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By: Chris Rowe — October 12, 2009

It's Time to Put Your Profit System Into Place

No matter what your comfort level is, what your investing time horizon is, or whether you are a momentum trader or value investor, it's incredibly important to have some kind of system for choosing trading/investing opportunities.

Not only is it important to have a system, but also to adhere to it when it comes to managing these opportunities.

The Rules of the Investing Road

Some investors watch financial television or the latest headlines to find the "next big thing" for their portfolio. Others keep a close eye on company news or stock charts ... or both.

No doubt, you have your own set of "rules" when it comes to entering or exiting a position. Personally, I'm a big fan of technical analysis when it comes to adding new names to, or pruning slow-performing names from, my portfolio.

Opportunities present themselves to us every single day. It doesn't matter how they appear to us -- it's how we evaluate them before putting real money to work that matters.

(Don't) Buy it Like Buffett

For example, one of the best and brightest stock-pickers in the world might tell me that it's time to buy XYZ stock. But that doesn't mean now is the time to buy ... for me, anyway.

MY reason for not buying the stock is simply that my system wouldn't allow it.  It doesn't fit into my specific approach.

My approach to investing might also keep me from buying most of what the world's wealthiest, and most-successful, investor -- Warren Buffett -- buys, as well.

That doesn't mean that you can't make handsome profits with Warren Buffett's or any other financial guru's approach or system.  It just doesn't fit into my program.

And I wouldn't even buy a stock that didn't fit with my system if Warren Buffett himself whispered into my ear, telling me he is accumulating it quietly (although I would try to convince him to adopt me).

In fact, the reason that most individual investors lose money in the market is because they invest in stocks, or withdraw from the market, based on what they hear in the news (whether they realize it or not), which is backward.

You have GOT to have a system and a set of rules that you stick to.  Otherwise, you could be all over the map, which is a recipe for expensive mistakes.

Here's a look at some of the mechanics behind my system...

Stay Ahead of the Herd

The internal market leads the external market.  In fact, the order that things usually move in is:

1. Sentiment
2. Internal market
3. External market
4. Sentiment
5. And so on...

It starts off with "the market" moving lower, and as we get to a low point, investors become more and more bearish ... and less and less bullish. 

But the fact is that when market sentiment gets to be excessively bearish, it's a contrary indicator -- meaning that it's actually a bullish sign.  Remember, the sentiment is basically a reaction to what people see when they look at the external market.

The goal is to stay ahead of the crowd.  So, I make it a point to clearly identify what's happening right now. 

When I see sentiment is way too bearish, I'm preparing to get more bullish by putting together a shopping list of bullish positions that I will take when I get the next signal which comes from the internals.

Here's how the cycle works:

1. First the breadth of the market changes.  If we are talking about reversing higher from a low point, we would see a larger number of stocks moving up again as more and more stocks join that bullish party.  We usually see this happen before the external market turns around and it becomes obvious to everyone else who mainly watches the external market.

2. The external market turns around. 
At this point, individual investors and even professional investors are watching the S&P 500, Dow, Nasdaq, etc. to see if they break certain "resistance levels" or move above certain moving averages.  What they're looking for is confirmation that the new market rally "has legs." 

This does make sense, and I do focus on that aspect, too.  But by this time, the internal market (if it's a real rally) would have already turned around.  We already saw the sentiment indicators change, and we saw the internals change, so we are already confident in the move.

(NOTE: Everyone who sees a market bounce off of a double-bottom feels much more confident than when it made its first bounce..

3. Sentiment changes.  In this case, the sentiment will have already changed from excessively bearish (a bullish sign) to kind-of-bullish and kind-of-bearish.  Eventually, people become more and more bullish until there is finally excessive bullishness. 

At this point, the cycle begins again as we take it as a warning sign to reduce bullish exposure.

Internal vs. External Markets

The ”internal market,” also known as the “breadth” of the market, is basically the study of the number of advancing stocks versus the number of declining stocks. 

So if a larger number of stocks are advancing, and a smaller number of stocks are declining, the “internal market” is “up” or “strong” or “positive.” 

Focusing on the internal market gets me bearish at market tops and bullish at market bottoms.

The “external markets” are what just about everyone focuses on.  They’re the S&P 500, the Nasdaq, the NYSE and the Dow Industrials. 

The importance of constantly focusing on the market “internals” cannot be overstated.  In short, it’s what’s really happening in the stock market.

In a nutshell: If four out of five stocks are trading up, and you throw a dart and buy whatever stock that dart landed on, there’s an 80% chance that you would make money. 

But the fact is that even if four out of five stocks are trading higher, it’s possible that the “external markets” can move lower.

A Measure of the Markets

The “external markets” are “weighted indices.”  Different stocks in the Dow, S&P 500, Nasdaq and NYSE have a different amount of influence on the direction of each index.

As of the time of this writing, Exxon Mobil, which has the highest valuation out of any stock in the stock market, has a nearly 5% weighting in the S&P 500.  The smallest 100 companies on the S&P 500, on the other hand, have a cumulative weighting of approximately 3%.

So if the smallest 100 companies in the S&P 500 move up by 10%, and on the same day, Exxon Mobil moved down by 10% while all other stocks in the S&P 500 did not move higher or lower, the S&P 500 index would actually move lower.

Here's how that breaks down:
  • 100 stocks up 10%
  • 1 stock down 10%
  • The S&P 500 would move lower
  • People who don’t focus on internals/breadth believe that "the market" declined.
This isn’t some earth-shattering news that nobody knows about.  Many investors know this but don’t use it to their advantage.  The fact is that the internal market tends to LEAD the external market.

A Fine Line Between Mistakes, Opportunities

What that means is that the internal market changes direction before the external market does.  In a market that trends higher, you would usually see the external market as well as the internal market moving higher.  But toward the end of that uptrend, before the external market turns around and starts moving lower, the internal market tends to turn around and move lower.

Market tops and market bottoms are where the biggest, most-costly mistakes are made.  They also present the biggest opportunities.  So, focusing on internals, and looking for divergences between the internals and externals, is essential when investing and trading.

There are a few extremely helpful internal indicators that I use such as different "Bullish Percent Indices."  There are five others that I believe that anyone should stay focused on. 

These indicators tell the true story of what's happening in the market currently, they give perspective on the level of risk that the market holds, and they give us warning signs before major "market" moves happen.  Nobody should trade without focusing on them.

Make Money from Market Strength (and Weakness)

To profit whether the market is moving up or down, which is why I like to identify both strength and weakness.  In short, I like to fight the easy battles.  When I profit from downside moves, I feel like a schoolyard bully beating up on the weakest kid.  (OK, bad analogy.  I can see some people's eye twitching as they get flashbacks of having to give up the lunch money to a kid named "The Gooch.")   

Anyway, I take bullish positions in the stocks with positive relative strength, and I take bearish positions in the stocks with negative relative strength.

Positive Relative Strength:  When a security outperforms the market over a significant time frame.

  • Stock market moves up by 10%, while XYZ stock moves more than 10% higher.
  • Stock market moves down 10%, while XYZ stock either moves up, or moves less than 10% lower.
Negative Relative Strength:  When a security underperforms the market over a significant time frame.
  • Stock market moves up by 10%, while XYZ stock either moves down or moves less than 10% higher.
  • Stock market moves down 10%, while XYZ stock moves more than 10% lower.
Anyway, that barely scratches the surface of my system, but I hope that whatever it is, YOU have a system. 

If you don't, then it's time to stop trading and start reading because you, or someone else, worked too hard to get the money that you have for you to be investing or trading it without a system.

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