Stock trading is largely an endeavor of navigating market probabilities. Stock prices constantly move up and down based on prevailing conditions on supply and demand.
With all the factors affecting how stock prices behave, it is very important that a trader (especially in the short term timeframe) stick to trades that have a higher probability of giving profit. To do this, traders will look for stocks based on a rigorous checklist of technical and fundamental criterias. These 'criterias' differ from one trader to another depending on their risk appetite and time horizon. But generally, traders want to allocate a major part of their capital to stocks that show multiple bullish signals to increase the probability of scoring a winning play. The stock setups that pass this meticulous checklist are what we call High Conviction Trades.
In this post, we'll outline some helpful tips to help you spot and plan for High Conviction Trades.
What Qualifies a Stock Trade to become a High Conviction Trade?
A stock trade is considered as high conviction if it is supported by multiple technical bullish signals, has underlying fundamental strength and is validated by increasing buying volume. Here is a brief formula to keep in mind:
Multiple Bullish Chart Signals + Strong Fundamentals + Above Average Volume Turnover = High Conviction Trade
In essence, the formula states that a high conviction trade is an additive culmination of positive technicals, fundamentals and volume.
To explain it further, here is a breakdown of each:
1. Multiple Bullish Chart Signals (Technical Analysis)
Using technical analysis, a trader will look for bullish price patterns that are all converging on a specific price range and is validated by above average volume. To explain it simply, these signals mean that at a specific price, there is overwhelming buying interest in the stock. When buyers overpower the sellers, the stock price moves up and will continue to move up until the buying pressure is exhausted.
As a brief reference, here are some chart examples of how these signals look like individually:
Bullish Reversal Signals:
a. Inverted Head & Shoulders
An Inverted Head & Shoulders pattern appears as a three-base formation along a neckline resistance. This reversal pattern points to a bearish-to-bullish transition.
b. Cup and Handle
A Cup and Handle pattern is a bullish formation defined by a “U” shaped basing formation which is followed by a brief pullback with lowering volatility. A breakout usually happens after the completion of the pattern.
c. Bullish Divergence
A Bullish Divergence is illustrated in the chart when the RSI starts to make a new higher low while the price of the stock is establishing a new lower low. This signifies weakening selling pressure that might result to an uptrend shift.
Bullish Continuation Signals:
a. Pennant
A Pennant is a continuation pattern characterized by a brief consolidation with lowering volatility that is followed by a surge in price.
b. Wedge
Wedges are continuation patterns that appear in stocks with sharp trend movements. The price briefly shifts in the counter direction with decreasing volatility and a dry up in volume.
c. Flag
Flags are small rectangle formations that interrupt the direction of an ongoing trend. When appearing in an uptrend, the pattern is completed by a breakout from the flag pattern followed by a continuation of the existing trend.
For further reference, check out our blog post on Support and Resistance Confluences: https://www.valuevoyagers.com/post/spotting-support-and-resistance-confluences
2. STRONG FUNDAMENTALS
(FUNDAMENTAL Analysis)
High conviction trades usually have a strong underlying fundamental value driving institutional buying. This fundamental value could be due to various catalysts: strong earnings, positive mergers & acquisitions, big ticket projects, and other fundamental catalysts that translate to improved company profitability.
A quick way to check fundamental data of any stock is to check their quarterly earnings, company disclosures and press releases. In the Philippines Stock Exchange for example, sites like Investagrams or your local online broker (COL Financial, TIMSON, Firstmetro Sec) will provide reports and sections that make these data available for each stock.
3. above average volume turnover
Volume in the context of stock trading is defined as the mount of shares being traded at any given time frame. Volume validates Price Action. The bigger the volume, the stronger the price action is.
Whenever a stock creates a successful bullish reversal or continuation pattern, it will always be validated by above average volume turnover as it breaks out from the pattern. Volume, in this sense is a confirmation that the breakout is sustainable and a rally can be sustained. How long this rally lasts will all depend on how strong the buying volume can be maintained over time.
For further reference, check out our blog post on Volume Analysis: https://www.valuevoyagers.com/post/volume-analysis-navigating-the-waves-of-the-market
How does a High Conviction Trade look like in the chart?
Now that we have individually explained the criterias that qualify a High Conviction Trade, let's see how they look like in the chart when combined together.
Sample 1:
The chart below is an example of a High Conviction Trade setup at ALI with a 23% upside leading to its multi year resistance.
The signals are as follows:
Technicals:
Bullish Wedge
Bullish Divergence
EMA9+MA20 crossover on breakout
Price bouncing on its multi year support level
Fundamentals:
From the time it reached the price level of 30, it is deemed undervalued as per price to book ratio. Although the quarterly earnings were negative due to the pandemic crisis, overall fundamental strength of the company and continuous CAPEX spending offset the bearish short term risks.
Volume:
Looking at volume, selling pressure was increasing as the price retraced to its multi year support level. As the bullish wedge formed, volume decreases. On breakout from the bullish wedge, price starts to increase. As EMA9 and MA20 crossed and price pivots above, volume spiked to above average turnover validating the move.
Sample 2:
The next example below is a High Conviction Trade setup at BDO with a 25% upside leading to its multi year resistance.
The signals are as follows:
Technicals:
Inverse Head and Shoulders
Bullish Divergence
Price bouncing on its multi year support level
Fundamentals:
General market condition during this time was being battered by 6% inflation rate. As such, the index experienced a year long weakness wherein most bluechips retraced back to multi year support. Since the heightened inflation rate was merely transitory, the market recovered and stocks like BDO with robust fundamentals attracted institutional investors due to its undervalued price at that time.
Volume:
Looking at volume, selling pressure was increasing as the price retraced to its multi year support level. As the bullish divergence formed, increased selling was also met with steady buying resulting to a price bounce. Buying volume spiked as price broke out from the inverse head and shoulders pattern.
What are the Advantages of a High Conviction Trade?
The goal of any active trader is clear: Small Wins + Small Losses + BIG Wins. Losses are normal in trading and can never be avoided. As such, losses should be kept at a minimum by strictly imposing a stringent criteria on what stocks are worth trading. Understanding this means that a bulk of your capital must be placed on trades that show a HIGHER PROBABILITY of moving up according to your analysis. Thus, a High Conviction Trade allows you a higher chance of trading stocks that will net you consistent profits and will allow you to avoid low probability trades that may lead to BIG losses.
High Conviction Trade provide you two major benefits:
1.Maximum Portfolio Allocation
Portfolio allocation is the process of qualifying how much of your capital must be placed on a particular stock trade. Since High Conviction Trades have a high probability of success, a bigger amount of money can be allocated for the trade. This means that even a 20-30% trade can be leveraged to maximum profitability since it allows for maximum portfolio allocation.
2. High Upside : Low Risk
Many traders bet huge money on low probability trades and they pay that risk by incurring BIG losses. High Conviction Trades are usually low risk since you are trading fundamentally strong stocks at multi year support levels with strong institutional demand. This means that a breakdown is negated since big institutional investors will surely lift it back up from the support level. Thus, it provides a high upside while maintaining little risk.
In a Nutshell
To effectively detect a High Conviction Trade, a strong understanding of technical and fundamental analysis concepts is mandatory. This is why it is always stressed that much of the the success of profitable traders are all determined by their consistent market analysis and research coupled by rock solid patience and discipline.
High Conviction Trades rarely show up. In our experience, you get only 3-5 of these per year. This is where consistent planning coincides with market opportunity. The more you work hard, the luckier you get. The more you practice proper trading methodology, the more skilled you become. As you get better as a stock trader, big profits naturally follow. So focus on the process. The results will take care of itself.
We hope you loved our posts! To learn more about trade and investment, access the Online Learning section of our website to enjoy our free Learning Module.
Comments