Here's how a stock can make it to my watchlist: sector analysis

The most frequently asked question I receive is some variation of how I find the stocks that make it to my watchlist. My senses tell me that most of those asking these questions expect that I have some magic formula I plug in that spits out stocks that fit the setups I trade. While I know many traders that do use very specific scans to find stocks to trade, I use a much different approach. I look at charts. Lots of charts. Probably too many charts. At the least, I probably look at over 100 charts a night. Most nights, it's a lot more than that.

That's not to say I go to a list of stocks, start at AA and work my way to ZZ. I use a variety of resources to view charts that are likely to yield setups that I like to trade. As I've mentioned before, one of my favorites is prophet.net's Industry Ranking. I'll guide you through my process by showing you how X (United Steel) made it to my watchlist.

I start off by pulling up the top 10 sectors over a given period of time. In this case, I'm looking at the strongest sectors over the past 15 days.


Metals Fabrication has been the best performing sector over the past 15 days, so I start with charts from this sector. Only four of the 12 stocks in this sector show up because of the filter controls I set (average volume above 300,000 and stocks must be above $10).


After eyeballing these charts, I see that X (United Steel) looks like it may have broke out from a cup and handle. If this is the case, it would make my watchlist as a "cup and handle pullback" setup. Just as it sounds, I go long if the stock successfully tests the new support area (other criteria, such as volume, also need to be met).


Upon closer review, the stock has broken out of a cup and handle and looks strong technically, making it a good pullback candidate. I'll keep a close eye on this stock and do some further analysis. For example, I'll check to see how this stock and sector historically handles cup and handle breakouts.

I repeat this exercise for the remaining top 10-20 sectors. I then do the same thing for the bottom 10-20 sectors, looking for short setups. Once completed, I will have viewed 50-100 charts. I then move on to other sources for watchlist candidates. Some of these include: high volume stocks, 52 week highs, the usual momentum stocks I track and other blogs.

I could go a different route and just have a filter spit out stocks I need for my setups, but I don't think I could be successful using that method. Viewing all these charts gives me a good feel for the market. I have a good idea of where money is flowing and I can see patterns emerging that I might not otherwise catch.

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Strategy: Under the Radar Sectors (Today it's Foreign Utilities)

As I've discussed before, I like to scan the top and bottom ten peforming sectors over a given time period for charts providing nice looking setups. While this is a good method for providing setups, it can also lead to a lot of "whipsaws" or failed setups, since just about everybody is watching these sectors. Therefore, I usually wait for pullbacks, rather than breakouts, when trading these stocks.

Another strategy I employ for finding interesting patterns is looking for sectors and stocks that might be flying under the radar. Instead of focusing on the top ten sectors, I set my sites a little lower, looking at the 11-30 best and worst performing sectors. Here you'll find stocks that have been performing well but haven't been plastered all over the media and blogosphere.

For example, have you heard much about foreign utilities? Surprisingly, this sector came up at the 13th best performing sector on prophet's industry rankings. Take a look at the sector chart:

Three charts made it to my watchlist: CIG, ENI and SBS. Here is CIG's chart. I'll be looking for a breakout above $50 or a pullback in the $47-48 range for entry points.

Applying the Strategic Elements of Sports to Trading

Trading psychologist Brett Steenbarger wrote an excellent post relating sports psychology to trading. I highly recommend it to anybody in the trading game.

This paragraph struck a cord with me:

"The finding that experts in a particular sport are better than novices, not merely at physical skills but also on the underlying perceptual, cognitive, and strategic components of sport, is robust in both laboratory and field research" (quoting Dr. Janet Starkes). In other words, when people become skilled, they literally learn to see things in new ways and think in new ways. It's not just a difference of hardware (having better memory, vision, or concentration); experts develop their own software: internal programs that enable them to recognize patterns and act upon them rapidly.

Here is some of my own anecdotal evidence. During my sophomore year, I was the most talented player on my high school basketball team. I knew it, my teammates knew it, and my coach knew it. When we played on the playgrounds, I was almost always the first or second pick and would dominate the games. However, during a camp before the season, these same players schooled me. It was disheartening and I was completely embarrassed. I was the guy that would screw up, get blasted by the coach and have to run extra to make up for my mistakes.

One day after practice, the coach called me into his office and explained to me that the kids I was playing with had been a part of school's feeder system and had been playing organized ball since they were seven years old (I had never played because my parents wanted me to focus on studies). They had a better "feel" for the game and could see things that I couldn't. The only way I'd make the team was by working on my "basketball IQ".

After this talk, I dedicated myself to understanding the game. Not only would I attend my own team's practices, I would sit in on the freshman and junior varsity practices. I taped tons of college and NBA games and devoured every book on basketball strategy I could find. My parents even shelled out some big bucks so I could attend the Michael Jordan camp.

It all paid off. By the end of the season, I understood things about the game that I was clueless about before. For example, I learned that basketball is a game of different speeds and misdirection. Whereas before I would run to a spot and cut all in one speed, I'd now go half speed to the spot and explode on the cut. Before the cut, I would look at the player guarding the lane. If he was eying the guy with the ball and not taking in the entire court, I knew the lane would be open.

Here is another "pattern" that I had figured out through watching tapes and repetition in practice. If a player guarded me with his right foot way in front of his left, I knew he liked to push the ball handler to the right and was susceptible to a crossover. I would be able to drive into the lane at will against this guy. This, and the observation above, is something I had never thought about before. Now, it was second nature. You could say I had an "internal program" that would process the patterns in a way that would never work if I actually had to ask myself "where is his foot" during a game.

I can see this starting to happen in trading as well. Maybe it's because of my background and the need I feel to practice, but I rarely use scans, although many are readily available to me. Every night I start charting by looking at sectors that interest me for one reason or another. From there, I go through all the stocks in those sectors (I like to use prophet.net for this). This used to take a long time, as I would go through what I was looking for in each individual stock, point by point. Now, I look at a chart and within a few seconds I either toss it and move on or put it in my watchlist for further study. It doesn't even feel like I'm thinking anymore. I just "know" that stock works for me. It's the "internal program" again. Interestingly, I don't use indicators on my preliminary "toss or watch" analysis, but when I later scrutinize the "watch" stocks with indicators, they almost always are at important levels (for instance, an oversold Stochastic or diverging MACD).

The moral of this long winded story is that it's not the most talented players that become champions, it's the players with the best understanding of the game. This applies to any field, including our own. You gain that understanding with a strong work ethic, practice and in-depth analysis. Hey, if you don't believe me, ask yourself this question: Why is it that Larry Bird has plenty of championship hardware while the likes of J.R. Rider and Christian Laettner have none? Or for the non-sports inclined, why is it that Marty Schwartz can make millions trading while so many high IQ professionals come away from trading scarred for life? I'm willing to bet it has a little something to do with what we just talked about.

Again, please make sure to read the good doctor's post, and apply his teaching to your own trading.

Update: I wrote this post about a year ago and reprinted it today. Since that time, I have implemented a few daily and weekly scans. However, I still rely heavily on sector reviews. Both methods (scans and sector reviews) rely heavily on recognizing chart and volume patterns.

Monday's Watchlist: csx, abv, elx, cnw, eth, ksu, sfnt, trn, vdsi

Here are five bullish and five bearish stocks from my watchlist. All of these stocks came from my weekly review of best and worst performing sectors. Charts and sector review courtesy of prophet.net

Note: For some reason these charts are doing a number on my site, so I had to remove them. They can be viewed at stockcharts.com.

The stocks include: csx abv elx cnw eth ksu sfnt trn vdsi