Perhaps more important than the CANSLIM method of investing proposed by William O’Neil in his book “How To Make Money In Stocks”is his strict set of rules and his system. They are to never take a loss at more than 7-8%, sell your winners and take profits if you are up 20% with one exception. The exception is that if the stock is so powerful that it breaks out to 20% within a few weeks, it is the stock you want to keep a lot of your money in as it is doing well. If a stock is up 20% in less than 8 weeks, you should at least keep it for 8 weeks. Only after that time period should you consider whether or not you want to hold it longer or not.
So set your stops at 7%, and take profits at 20% This way your wins will be 2.8 times more than your losses, and you will not even need to win morethan you lose.. If the stock hits 20% in less than 8 weeks, that means you will want to wait for a full 8 weeks before you take profits, but move your stops up to break even, or even trail with a 20% stoploss
If you buy into this trading system, you will have to forget about being right or wrong. If your stock starts trading lower, do not adjust your stop.Once your tradeis in place, you will leave it.
This is the actions you might take
1) select a stock using whatevermethods you use.
2) set a market order provided there isn’t a wide spread between bid and ask.
3) set a stoploss 7-8% below the current price.
4) once your stock is up about 17%, remove your stop and replace it with a trailing stop of around 20%. This will still keep your initial stop at 7% below, but as the stock rises, from this point on your stop will rise as well. This allows you to let your profits run.
5) After 8 weeks is up, sell if you are up 20% or mroe. If you are not up 20%, set a limit sell order 20% higher than your purchase price while leaving your trailing stop.
Note that if you trade this way, it doesn’t even matter your stock selection method. Your losers will not go lower than 7% while your winners will go 20% and possibly more. As long as you win 1/3.8 times, or over 26% of the time, (possibly more to account for fees and commission), you will have a profitable system. The only thing that could mess this system up is if you risk too much money at one particular time. Howeverr,According to the Kelly Criterion, with this system, without trading on margin, even if you were fully invested and every single stock stopped out, you would never risk too much more than 7% of your total capital. Theoretically you could have a stock’s company get busted for accounting fraud or get shut down as a business and lose much more than your stoploss might indicate, but with more than one investment that’s more rare. Theoretically, if your stop losses are exactly limited to 7%, as long as you have a 32% chance of winning or greater, this system will still work. If you have more than 27% but less than 32% the system will still work if you keep enough cash on the side. Realistically a 32% isn’t enough to justify investing everything, as there will be some losses that are much larger than you anticipate. If you want to invest everything you would need at least a situation in which you are only risking 1/2 the “kelly criterion” which requires a 37% chance of winning or higher on every trade.
Being that past history is not an indication of future success, that you want to have a higher probability of winning, that there may be better opportunities that you will miss out on if you do not have cash on the sideline, andthat it is better to be safe and show a profit than be overly aggressive and mess up, I would say you would want at least 1/4th kelly criterion. Thismeans the kelly criterion should indicate that the most you can risk is 21% of your capital. This is misleading because a “loss” is not exactly losing everything, it is only losing 7%. your return is not to return 2.8 times your bet either. So a 42% chance of winning is needed. In this case, you could invest 100% of your capital and lose 14 times in a row without even adjusting your investment size and still not lose everything. You would be expected to win 10.5 times on average in that period.
However, you always will want to be on the safe side. That means that you should always trade in a way that has a higher probability of success than 42 by as much as possible, you should generally keep some cash on the side anyways, and you also may want to have a source of income flowing into your investment account so that you can have additional capital. This way a bad streak won’t result in you investing a much smaller amount, and thus require you to win a lot more to get back to even after a loss, due to the lowered bankroll.
How do you determine probability of success? Personally, I like to use the statistics of chart patterns gathered from encyclopedia of chart patterns. A cup and Handle or a double bottom are the two patterns mentioned in IBD aside from the high tight flag which is more rare and harder to identify.
According to Encyclopedia of Chart Patterns, a cup and handle has a 50% chance of reaching it’s target with a 5% break even failure rate. This means that 45% of the time your stock will hit your price target. If you make sure the prce target is 20%, and that you are in a bull market, you will be okay investing in cup and handle chart patterns provided you buy at the breakout point or very close to it (within 3% if you want to have the 42% threshold). However, in bear markets only 27% meet their price target.So it is of vital importance as O’Neil has stressed, to only invest in bull markets as stocks are emerging from solid bases.
What about double bottoms?
Bulkowski made a distinction when looking at double bottoms, an “eve” bottom is more of a flattening bottom, while an “adam” bottom is more of a quick spike to the bottom. Both the adam and then eve bottoms and the eve and eve bottoms are okay to invest in a bear market. if you were extra cautious about the amount of capital you riskm, you could invest in a bear market for the other kinds of patterns as they are at least mildly profitable, however, it’s really not a good idea to try to get a small profit when your money could be gaining interest and saving money on commissions in a money market account with virtually no risk.
Which Chart patterns expects higher gains?
Well the high tight flag is the best and works both in bull markets and in bear markets but is a rare occurance, and takes a little more attention to detail to identify. However aside from this, the double bottom is slightly stronger in all forms in it’s average price gain in bull markets.
Other chart patterns…
You can borrow a lot of the ideas from IBD but still have your own system. Since you have the data of the charts that will hit their price pattern and their average gain, you can simply identify price patterns, factor in the probabilities of reaching their price target, set the stoploss and figure out if the kelly criterion will allow you to be fully invested or not. You can take profits at the actual price target and make no exceptions. Either way, if you set the system up right, it doesn’t matter whether or not you can identify the next Google or not. If you did, you would probably sell before it’s gains anyways, unless it were to run up inside of 8 weeks and you decided to use the exception to the rule
In any case, it doesn’t really matter all that much which stock you select. Amatures worry about the “hot stock tip” and pros will hapily give it to them. However what good is it to have a stock tip if the pro knows it is either going to go up 1000% or down to 0, and will go to zero 7 times out of 10 but sets a stoploss at a 20% loss and only invests a small amount. Their system will work fine, the amature who holds and invests too much capital will get burnt. Meanwhile the stocks that the pro is right on, will be used as evidence to buy into their newsletter as they may actually occasionally uncover a big winner. The point is, the person with the trading system wins, where even a better stock picker who has the odds in their favor consistently will lose money in the long run if they don’t manage money correctly.
Recent Comments