Gregg S Fisher, the founder of Gerstein Fisher, wrote about it recently in a Forbes column.

The research found that from the the start of 2004 to the end of 2011, in 16 out of 21 countries, a ‘momentum index’ outperformed the benchmark index; on average it outperformed by 3.13 per cent.

The research also found that momentum can reduce volatility when deployed across a diversified international equity portfolio:

“We looked at the average correlation among momentum indices compared to the average correlation among market indices for the 21 non-US developed nations from January 1, 2004 through December 31, 2011. Result: the average correlation among all pairs of momentum indices was 0.68, compared to 0.77 for all pairs of market indices.”

There is significant academic and industry research that proves a momentum premium exists: ie, you can beat the market with momentum stocks. As Fisher said in his article, ‘why’ a premium exists is still debated; some academics also debate whether the premium can be harvested if you strip out costs.

But the fact is that, if you’re trading, you’re better off focussing on an area where considerable and serious research indicates there is a chance to outperform. Otherwise, put your money in index funds

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Down here in Australia, a train company, QR National, listed on the ASX. But before it listed there was a barrage of negative publicity and about how it was overvalued, etc. It, too, has been a particularly successful IPO.

I haven’t looked closely at Facebook, but make sure you do your own work on it and ignore the media negativity (or hype).

Dan Zanger made $20 million trading Google after its IPO. In an interview I asked him how he ignored the media negativity:

Q: One of your most successful trades was Google. At the time most experts were saying it was way overvalued. What did you see that they didn’t?

Zanger’s Answer: Most of them were talking it down saying it was expensive and overpriced. Actually it was one of the most underpriced stocks I had ever seen. Earnings were up 150 per cent and revenue was up 120 per cent. Even before the internet bubble, a stock growing 100 per cent annually would have a PE of 100. Google had a PE of 45: it was trading at half its growth rate. I haven’t been as excited about a stock as I have on Google. It shows how clueless those broadcasters on TV are.

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Chris Kacher is amazingly talented. He was a child piano prodigy and then worked as a scientist helping produce major breakthroughs in nuclear physics. But his passion is trading.

Like his colleague Gil Morales, Chris is a protégé of William O’Neil, the legendary investor and author of ‘How to Make Money in Stocks’. Along with Morales, Chris is one of the few to have traded O’Neil’s own funds as an in-house money manager.

Chris now runs his own money management operation, but he also teaches traders through his internet site www.virtueofselfishinvesting.com.

Chris and Morales recently released their book ‘Trade Like An O’Neil Disciple: How We Made 18,000% in the Stock Market’ which gives insights into O’Neil’s CAN SLIM strategy and how they’re adapted the strategy for their own needs. The book also tells the story of Chris’s amazing 18,000 per cent return on his private portfolio.

Chris spoke with Your Trading Edge’s Ben Power about how he delivered his amazing returns, his raft of market research discoveries, and the influence of William O’Neil. (The interview was conducted in September 2010)

You’ve had an interesting and diverse career, including music and nuclear physics, so how did you become a trader?

I always tell people to find your bliss, to find your passion. My first love was music and I composed my first song when I was five years old.

I had exposure to the market through my mother, a top broker from Merrill Lynch, and had read about stocks. I bought my first stock when I was 11 years old. While I wasn’t actively trading at that age, I was dabbling, learning, and reading.

I went to grad school – science always came easily to me – where I had an interest in nuclear physics. But half way through my degree I started spending more time in the business library than the particle accelerator, and I realised that my passion was not in science.

At grad school I was reading books, trading the market and building strategies. In 1989 I read William O’Neil’s book (How to Make Money in Stocks), and in 1991 I put everything together and had my first good year in the market; prior to that I was fumbling around.

By 1993 I had my third good year in the stock market and I wanted to switch and go into portfolio management. In 1995, I started one of the first stock investment advisory websites on the internet. The site shared the same URL as the site I run today, www.VirtueOfSelfishInvesting.com, taken from Ayn Rand’s classic book, The Virtue of Selfishness.

You are one of the rare people who have traded William O’Neil’s money. How did you get that opportunity?

At grad school, after deciding to go into portfolio management, I started prospecting and doing informational interviews with a variety of employers. In 1995 there was interest in someone with my – apparently quite unusual – background.

My research group at UC Berkeley made the front page of the New York Times and San Francisco Chronicle doing a confirmation discovery of element 106, then made the first atom of element 110 at the High Energy Linear Accelerator, one of the particle accelerators at Lawrence Berkeley National Laboratory. Having this on my resume made some portfolio managers take notice.

Half way through the year, I got my foot in the door. I got a job with Trust Company in the West working with Charles Larsen. They let me work from UC Berkeley – the first time they had let someone work remotely – and I would provide Charles with my own stock picks. Charles is the one who opened the door for me into this field.

Then Bill O’Neil offered me a job after three rounds of interviews. I joined in January 1995. At that point I told all the companies where I had job possibilities that it wasn’t about the money; it was about being in an environment where I felt I would fit in best. From the very first day I worked with Bill O’Neil it was beyond anything I could have possibly imagined.

Can you describe William O’Neil as a person?

He is very intense, very driven and has what we call ‘insane focus’. We all – Bill, myself and Gil Morales – have it. After sharing some results with him, Bill told me that since I was doing so many research studies I could call him morning noon or night if I had made an interesting finding. It showed how passionate Bill was about the stock market.

I also really appreciated that, despite all his success in the market, he always maintained a humble demeanour. He was always listening to what you had to say. Even if there was a difference of opinion there was a lot of respect. And sometimes we wouldn’t agree.

For example, in the late 90s some internet companies such as Amazon had no earnings. The ‘CA’ in CAN SLIM has to do with earnings. Bill wouldn’t look at a company if it didn’t have earnings. But the price appreciation of these companies was huge. I said to him ‘I think we have to revise CAN SLIM or make an exception’. The first couple of times he wasn’t convinced; the third time he started to change his views. He could see the evidence; it was his flexibility of thinking.

What makes him stand out as an investor?

His humility keeps him grounded even when he’s making a lot of money. He always reviews his trades regularly, printing and marking up stock charts showing where he bought and where he sold. This is a powerful visual and it enables him to analyze his mistakes and learn from them. He also studies many stock charts regularly and marks them up. This enables him to fine-tune his investment strategy even further, which keeps him on track.

He relentlessly focuses and has passion for studying the market every day. The markets will change on you in subtle ways. It’s important to always be on top of the market so you will see those subtle changes.

While you were with O’Neil, you generated amazing returns of 18,241 per cent on your personal account? Were you essentially trading O’Neil’s CANSLIM system, or had you tailored it to yourself?

I always say trading is like a finger print – everybody trades a little differently. My trading, in its inherent logic, shares much with the CANSLIM philosophy. But Bill O’Neil himself doesn’t trade CANSLIM to a tee. CANSLIM is for the retail investor who will read his book and who will benefit enormously from it. But in practice we all have our slight variations.

For example, everybody’s got their own risk management levels and risk tolerance levels. I prefer to hold more than a handful of names; Bill O’Neil and Gil Morales prefer to hold just a handful of stocks and pyramid up. I prefer the lower volatility. I find that even when I traded a small account, I preferred to have 12 to 18 names; and with much larger accounts, I still preferred to hold 12 to 18 names.

You said Bill O’Neil doesn’t trade CANSLIM to a tee, what are some of the things he does differently from what he teaches?

He will sometimes buy a stock that is not breaking out, but will still take a position. Such circumstances are rare, but it often sets him apart from the rest, as he will see divine opportunity to buy where others see chaos or are wholly pessimistic about market conditions.

What is one trade you made during you time with O’Neil that stands out in your mind?

Ebay is a big symbolic trade for a number of reasons. One thing I love about trading is it allows me to keep an eye on changing technology and on the cutting edge of evolution. If there’s a company that’s pushing that evolutionary edge I want to know about it.

Ebay had the first mover advantage in peer-to-peer auctions. I knew they were around, but when I read their pre-IPO of what the company actually did I got very excited about it. I told Bill immediately. But when it IPOed it promptly lost half its value, dragged down in October 98 by the markets that were spiralling downwards when the NASDAQ lost a third of its value.

When the market headed back eBay was the first to turn higher and move aggressively back to its IPO price, forming what I call a ‘U’ pattern. It then gapped up and that was my first buy point. From that point on it went up five times in value before basing again. It was an amazing company with amazing price action.

The market has changed significantly since those heady days: it’s choppier and dominated by high-frequency trading. How has that affected the way you trade?

In 2004 the markets got sloppy. If you look at a chart of the Nasdaq from 2004 to 2005 you see a grinding rally. A lot of base breakouts didn’t work. I realised there was a danger I was going to get ‘nickel and dimed’. That’s when I developed the ‘pocket pivot’ trade. That worked so beautifully that in late 2005 I more than made up for losses. In 2006 I had my seventh triple digit year.

What is a pocket pivot trade?

It lets you buy early in the base before the break out. So your average cost by buying the pocket pivot, then the base breakout, is lower than had you just bought the base breakout alone. You are also in a psychologically stronger position to hold onto the stock instead of getting whipped out of your position, which has been common in the 2000s.  

As with breakouts, you want to focus on fundamentally and technically strong stocks in leading industry groups. The day’s volume should be larger than the highest down volume day over the prior 10 days. My ten rules for pocket pivots are shown at www.virtueofselfishinvesting.com/faqs and many chart examples are given at www.virtueofselfishinvesting.com/reports.

If you miss a breakout, you can still buy into the stock when it flashes a pocket pivot point since some pocket pivots may occur after the stock is extended from the base. If the pivot occurs right near its 10-day moving average, it can be bought; otherwise it is extended and should be avoided. Give the 10-day moving average the chance to catch up to the stock, where the stock would consolidate for a few days, before buying such a pocket pivot.

What is the success rate of pocket pivots?

In practice about half of high quality stocks showing pocket pivots, even in the 90s in the middle of a beautiful bull market, won’t work. This is roughly equivalent to the success rate of standard base breakouts. So, like with any stock they buy, it’s important people keep their stops appropriately tight on every position they initiate.

Do you have an example of a pocket pivot trade?

A recent example is CYT, which manufactures specialty chemicals sold worldwide for the aerospace and adhesives industry. It has strongly rebounded in both earnings and sales, and is in the top 10 per cent of industry groups. It had a pocket pivot on September 10. The next day it traded up 5.7 per cent, which also coincided with a base breakout, so it could have been bought a second time.

IGTE also had a pocket pivot on September 8 and is up 9.7 per cent as of its closing price on September 14. IGTE is in the information technology business, providing business process outsourcing and clinical research services and has enjoyed both accelerating earnings and sales over the last three quarters.

You also trade stocks that gap up, which is something O’Neil doesn’t recommend, particularly if they move too far from the base

Gap ups are something I discovered in 2005 in the challenging, sideways, grinding markets that characterized that year. I found that fundamentally strong stocks that gap up in a certain way, and that have certain technical patterns, can be bought even though they look too expensive up there.

This gap up concept, as with my other concepts such as the pocket pivot, came about from my love of doing research studies in the market. I spent time every day looking at many gap up examples going back decades and marking up charts and isolating key variables. Our book discusses gap ups and pocket pivots in detail.

What are some of the characteristics that make a gap up attractive?

The stock should ideally be a leading stock in a leading industry group. The chart pattern leading up to the gap up should be constructive. Gap ups where the stock jumps 10 per cent or more overnight are often due to fundamentally strong news that can set the stock on a completely new course. So while the stock may seem expensive, it actually can move a lot higher from its gap up price. I’ve created a number of rules on how to identify gap ups, and how to handle them as they move higher, and how to sell them. These rules are discussed in detail in our book.

One of the most important but often neglected parts of CANSLIM is the M – the need to time the market. You’ve created your own market timing model. Can you describe it and how it differs from O’Neil’s?

My model is based on my statistical studies of how the major stock market averages actually behave on a price/volume basis ng back many decades. A live version of the model with past signals can be viewed at www.virtueofselfishinvesting.com. My model is largely responsible for my KPMG-verified long-term track record and has kept me on the right side of the markets since 1991.

I developed the model in the early 1990s. Being in grad school and being very much a quant, I started studying price volume action and created rules. The M in William O’Neil’s CANSLIM stands for market direction. My research studies that started in 1991 were motivated and inspired by that. But there was a lot of confusion as to what, say, was a proper distribution day and a proper follow though day. The different variables were not defined in a way that was consistent and it created a lot of confusion.

My model differs somewhat from O’Neil’s system. O’Neil, for example, used to primarily want to see follow through days in the fourth to seventh days of the attempted rally; but you can sometimes get follow through days that work on the third day, or even the 12^th or 14^th days, as long as the quality is good and it occurs with some leading stocks showing constructive price volume patterns. One important aspect to my model is risk management. Whenever my model issues a buy or sell signal, it has a fail-safe built in so if the signal proves to be false, the model will go to cash.

Do you trade the market timing model as a standalone, or do you use it to guide buys and sells of stocks? (ETFs)

I use the timing model to keep me on the right side of the market. When it issues a buy signal, I look to aggressively accumulate leading stocks in leading industry groups. I buy stocks rather than ETFs because I can make more money buying stocks. That said, with the advent of 2-times and 3-times ETFs, big money can be made going long 100 per cent a 3-times ETF such as TYH which moves 3-times the Russell Technology 1000 and is a relatively good proxy for 3-times the NASDAQ Composite.

What is your view on mechanised trading? Is it something you’re doing?

In 1998 I worked with Rashneesh Gupta, the head programmer at O’Neil. We wanted a computer to identify the quality of a base and act accordingly. But what we found was it’s virtually impossible to tell a computer what Bill O’Neil is seeing or what I’m seeing. There are too many exceptions. There’s no substitute for monitoring a market daily, running screens, looking at charts and hand picking the best of the bunch.

Your colleague Gil Morales has done well shorting, is that something you’re into as well?

I tend not to short individual stocks simply because it doesn’t suit my trading personality. There’s a lot of volatility and I don’t like that degree of volatility. When my model issues a sell signal, I look to buy inverse ETFs such as TYP which is the inverse of TYH I mentioned earlier.

You manage money for wealthy individuals and institutions, but also write newsletters. What attracted you to newsletters?

This dates back to my days in grad school. I always loved to teach and see someone understand what I’m saying. I then went on the road with Bill O’Neil talking to audiences as large as 800 people. I loved the Q&A session at the end. People would come up to us and throw lots of questions to us. People were hungry for knowledge and I’d just love seeing the light bulb go on when they understood something. I also find that I learn much by teaching others, so it keeps my trading on track. Lastly, by sharing my wealth of information with others, I find there is often brilliant reciprocity which gives me ideas for new research projects.

Are there signs the current market is getting healthier? Is it still dominated by what you’re referred to as ‘junk’

My model put in a buy signal on September 1. It’s still on a buy signal (at September 15). We saw evidence of constructive price volume action on leading stocks shortly before September 1. The buy signal was added confirmation and we have taken positions in leading stocks since then.

Keep in mind the market likes to climb a wall of worry. According to sentiment surveys around 50 per cent of investors were recently bearish, compared to just 20 per cent bullish. From a contrarian point of view that’s bullish. So this market may continue to climb a wall of worry. There are a lot of reasons to be worried; there are a lot of headwinds coming up for this market. But until I see evidence of that in price and volume action in major indices and in leading stocks, I’m going to stay bullish.

The best names will often go higher in markets like this. Stocks such as VMW, CTXS, RVBD, CRM, NFLX, APKT, FFIV, ARUN, and MCRS should continue higher, outpacing the general market if it continues to go up. Most of these names have shown pocket pivot action, enabling an investor to get on board early, or buy late if they missed the breakout. They’ve been going higher in force over this downward sideways market.

Finally, what is one thing that a trader can start doing now to improve?

Go back through all your trades for the last two to three years. Print out the charts and take out a red pen and mark where you bought and where you sold. Then make a list of the mistakes you have made. Write out a list of how not to make those mistakes and paste that list up on a wall. Carry the charts with you so you can review them frequently. This reinforces what you did right, and what you did wrong.

MORE EXCLUSIVE TRADER INTERVIEWS:

Mark Minervini: Market Wizard and trading legend – How to achieve compound annual returns of 220%

Henry Carstens: Victor Niederhoffer protege — How become a profitable systems trader

Victor ‘Trader Vic’ Sperandeo: Trading legend — Why he’s a gold bull

Ernest Chan: Private quant trader — How private traders can use quant trading to compete with the big banks and hedge funds

Mike Bellafiore: Prop trader — Creating the best trader education programme on Wall Street

Ari Kiev: billionaire Steve Cohen’s late coach and trading psychologist: Walking among trading giants

Dan Zanger: World record trader — How to turn $10,000 into $42 million

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Ahhhhhhh!!!!!

It’s becoming a major issue.

Information, of course, is potential power: it can be used for good or to profit. But the problem now is the sheer volume thrown at us. The market, with constant noise and movement and opinion, is particularly bad.

The constant flow of information draws use closer and closer to the market until we’re completely beholden to it. Before you we know it, our emotions rise and fall with each market rise or fall. We totally lose perspective on what’s happening.

Talking to traders, that’s exactly what happened in 2011: everyone became so obsessed with a bit of volatility and economic doom that they totally forgot it wasn’t a really disastrous year; and that the US market’s are still probably in a bull market.

So what to do? ‘

Here are a few things to help cut information overload:

1. Focus on what is happening, not what might happen

Ignore constant predictions about what might happen, which can cause panic and confusion, and focus on what is happening right now. That is the best clue to the future. For aggressive growth investors, are bullish chart patterns developing? What companies are generating accelerating sales and earnings? What companies are developing innovative new products? When it comes to the broader market, are there signs of accumulation? Is the market in an uptrend or down trend? Are new highs bigger than new lows? Look at the facts now, and stop worrying about the future, which you can’t predict.

2. Look at the bigger picture

As I said, the market draws us in. Practice drawing yourself back out. Look at long-term charts: weekly and monthly. Look at the big picture: is the market actually in a bull market, but just undergoing a correction? Or are we in a long-term downtrend?

3. Turn off the computer and other devices.

Mobile devices are handy, but a nightmare when it comes to information overload. Turn them off, at least, over the weekend, or just check them once or twice. Most people are addicted and it will be difficult. The urge to turn them back on is overwhelming, but try and ride the urges and it will get better. The reward is a clearer head on Monday morning.

During the week turn off every device after work. That includes mobiles, ipads, and computers. Give your brain a rest from the bombardment.

3. Ditch any non-essential information services, newsletters, blogs, etc.

Perform an audit on information you receive: does it actually add value? Does it actually help you make money? Does it contribute directly either to learning new strategies to make money, or directly to trading decisions? If the answer is no, ditch it.

4. Start reading printed products again.

Everything has gone digital. But to help your brain slow down and contemplate start reading printed products and magazines again. I’ve found sitting down and reading The Economist magazine, for example, gives me a fresh perspective on events, particularly big-picture trends; but being printed it’s not delivered in that frazzling, digital blur.

5. Print things out.

Rather than read everything online, which tires out your brain and contributes to overload, print articles and information out and sit somewhere quiet and read it. Again, it’s a slower more contemplative way to absorb information.

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I’ve developed a simple system that helps you monitor hot stocks that you’re about to trade, but also allows you to keep an eye on other stocks that have potential but that you aren’t yet ready to place orders on.

As you can see in the screen shot below, you simply divide stocks into three categories: targets, watchlist, and uptrend. You can do it for longs and shorts as I have.

Every time I do a complete market scan I filter stocks into these three categories

So how do I determine what goes where?

Uptrend stocks – They’re trading above their rising 50-week moving average. But they may be overextended or have slightly sloppy charts. Basically I want to monitor them because they’re strong, but I don’t think I’d be likely to place a trade in the next few weeks at least.

Watchlist stocks – These guys are more interesting. They usually fall into two categories: they’re forming a base/consolidation pattern that means they could be traded in the next few weeks; or a fundamental screen has shown them to have excellent fundamentals. Unlike uptrend stocks, there is potential for a trade in at least the next month. I want to keep a close eye on them.

Target stocks – These are the stocks I have decided to trade and where I have identified a point where I want to buy them. When they hit this category I fill out a spreadsheet with checklist of a series of technical and fundamental factors; I fill out a separate spreadsheet with a checklist of factors that indicate the strength of the market. Finally, before I actually place a trade, I fill out a spreadsheet with details including buy point, stop loss, amount of account I will risk, number of shares, etc.

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Minervini honed his strategy and – as highlighted in Jack Schwager’s Stock Market Wizards – in a five-and-a-half-year period generated an average annual compound return of 220 per cent. To put that in perspective, a $10,000 account would explode to $3.3 million under those returns. Even more impressive was his risk – Minervini had only one losing quarter when he was down just a fraction of one per cent. 

Minervini also took out the 1997 US investing Championship with a 155 per cent return, and went on to run a successful investment advisor firm, Quantech, which worked with some of Wall Street’s leading hedge funds and investors.

But it has just been spectacular returns that has marked Minervini out. He has also made a series of prescient market calls and protected his account with defensive moves. In August 1998 he publically said the market was showing similarities to the 1987 crash. The next day the market slumped 508 points. He then turned bullish a month later and rode several stocks to huge gains. In May 2000 Minervini successfully called the bear market in internet stocks and put most of his account in cash.

The core of Minervini’s strategy is SEPA (Specific Entry Point Analysis), a proprietary computer-driven technology based on the models of historic winners. SEPA combines quantitative screening, fundamental research and qualitative analysis as part of its core selection criteria to identify stocks with the potential for significant price appreciation.

In addition to his own trading, Minervini has turned to educating traders with Minervini Private Access, with members gaining access to live stock selections and even a live trading room where a live moderator reviews and explains rational and analysis on Minervini’s trades.

Mark spoke with YTE’s Ben Power

You started your career as a drummer, how did you shift into trading?

I simply opened a brokerage account and started trading my own money. I saw the stock market as the ultimate financial opportunity without prejudice. That’s the beauty of the stock market, it’s just you and the market; you don’t need anyone’s permission. The market doesn’t care about pedigree, it treats everyone equally. It doesn’t care if you’re a drummer or a plumber. It gives you pure, instant feedback, and it never lies to you. Each night, you get an honest assessment or “report card”, your account balance. I began investing in stocks in 1983. I started with a small amount of capital that I earned working as musician. For about five or six years I didn’t make any money. In fact, I lost money. It wasn’t easy to stick with it through those difficult years, but my love of speculation kept me going. Eventually, I acquired the necessary skill to succeed. Over time, I grew my trading account. The rest is history.

How did being profiled in Stock Market Wizards change your career?

It didn’t really change my career very much. My career had consisted mainly of trading my own money. Although I sold research to institutional clients for a period of time, 95 per cent of my wealth has been created trading my own account. By the time I was interviewed in Stock Market Wizards, I had pretty much already accomplished my financial goals. I have never really been too interested in managing other people’s money, so I didn’t really leverage the book nearly as much as I could have.

In your Market Wizards interview you cited Richard Love’s book Superperformance Stocks as a major influence. His book is long out of print. How exactly did Love define a ‘Superperformance stock’?

A stock that advances 300 per cent or more within a two-year period.

Believers in the efficient markets hypothesis, who say it’s almost impossible to beat the market, concede that momentum stocks are one strategy that can deliver above-market gains. Would you describe your trading as momentum?

I don’t really like labels, but I guess I fall into the trend following/momentum camp. I definitely have a bias toward growth. 

You call your strategy Specific Entry Point Analysis (SEPA). Can you explain it a little?

SEPA® is s strategy of precision. Timing is a key component. The objective of SEPA® is to take all the pertinent information available, and pinpoint the precise spot at which to enter a high-probability trade in terms of reward versus risk. This is achieved by taking into account what we know influences institutional buyers. 

The key is convergence. SEPA® employs a method of stacking supporting probabilities. For example, if one variable is present, you may have a certain theoretical probability of a particular outcome. While a separate variable may have a certain probability; and so forth, the probability of combining the variables is not as simple as just an average. By stacking supporting probabilities, the cumulative probability can increase exponentially as each variable is added to the equation. 

We take into account all sorts of data including fundamental and technical.  Once the supporting criteria are met, we look for a low risk entry point.

What fundamentals are you looking for in a stock?

Optimally, I want to own companies that are delivering the goods; strong earnings, sales and margin growth. I’m looking for the ones that have something really great going on, which translates into bottom line success. Not much different than what any good growth manager would look for.

You’ve said you enter when a stock breaks out of a constructive consolidation. How do you define a constructive consolidation?

A constructive consolidation is one that has gone through the proper supply/demand dynamics that then sets the stock up for a line of least resistance. If the stock is under accumulation, the consolidation will represent a period of time where strong holders ultimately absorb the weaker ones. Once the “weak hands” have been eliminated, the lack of supply allows the stock to move higher because even a small amount of demand will overwhelm the small supply. Stocks that are under institutional accumulation will rest and consolidate within the context of a long-term uptrend and then continue higher. Most of these situations will show tell tale signs. 

You’ve said you stick to your system even when it’s not performing well. Does your system perform best in a trending market?

Yes. As defined by our Trend Template qualifier, I require a stock to be in a confirmed uptrend prior to my purchase. So, by definition, a trending market is the best environment for my style.

How did your system perform during the recent bear market?

With the exception of some short positions, I was in cash during the grand majority of the decline. I’m not likely to be caught in a major decline because our stop-loss discipline gets us out fairly early. You won’t get too far off track, if you allow the market to guide you.  However, if you argue with the market, eventually you will suffer a major setback.  

For a strategy like the one I employ, a back and forth volatile market is actually riskier and potentially more destructive than a declining market. If the market breaks down and trends, I’m out and that’s the end of it. However, in a whipsaw environment, the risk of using relatively tight stops is getting repeatedly stopped-out and suffering a large loss as a result of a bunch of small losses. 

We’ve seen big gains lately in the US stock market particularly, but it was led by a lot of stocks with poor fundamentals. Is that changing? And how have you played this bull market?

I don’t think I would necessarily categorize this bull market as being led by stocks with poor fundamentals. Many of the leaders during this bull run sported excellent fundamentals. NFLX, AAPL, BIDU, CMG, FFIV, RVBD, PAY, LULU, TIBX, GMCR are all examples of leaders that had great fundamentals. 

Do you have an example of a recent winning trade?

Body Central Corp. (BODY) –  Stock went IPO in October 2010.  I bought it on January 5, 2011 and sold it just 5 days later on January 11, 2011.  The stock rallied almost 50% in 6 days. This is the type of situation I look for.

You’ve said you often sell too early. What would trigger your exit from a winner?

I may simply sell when I have a big gain that I’m satisfied with. I’m not really concerned with getting the highest price, I’m concerned with making more than I risk and doing it over and over again consistently.  

The five or ten-bagger is not something I need to achieve to make big returns. When I make a really good gain, generally when it reaches a multiple of my risk, I then look to protect what I’ve made, and at some point sell the stock. If the stock is really strong, I may stay with it, unless I think it’s gotten too far ahead of itself and it appears vulnerable. The key is to make more than you risk, do it consistently, and avoid large losses.  Once you can do that, then you can work on optimizing your trading. 

Where do you set your stop-loss points?

Depending upon my position size and the liquidity of the stock, my stops generally range between low-to-mid single-digit.  My “Uncle Point” is 10 per cent maximum. I never want to lose more than that on any one trade. I will also sell if I think the trade has technically or fundamentally gone sour, often before my stop is hit. I back into risk; position size is based on where the stop-loss is. 

SEPA looks for trades with high potential reward/risk ratio. How do you determine reward/risk?

After trading tens of thousands of stocks, I have a pretty good idea of what I can expect from my trades on average; intuitively and scientifically. That’s because the buys are made under very consistent, reliable conditions (the set-up). I also rely upon our Leadership Profile® of past stock market winners for models as a guide. This is in addition to in-depth post-analysis of my own trades. 

The estimated profit is a very important consideration when deciding the amount of risk I’m going to take. I back into risk according to what expect I can gain. From that perspective, the stop is a mathematical calculation.  However, the price action of the stock is also very important and telling. I enter trades at very specific points using charts. So, it’s a balancing act between math and technical analysis.    

How long do you tend to hold stocks for?

On average, maybe 20 trading days, however, much of that is due to high turnover as a result of loss cutting, which generally occurs quickly within the first 5-10 days on average.  It’s not uncommon to hold a winner for several quarters.  However, I rarely hold for long-term capital gains (a year or more). 

Are you still shorting stocks?

Yes, but I do relatively less shorting in a bull market than a bear market.

Many traders say the biggest challenge is when markets change and their system starts underperforming. Do you thing markets change, and have changed? Or do you think they cycle? (The former implies the need to reinvent new systems constantly; the latter implies sitting out rough patches)

Not really. Stocks today rise and fall for the same basic reasons as before: people drive stock prices, and people stay basically the same. Fads come and go. Businesses grow by doing things better, cheaper, and more effectively. Has the way you throw a baseball, a football or a basketball changed very much?  Has the way you throw a punch in boxing changed much over time? I certainly strive to improve my techniques, but there are certain fundamentals that, for the most part, are timeless. 

Very little has changed in the market except more information moves faster than before. I try to approach trading through timeless truths. If you base your approach on timeless principles, you will have the best chance for longevity, and you won’t have to constantly reinvent your method. I’m doing the same things I’ve done for several decades, and the results are quite consistent.   

You’ve recommended new traders get a mentor. Do you have one yourself?

I never had the luxury to have a personal mentor other than reading books.  Back in the day, during my first six or seven years trading, I spent most of my time in libraries because I didn’t have much money to buy books. However, you don’t have to go it alone these days. Today, we have access to all sorts of information and talent via the internet and technology. Take advantage of it.  The learning curve is shorter than ever.  Minervini Private Access was created to help traders not only learn and profit from our SEPA® approach, but more importantly, to become a self reliant, successful trader. Shameless plug… LOL!

In Stock Market Wizards you said you rarely took a holiday from the market. Does trading success require that kind of obsession and focus?

I think to be really outstanding at anything it requires a major commitment. In order to be great at something, you must be focused and somewhat unbalanced and maybe even obsessed. Champions don’t have balanced lives; they are laser-focused and obsessed with winning.  Passion is unbridled. 

Finally, what is one thing traders can start doing now to improve their performance?

Know the truth about your trading. Find out where you’re going wrong and what areas need improvement. Look for common denominators and your emotional tendencies. Understand why you do what you do. Improve your weaknesses until you have no weaknesses. 

Believe it or not, few traders really take the time to analyze their results and truly understand their trading. It takes time and attention to detail; big success is not going to happen overnight, and it’s definitely not going to be easy. However, the rewards are it well worth the effort.

Bottom line: Those who can weather the learning curve and those who can handle the truth about their trading make it, and those who can’t find another line of work. And then, there are those who are oblivious; they eventually self destruct. As Gordon Gekko put it: “A fool and his money are lucky enough to get together in the first place.”

MORE EXCLUSIVE TRADER INTERVIEWS!!!!!!!!!!!

Dan Zanger: World record trader — How I turned $10,000 into $42 million trading stocks

Henry Carstens: Victor Niederhoffer protege — How become a profitable systems trader

Victor ‘Trader Vic’ Sperandeo: Trading legend — Why he’s a gold bull

Ernest Chan: Private quant trader — How private traders can use quant trading to compete with the big banks and hedge funds

Mike Bellafiore: Prop trader — Creating the best trader education programme on Wall Street

Ari Kiev: billionaire Steve Cohen’s late coach and trading psychologist: Walking among trading giants

Dan Zanger: World record trader — How to turn $10,000 into $42 million

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2011 was a tough year for everyone.

Hopefully 2012 will be better.

While things are difficult now, it’s often worthwhile looking back at previous tough patches and realising that we come through them eventually.

Also opportunities always spring from bad times.

The economy will heal, and get better, there will be another boom, and everyone will have forgotten this period.

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Stocks like Green Mountain Coffee Roasters (GMCR) and Netflix (NFLX) have plummeted over the last six months or so.

 ‘Oh my god, a momentum stock has cratered’!!!!

I know it’s not pleasant getting caught up in crashes, but if you don’t think momentum stocks should or will fall, then you have no business trading them.

It’s called risk and volatility.

We’re riding the gales of creative destruction.

Momentum stocks are risky. That’s why they outperform the market over time. It’s why momentum traders earn a premium.

So what can you do about it? Here’s 9 things:

1. Accept the risk.

Momentum stocks sometimes implode. Of course they do. That’s the nature of the beast. They are growing rapidly and have high earnings estimates. When that growth slows the market is disappointed. You’re also playing the game with other trigger-happy traders who flee at the first sign of trouble.

If you don’t like risk and volatility, buy bonds, or invest in cash, or buy an index fund. All are very valid options.

2. Get out as soon as a stock falls 

There is no excuse for being caught in a steep sell off. As soon as the stock starts going down, as defined by the Only Profit-taking Rule You Need, you’re out of there.

I spoke about this recently with regards to GMCR

That said, sometimes you just can’t avoid getting caught in a company, with a strongly trending chart, that issues a profit warning.

There are some things that may minimise the chances of getting caught in a profit warning, and help minimise the damage to your portfolio; but they never eliminate the risk totally:

3. Try and get on board early

Buy at the start of a momentum stock’s second big leg. It’s about when the 50-week moving average starts to turn up (usually after the stock has already gained 50 to 100 per cent).

4. Consider adding some quality screening factors

Here is a summary of five factors to look for to judge the health of a company (this article refers to beaten down growth stocks, but it applies equally to strong stocks)

5. Sell more quickly

I advocate riding a stock till the end. But you might choose to take profits more quickly to avoid exposure. That’s an option. But it still doesn’t remove risk. Short-term traders also get caught holding stocks that issue profit warnings and gap down.

6. Do deeper qualitative research

Get to know a company better: monitor the market it operates in closely and be ready to detect any change in conditions and sales. This, obviously, is more suited to investors with more time and resources.

7. Diversify risk

Don’t risk more than 2 per cent of capital in stock. Don’t let one stock become more than 25 per cent of your portfolio. If a stock crashes 20 per cent in a profit warning and it makes up 25 per cent of your portfolio, the damage done to the portfolio is only 5 per cent.

8. Don’t pyramid up

Don’t keep adding to your position as it goes up.

9. Don’t use margin

I’ve found that when I go on margin, because I’ve run out of cash to buy, it’s time for a steep correction in the market or stock.

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But at the same time, the chart below shows it has clearly made a lower high. If it falls below the last recent low then it would be in a fresh downtrend.

As I wrote recently, there have been opposing forces at work with gold. On the bull side are fundamentals (ie central banks printing money and global uncertainty) and the long-term uptrend; on the bear side is the fact that gold has become too popular.

When there are opposing forces like this what do you do? Firstly, nothing drastic. You don’t go massively long or short. There’s no harm waiting for more information. If gold enters a downtrend and breaks the support of the long-term trend line and 50-week moving average, then you might peel off some of your position if long; and perhaps initiate or add to your position if short.

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I then said my retirement account was invested purely in index funds. Naturally, as an active fund manager, he was offended and he pretended to ask for the bill back so I could pay for my own f-ing lunch.

I explained my rationale: over a 30-year period (about when I’ll be retiring) it’s almost impossible to beat the market. My retirement fund and paying down my mortgage would mean I’d have a very comfortable retirement.

Moonshots

I then said that, outside of my retirement account, I would make “shoot for the moon” investments. I called them “moonshots”.

Moonshots?

Basically, investments that have potential for massive returns: investments that could turn $5,000, into $50,000 or even $500,000; investments that could make a material difference to your medium-term wealth.

A moonshot has limited downside, but huge upside. It’s a stock where you risk $1 a share but could earn $100 or more.

Moonshots provide spice, and hope, if your income potential is limited and most of your portfolio is conservatively invested.

Made $30 million and retired

My friend was sceptical when I mentioned moonshots.

Then he remembered what he described as ‘coterie’ of London-based Australian brokers who had done exactly that – bought moonshots.

They bought into an Australian resources company at around 5c a share. It was later bought out for over $5 a share. They made around 100 times their initial investment. One broker pulled out a million; the other made close to $30 million and retired for life.

I got the idea for moonshots from the late Peter Bernstein, the highly respected economist, money manager and author of books like ‘Against the Gods’.

Berstein was one of those wise old guys that I increasingly listen to.

Advice for youngsters

In an interview Bernstein talked about shooting for the moon.

He was asked this question:

Is there any specific advice you can offer to financial advisors that manage assets for younger clients?

His answer:

I learned from managing individual money that investors with small portfolios, relative to other assets, take too little risk. Their overriding criterion is the consequences of loss. But when you are young you can afford a loss. Shooting the moon and losing is not terrible. But making a killing makes an enormous difference. The fear of regret is weighted too highly. Investors can take risk through higher equity allocations, exposure to small cap and international stocks, and by being less diversified.

A long time ago I gave a talk at the New School of Social Research. A man – not too well dressed – came up afterwards and asked if we were looking for a new client. I said “sure, send us your portfolio.” He owned only three stocks, like U.S. Steel, that he had bought on margin and now had big profits – on the order of $150,000. He was doing very well, so we asked him why needed us. He was a reporter with the Brooklyn Eagle, and he was losing his job because it was going out of business. Had only $15,000 in the bank and was going to be broke in a year. But, with his investment success, he had a comfortable amount. He took the right risks at the right time, and it paid off. I learned a lot from that person, and I think about it often.

Frustratingly, Bernstein didn’t really go into too much detail. But his point is this: sometimes we take too little risk. Steve Cohen’s coach Ari Kiev used to say too little risk for traders is as big a problem as too much risk.

Context of lives

I need to put moonshots principle in the context of people’s lives. Some people have limited capacity to earn big bucks. Some people are not business people — they will never start a business, grow it and cash out.

So for them, they look ahead and see a reasonably good income, then after 30 years of disciplined savings and investing a comfortable or affluent retirement.

That’s comforting, but also kind of depressing – where is the upside in the meantime, at 40, 50, 55?

I’m convinced that almost all men need to pursue the accumulation of a modest fortune. Psychologists and socialists will tell you that’s crap and that there’s more to life.

There is (which is why I’m a self-employed writer!), but the material impulse in man is also powerful and dangerous. Crush it and deny it and it can warp you.

The most jealous people I meet are often school teachers and public servants with limited monetary upside who become embittered with the world because all they see around them are rich people; rich people who have what they never will.

Money makes you more satisfied

Psychologists are also revising the notion that money doesn’t make you happy. Yes, they’ve found that money does make you happier up to about $US75,000, then it tails off. But they’re also finding that the more money people have, the more satisfied they are with their lives: when people look back at their life and achievements, the more money they’ve earned the more satisfied they are.

My point is that having some kind of medium-term financial upside potential – call it hope – is extremely important.

But if you can’t earn a big income or are not suited to business, then you need moonshots for that – you need a portion of your income at risk in the hope of making a big enough return in the next five to ten years to make a substantial boost to your wealth.

Buying penny dreadfuls?

So am I going to go out and start buying penny dreadfuls and hope to make 100 times my money?

No.

But what the ‘shooting for the moon’ principle does is reinforce my belief in the aggressive-growth, momentum trading style and where it fits in my portfolio: it is the portion where you go for it, and which could deliver a significant windfall in the medium-term – it gives you hope that something will change for the better as you plod towards retirement.

As usual, there is a caveat. Moonshots, as mentioned, need to have limited and defined downside and virtually unlimited upside. It’s like the Aussie brokers inLondon. The worst that could have happened is they’d lose 5c a share (unless they were using margin). If the resources company failed they weren’t going to end up in debt.

Sensible people

Momentum stocks are similar: a well-placed stop limits the downside, but the companies have huge potential to earn big returns in a relatively short time-frame. They have moonshot potential.

Sensible people will tut tut and frown at all this. For the most part sensible people are right and I certainly listen to them. But as I’m learning, life is more complicated than sensible people lead you to believe – we all need a bit of hope in all aspects of our lives, including financial.

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