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!

Lg-Cap Review: Top Performers Lead

Markets remained volatile this week with the SP500 declining -1%. Notable relative strength was seen in Small Caps as the Russell 2000 posted a gain of  +1%.

We had no new entries in our Lg Cap portfolio. Due to the nature of this environment, my growth portfolios have been performing better and showing more potential new opportunities. There just isnt much within the SP100 that looks ready for good R/R. Banks are getting close like WFC and GS. But it is the Small and Mid Cap Regional bank space that looks most interesting.

Russell 2000 Small Caps vs SP500 Lg-Caps 

The media has all sorts of reasons "why" we are seeing a discrepancy between Large and Small Cap stocks here: a strong Dollar, speculation on rising interest rates, falling Energy prices, etc. While all of these are factors, its impossible to say when or if these conditions change. That is not our concern. What we need to focus on is how to navigate this environment and continue to profit in a volatile market. 

Despite this "changing" environment, our top performing holdings continue to show standout strength and managed to achieve gains this week.  

SBUX

DIS

UNH

BMY

This is why its so important to stick with winning positions. They tend to continue winning in the face of all the "fears" swirling around the financial media. Nobody knows when an uptrend will end, but by sticking with the best performing stocks, you give yourself the best possible chance of outperforming. 

We also saw many of our holdings begin to test key trend support this week as the markets remained under pressure. While all these remain above our stop levels, it will be important to see how they deal with their initial supports. 

BA

Boeing isn't anywhere near stops or any kind of meaningful support. For that reason its foolish to try to time when this trend will end. Just stand back, let it come in a bit and build some sort of consolidation. We need to let the market tell us where the buyers are instead of guesses or "feelings". 

That being said, we can trail stops up to just below our entry near $130. A break of that area would suggest the breakout is failing. It would also take out the 20 WMA and make new 50-Day lows.

Don't worry about giving back our measly 15% open gains here. Give it some room to see if it can become the winner that makes our year. Maybe it does, maybe it doesn't...Who knows? Anyone that says they know is lying.

*I heard a little secret too...When Goldman downgrades a stock its not to sound smart if it comes down, its to buy a strong stock cheaper if traders sell it due to their commentary.

Stick with BA.

PPG

We are raising trailing stops to $219.80. A breakdown from there would suggest more caution ahead.

IP

Also raising trailing stops to the lowest close of the last 10+ weeks. 

HON

TWX

AAPL

CSCO

LMT

UNP

PCG

With the exception of UNP and PCG, all of our positions are in clear uptrends and ABOVE all key support levels for our time frame.

UNP and PCG are in the midst of solid pullbacks, -9% and -16% respectively from their all-time highs. Stops are nearing, I will be watching these closely for some new buying interest and stabilization.

Sometimes we give up gains as trend traders, but its because of this behavior of sticking with winners that we are also able to catch the most remarkable moves in the market. The is no free lunch. To achieve outsized winners you have to willing to sometimes watch open profits fade, its just the price we pay as big trend participants.

Thanks for reading. For weekly updates and new trade ideas, Follow on Twitter and Stocktwits @ZenTrends.

Lg Cap Portfolio Review

The market took a rest this week with the SP500 declining -1.6%. The pullback appears to be little more than a retest of the prior breakout level and polarity support at 2,065. The two levels to watch going forward will be this 2,065 retest and most importantly the swing lows at 1,995.

SP500 weekly chart

While Friday's reaction to the better than expected Payroll number was a bit disconcerting, the intermediate trend remains higher as we continue to see higher highs. You have to be willing to stomach a little volatility if you wish to remain aligned with long-term trends. This is why we have rules in place to encourage us to act in a competent way when stress begins to elevate.

Looking at our Large Cap Portfolio this week, we do have one Exit and no new entries. After a 14-month run we will be closing our 20+ Year Treasury Bond (TLT) position. While rates and rate sensitive names continue to get beaten, the overall picture for our portfolio remains on solid footing.

EXITING TLT

It was a good run for our Treasury position. While we did give back some gains at the end (as will always be the case with a trend based strategy), clearly we stuck to our trade until the trend showed serious signs of deterioration.

With the convincing break of support this week, we will step aside collecting a 15% gain and all those 1st of the month payouts along the way. Overall it was a super trade and we stuck with our plan all the way.

This week we are going to look at our remaining positions on a Year to Date basis to see how each is performing so far in 2015. The SP500 is currently sitting on a 0.5% gain for the year.

Daily Charts YTD

SBUX

Stop: $79

BA

Stop: $120.75

DIS

Stop: $90.95

UNH

Stop: $100

BMY

Stop: $57.50

AAPL

Stop: $106

IP

Stop: $51.50

HON

Stop: $95.88

LMT

Stop: $188.35

CSCO

Stop: $26.35

PPG

Stop: $219.80

TWX

Stop: $77

UNP

Stop: $111.90

PCG

Stop: $49.50

10 out of our 14 holdings are currently outperforming the SP500 so far in 2015. What we need to focus on closely are our lagging positions. Winners take care of themselves, so we have nothing to do there except continue to let them work. 

Stops are in place to protect our account from suffering too large of a loss. As long as we stick to our plan of cutting our losses quickly and letting our winners run, we will be just fine.

Most of our holdings have seen reasonable consolidations after making new highs and no further action is required at this time. PCG and UNP are our most vulnerable holdings currently and will need to be watched closely.

Everything else looks just fine and to abandon those winning positions now would only be due to an emotional/fearful reaction. Always make your plan when the markets are closed, and most importantly always stick to that plan.

Follow on Stocktwits and Twitter @ZenTrends for up to date charts and market reaction.

What NOT to Look For

Energy still looks lousy

Last week I posted what to look for when buying a stock. These were high probability setups for strong upside with limited risk.

Oil and Oil Stocks look about as opposite to that as possible. Today we're looking at the Top 10 holdings of the Energy etf, XLE and Lumber Liquidators.

WEEKLY CHARTS

XOM

CVX

SLB

KMI

EOG

COP

OXY

PXD

APC

WMB

With the exception of KMI, which is still in a manageable uptrend, the entire Energy group looks weak and in a clear downtrending cycle. I know this is the area most people are focused on and trying to call the bottom in oil. But this trading behavior is the best way to implode your account equity.

Oversold can become more oversold and cheap can always become cheaper. These are not reasons to own downtrending stocks, they are excuses for losing money

Energy will present a fantastic opportunity, eventually. But we must be patient until the trend begins to turn in favor of the Bulls.

Garbage IN, Garbage Out

Lumber Liquidators (LL) Weekly chart

The big story in the news this week was the investigation and obliteration of Lumber Liquidators. A 60 Minutes expose discovered some major health and quality violations and the stock is currently down -45% from last Friday's close. That's horrendous.

What's more horrendous is that people are actually Long this stock!! 
I mean...WOW! Really?! What possible reason could people have to own this stock at any point in the last year?

As you can see LL has been trapped below a declining 20 WMA since the end of 2013 and is down more than 66% from the initial violation of the 20 WMA on 11/22/2013. Each attempt at a rally has failed at or near the declining 20 WMA.

Momentum (a lagging indicator) has been in a bearish range since April of 2014. That "lagging" signal still came at a weekly closing price of $85.68...Still a 61% markup from today's close.

If you had disregarded all of that prior decline and sold at the close LAST WEEK, you would have saved yourself 45% of your position equity.

Its never too late to sell, but the point is you should never be in a situation like this to begin with. The time to exit this stock was in early 2014 after seeing lower lows and lower highs while Momentum broke into a downtrending environment.

If you adopt a trend based approach you won't pick the bottoms and get out at the tops, but you will also never implode your account by falling into the trap of buying a meltdown. Most advisors will talk about compounding returns and long term results. But research has shown that avoiding negative compounding is much more beneficial in the long term.

If you lose 50% of your money it will require a 100% gain just to break even. Avoiding losses is the #1 thing you can do to improve your long-term returns. To do this you need only to identify highly probable situations and have the discipline to stick to a consistent strategy of buying winners and not buying losers.

"Temptation is always present for us to fight the overall trend no matter which direction that trend may be." -Charles Kirk