A Simple Breakout/Trend Reversal System
Well, now that we’ve spent a little time getting to know some basic technical indicators and how to read a stock chart, it would seem to be a good time to put it all together in a simple system which will allow us to find stocks to invest in. Right now, it may seem awkward to you that we’re going to be valuing stocks completely based on their charts and not necessarily by what the company does or what it sells. You might be wondering to yourself, “Can I really invest in stocks without knowing anything about the company?” The answer to this is actually yes and no. When looking to invest long term or invest a lot of money in a company, it is important to get to know the heart and soul of that company and its industry. That way you can make better estimates as far as the company’s growth and its potential.
That being said, it is my opinion that most investors are not investing in a company as much as they are investing in a stock. Ultimately, most individual investors don’t have enough money to have any real controlling stake in a company and are merely looking for a vehicle with which to grow their savings. To use a word with some dirty connotations, most individuals, whether they admit it or not, are “speculating” – attempting to buy a stock now and sell it later when it is worth more money as opposed to really trying to find a strong company to “invest” in. Ask yourself this question, if you’re discussing personal finances at a dinner table, would you rather be bragging about your returns on your portfolio over the last few years or about the company that you’ve invested heavily in because you know in a few years it’s going to be a great success?
If your preference is the first choice, then my suggestion is to look to invest for periods of time ranging from three months to a year and, in this case, a system which is reliant on charts and technical indicators is often your best option (as long as you’ve done the due diligence to know that the company who’s stock you’re buying isn’t days away from bankruptcy or in other sort of dire straights). These trading systems take out a lot of the emotional and subjective decisions we might otherwise make about a stock. And, being as most individual investors are not experienced enough to have trustable intuition about companies and their future success, it is often best to attempt to take out as much of the subjectivity as possible. That being said, you must remember to follow the guidelines of any investment strategy in a disciplined manner. It’s never a good idea to say to yourself, “Well, maybe the charts were wrong I’ll hold onto the stock just a little bit longer. It has to go up…” If you’ve lost some money and the charts are telling you to sell, it’s time to sell!
So, let’s get started with our simple stock valuation system.
I happen to be looking for a stock to buy for my portfolio so you’ll get to see my thought process here as well. An important thing to remember is that some of the indicators we looked at are based off of the same statistics. For example, Bollinger Bands are built around simple moving averages so using other statistics using simple moving averages (like Price Channel) to confirm buy signals is not a true confirmation and instead is just a co-linearity. For our system, I am going to use the MACD, Volume+, and Price Channel for our buy signals. For sell signals, I will be combining Volume+ and Parabolic SAR.
The reason we call this a breakout/trend reversal system is that these charts will allow us to identify the point when a stock’s downtrend has ended and it has begun a new uptrend. As you can see in a lot of stock charts, trend reversals are not always lasting and often times are fleeting. That is where the breakout comes in. The breakout point often signals what will be a prolonged uptrend with a likely 10-20% increase in the stock’s price.
We will begin by looking for stocks that have a MACD chart which shows the primary curve crossing above the signal line in the positive region of the graph but not highly positive (just above 0). Next, we will watch these stocks looking for a day which has higher than average volume and significant positive price movement. That is the breakout point and our corresponding buy point. (You will likely see the price rise as well as the MACD curves while you wait for a breakout, but it is important to wait for the breakout before buying.) To confirm the breakout, we can use Price Channel and make sure that the price has moved to break past the upper Price Channel bound. An example of such a stock, would be the one in the chart below.
Here’s the chart for Nucor Corp., a manufacturer of steel products in the United States. I’ve done a quick check of its company financials and it turns out to be a $19 billion with good strong (compared to industry) year-over-year quarterly earnings growth and revenue growth. It also has positive ROA and ROE (that is the company is profitable). While there are some concerns about the United States steel industry (declining prices etc.), it seems that the industry’s stocks has been doing decently well and this looks to be a very secure company to invest in. For me, that’s enough. The charts tell me the rest of the story. It had a pretty strong breakout today, MACD shows the primary curve inching passed the signal curve which signals a buy, and we see the stock pushing rather significantly passed the upper price channel bound. This stock should be ready to move a bit. I’ll be buying it tomorrow morning.
So, when do we sell? What if the pick was wrong? Well, I like to stick buy a strict policy of never allowing the stock to fall more than 8% of my buying price. This should give enough leeway if the stock doesn’t ascend immediately but also is a safe number for pulling out of a loser. After the stock has gained some, I will begin to use the Parabolic SAR to establish my sell point. Should the stock drop to the Parabolic SAR support line, I’ll sell and take profits. When I do sell this stock, we’ll revist this post and I’ll show an example of the charts.
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