How to Make Money in Stocks

The McGraw-Hill Companies, Inc.

Contents

Chapter One

In this latest revised edition, you'll observe 100 charts of the greatest winners from 1880 to 2009. Study them carefully. You'll discover secret insights into how these companies set the stage for their spectacular price increases.

Don't worry if you're a new investor and don't understand these charts at first. After all, every successful investor was a beginner at some point—and this book will show you how to spot key buying opportunities on the charts, as well as critical signals that a stock should be sold. To succeed you need to learn sound, historically proven buy rules plus sell rules.

As you study these charts you'll see there are specific chart patterns that are repeated over and over again whether in 1900 or 2000. This will give you a huge advantage once you learn to, with practice, recognize these patterns that in effect tell you when a stock is under professional accumulation.

It is the unique combination of your finding stocks with big increases in sales, earnings and return on equity plus strong chart patterns revealing institutional buying that together will materially improve your stock selection and timing. The best professionals use charts.

You too can learn this valuable skill.

This book is all about how America grows and you can too. The American dream can be yours if you have the drive and desire and make up your mind to never give up on yourself or America.

Chapter Two

In the world of medicine, X-rays, MRIs, and brain scans are "pictures" that doctors study to help them diagnose what's going on in the human body. EKGs and ultrasound waves are recorded on paper or shown on TV-like monitors to illustrate what's happening to the human heart.

Similarly, maps are plotted and set to scale to help people understand exactly where they are and how to get to where they want to go. And seismic data are traced on charts to help geologists study which structures or patterns seem most likely to contain oil.

In almost every field, there are tools available to help people evaluate current conditions correctly and receive accurate information. The same is true in investing. Economic indicators are plotted on graphs to assist in their interpretation. A stock's price and volume history are recorded on charts to help investors determine whether the stock is strong, healthy, and under accumulation or whether it's weak and behaving abnormally.

Would you allow a doctor to open you up and perform heart surgery if he had not utilized the critical necessary tools? Of course not. That would be just plain irresponsible. However, many investors do exactly that when they buy and sell stocks without first consulting stock charts. Just as doctors would be irresponsible not to use X-rays, CAT scans, and EKGs on their patients, investors are just plain foolish if they don't learn to interpret the price and volume patterns found on stock charts. If nothing else, charts can tell you when a stock is not acting right and should be sold.

Individual investors can lose a lot of money if they don't know how to recognize when a stock tops and starts into a significant correction or if they have been depending on someone else who also doesn't know this.

Chart Reading Basics

A chart records the factual price performance of a stock. Price changes are the result of daily supply and demand in the largest auction marketplace in the world. Investors who train themselves to decode price movements on charts have an enormous advantage over those who either refuse to learn, just don't know any better, or are a bit lazy.

Would you fly in a plane without instruments or take a long cross-country trip in your car without a road map? Charts are your investment road map. In fact, the distinguished economists Milton and Rose Friedman devoted the first 28 pages of their excellent book Free to Choose to the power of market facts and the unique ability of prices to provide important and accurate information to decision makers.

Chart patterns, or "bases," are simply areas of price correction and consolidation after an earlier price advance. Most of them (80% to 90%) are created and formed as a result of corrections in the general market. The skill you need to learn in order to analyze these bases is how to diagnose whether the price and volume movements are normal or abnormal. Do they signal strength or weakness?

Major advances occur off strong, recognizable price patterns (discussed later in this chapter). Failures can always be traced to bases that are faulty or too obvious to the typical investor.

Fortunes are made every year by those who take the time to learn to interpret charts properly. Professionals who don't make use of charts are confessing their ignorance of highly valuable measurement and timing mechanisms. To further emphasize this point: I have seen many high-level investment professionals ultimately lose their jobs as a result of weak performance.

When this happens, their poor records are often a direct result of not knowing very much about market action and chart reading. Universities that teach finance or investment courses and dismiss charts as irrelevant or unimportant are demonstrating their complete lack of knowledge and understanding of how the market really works and how the best professionals operate.

As an individual investor, you too need to study and benefit from stock charts. It's not enough to buy a stock simply because it has good fundamental characteristics, like strong earnings and sales. In fact, no Investor's Business Daily® reader should ever buy a stock based solely on IBD's proprietary SmartSelect® Ratings. A stock's chart must always be checked to determine whether the stock is in a proper position to buy, or whether it is the stock of a sound, leading company but is too far extended in price above a solid basing area and thus should temporarily be avoided.

As the number of investors in the market has increased over recent years, simple price and volume charts have become more readily available. (Investor's Business Daily subscribers have free access to 10,000 daily and weekly charts on the Web at Investors.com.) Chart books and online chart services can help you follow hundreds and even thousands of stocks in a highly organized, time-saving way. Some are more advanced than others, offering both fundamental and technical data in addition to price and volume movement. Subscribe to one of the better chart services, and you'll have at your fingertips valuable information that is not easily available elsewhere.

History Repeats Itself: Learn to Use Historical Precedents

As mentioned in the introduction, and as shown on the annotated charts of history's best winners in Chapter 1, our system for selecting winning stocks is based on how the market actually operates, not on my or anyone else's personal opinions or academic theories. We analyzed the greatest winning stocks of the past and discovered they all had seven common characteristics, which can be summarized in the two easy-to-remember words CAN SLIM. We also discovered there were a number of successful price patterns and consolidation structures that repeated themselves over and over again. In the stock market, history repeats itself. This is because human nature doesn't change. Neither does the law of supply and demand. Price patterns of the great stocks of the past can clearly serve as models for your future selections. There are several price patterns you'll want to look for when you're analyzing a stock for purchase. I'll also go over some signals to watch out for that indicate that a price pattern may be faulty and unsound.

The Most Common Chart Pattern: "Cup with Handle"

One of the most important price patterns looks like a cup with a handle when the outline of the cup is viewed from the side. Cup patterns can last from 7 weeks to as long as 65 weeks, but most of them last for three to six months. The usual correction from the absolute peak (the top of the cup) to the low point (the bottom of the cup) of this price pattern varies from around the 12% to 15% range to upwards of 33%. A strong price pattern of any type should always have a clear and definite price uptrend prior to the beginning of its base pattern. You should look for at least a 30% increase in price in the prior uptrend, together with improving relative strength and a very substantial increase in trading volume at some points in the prior uptrend.

In most, but not all, cases, the bottom part of the cup should be rounded and give the appearance of a "U" rather than a very narrow "V." This characteristic allows the stock time to proceed through a needed natural correction, with two or three final little weak spells around the lows of the cup. The "U" area is important because it scares out or wears out the remaining weak holders and takes other speculators' attention away from the stock. A more solid foundation of strong owners who are much less apt to sell during the next advance is thereby established. The accompanying chart from Daily Graphs Online® shows the daily price and volume movements for Apple Computer in February 2004.

It's normal for growth stocks to create cup patterns during intermediate declines in the general market and to correct 1½ to 2½ times the market averages. Your best choices are generally stocks with base patterns that deteriorate the least during an intermediate market decline. Whether you're in a bull market or a bear market, stock downturns that exceed 2½ times the market averages are usually too wide and loose and must be regarded with suspicion. Dozens of former high-tech leaders, such as JDS Uniphase, formed wide, loose, and deep cup patterns in the second and third quarters of 2000. These were almost all faulty, failure-prone patterns signaling that the stocks should have been avoided when they attempted to break out to new highs.

A few volatile leaders can plunge 40% or 50% in a bull market. Chart patterns correcting more than this during bull markets have a higher failure rate if they try to make new highs and resume their advance. The reason? A downswing of over 50% from a peak to a low means a stock must increase more than 100% from its low to get back to its high. Historical research shows stocks that make new price highs after such huge moves tend to fail 5% to 15% beyond their breakout prices. Stocks that come straight off the bottom into new highs off cups can be more risky because they had no pullbacks. Deep 50% to 75% cup-with-handle bases worked in 2009 since they were made by a 58% drop in the S&P 500.

Sea Containers was a glowing exception. It descended about 50% during an intermediate decline in the 1975 bull market. It then formed a perfectly shaped cup-with-handle price structure and proceeded to increase 554% in the next 101 weeks. This stock, with its 54% earnings growth rate and its latest quarterly results up 192%, was one of several classic cup-with-handle stocks that I presented to Fidelity Research & Management in Boston during a monthly meeting in early June 1975. Upon seeing such big numbers, one of the portfolio managers was instantly interested.

As you can see by this example, some patterns that have corrected 50% to 60% or more coming out of an intermediate bull market decline or a major bear market can succeed. (See the charts for Sea Containers and The Limited.) In most cases, the percent of decline is a function of the severity of the general market decline and the tremendous extent of the stock's prior price run-up.

Basic Characteristics of a Cup's Handle Area

The formation of the handle area generally takes more than one or two weeks and has a downward price drift or "shakeout" (where the price drops below a prior low point in the handle made a few weeks earlier), usually near the end of its down-drifting price movement. Volume may dry up noticeably near the lows in the handle's price pullback phase. During a bull market, volume in the majority of cases should not pick up during a correction in the handle, although there have been some exceptions.

Although cups without handles have a somewhat higher failure rate, many stocks can advance successfully without forming a handle. Also, some of the more volatile technology names in 1999 formed handles of only one or two weeks before they began their major price advances.

When handles do occur, they almost always form in the upper half of the overall base structure, as measured from the absolute peak of the entire base to the absolute low of the cup. The handle should also be above the stock's 10-week moving average price line. Handles that form in the lower half of an overall base or completely below the stock's 10-week line are weak and failure-prone. Demand up to that point has not been strong enough to enable the stock to recover more than half its prior decline.

Additionally, handles that consistently wedge up (drift upward along their price lows or just go straight sideways along their lows rather than drifting down) have a much higher probability of failing when they break out to new highs. This upward-wedging behavior along low points in the handle doesn't let the stock undergo the needed shakeout or sharp price pullback after having advanced from the low of the base into the upper half of the pattern. This high-risk trait tends to occur in third- or fourth-stage bases, in laggard stock bases, or in very active market leaders that become too widely followed and therefore too obvious. You should beware of wedging handles.

A price drop in a proper handle should be contained within 8% to 12% of its peak during bull markets unless the stock forms a very large cup, as in the rather unusual case of Sea Containers in 1975. Downturns in handles that exceed this percentage during bull markets look wide and erratic and in most cases are improper and risky. However, if you're in the last shake-out area of a bear market bottom, the unusual general market weakness will cause some handle areas to quickly decline around 20% to 30%, but the price pattern can still be sound if the general market then follows through on the upside, creating a new major uptrend. (See Chapter 9, "M = Market Direction: How You Can Determine It.")

Constructive Patterns Have Tight Price Areas

There should also be at least some tight areas in the price patterns of stocks under accumulation. On a weekly chart, tightness is defined as small price variations from high to low for the week, with several consecutive weeks' prices closing unchanged or remarkably near the previous week's close. If the base pattern has a wide spread between the week's high and low points every week, it's been constantly in the market's eye and frequently will not succeed when it breaks out. However, amateur chartists typically will not notice the difference, and the stock can run up 5% to 15%, drawing in less-discriminating traders, before it breaks badly and fails.

Find Pivot Points and Watch "Volume Percent Change"

When a stock forms a proper cup-with-handle chart pattern and then charges through an upside buy point, which Jesse Livermore referred to as the "pivot point" or "line of least resistance," the day's volume should increase at least 40% to 50% above normal. During major breakouts, it's not uncommon for new market leaders to show volume spikes 200%, 500%, or 1,000% greater than the average daily volume. In almost all cases, it's professional institutional buying that causes the big, above-average volume increases in the better-priced, better-quality growth-oriented stocks at pivot breakouts. A full 95% of the general public is usually afraid to buy at such points because it's scary and it seems risky and rather absurd to buy stocks at their highest prices.

Your objective isn't to buy at the cheapest price or near the low, but to begin buying at exactly the right time, when your chances for success are greatest. This means that you have to learn to wait for a stock to move up and trade at your buy point before you make an initial commitment. If you work and cannot watch the market constantly, small quote devices or quotes available on cell phones and Web sites will help you stay on top of potential breakout points.

The winning individual investor waits to buy at these precise pivot points. This is where the real move generally starts and all the exciting action begins. If you try to buy before this point, you may be premature. In many cases the stock will never get to its breakout point, but rather will stall or actually decrease in price. You want a stock to prove its strength to you before you invest in it. Also, if you buy at more than 5% to 10% past the precise buy point, you are buying late and will more than likely get caught in the next price correction. Your automatic 8% loss-cutting rule (see Chapter 10, "When You Must Sell and Cut Every Loss ... Without Exception") will then force you to sell because the stock was extended in price and didn't have enough room to go through a perfectly normal sharp but minor correction. So don't get into the bad habit of chasing stocks up too high.

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Excerpted from How to Make Money in Stocksby WILLIAM J. O'NEIL Copyright © 2009 by William J. O'Neil. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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