Buy Signals Sell Signals Strategic Stock Market Entries and Exits By Steve Burns & Holly Burns www.NewTraderU.com Table of Contents - Trading price action instead of fundamentals - Trading price signals instead of emotional signals - Reactive technical analysis versus predictions - Different types of markets (Range bound, volatile, trending) - Additional dynamics to consider - Why you build your own signals - How to build your own signals - Mechanical versus discretionary systems - Basic signal examples - Basic system examples - The Legendary Turtle Traders System - Simple trend following systems - Learn More at NewTraderU.com © Copyright 2015, Stolly Media, LLC. All rights reserved. No part of this publication may be reproduced, distributed, or transmitted in any form or by any means, without the prior written permission of the publisher, except in the case of brief quotations embodied in critical reviews and certain other noncommercial users permitted by copyright law. This ebook is licensed for your personal enjoyment only. This ebook may not be re-sold or given away to other people. If you like to share this book with another person, please purchase an additional copy for each person you share it with. Version 2015.10.22 Disclaimer: This book is meant to be informational and should not be used as trading advice. All traders should gather information from multiple sources, and create their own trading systems. The authors make no guarantees related to the claims contained herein. Please trade responsibly. Trading price action instead of fundamentals “When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart. Why work when Mr. Market can do it for you?” – Paul Tudor Jones Fundamental analysis is the examination of the underlying forces that affect the well being of the economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements. - Definition courtesy of StockCharts.com Technical Analysis is the examination of current and past behavior of participants that are buying and selling a particular financial market based on price action. The goal of technical analysis is to find patterns in price action that are profitable. More than twenty years ago, my father-in-law bought a used truck that he wanted to flip for a quick profit. He looked at the mileage on the odometer, the condition, the make, model, age, and the fact that it was a stick shift, and decided on a price based on all these factors. I thought his price was high because there were plenty of used trucks in the world and not a lot of buyers looking for this particular type. He asked me what I thought the value of the truck was. I thought about it and told him I thought the value of the truck was exactly what he could get someone to pay for it. The value would be established as offers to buy the truck came in, versus his initial sell price. The suggested value for the truck he would find in books was only a fundamental valuation. The publisher of Kelley Blue Book was not offering to buy the truck, they were giving him a value guideline. The true value would be set by the first person with cash offering to buy his truck. Values are based on buyers and sellers and not opinions or fundamental valuations. Prices can move so far away from fundamentals that they are useless. Needless to say, my thoughts about technical price action versus the belief of value didn’t go over great with my former drill sergeant father-in-law. He was not impressed that I would question his wisdom on buying a depreciating asset as an “investment”. But he is not unlike the millions of fundamentalist investors in financial markets who get angry when price doesn’t align with their belief about value. Similarly, fundamentalist investors that buy companies based on what they should be worth but can’t make money off their investment portfolio during bear markets and downtrends, can become easily frustrated because they have placed their trust in the belief of value. This book is about trading price action instead of investing in a company based on its balance sheet and stock price versus book value. The concepts in this book will show you how to create actual trading plans for buying high probability setups, trading on the right side of a trend, and exiting with a profit without having to look at fundamental valuations. This is a book for traders that want to profit from price action and not for investors wanting to buy a company that is undervalued in the hope that one day the true value will be priced in. There are trading systems that incorporate fundamental valuations like price-to- earnings ratios, return on equity, sales growth, and other metrics that create their watch lists based on fundamentals, but still trade based on technical price action, a trading system, or chart patterns. Even if you can find the best value stocks or growth stocks to trade, you will only profit if you buy them and sell them at the right time. Let price guide your decisions on buying and selling? Inside the investing world this will seem like blasphemy. Regardless of what anyone believes a company is worth, the company and the stock are two different things. A company is a corporate entity with a profit and loss statement that is charged with making profits for shareholders and making Wall Street happy by beating earnings. Businesses must create earnings by selling goods to customers in an efficient and cost effective way that makes money. Corporate profits end up on the company’s balance sheet, which can be used to reinvest in the company through capital expenditures, or to pay a dividend to company shareholders. The company’s stock is all together different, because it trades on an exchange and buyers and sellers determine the price of that stock and what they are willing to pay. In my experience, very little buying and selling is based purely on fundamental valuations. Most market action is based on a trader or investor’s emotions. Every buyer and seller has a different motivation for buying or selling. The only rational reason to buy a stock is because you think that the stock is going to go up in price and you will make money. Even when short sellers buy a stock back to cover their short position, it is because they want to lock in their profits before the stock goes higher. While there is only one reason to buy a stock, people will sell a stock for many different reasons: - They need the cash. - They see a better investment or trade. - They are fearful that the price will go down. - A mutual fund manager has to sell holdings to raise cash. - They believe the future of the company is in peril. - They are fearful about the economy. - They believe a new technology will disrupt the company. - Something on the daily news. - A rumor that is causing the stock to drop. - They are nearing retirement and changing their portfolio balance. - They are rebalancing their portfolio by selling positions that have gotten too large. - The shares are inherited and the heirs prefer cash. All of these reasons for selling play out every day. None of them required a balance sheet or a price-to-earnings ratio. The markets are largely driven off the decisions of the asset holders rather than fundamental valuations. The buyers and sellers on stock exchanges can be value investors, high frequency traders, trend followers, day traders, swing traders, growth investors, mutual fund managers, or hedge fund managers. All market participants have one motivation: to make money. Always remember: While there are many reasons to sell a stock there is only one rational reason to buy a stock: because the buyer believes it will go up in value and they can sell it for a profit in the future. The ‘future’ can be different things to different people. For Warren Buffett the future may be ‘never’ and for a day trader it could be in 30 minutes. The only thing that makes stock market participants money is exiting a position with a profit after price moves in their favor. Stock prices are driven by the specific supply and demand of their stock, not by the underlying company’s results. It’s the perception of the company’s current and future results that interests buyers and sellers. A company’s stock price has to go through the filter of all the market participants’ perceptions, opinions, and predictions about what the current price should be versus what the future price may be. Fundamental analysis is a long-term game that can last for years. Warren Buffett’s success as the greatest investor of all time is not based on simple fundamental value investing. The real key to Buffett’s incontrovertible record is based on his ability to create the best margin of safety on his purchases. By picking the right ones the majority of the time, holding a concentrated portfolio of only his best picks, with an unlimited holding period, he has compounded his returns for decades. One of the keys to his success was acquiring the textile company, Berkshire Hathaway. Initially an aging business model, Buffet converted it into a successful insurance holding company whose insurance premiums could be used to acquire healthy companies with great cash flow, and those with ‘moats’ around their business models that make it difficult for industry competition. His patience is legendary, often waiting years for a desired price. His buy signals are often triggered by extreme fear, when stock is available at a large discount. This value ratio creates a margin of safety that limits the downside risk even if he’s wrong. His risk/reward ratio offers a significant gain if he’s right, and the stock returns to a price that better reflects an accurate fundamental valuation of the company. Warren Buffet rarely sells, but he will exit his holdings when the business conditions are no longer favorable and there is little upside. Very few people will have the patience, discipline, genius, and luck to be anything like Warren Buffet. However, most people can trade simple price action trading systems on a comfortable timeframe. If they use position sizing correctly, they can handle the emotional issues that hinder the majority of other traders and investors. Fundamentalists can suffer from long losing streaks. Investors tend to have larger drawdowns in capital and can give back years of returns very quickly during bear markets and financial crises. A good trader will have tight controls over losses, risk exposure, and drawdowns in their capital. Conservative buy and hold investors have dealt more pain over the past 15 years than most traders experienced with the 2000-2002 bear market, and the 2008- 2009 financial crises. Traditional buy and hold investors focused on retirement generally set their buy signals for every payday resulting in a new contribution into their retirement account. Young buy and hold investors not worried about their retirement accounts look for buy signals all day, every day. Buy and holder investors generally sell when they are rebalancing their portfolios once a quarter, or annually when they sell their winning positions to use the capital to buy positions that haven’t kept up, like bonds or other equity sectors. Another time that they will start selling positions is when they get closer to retirement, as they start to move their portfolios from stocks into lower risk and more stable bonds. Buy and holders expose themselves to unlimited risk with no stops because their investing system is based in the belief that stocks will have good returns the majority of the time over a ten-year period. This system seems to be more for the benefit of the mutual fund industry than investors. A little later in this book, we will explore some simple trend following systems that easily outperform buy and