Trade Like a Stock Market Wizard

Question 1

What does SEPA stand for?

Answer 1

Specific Entry Point Analysis

Question 2

What are the five key elements of SEPA?

Answer 2

Trend, Fundamentals, Catalyst, Entry points, Exit points

Question 3

What P/E did the biggest winning stocks in history trade at before experiencing their largest advance?

Answer 3

30 or 40 and more

Question 4

When stock falls 25% from purchase price and P/E below industry average, should you feel good?

Answer 4

No, you should ask if sellers knows something I don’t

Question 5

What does Mark use P/E for?

Answer 5

A sentiment gauge for investor expectations. High P/E = high expectations, low P/E = low expectations

Question 6

Based on historical data, how much has P/E increased for superperformance stocks from beginning to end of major price moves?

Answer 6

between 100 and 200 percent on average

Question 7

When should you start looking for sell signals based on P/E?

Answer 7

once P/E nears 2x and especially around 2.5x to 3x and greater from start of major move. It could top soon.

Question 8

What are the four market cycles?

Answer 8

1. Stage 1 - Neglect phase: consolidation 2. Stage 2 - Advancing phase: accumulation 3. Stage 3: Topping phase: distribution 4. Stage 4: Declining phase: capitulation

Question 9

Why do we avoid buying in phase 1?

Answer 9

learn to spot where momentum is strong during phase 2. The goal is not to buy at the lowest or cheapest price, but at the “right” price just as the stock is ready to move significantly higher. We need to maximize the effect of compounding, meaning concentrating on stocks that move quickly after we buy them.

Question 10

stage 1 characteristics?

Answer 10

1. Price moves in sideways fashion with lack of any sustained movement in either direction 2. Stock oscillates around it’s 200-day MA and lacks any trend 3. Often this basing stage happens after the stock price has declined during phase 4 for several months or more

Question 11

stage 2 criteria?

Answer 11

1. Stock price above both the 150-day and 200-day moving average 2. The 150-day moving average is above the 200-day moving average 1. Short term moving averages above long term moving averages (eg. 50-day above 150-day) 3. The 200-day moving average has turned up 4. A series of higher highs and higher lows has occurred 5. Large up weeks on volume spikes are contrasted by low-volume pullbacks 6. There are more up weeks on volume than down weeks on volume

Question 12

Trend template checklist

Answer 12

1. The current stock price is above both the 150-day and the 200-day moving averages 2. The 150-day MA is above the 200-day MA 3. The 200-day MA line is trending up for at least 1 month (preferably 4-5 months minimum in most cases) 4. The 50-day MA is above both the 150-day and 200-day MAs 5. The current stock price is trading above the 50-day MA 6. The current stock price is at least 30% above it’s 52-week low. (Many of the best selections will be 100%, 300% or greater above their 52-week low before they emerge from a solid consolidation period and mount a large scale advance.) 7. The current stock price is within at least 25 percent of it’s 52-week high (the closer to a new high, the better. 8. The relative strength ranking (as reported in Investor’s Business Daily) is no less than 70, and preferably in the 80s or 90s, which will generally be the case with the better selections.

Question 13

Stage 3 characteristics

Answer 13

1. Volatility increases, more erratic vs stage 3 and moving back and forth in wider, looser swings 2. Usually a major price break in the stock on an increase in volume. Often it’s the largest one-day decline since start of stage 2 advance. On weekly chart might print largest weekly decline since beginning of the move. These price breaks almost always occur on overwhelming volume 3. Price may undercut 200-day MA. Volatility around the 200-day MA is common as many stocks in stage 3 bounce below and above the 200-day MA several times while topping out 4. 200-day MA will lose upside momentum, flatten out and roll over into downtrend

Question 14

Stage 4 characteristics

Answer 14

1. Most PA below 200-day MA 2. 200-day MA in downtrend 3. Stock price near or hitting 52-week new lows 4. Lower lows and lower highs 5. Short term MAs are below long term MAs 6. Volume spikes on big down days and big down weeks and rallies are low volume 7. More down days and weeks on above-average volume than up days and up weeks on above-average volume

Question 15

Top usually comes after how many bases?

Answer 15

Top usually comes after 3 to 5 bases, by when the accumulation has become too obvious and smart money starts selling out.

Question 16

Which base is best for getting in?

Answer 16

Best time to buy is base 1 and 2 off a market correction. Base 3 is still tradeable, although obvious. Base 4 and 5 fail more frequently.

Question 17

Why are we willing to give up the first leg up?

Answer 17

The goal is not to buy at the cheapest price but to sell your stock for significantly more than the price you paid in the shortest period. We’re willing to give the first leg up in a stock to someone else in exchange for confirmation that the trend is definitely in stage 2 with some momentum building.

Question 18

What does trust your eyes, not your ears mean?

Answer 18

Many times before a fundamental problem is evident, there will be a hint in the form of a material change in price behavior. That change should always be respected even if you don’t see any reason for the sudden change in sentiment.

Question 19

Six categories companies fall into

Answer 19

1. Market leaders 2. Top competitors 3. Institutional favorites 4. Turnaround situations 5. Cyclical stocks 6. Past leaders and laggards

Question 20

Companies usually fall into one of six categories. Name them

Answer 20

1. Market leaders 2. Top competitors 3. Institutional favorites 4. Turnaround situations 5. Cyclical stocks 6. Past leaders and laggards

Question 21

Which type of companies stocks made Mark the most money?

Answer 21

market leaders

Question 22

Why have most investors psychological difficulty buying market leaders?

Answer 22

Think they have run up to far. Concern is not how far the stock has already advanced, but where it’s going and prospects for future growth

Question 23

What is scalable growth?

Answer 23

gaining market share in a growing industry

Question 24

What are ultrafast growers?

Answer 24

these companies grow so fast that Wall Street can’t value them very accurately. This can leave a stock inefficiently priced, providing a big opportunity.

Question 25

What is the risk in high-growth companies?

Answer 25

They live and die by earnings expectations and they have to constantly beat consensus forecast and as they report better than expected earnings, the bar moves up to beat them next time and eventually the bar will be too high and company will miss. The goal is to identify and invest in market leaders relatively early in the growth phase when profits are accelerating.

Question 26

What is a category killer?

Answer 26

company whose brand and market position are so strong that it would be difficult to compete against it even if you had unlimited capital.

Question 27

What is the cookie cutter concept?

Answer 27

when a firm produces a successful formula in one store and then replicates it over and over. Easy to spot and their earnings up cycles last for long enough time for you to identify earnings growth while they still have plenty of growth in the future.

Question 28

What is the earnings maturation cycle?

Answer 28

Question 29

What are the key stats for cookie cutter companies?

Answer 29

Same-store sales (comparable store sales) = statistic that compares sales of stores that have been open for a year or more. You want to see same-store sales increasing each quarter. High single-digit to moderate double-digit same-store sales growth is high enough to be considered robust but not so high that it’s unsustainable (25-30% or more same-store sales growth is definitely unsustainable over the long term). In general, 10% or more is considered healthy.

Important because although new stores are a major part of a company expansion and earnings growth, a saturation point in which future sales growth is determined by same-store sales growth eventually occurs. And with these comparisons, we can measure sales performance against other retailers that may not be as aggressive in opening new locations during the evaluated period.

Two factors - prices and customer volume

Falling same-store sales could mean one of few things:

Brand is losing strength and people aren’t shopping at the company’s stores

Economy is worsening and people aren’t interested in shopping anywhere

Company has too many items at discount prices and dollar volume per customer is less than usual

Another important consideration - past track record of success in diverse geographic locations (evidence the model is scalable). But too much too fast can be a red flag.

Sales per square foot and sales per dollar of capital invested per unit with other companies in the same business

Question 30

Define the top competitors category

Answer 30

Usually only one, two or possibly three companies truly lead an industry group

Blockbuster vs Netflix

Question 31

Define the institutional favorite category

Answer 31

Generally have a good track record of consistent sales and dividend growth and they often attract conservative institutional capital because of their proven history or management’s ability to increase earnings, expand margins and create shareholder value

Big and sluggish by the time they reach this status, so growth slow and little room for rapid price appreciation

Good buy coming out of correction phases (mismanagement or severe bear market correction)

Question 32

Define turnaround situation category of stocks

Answer 32

Troubled companies that turn around

Apple called the greatest turnaround in corporate history. From its 2003 low, Apple’s stock price increased in value more than 10,000 percent; 73 percent of that phenomenal growth came from newly launched products.

You should see at least two quarters of strong earnings increases or one quarter that is up enough to move the trailing 12-month earnings per share to near or above its old peak.

Are profit margins recovering , and are they at or close to the peak?

Are the results based only on cost cutting?

What is the company doing to increase earnings beyond cost cutting, productivity enhancements, and shedding losing operations?

How much cash does the company have? (you can assess burn rate and debt load to get an idea of how long it can last while running in the red)

The most important question to ask in purchasing a turnaround: Is the stock acting well in market? And are the fundamentals coming in strong? You want to see both

Question 33

Define cyclical stocks

Answer 33

Cyclical company = sensitive to the economy or to commodity prices (auto manufacturers, steel producers, paper stocks, chemical companies, etc)

Inverse P/E cycle = high P/E when poised to rally and low P/E near end of cycle. This is because Wall Street analysts try to anticipate the earnings-cycle dynamics of these companies, dependent on business cycle.

The trick is to figure out whether the next cycle turn is going to happen earlier or later than usual

At the bottom of cyclical swing:

Earnings are falling

Dividends may be cut or omitted

The P/E ratio is high

News is generally bad

Top of swing:

Earnings are moving up

Dividends are being raised

The P/E ratio is low

News is generally good

Question 34

Why do we stay away from laggards?

Answer 34

belongs to same group as market leader, but has inferior price performance and in most cases inferior earnings and sales growth (there is always a reason why one stock trades at a high multiple and another at a low multiple)

Question 35

Specific industry groups lead new bull markets. How do we identify these?

Answer 35

The industry groups with a healthy number of stocks hitting new 52-week highs early in a bull market will often be the leaders. Your portfolio should consist of the best companies in the top four or five sectors.

The top relative strength leaders in these groups typically lead their group’s advance from the beginning and are likely to show the greatest appreciation

Mark has found that more often than not, the best stocks in the leading groups advance before it’s obvious that the group or sector is hot. Therefore he focuses on stocks and let them point him to the group.

Big winning stocks tend to favor certain industry groups:

Consumer/retail

Technology, computer, software and related

Drugs, medical and biotech

Leisure/entertainment

New innovations create new opportunities

Group cycle dynamics = events in one industry group can have an effect on other industry group

When the leader sneezes, the group can get a cold

New technologies become old technologies

Question 36

Stocks move for two basic reasons…

Answer 36

anticipation and surprise.

Question 37

What is the earnings surprise and post earnings drift?

Answer 37

Be on the lookout for companies that are beating earnings estimates; the bigger the earnings surprise, the better. The post earnings drift can last for months (liquidity and impossible for everybody to respond at exactly the same time.

Question 38

What is the cockroach effect?

Answer 38

Quarterly results much better than expected = probably more good quarters ahead and other companies in the same industry or sector might post upside surprises as well.

Question 39

Why are not all surprises created equal?

Answer 39

Companies guide expectations and analysts converge around a number…nobody wants to stand out.

Question 40

Why do we pay attention to analysts’ revision of estimates?

Answer 40

Meaningful earnings surprise should lead to estimates raised not only for the current quarter but also current fiscal year. Upside revision of 5% and more usually leads to better than average stock performance. Look for companies for which analysts are raising estimates - quarterly as well as fiscal year revisions should be trending higher and the bigger the estimate revisions, the better).

Big earnings attract big attention.

Question 41

Considering the earnings maturation cycle, where do we look for opportunities and why?

Answer 41

Look for stage 2 uptrends supported by strong earnings growth.

Don’t focus on most recent quarter only. Past two or three quarters should also show good gains.

Really successful companies generally report earnings increases of 30-40% or more during their superperformance phase.

Question 42

Why do we want to see earnings acceleration?

Answer 42

more than 90% of the biggest stock market winners showed some form of earnings acceleration before or during their huge price moves.

Question 43

Why do Mark often use a two-quarter rolling average over the past 4, 6 or 8 quarters?

Answer 43

One quarter here and there might not show acceleration, which is ok. Long term matters

Question 44

What is a breakout year?

Answer 44

earnings break out to the upside from a range established over several years.

Question 45

How do we spot turnaround situations?

Answer 45

The company should be doing significantly better percentagewise in light of easy comparisons. Current earnings should be very strong (+100% or better in the most recent one or two quarters)

Compare current annual growth rate or current quarterly results with the three or five year growth rate. A company that has been growing 12% a year and suddenly starts to show growth of 40% and then 100% could be a hot prospect.

Deceleration is a red flag

Question 46

In summary, what do institutions like to see?

Answer 46

Earnings surprises

Accelerating EPS and revenues

Expanding margins

EPS breakout

Strong annual EPS change

Signs that acceleration will continue

Question 47

Three ways a company can increase profits

Answer 47

Question 48

How do we determine if the market is looking favorably on a company’s earnings?

Answer 48

It’s not uncommon for stocks to sell off on profit taking after a rally and decline on news, but a superperformance stock will come back and resume trend. And there should not be a huge sell off that breaks the whole leg of the stocks’ upward move.

Initial response

Subsequent resistance

Resilience

Question 49

How do you know what the market wants other than the published estimates?

Answer 49

Study how the stock price responds.

Question 50

What do we look for in Company-issued guidance?

Answer 50

Look for better than expected earnings along with positive earnings guidance. Sometimes the reaction to guidance is stronger than the reaction to actual earnings report when announced.

Question 51

How important are Long term projections?

Answer 51

No one, not even management, can accurately forecast what a company will earn or what it’s rate of growth will be a year or two down the road. Positive long term projections are usually just spins on bad news.

Question 52

Why do we compare inventory with sales?

Answer 52

Think of inventory as merchandise waiting to be sold. Under most conditions, inventories should rise and fall in a pattern similar to that for sales. When inventory grows much faster than sales, it can indicate weakening sales, misjudgment by management of future demand, or both. In case of inventory buildups, look for explanations.

Question 53

How do we analyze receivables?

Answer 53

Receivables increasing at a greater rate than sales or if the trend is accelerating, this could be warning that company having issues collecting from customers. And if receivables and inventories both increasing at a greater rate than sales (twice or more without explanation) = could be double trouble!

Question 54

What is differential disclosure?

Answer 54

Example: if a company is reporting great earnings but is not paying much in taxes, be skeptical.

Question 55

What is the lockout?

Answer 55

If the major market indexes ignore an extremely overbought condition after a bear market decline and your list of leaders expands, this should be viewed as a sign of strength. Those waiting for pullback are locked out.

Question 56

The best stocks make their lows first. Expand on this statement…

Answer 56

Many of the very best leading stocks tend to bottom and top ahead of their respective sectors, whereas specific industry groups can lead a general market turn. Although it’s true that many of the market’s biggest winners are part of industry group moves, in Mark’s experience, often by the time it’s obvious that the underlying sector is hot, the real industry leaders - the very best of the breed - have already moved up dramatically in price.

Question 57

What is the window of opportunity after a market low?

Answer 57

The stocks that hold up the best and rally into new high ground off the market low during the first 4 to 8 weeks of a new bull market are the true market leaders, capable of advancing significantly. You can’t afford to ignore these golden opportunities.

Question 58

The relative strength line of a stock…

Answer 58

…should show steady improvement as the market declines. It’s important to study carefully the price action of individual companies with new positive developments and strong earnings per share during major market declines. Many of the most strongly rebounding stocks and the ones that hold up the best are likely to become the next up cycle’s superperformers.

Question 59

What are we looking for as a sign of a bottoming market?

Answer 59

A first wave of market leaders emerge and build bases in a stair-step fashion (Humana example below)

Stock set-ups proliferate while the original leaders give up relatively little ground and rebound fairly quickly from any sell off. Leading stocks will generally advance 15-20% and then rest, during which time they may pull back 5-10%.

The majority of leaders should hold their ground. Even though there are bound to be some stocks that emerge and then fail, you don’t want to see most of the leaders that broke out come crashing down and not able to rally.

Volume on the major averages should also be watched for signs of distribution. If this is accompanied by increasing volume on down days versus up days, it may be too early, and you may need to revert back to cash for protection.

Question 60

What are Secular growth cycles?

Answer 60

Relative strength vs weakness, market vs stock earnings cycle.

Question 61

Does a stock have to rally to build relative strength?

Answer 61

Stock doesn’t have to rally much, sideways vs market decline builds relative strength ranking.

Question 62

What does it mean to look for a technical theme?

Answer 62

A growing number of stocks displaying positive, divergent price behavior during a general market decline can tip you off to where the next group of market leaders may emerge or what stocks are likely to blast off first when the market starts to rally.

Question 63

Which leaders to buy first?

Answer 63

Let the strength of the market tell you where to put your money, not your personal opinion, which rarely is a good substitute for the wisdom of the market. The stocks that emerge first in the early stage of a new bull market with the greatest power are generally the best candidates for superperformance.

When a market is bottoming, the best stocks make their lows ahead of the absolute low in the market averages. As the broader market averages make lower lows during the last leg down, the leaders diverge and make higher lows.

Question 64

Why are leaders a double-edged sword?

Answer 64

Just as leaders lead on the upside, they can also lead on the downside because they have made their big moves and smart money will move out swiftly at the first hint of slowing growth. History shows that one-third of superperformers give back all or more of their entire advance. On average, their subsequent price declines are 50-70%, depending on the period measured.

Question 65

How can leaders forecast trouble ahead?

Answer 65

Leaders tend to top around the same time the general market starts to show signs of distribution.

Leaders of one bull market are rarely the leaders of the next. One caveat, if the leaders/sectors started emerging near the end of the bull market cycle

Question 66

How many of the leaders of this rally will lead the next one?

Answer 66

The leaders of the past bull market rarely lead the next rally, so expect to see unfamiliar names. Fewer than 25% of market leaders in one cycle generally lead the next cycle.

Question 67

Is the train on schedule? What does this mean?

Answer 67

The key is not knowing for sure what a stock is going to do next but knowing what it should do. Then it’s a mater of determining whether the proverbial train is on schedule.

Question 68

Are charts the effect of the cause?

Answer 68

The effect, not the cause. Chart patterns are not the cause; they’re the effect. The supply and demand picture does not dictate to the market; human behavior does, and human behavior hasn’t changed and isn’t likely to change much in the future.

Question 69

What are the first things first with a technical picture?

Answer 69

Mistake amateurs make is ignoring big picture. First and most basic information charts show us is the prevailing trend of a stock.

You should limit your selections to those stocks displaying evidence of being supported by institutional buying. You’re not trying to be the first one on board; rather you’re looking for where momentum is picking up and the risk of failure is relatively low.

The current chart pattern is only as good as where it resides within the context of its longer-term trend. If you are too early, you run the risk of the stock resuming its downtrend. If you’re too late, you run the risk of buying a late-stage base that is obvious to everyone and prone to failure.

Never go against the long-term trade. Go long a stage 2 uptrend and go short a stage 4 downtrend.

Question 70

What is the next step after having identified a stage 2 uptrend?

Answer 70

the next step is to look for the conditions that facilitate a sustainable move higher: a proper base.

Question 71

What is the volatility contraction pattern (VCP)?

Answer 71

A common characteristic of virtually all constructive price structures (those under accumulation) is a contraction of volatility accompanied by specific areas in the base structure where volume contracts significantly.

Question 72

What is the contraction count during a VCP?

Answer 72

During a VCP, you’ll generally see a succession of anywhere from two to six contractions. Progressive reduction in price volatility, accompanied by a reduction in volume.

Rule of thumb: like to see each successive contraction contained to about half of the previous pullback or contraction. Typically, most VCP setups will be formed by two to four contractions, but sometimes there can be as many as five or six.

Contraction = “T”

Not all price patterns display VCP characteristics. There are square-shaped Darvas box pattern, or a flat base structure that is four to seven weeks in duration (with this type of base, there is no real volatility contraction as it remains a tight and narrow pattern moving in sideways range with 10-15% corrections.

Question 73

What is the technical footprint in relation to VCP?

Answer 73

The immediate distinguishing features of the VCP will be the number of contractions that are formed (typically between two and four), their relative depths throughout the base, and the level of trading volume associated with specific points within the structure. Quick reference:

Time. How many days or weeks have passed since the base started?

Price. How deep was the largest correction, and how narrow was the smallest pullback at the very right of the price base?

Symmetry. How many contractions (Ts) did the stock go through during the basing process?

Question 74

What does volatility contraction tell us?

Answer 74

Tightness in price from absolute highs to lows and tight closes with little change in price from one day to the next and also from one week to the next are generally constructive.

Almost every failed base structure that you experience can be traced back to some faulty characteristic that was overlooked. You need to have an understanding of the supply and demand forces that give rise to high-probability setups as opposed to head fakes.

Question 75

What is overhead supply?

Answer 75

You need to understand the supply/demand dynamics - trapped buyers looking to get out even, bottom fishers taking profits, supply drying up, normal process of shares changing hands from weak holders to strong ones, etc.

As a trader using a stop loss, you are a weak holder. The key is to be the last weak holder; you want the other weak holders to exit the stock before you buy

Question 76

Why buy near a high?

Answer 76

No overhead supply to contend with. When a stock reaches a new high in a confirmed stage 2 uptrend supported by big volume cues, it has been propelled upward by institutions taking positions because they believe that the fundamentals are solid and the prospects for the future are even better.

Question 77

Why are deep correction patterns are failure-prone?

Answer 77

Mark rarely buys a stock that has corrected 60% or more; a stock that is down that much often signals a serious problem. Most constructive setups correct between 10% and 35%. You will have more success concentrating on stocks that correct the least vs the ones that correct the most.

Question 78

What is time compression?

Answer 78

Shows up as V-shaped price action or the absence of proper right-side development. It takes time to digest and work through a buildup of supply, for strong hands to relieve the weaker players, etc. Price action displaying VCP characteristics = you’ll increase chances of identifying a stock in which supply is diminishing and a sound point for entry is developing, which will lead to immediate and sustained advance.

Question 79

What are shakeouts?

Answer 79

Always include in your thinking that whatever you’re seeing in the marketplace is also visible to everyone else. Price shakeouts will strengthen the setup at the completion of the base (elimination of weak holders).

Question 80

How do you look for evidence of demand?

Answer 80

A spike in price on overwhelming volume often indicates institutional buying, which is exactly what we’re looking for. After a price shakeout, it’s a good sign if the stock rallies back on big volume. Look for big up days that are larger and occur more frequently than big down days. Avoid a stock that follows a big demand day with even bigger down days on volume.

Question 81

What is the pivot point?

Answer 81

Trigger to enter trade. Jesse Livermore described as the line of least resistance. When a stock breaks through the line of least resistance, the chances are greatest that it will move higher in a short period of time.

Question 82

How about volume at the pivot point?

Answer 82

Every correct pivot point will develop with a contraction in volume, often to a level well below average with at least one day when volume contracts very significantly. The decreased volume means that stock has stopped coming to market and with very little supply, even a small amount of buying can move the price up rapidly.

Question 83

Do we extrapolate volume intraday?

Answer 83

After the last narrow contraction in a VCP pattern on light volume, ideally you want to see an upward move in the making in stronger than usual volume. And you can extrapolate this intraday, placing the trade when price goes through the pivot point.

Question 84

Do we always wait for the stock to pivot?

Answer 84

YES! If the pivot point is tight, there is no material advantage in getting in early; you’ll accomplish little except to take on unnecessary risk. Let the stock break above the pivot and prove itself.

Question 85

What are squats and reversal recoveries?

Answer 85

Break out from pivot point only to fall back into range and close off the day’s high. Don’t jump ship right away (unless triggers stop or closes below 20-day MA). Mark often waits a day or two to see if stock can stage a reversal recovery (this recovery can take longer though, but stop and 20-day MA will guide you).Sometimes you’ll see a series of squats and recoveries.

Question 86

How do you know a breakout has failed?

Answer 86

After breakout, stock should hold it’s 20-day MA and in most cases not close below it. Pattern should not get wider (up and down movements); up is good but wild swings back and forth are not.

Question 87

How do you deal with an early day reversal?

Answer 87

Stock moves up in the morning and then comes back down to the breakout before noon or 1pm. Try to give the stock until EOD unless protective SL triggers.

Question 88

The natural reaction vs tennis ball reaction

Answer 88

Price reactions allow to determine is your stock is a tennis ball or an egg. Own tennis balls. Often a stock will emerge through a pivot point and then pull back to or slightly below that initial breakout point. This is normal as long as the stock recovers fairly quickly within a number of days or perhaps within one to two weeks. Signs to look for once you have bought a stock emerging from a VCP:

At the beginning of move, volume should expand over a number of days

Prices generally should move upward for a few days with little resistance

A normal reaction will occur: volume should decrease compared with the volumes observed during the initial trend, and the price may move against the trend somewhat

Within a few days or perhaps a week or two of the normal reaction, volume should increase again and the price trend should be resumed.

Question 89

What is a saucer with platform?

Answer 89

Later became popularized as the cup-with-handle pattern, which is the most repeatable and reliable price structure for superperformance stocks.

Question 90

What is the 3C pattern?

Answer 90

The cup completion cheat (3C) is a continuation pattern; earliest point at which you should attempt to buy a stock. You should not get involved any earlier than this point.

Valid cheat area should exhibit a contraction in volume as well as tightness in the range of price

Can use to scale into trade and lower average cost basis

It’s simply the cup portion being completed

Can form in as few as 3 weeks to as many as 45 weeks (most are 7-25 weeks)

Correction varies from 15-20% to 35-40%, sometimes 50% but more than 60% are too deep and extremely prone to failure.

Common for a cheat setup to develop during a general market correction

Question 91

Making the turn in relation to 3C pattern…

Answer 91

+breakout

Question 92

Why wait for the turn?

Answer 92

The most dangerous time to trade is when a stock is trying to bottom. This tends to be a very volatile period for stocks. When a stock is searching for a bottom, it can whip back and forth violently. Trying to pick a low can be very frustrating and costly.

Question 93

What is the Livermore system?

Answer 93

Question 94

What is the failure reset?

Answer 94

A failed setup can reset so keep watching

base failure = requires building a whole new base before it can be purchased again

pivot failure = can reset and recover within a small number of days

Question 95

What is the power play?

Answer 95

One of the most important setups, also referred to as high tight flag. Mark does not require for this setup to have fundamentals on the table (unexplained strength), but he does require it to display VCP characteristics. Qualification criteria:

An explosive price move commences on huge volume that shoots the stock price up 100% or more in less than 8 weeks. This generally occurs after a period of relative dormancy.

The stock price then moves sideways in a relatively tight range, not correcting more than 20-25% over a period of 3-6 weeks (some can emerge after only 12 days)

Within the base (usually just days before a breakout), volume will contract considerably

Question 96

What does it mean fundamentally sound vs price-ready?

Answer 96

The key to making big money in stocks is to align supporting fundamentals with constructive price action during a healthy overall market environment.

Question 97

What is a primary base?

Answer 97

The first buyable base after a company has gone public. The biggest part of a company’s growth usually comes in the 5-10 years following IPO

Ideally a base of 3-5 weeks and not correct more than 25-35%

Question 98

Why is risk management important?

Answer 98

Once I make a profit, that money belongs to me. It’s not house money, reset the starting balance and protect it!

End every day with a frank appraisal of all your holdings. Am I still bullish on this position today? If not, why am I holding it? Does my original reason for going long remain valid?

Evaluate stocks on the basis of the return you expect in the future vs what you’re risking

Sound principles provide clarity. Loss cutting, risk management, etc. It takes a lot of unspectacular practice to get spectacular results.

A lesson from master Jack. Greatness is built on a solid foundation of fundamental principles. “learn to stand before you learn to flip”

Losses make you work harder. Never permit yourself to lose an amount of money that would jeopardize your account. The larger the loss is, the more difficult it is to recover from it. Set max SL of no more than 10% and avg loss less, 6-7%.

Two up and one down. Losses work geometrically against you. Your gains must eclipse your losses on a risk/reward basis.

Convincing myself: The loss adjustment exercise. Capping all losses at 10% led to improvement in performance from -12% to +80%.

Accepting the market’s judgments. The first discipline you need to learn to be a successful stock trader is simple to comprehend mentally, but for the majority of traders it’s the most difficult to perform regularly: the best way to stay clear of the market’s wrath is to accept its judgment.

Knowing when you’re wrong. Regardless of your methodology or approach to stock investing, there is only one way to protect your portfolio from a large loss, and that is to sell when you have a small loss before it snowballs into a huge one. In three decades of trading, I have not found a better way.

When stock doesn’t do what we expect it to, it’s reason enough to step aside and reevaluate. You might have made an error in timing.

Question 99

What are the big risk management errors?

Answer 99

Avoiding large losses is the single most important factor for winning big as a speculator. You can’t control how much a stock rises, but in most cases, whether you take a small loss or a big loss is entirely your choice.

Holding losers too long and selling winners too quickly

Doubling down when stocks decline in value

Taking a small gain and not a small loss

Don’t become an involuntary investor. Every major correction begins as a minor reaction. You can’t tell when a 10% decline is the beginning of a 50% decline until after the fact

How low can it go? To zero🙂

A trip to the casino. The Achilles’ heel of most gamblers and speculators is the desire to play every hand, a common human weakness that allows impatience to override good judgment.

One in a million. If you regard each trade as just one out of a million over time, it becomes much easier to take a small loss and move on to the next trade.

What’s the difference? The goal is to make money, not prove you’re right. Drop the stock and you can make money in a different one.

What a deal. In the stock market, you have the luxury of being able to stay on the sidelines, free of charge, observing and waiting for the most opportune moment to wager. You get to see the market’s “cards” before you bet, free of charge. This is a wonderful advantage, yet few exploit it.

When a mistake becomes a mistake. No one will ever be so good that he or she will never take a loss. Being wrong is unavoidable, but staying wrong is a choice.

If you’re not feeling stupid, you’re not managing risk. Making you feel stupid is the market’s way of pressuring you to act foolish. Don’t succumb. Remain disciplined and cut your losses. The alternative to managing risk is not managing risk, and that never turns out well.

Why most investors fail to cut their losses. To have lasting success in the stock market, you must decide once and for all that it’s more important to make money than to be right. Your ego must take a backseat.

Losses are a part of trading and investing; if you’re not prepared to deal with them, then prepare to eventually lose a lot of money.

Question 100

What is contingency planning?

Answer 100

Your goal is not risk avoidance but risk management: to mitigate risk and have a significant degree of control over the possibility and amount of loss. Before the open of each trading day, mentally rehearse how you will handle each position based on whatever could potentially unfold during that day. Then, when the market opens for trading, there will be no surprises; you already know how you will respond. Four basic contingency plans:

The initial stop-loss

The reentry. Amateurs are scared of positions that stop them out once or twice or just weary of the struggle; professionals are objective and dispassionate. Some of Mark’s best trades were in stocks that previously stopped him out several times and then reset.

Selling at a profit. Once you’re multiple R in profit, never let your position turn into loss (BE SL or trail). And have a profit taking plan for both selling into strength and selling into weakness.

The disaster plan. Power failure and internet connection, big gaps SEC investigations, etc. The importance of contingency planning plays is that it enables you to make good decisions when you’re under fire, when you need it the most.

Question 101

What is a trader’s cardinal sin?

Answer 101

Allowing loss on a trade to exceed average gain. Rule of thumb = amount of loss should be no more than one-half of the amounts of expected gain. And recommendations is to not allow a stock to fall more than 10%.

Question 102

What does building in failure mean?

Answer 102

Expect the best and plan for the worst. The problem with relying on a high percentage of profitable trades is that no adjustment can be made; you can’t control the number of wins and losses. What you can control is your stop loss; you can tighten it up as your gains get squeezed during difficult periods. Mark maintains at least a 2:1 win loss ratio (but shoots for 3:1) with an absolute maximum stop loss of no more than 10%

Question 103

How to handle a losing streak?

Answer 103

Only two things can be wrong:

Your stock selection criteria are flawed

The general market environment is hostile

Leading stocks often break down before the general market declines

Scale down exposure and when trading plan is working well, do the opposite and pyramid back up. Definitely don’t increase position size trying to recoup losses!

A practice that will guarantee disaster. There is no shame in losing money on a stock trade, but to hold on to a loss and let it get bigger and bigger or, even worse, to buy more is amateurish and self destructive. Only losers average losers!

High-growth stocks that fall in value after you purchase them at a correct buy point do not become more attractive; they become less attractive.

Learn to pace yourself. If your trading is causing you difficulty or stress, something is wrong with your criteria or timing or you’re trading too large.

Build on success. If you’re not profitable at 25% or 50% invested, why move up to 75% or 100% invested or use margin? By pyramiding up when you’re trading well and tapering off when you’re trading poorly, you trade your largest when trading your best and trade your smallest when trading your worst. This is how you make big money as well as protect yourself from disaster.

Scaling in versus averaging down. Professionals scale into positions whereas amateurs average down. Even if trading a pullback, wait for the stock to turn up first. The lesson: never trust the firs price unless the position shows you a profit.

When to move up your stop. Move your stop up when your stock rises by two or three times your risk, especially if that number is above your historical average gain.

Not all ratios are created equal. Once your batting average drops below 50%, increasing your risk proportionately to compensate for a higher expected gain based on higher volatility will eventually cause you to hit negative expectancy; the more your batting average drops, the sooner negative expectancy will be achieved. If you’re trading poorly and your batting average is dropping off below the 50% level, the last thing you want to do is increase the room you give your stocks on the downside. This is not an opinion; it’s a mathematical fact. In difficult market environment, profits will be smaller than normal and losses will be larger; downside gaps more common and greater slippage. Smart way to handle:

Tighten up stop losses (for example from 7-8% to 5-6%)

Settle for smaller profits (ex 15-20% to 10-12%)

Get off margin if you trade with leverage

Reduce exposure (both position sizes and overall capital commitment)

Once you see your batting average and risk/reward profile improve, you can start to extend your parameters gradually back to normal levels

Question 104

Does diversification protect you?

Answer 104

Diversification does not protect you. You will never achieve superperformance if you overly diversify and rely on diversification for protection. By having your money spread all over the place, you accomplish three things:

Inability to follow each company closely and know everything you should know about the investments

Inability to reduce your portfolio exposure quickly when needed

A smoothing effect that will ensure average results

Concentrate your capital in the very best stocks - you should typically have between 4 and 6 stocks and for large portfolios maybe as many as 10 to 12. Mathematically optimal for a 2:1 trader is 25% position size (=4 positions)