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Mar 16

The Genesis Of A Trade Idea

We have another long idea: Corrections Corp. Of America ($CXW).

I was just putting together some charts to demonstrate our rationale when I thought it might be useful to share the entire process. What I’ll go through here is not what I do every time, but it represents some of the ways I might look at a stock to determine whether it merits further analysis or inclusion in our portfolio.

Where the idea itself first comes from is largely irrelevant. It can be through a portfolio screen I run on my trading platform, it can be from seeing it mentioned on twitter, or from hearing its name over dinner, just anywhere.

$CXW was brought to my attention by an article on Seeking Alpha by Michael Vodicka called “The Defensive Stock You’ve Never Heard Of,” and he’s absolutely right, I had never heard of it until I saw his post, and I like it.

Recognize though, that if I entertain an idea that has a fundamental narrative to it, I can never make that my basis for investing because I don’t have a means to know when it’s invalidated in fundamental terms. I’m just not smart enough to do fundamental analysis on stocks.

My ideas will often have survived some kind of fundamental screen for me to even look at the technicals, but I can only make the technicals the means for my analysis, entry, exit, position size, and assessment of the risk/reward.

Although it’s a theory I’ve never tested, I’m fairly sure that by the very nature of trend following, (buying stocks in strong uptrends), you are likely buying stocks with good fundamentals anyway. Trend following effectively acts as a filter to trading the best companies, bypassing subjective arguments over whether something is cheap or expensive, and instead concentrating on objective criteria like trend or price action to determine our involvement.

In the article he talks about the growth of the company, the demand for its business, its yield and PEG ratio. It all sounds like a compelling argument, so let’s now decide on our terms whether we want to buy it. Here goes.

Whenever I look at a stock for the first time, I usually start with a daily chart of the last six months, as below, that also has on it volume, and the 20, 50, 200-day moving averages. I like my 20ma to be exponential, which simply means it gives more weight to the more recent values. It’s not really a big deal but that’s just how I like to view it.

AlphaCapture

This gives me my first impression of a stock, and this has a lot of positives. I always look top-right first, concentrate on the most recent action. The first thing I notice is the triangle consolidation that’s formed right above the 50-day, and this is after a steady uptrend of at least six months, all very good. Price is a fair distance from its 200ma which tells me this uptrend likely goes back a while and was very strong out of a lengthy base.

The volume isn’t very instructive because of that one large bar, but there does appear to be an increase recently on the up days, which suggests a strong likelihood of resuming the uptrend from this consolidation.

Then, I determine the support and resistance levels.

I go to the highest close, and the previous gap or break of resistance that brought us here. I tend not to use intraday highs and lows as those are often spiked with emotion. Closing levels I believe carry much more significance. So, I mark up daily and weekly closes. Those carry the most weight to me.

So far, this could be a good enough basis for most to pull to trigger. But we have no context. We need to see where this 6mo window is in the bigger picture, where could we be headed, where have we come from, what would invalidate our rationale, and where is our stop. Let’s go to a weekly.

AlphaCapture

Weekly charts can often have huge price scales so I like to use log scales so you get a truer sense of the price movement relative to earlier periods. On weekly charts I always use 10-wk and 40-wk MA’s. I picked that up from Craig Johnson the Senior Technical Analyst at Piper Jaffray. Craig is a CFA and CMT, and produces some excellent long-term charts in his research.

So now we can see we’re in a solid long-term uptrend, which hasn’t paid much regard to its 10-wk MA. (I may also pan back to monthly, quarterly, or even yearly charts in order to see the all time high but will spare you that here.)

If a stock has recently made 52-wk highs I also take a look to see if there’s any major divergence.

AlphaCapture

I use MACD and Momentum to determine divergence. There’s some here, but it’s not textbook, and it’s not a major concern to me. So at this stage I know I want to be long if I can now determine a favorable risk/reward exit.

Even if I have a volatility or ATR stop to get me out, in case neither of those are triggered I still need to know a hard price level for my stop, so to do that I have to determine what price would invalidate the uptrend. For that I look at trend-lines and support levels.

AlphaCapture

Here, we see price just above the 50-day and a rising trend-line. At first glance a breach of both of these might appear to be a rational exit, but it isn’t. Here’s why. Rather than becoming fixated by lines like these try to take them off and imagine different price paths to determine what would invalidate an uptrend.

Look at the same chart below with potential price paths. It’s perfectly conceivable price could break both the 50ma and rising trend-line, find support at one of our previously cited support levels, and resume its trend higher. The long-term trend would still be intact.

In fact, I would go so far as to say that when conditions like this exist the supposed trend-line break is so obvious it’s an easy target to wash out weak longs. (We wrote about a similar thing with Nike ($NKE) this week.)

AlphaCapture

So what’s my risk? I think a close below that lower band of support at $35.82 would invalidate the uptrend, that’s 6.5% away from Friday’s close. What’s my upside? Well, the territory $CXW is navigating was last seen in the late 90’s when it suffered a precipitous decline, so there’s not much established resistance given it spent so little time at any level from $148. The best I can see is the break of the low $50’s, which seemed to cement its demise.

Bottom line, we have a favorable risk-reward with an established stop, in a stock showing signs of accumulation as it emerges from a consolidation within a long-term uptrend. We’ll use a close below $35.82 as our stop.

With all that determined, once entered I default back to a 3-month daily chart to monitor it going forward.

AlphaCapture

Links:-

The Greatest Defensive Stock You’ve Never Heard Of (Seeking Alpha)

Craig W. Johnson, CFA, CMT, Sr. Technical Analyst (Piper Jaffray)

 

9 comments

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  1. Chris

    Thanks for writing up this post. Very educational!

  2. uli808

    Jon, thanks for the really interesting insights you offer, they are very educational.
    Could you discuss briefly, how you would size trade position? Would you enter with x% of your portfolio or do you size the trade based on the stop price, e.g. (entry price – stop price) x # shares = 1% of portfolio size?
    Thanks!

    1. Jon Boorman

      Well you’ve hit the nail on the head, it’s not something I’ve got to talking about much yet, but this is where it gets interesting. Position sizing is what can turn a mediocre system into a great system, but it’s something that you need to tailor to your own objectives, there’s no one-size-fits-all. As you described, using example of $100,000 portfolio, you could either just invest 1% of the portfolio in stock ABC at $20, i.e 50 shares. Or, knowing your stop is at $18.50, so 1R is $1.50, you calculate $1,000 / $1.50 = 667 shares. The latter means you actually buy $13,340 worth of stock instead of $1,000. This is where you get into a whole host of other decisions regarding margin and your risk tolerance. I highly recommend exploring the many books and writings of Van Tharp who is the go-to person on position sizing strategies. His website is http://www.iitm.com

      1. uli808

        Thanks for the tip. I actually bought “Trade your way to…” a few weeks ago, but have not managed to get far reading it. I will certainly explore this part of trading further. Always enjoy reading your posts!

  3. Siva

    Thanks for the great blog. Do you use Fibonacci retracement in your analysis?
    I am reading Trend following and Van Tharp’s books, do you suggest any other book to get started in terms of chart patterns/technical analysis.

    1. Jon Boorman

      Thanks for reading. If I happen to mention or use a Fib level it will be incidental to the main analysis, it will be one of several factors to make a case. Larry Williams once did a thorough analysis of thousands of retracements across many markets and found that the famed Fib levels had no more accuracy than any other random level of predicting a pivot point. We tend to give weight to when something matches a fib level, but don’t mention all the times it doesn’t, and then of course there’s always another level, and another, so I don’t find them practical in my work.

      If you want to concentrate purely on chart patterns or general TA then I would pick up the Dahlquist and Kirkpatrick book on Technical Analysis that’s used for the CMT levels 1 and 2, it’s a great reference manual for all patterns and types of TA, and is a bit of an easier read than the Edwards and Magee one.

      1. Siva

        Thank you very much.

  4. rahagar

    Jon,
    Do you use a minimum predetermined risk/reward threshold or does that vary any based on other factors (like sentiment, other chart technicals, etc)?

    And, I get the risk determination…basically your stop loss level. But the reward (possible future equity price) is a tougher determination?

    BTW, I really appreciate your sharing of info and ideas here and on StockTwits and Twitter…all of you guys are a great benefit to we less experienced traders.

    1. Jon Boorman

      Thank you for the compliment, I’m glad its helpful.

      Re risk/reward, I’m going to cut and paste some comments I’ve made elsewhere on this:- It will vary, and the risk/reward concept is what remains from my days as a prop trader thinking in terms of 2:1 or 3:1 risk/reward, but it’s less relevant in trend following. In most cases you can use price history, resistance levels, previous highs. It’s obviously harder to define upside for something already at all time highs but that’s one of the key parts of trend following, you can never know where you are in the trend or how far it can go. When something’s at all time highs it’s already doing what you want it to do, it’s going up. Can it continue that trend enough to justify the risk? That becomes the question, and the risk is the price you’re willing to pay to find out. Sometimes it’s a harder proposition, like the TSLA entry, if I’m willing to have a stop 20% away did I think it was capable of going up 40-60% to justify that? Yes, it was perfectly possible. In the case of CI and ICON the stop is very close, less than 5% away, so could a stock at all time highs move another 10-15% higher? Yes, easily.

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