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Archive of Trading Education Articles

My 10 Steps to Finding Winning Trades By Dan Zanger*Posted: Mar 16, 2012

One thing about the market is that, no matter how long you've been trading, there are new lessons to be learned in every trade. Some lessons are positive, such as when you log a winner and look back on where you went right. Others, such as analyzing a trade that cost you money, aren't as much fun but can be more valuable. Win or lose, the market is always schooling you.

To be consistently profitable, it is absolutely essential that you:

    * Keep an open mind; assumptions matter less than results * Check your ego and emotions at the door; win or lose, it's not personal * Evolve a set of rules based on your trading experience and risk profile

It is also important that you understand that the market owes you nothing and that other traders are just as determined to take your money as you are to take theirs.

I am continually asked in my live trading rooms and seminars and by the media to explain how I have been able to make money consistently all these years. The steps provided below may seem simple, but it takes years to become proficient, not only at finding the best stocks to trade, but also at knowing when it's time to pull the trigger. A final caveat -- it may seem simple, but it's not easy!

1) Glide with the tide

You've undoubtedly heard the saying, "Never step in front of a moving train when trading." That wisdom holds for both bull and bear markets. It may seem obvious, but I can't count how many times I've seen traders get excited about a stock that's starting to move while completely ignoring market direction.

The only time I go long in a bear market or during a correction is when my market leaders are telling me that a new rally is underway. Likewise, I never sell stocks short when the bulls are in control.

Fighting the tide is a great way to exhaust your trading account. If you're intent on giving your money away, it's far better to find a worthwhile charity!

2) Become a leader specialist

Every big rally has it leaders. In the 1920s, it was housing stocks first and then radio stocks. In the 1990s, it was the Internet stocks that led the way. In 2003 - 4, housing stocks were the ones to follow.

Your job as a trader is to find the strongest sector and, then, focus on the strongest leaders in that group. Hint: If there are no clear market leaders, chances are, you're in a trading range-bound market. Trading this market is a good way of throwing you money away.

3) Train yourself to be a pattern pro

As any airplane ace pilot will tell you, it is essential that you learn to recognize an enemy aircraft in a heartbeat and shoot him down before he gets you. Although trading may not have the same dire consequences, it is a prerequisite that you be able to recognize money-making patterns in your sleep.

Of all the indicators I use, chart patterns are the single-most important factor. Patterns such as Head & Shoulders, Double and Triple Tops and Bottoms, Cup and Handles, Flags, Pennants, Saucer Bottoms and Wedges are but a few examples.

I've spent thousands of hours during my spare time pouring over daily charts to learn to spot these gems. It is also important to know the differences between continuation and reversal patterns. A pattern missed is a money-making opportunity lost. I outline 11 of the most powerful patterns in the education section of ChartPattern.com site.

Figure 1. My eSignal Screen of the Leaders I Followed in the Early Stages of the Bull Rally in March 2009. I focused on the stocks showing much greater volume than normal on big percentage moves.

4) Volume is the fuel that drives patterns and profits

Many traders make the mistake of ignoring volume when looking for trades. But, chart patterns without the proper volume profile are meaningless, and different stocks exhibit different volume patterns.

As we see in Figure 2, volume increased dramatically through 2004 and into 2005 as the rally gathered momentum. Each time AAPL consolidated in a flag or pennant pattern, volume went ballistic on the breakout.

For most stocks, I like to see volume steadily increase throughout a rally, but I get leery any time overall volume starts to decline unless it's accompanied by a continuation pattern, such as a flag or pennant.

5) Pick your entries and exits

Once you've discovered a chart pattern with supporting volume, you need a buy or sell point. A buy signal occurs when the stock breaks up through resistance and a sell when it breaks down through support.

Support and resistance can be horizontal lines, or they can be sloped. They can also be curved, such as in the case of a moving average or parabolic support and resistance (SAR). But, whether you are buying a pattern breakout or using moving averages, you don't make a dime until you buy and then sell or vice versa.

And, believe it or not, it's better to be a pessimist in a trade. That way, when your stop is hit, you get out first and don't second guess it. I can't count the number of times I've seen traders stick with a losing trade because they were optimistic that it would turn into a winner, and then they lost a bundle.

Figure 2. Daily Chart of Apple Computer in February 2005, Showing the Powerful Move Demonstrated by the Flag and Pennant Patterns with Buy Points All the Way Up. Note the powerful volume that accompanied the rally.

The first five points were technical. Now, let's look at some fundamental factors that I use to help find winning trades.

Very short-term trades are 90 percent technicals and maybe 10 percent fundamentals. But, as the time frame increases, fundamentals become more important. Warren Buffett is an extreme example of a fundamentally driven trader whose ideal time in a trade is forever. But, for most of us, fundamentals serve a purpose that is influenced by the fact that the data lags, so they should not be used independently to enter or exit trades.

This painful lesson was demonstrated again during the housing market bubble -- and beyond -- when builder fundamentals remained strong long after the housing sector had broken down in 2005 and 2006. Those who waited for a decisive breakdown in revenues and earnings lost a lot of money!

Figure 3. Two Examples of Resistance Buy Points on Las Vegas Sands (LVS). The first is the sloped downtrend line and the second, the horizontal trendline.

6) Hunt for earnings powerhouses

Market-leading stocks generally lead their respective industrial sector. Taser (TASR) was the clear industry leader in 2003 - 4. Google, launched in 2004, quickly became the Internet search leader. Apple is another big leader that dominates its market.

I look for companies with earnings of more than 70 percent in the most recent quarter as compared to the same quarter the year before. In the case of Taser, earnings jumped more than 200 percent.

It is not uncommon for these monster leaders to gain anywhere from 500 to 5,000 percent before the move is over. For example, CMGI moved more than 6,000 percent in less than two years during the Internet heyday.

7) Look for new companies, new products, new markets

Market leaders are usually either new companies that recently went public after successful Initial Public Offerings (IPOs) or have launched a new game-changing product or service. They can also be companies that have recently experienced radical management changes. Examples of new companies include Google and Apple. But, more established companies, such as housing powerhouses, Hovnanian Homes and Pulte Homes, which dramatically gained market share during the housing bubble, also became market leaders.

Research in Motion (RIMM) was another example of this with the launch of the revolutionary BlackBerry mobile phone -- until they began to lose subscribers.

8) Focus on companies that dominate their space

Another factor I look for in my continual search for market leaders is companies that dominate their space. To keep earnings growing at a dramatic pace, it is essential that companies absolutely rule their markets and continue to make it extremely difficult for competitors to catch them and gain a foothold in their market.

9) Look for stocks still off the radar

My goal is to discover market-leading gems before the institutions do or at least as the institutional managers are beginning to accumulate the stock. How do I do it? I look for stocks with relatively small floats (shares available to trade).

Ideally, the float should be less than 100 million shares. Stocks with a limited supply of stock and a compelling product or service story can go ballistic when institutions -- and then the public -- start to buy.

Remember Taser? It started out with a float of approximately 3 million shares. That number subsequently grew to more than 50 million shares, but, by that time, the biggest moves were behind it.

10) Take other factors into account

I mainly rely on chart patterns and volume to trade, but many other factors can't be ignored. For example, stock seasonality can be very important, especially with respect to stocks in the commodity space, such as fertilizer giants Potash Corp. (POT) or Agrium (AGU).

Some of the more traditional indicators, such as the Relative Strength Index, stochastics or even Elliott Wave analysis, can be useful tools, but you need to understand how they work, as well as know their weaknesses.

I use specially designed indicators in my chatroom and newsletter that help me recognize when stocks are getting near a top or bottom. I also find daily, weekly, monthly and yearly cycles valuable in helping me anticipate big moves.

Finally, find a market mentor -- someone with the track record you'd like to have and learn from that person. Learning from someone else's experience and mistakes is far easier and cheaper than having to learn these lessons the hard way on your own!

A Journey of a Thousand Miles Begins...

Trading can be the most stressful, as well as the most rewarding, job in the world. The difference is in how you approach it. Those who treat trading like a day at the casino will find themselves on an emotional rollercoaster ride that ends in the poorhouse.

On the other hand, a structured, disciplined, business approach to the game that employs a clearly defined trading plan will go a long way toward putting the odds in your favor.

*Reprinted (and modified) with permission from Dan Zanger, chart pattern recognition specialist, president and founder, Chartpattern.com and editor, The Zanger Report, as well as a contributor to eSignalLearning.com's Trading Educator's Corner.

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