Determining which equity to buy and when to buy it is the primary focus of most market participants. Intuitively this decision seems to matter more than any other though the reality is that this is just one of many important decisions, none of which is individually so powerful that it guarantees you will ultimately close the trade with a profit. Instead of spending a great deal of time looking for the perfect entry point, the better approach is to focus your attention on exactly following your entire trading plan. The combined effect of following your system exactly (e.g. entries, exits, trade and portfolio management, etc.) versus focusing too much on entry points will consistently yield profitable results over many trades.
Determining which stock to buy and at what price to buy it can consume a lot of valuable time and lead to “paralysis by analysis” where no trade is made. Trusting the system you’ve chosen helps make this process more efficient. It can also make sense to have a couple of strategies for quickly screening stocks to trade. If you find yourself spending more time trying to determine which stock to trade (and what price to buy it), and less time on determining where to exit the trade or how much to put into the trade, or how to adjust the trades you have on already, then you are probably spending too much time on this part of the system.
There are several characteristics of price movement in which persistent statistical advantage can be found. This lesson will detail three of them: gaps, tall range days, and the start of a new month.
An extensive study conducted by researchers and published in the Journal of Technical Analysis in the year 2013, concluded that an overnight jump in the price of a stock actually implies an improved statistical probability that the stock will outperform the S&P 500 in the next month. This is a fascinating finding and it seems to hold true as a bullish indicator in bull and bear markets alike. The researchers found that the most productive gaps were those that were large enough to signal a potential change trend from a downward to a new upward trend. To identify such gap movements, three characteristics were determined to be beneficial:
Gap signals that exhibit these characteristics were shown to have a 58% to 60% probability of outperforming the S&P 500 over the following month. Notice that this is not a wins-every-time signal, but it has a significant advantage over outcomes generated at random and can therefore improve your trading edge.
These three gap characteristics can be searched for in many common screening tools. If you are interested in adding these to your arsenal of trading ideas, check in with your instructor and class for some ideas about which tools you can use to find stocks that have these characteristics.
Studies* show that bullish entries made immediately AFTER a tall candle that opens low and closes high and is at least 1.4 times larger than the ATR of the last 10 days also exhibit roughly a 60% probability that they will outperform their benchmark over the following month.
To find such signals you would simply search for stocks that held the following characteristics:
It isn’t difficult to search for stocks that have traded with an unusually high ATR for the day, but the last two characteristics are a bit more difficult to find with most screeners. You will most likely have to visually confirm the best one or two trades to select from the search results.
*In his book, New Trading Systems and Methods, fifth edition, author Perry Kaufmann identifies the fact that the opening price of the trading day is eight times more likely to be very near the high or low for that day’s price movement than at any other time of the day. He also notes that this fact has held true for over fifty years. Why should this be? The answer is that even random prices trend, and the opening price of the day kicks off a trend in one direction or another more often than not. Additionally the first few minutes of the trading day are, by far, more active than any other similar time frame on average.
A working paper released on ssrn.com in 2012 detailed what it called “a curious seasonal anomaly” referred to as the turn-of-the-month effect. It showed that buying stock near the end of the month provided statistically significantly better returns than entries on other days of the month. Think about it. The largest participants in the markets are those who manage billions of dollars in defined retirement plans such as 401(k) plans. These funds receive an influx of new capital to invest from pay periods often timed to the beginning or the end of the month.
Additionally, many of these funds track performance on a calendar-month basis. This monthly performance report often leads these fund managers to buy and sell dramatically in a “window dressing” effort to make their results look better. Thus entry signals on stocks where fund managers have decided to add significantly their holdings may show up in the last two or three days of the month or on the first day of the month. If so, these are likely to be more productive entry times than other days of the month.
To take advantage of this anomaly, a person could do one (or all) of three things:
We’ve purposely limited these entry signals and tactics to those that can also be used in conjunction with the ones you’ll learn in class.