish, stocks are likely to head higher. And when its bearish, stocks are likely to head lower.
So, before you think of what stocks to buy, first, determine the current market condition.
You want to buy stocks when the market is bullish, not bearish.
Now you’re probably wondering:
“How do I know if the market is bullish or bearish?”
Well, one simple technique is to buy only if the stock market index is above the 100-week moving average, and stay in cash if it’s below it.
Now, this is not 100% foolproof as you’ll encounter false signals along the way.
But, it’ll keep you on the right side of the markets more often than not.
#2: Look to buy the strongest stocks (ignore the weak ones)
So, once you have determined the broader market condition, what’s next?
Well, it depends on what’s the state of the market.
If the overall market is in a downtrend, then stay in cash. That’s the best thing you can do instead of trying to “fight” the markets.
But if the market is in an uptrend, then you want to focus on buying the strongest stocks out there.
You’re probably wondering:
“What do you mean by strongest?”
I’m referring to stocks which have increased the most in price over the last 6 – 12 months (in other words, strong momentum stocks).
The reason is because stocks which exhibit strong momentum tend to continue moving higher as shown by numerous academic studies like…
- A Century of Trend Following Investing – Hurst, Ooi, Pendersen
- Two Centuries of Multi-Asset Momentum – Geczy, Samanov
- Returns to Buying Winners and Selling Losers – Jegadeesh and Titman
So how do you filter for the strongest stocks out there?
Well, you can use a platform like Thinkorswim and run a scanner on it.
- Select the market universe to run your scan on (e.g. Russell 1000)
- Rank the stocks according to their rate of change (ROC) over the last 50-weeks, from highest to lowest
Step 1: Selecting Russell 1000 as the market to scan on ThinkorSwim
Step 2: Ranking the scanned stocks based on their Rate of Change
Not difficult, right?
#3: The stock must be in an uptrend
Most of the time, the strongest stocks are already in an uptrend.
Still, there’s no guarantee (especially during a recession).
So, one way to go about it is to only buy stocks which are above their 200-day moving average (MA).
But why the 200-day MA?
Well, according to the book The Alpha Formula by Larry Connors and Chris Cain, they found that stocks above the 200-day moving average tend to move higher (and stocks below it tends to move lower).
Here’s an example…
Google 1-Hour Timeframe:
Now you might be wondering:
“Should I use simple or exponential moving average?”
It doesn’t make a difference because the concept is what matters—not the best settings or parameters.
#4: A valid trading setup
- The overall market is bullish
- You’ve identified the top 5 strongest stocks
- The 5 stocks are in an uptrend
At this point, the odds are in your favour because you’ve identified the strongest stocks in a bull market.
But the question is, when do you pull the trigger?
Well, you can use chart patterns like:
- Bull flag
- Ascending triangle
- Breakout with a buildup
The bull flag is a trend continuation pattern that consists of two legs.
A trending move which is the “stronger leg” of the trend and a retracement move which is the “weaker leg” of the move.
Here’s how it looks like…
Shopify Daily Timeframe:
Trading the bull flag pattern is straight forward.
You can buy when the price breaks out of resistance with a buy stop order and have your stop loss 1 ATR below the lows of the flag pattern.
The ascending triangle a bullish chart pattern that signals the market is about to head higher.
It looks like a series of higher lows coming into resistance.
Here’s how it looks like…
Boeing Daily Timeframe:
To trade the ascending triangle pattern, you can place a buy stop order above the highs of resistance, and if the price trades above it, you’ll get into a long trade.
Breakout with a buildup
The breakout with a buildup is another bullish chart pattern which signals the buyers are in control.
It occurs when the price approaches resistance and forms a tight consolidation (otherwise known as a buildup).
This is a sign of strength as it signals the buyers are willing to buy at higher prices (despite the price being at resistance).
Here’s what I mean…
MSFT Daily Timeframe:
The trade execution is similar to the earlier chart patterns. You can buy when the price breaks out of resistance and have your stop loss 1 ATR below the lows of the buildup.
Anyway, if you want to learn more, then check out Stock Chart Patterns That Work.
For now, let’s move on…
#5: A sound exit for profits and consistency
Here’s the deal:
You can identify the best trading setup, pinpoint the finest entry, and buy the strongest stocks.
But you’re not going to make a single cent till you exit your trade—and that highlights the importance of your exits.
So now you’re probably wondering:
“So how do I exit my trades?”
Well it depends on your goal, whether you want to ride a trend or capture a swing.
Let me explain…
How to ride massive trends in the stock markets
The secret is this…
You must use a trailing stop loss.
This means you won’t have a fixed target profit, but instead, trail your stop loss as the price moves in your favour.
For example, you can use the 200-day moving average to trail your stop loss.
Here’s what I mean…
S&P 500 Daily Timeframe:
If you want to learn more, then go read this post on trailing stop loss techniques.
How to capture swings in the stock markets
As a swing trader, you want to capture one move in the markets—and exit your trade before opposing pressure steps in.
Some of these areas include:
- Swing high
- Fibonacci extension
Here’s an example of exiting your trade before resistance…
United Airlines Holdings Daily Timeframe:
Here’s a recap of what you’ve learned:
#1: Pay attention to the overall state of the market. If it’s bearish, then hold onto cash. But if the market is bullish, then move onto the next step…
#2: Identify the strongest stocks out there. You can rank stocks according to the largest % increase over the last 50-weeks.
#3: Filter out the top 20 strongest stocks and make sure they are in an uptrend (above the 200-day moving average)
#4: Wait for a valid trading setup like a bull flag, ascending triangle, breakout with a buildup, etc.
#5: Have a plan to exit your winners, it could be riding a trend or capturing a swing.
And there you have it!
The 5 things to look for before you place a stock trade.
Now over to you…
What are some of the things you look for before you place a trade?
Leave a comment below and share your thoughts with me.