Sunday, March 15, 2015

Building a Trade: 1. Finding Intriguing Setups

Markets move up and down in a seemingly irrational way, how do we make heads or tails about when and what to buy? I want to walk through my trade process starting from the beginning to show just how it is I approach a new potential position. This will be a multi-part series as we identify and select, enter, manage, and then exit a trade. (note, this process will take some time. Finding quality setups and playing out a trade is a long process. But I hope this will be rewarding to you.)

Finding Intriguing Setups

Everyone has a different method for how they identify new potential opportunities. Some use screeners that select stocks based on certain fundamental and technical criteria. Others simply scan charts of a particular index like the Nasdaq or S&P100. However you choose to search for new trade setups, you should be looking for the highest risk/reward ratios; opportunities should present the lowest risk possible for your strategy while still leaving maximum potential reward.

I prefer to use some sort of fundamental filter to insure I'm finding the strongest most stable companies, or that display high growth metrics based on Earnings and Sales increases. 

While I feel it's very difficult to be a "fundamental only" investor, knowing the stock in question is strong can be very helpful when considering a position. Once I identify a strong company, one that's showing positive Sales and Earnings trends, I'm then ready to put it through more rigorous technical analysis.

Once I have identified strong fundamental stocks I simply start looking at charts. Weekly timeframe, Daily, etc. There is no way around it, if you wish to succeed at selecting stocks you will have to look at tons of charts. An important technical scanning criteria can help with this initial process. I only consider a stock to be "strong" if it is at least making new 50-day highs. It can have the best fundamental story in the world, but if the market is not rewarding that story then it doesn't matter in terms of short-term profits.

To recap so far:

-Potential candidates should be displaying strong and increasing EPS and Sales growth
AND
-Should be making at least new 50-day highs, preferably new 52-week highs.

Using this criteria I have recently found the Banking and Regional Banking space quite attractive. My initial filtering process has uncovered several strong opportunities: HOMB, SFNC, SBNY, LION, and PACW.  (click on a ticker symbol for an overview on Finviz.com. My preferred stock screen).
All of these stocks show strong recent Sales and Earnings growth as well as fairly inexpensive valuations. Several pay dividends as well (always a plus). Now that we know they are all fairly comparable with regards to Fundamentals, we need to look at the charts to see which offer the best opportunity.

Weekly Bars

HOMB (Home Bancshares)
Current price: 33.95
Initial stop: $31.30
Distance from entry to stop (Risk): 7.6%

SFNC (Simmons First National)
Current price: 44.33
Initial stop: 39.65
Distance from entry to stop (Risk): 10.5%


SBNY (Signature Bank)
Current price: 131.32
Initial stop: 123.35
Distance from entry to stop (Risk): 6%


LION (Fidelity Southern)
Current price: 16.91
Initial stop: 15.69
Distance from entry to stop (Risk): 7.2%


PACW (PacWest Bancorp)
N/A
No entry due to lack of breakout highs

I think you could throw a dart at this screen and make the case for any of these positions as new entries. But here are a couple things I notice right away:

First PACW has not broken above recent highs like the others have. So right away that one is eliminated (although I feel they do offer the best fundamental structure currently, go figure).

Second I want to look for the distance from current price (entry point) to where I would place my stops:

HOMB- 7.6% risk
SFNC-  10.5% risk
SBNY-  6% risk
LION-   7.2% risk

SFNC is simply too extended relative to the other 3 options, so it gets the boot.
Based strictly on initial risk SBNY looks the most attractive. But since there is only a ~1% difference between the Top 3 candidates I want to look a little closer at the Fundamental picture to see if anything stands out to tip the scales.

Upon reviewing HOMB, SBNY, and LION I notice a couple things:
SBNY pays no dividend and has 95.5% Institutional ownership
HOMB pays a 1.47% dividend and has only a 54.2% Institutional ownership
LION pays the best yield at 2.13% but has a 64.3% Institutional ownership

I don't pretend to know much about Institutional ownership trends, but logically the lower the Institutional position in the stock, the larger potential upside remains should it attract attention.

Therefore I'm eliminating SBNY (but really its so close to call, no problem with buying this stock here).

The final contenders are HOMB and LION. Almost identical initial risk , very close dividend payouts and similar chart formations. What I want to do is now zoom out these charts and see which has performed the best over the long-term:

HOMB Monthly chart

LION Monthly chart

Its abundantly clear to me that HOMB has shown the least downside volatility and especially solid performance during the financial crisis in 2008-2009. While both have rallied dramatically off recovery lows, I prefer the lower downside risks HOMB has demonstrated. This is no guarantee of future results, but we are looking for any edge we can find.

Based on this analysis I will be entering a position in HOMB at Monday's open (3/16/15)

Going back to the weekly chart, I will be purchasing a 1R portfolio risk with initial stops at the 31.30 weekly swing lows and rising 20 WMA.

 Using a $10,000 account size as an example, we know we can risk up to $100 as our 1R (1%) of account equity. That means with a stop at 31.30 and entry near 33.95 we can purchase 38 shares or about ~$1,300 worth. (33.95-31.30=2.65) $100/2.65=37.7 shares

As the trade develops I will discuss the ongoing management as Part 2 of our study.

Good Luck trading!

1 comment:

  1. s&p 50 DAY AND 200 DAY. ARE WE WE APROACHING DEATH CROSS TERRITORY?

    ReplyDelete