Addition By Subtraction: Building Your Watch List

Recap

Last week I released the 2nd part of my 5 part series on building a better watch list.  Based on the emails I've gotten so far, it seems like this theme of addition by subtraction is really resonating with people. 

So I decided to expand on this with my guest blogger posts on MyTradingBuddy where I introduced my "funnel" based method of watch list building.  In this week's iteration, I'm going to explore the lower portion of the funnel, where we begin stripping out stocks by the variables tied to them.

I view variables on a stock as physical barriers that get in the way of further action (i.e. placing it on my watch list).  Here's a break down of some the riskiest variables I like to avoid, along with some background on each.

Are Institutions Maxed Out?

I use institutions throughout my process and I offered some thoughts on why in a previous post.  It's rare that institutions will come into a position in full and all at once because it creates volatility and artificially inflates value, which ultimately has an impact on their potential profits.  Instead, they prefer a measured transition which is easy to spot if you know what to look for.  

However, some times institutional activity in a position begins to slow down.  It's hard to say why, exactly.  Perhaps there are other stocks that have caught their attention, or perhaps they're maxing out.  Either way, this is going to have an effect on the momentum of the stock and it's more likely to move sideways than upwards.

Earnings

Some people have made their living trading around earnings but it's too risky an endeavor for my taste.  The reason I see earnings as a variable is because I can't predict how institutions will react to the information in a report.  When a normal person like me looks at a glowing earnings report, I may think to myself, With these numbers, this thing is about to break out!

I have no idea if that's the case, because unfortunately, I don't have access to what institutions are seeing.  They may be looking at multiple companies simultaneously and if the one I'm looking at is the 3rd best earnings performer in their eyes, then taking a position on my target exposes me to additional risk.

This is why I like to wait at least 3 sessions after earnings before taking any kind of action.  If the stock is solid, I'm good to go.  if not, my capital is safe!

Passing The Buy Point

I'm sure that every reader of IBD® has run into this at one point or another.  When a stock has solid fundamentals but has passed its buy point it's easy to assume that it's safe to chase.  I can't stress enough how bad an idea this is!  Sooner or later this approach will come back to haunt you.  If the stock is really a winner then it's going to offer you another buy point or it's going to retrace and you can get involved then.

Government Involvement

This one probably seems like a no-brainer but I've still got to mention it.  The only thing more impactful than the behavior of institutions is the behavior of the government!  When I'm looking at a bio-tech company that's got solid fundamentals, I want to know if there are any approvals pending with the FDA or anything like that.  If I've got 10 stocks that have made it this far down the funnel but 2 have government involvement swirling around them?  I'm down to 8!

8 Week Hold Rule

This one circles back to the idea that Institutions can max out.  When IBD® shows that a stock is on the 8 week hold rule, what they're really saying is that you need to wait for 8 weeks for institutions to fully digest their existing position.  Remember, when institutions are sitting things out, the price of a stock is more likely to move sideways.  That's just one more variable I eliminate from my trading equation.  

Growth Stocks Should Survive

You can make money investing in all sorts of ways.  Some people live and die by IPO's.  Some work penny stocks while others rehab and flip real estate.  There's no "best" way to make money investing but I prefer to work with growth stocks.  By using the variables I laid out here, I'm able to better pin point the true growth stocks.

At this point in my process, I've usually got somewhere between 3 and 5 stocks that have made it through my funnel and on to my watch list.  In the 4th part of this series we're going to look more closely at how I structure my watch list and how I rate stocks in a side by side comparison.

As always, keep the comments and emails rolling!

Amin