Trade Like an O'Neil Disciple

How We Made Over 18,000% in the Stock Market

Gil Morales, Chris Kacher

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470886755
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

How two former traders of William J. O'Neil + Company made mad money using O'Neil's trading strategies, and how you can, too

From the successes and failures of two William O'Neil insiders, Trade Like an O'Neil Disciple: How We Made Over 18, 000% in the Stock Market in 7 Years is a detailed look at how to trade using William O'Neil's proven strategies and what it was like working side-by-side with Bill O'Neil. Under various market conditions, the authors document their trades, including the set ups, buy, add, and sell points for their winners. Then, they turn the magnifying glass on themselves to analyze their mistakes, including how much they cost them, how they reacted, and what they learned.

• Presents sub-strategies for buying pocket pivots and gap-ups
• Includes a market direction timing model, as well as updated tools for selling stocks short
• Provides an "inside view" of the authors' experiences as proprietary, internal portfolio managers at William O'Neil + Company, Inc. from 1997-2005

Detailing technical information and the trading psychology that has worked so well for them, Trade Like an O'Neil Disciple breaks down what every savvy money manager, trader and investor needs to know to profit enormously in today's stock market.

CHAPTER 1

The Evolution of Excellence

The O’Neil Trading Method

As portfolio managers who once ran money for William J. O’Neil, we have observed that a meaningful portion of the O’Neil “body of thought” is derived from the philosophies of those who preceded him, particularly the works of Richard Wyckoff and Jesse Livermore. When it comes to market thought, you can never entirely understand Bill O’Neil until you have read and understood these two gentlemen. Obviously, the techniques and philosophies of the famous trader Jesse Livermore, as presented in the classic Reminiscences of a Stock Operator, by Edwin Lefèvre and Livermore’s own How to Trade in Stocks, figure heavily in the underlying pulse that governs the way Bill O’Neil and his stable of portfolio managers trade. Richard Wyckoff, as one of the first to write about Jesse Livermore in his original work, Jesse Livermore’s Methods of Trading Stocks, espoused much of the common sense investment philosophies and maxims that have found their way into the writings and investment thought of William J. O’Neil. Even Nicolas Darvas, in his famous book, How I Made $2 Million in the Stock Market (Carol Publishing Group, 1998), laid the foundation for O’Neil’s “chart bases” with his own “boxes,” which he described as simply normal consolidation channels within which a stock’s action was judged to be normal or abnormal.

The themes that echo from Wyckoff, Livermore, Darvas, and others weave the essential fabric from which “O’Neil-style” investment methodologies are cut. These methodologies utilized the work of O’Neil’s predecessors by bringing into play the time-tested characteristics of winning stocks that O’Neil painstakingly identified, analyzed, catalogued, and verified in his numerous Model Book Studies, some of which your authors had the privilege of producing and contributing to. By sifting through the best-performing, institutional-quality leading stocks in each and every type of market cycle, O’Neil identified their key common characteristics, the most basic of which provided the genesis for O’Neil’s unique stock-selection template, commonly known to the investing public as CAN SLIM. Certainly, O’Neil owes a debt to the thinking of Livermore, Wyckoff, and others, and the roots of the O’Neil investment methodologies run deep in this regard. However, as former portfolio managers for William O’Neil + Company, Inc., we can vouch for the fact that such roots do not imply that O’Neil simply copied his predecessors. That would be a gross oversimplification, since the truth is that the O’Neil methodologies took the thinking of these outstanding stock market investors from the past to a much higher level by bringing greater clarity to the process as he formulated a concrete, concise, and practical approach to making money in the stock market.

The parallels between O’Neil and his predecessors provide an over-arching backdrop to a general philosophy, a certain ethos, if you will, toward the market that is more than just Livermore’s, or Wyckoff’s, or even O’Neil’s. As O’Neil himself used to tell us, “It’s not MY system. It’s the market’s, because it is based on how the market actually works.” In this manner, O’Neil simply sees his own work as furthering the basic process of understanding the market through observation and the application of common sense rules gained thereby. It is nothing more or less than understanding all the small realities that make up the stock market. Reviewing how O’Neil has taken and expanded upon the works of his predecessors is a useful exercise, and sets the backdrop for much of the research we have done to further our approach to the O’Neil/Livermore/Wyckoff approach to the market, and which is one of the main topics of this book.

PREPARATION, STUDY, AND PRACTICE

Don’t dabble in stocks. Dig in and do some detective work.

—William O’Neil, How to Make Money in Stocks, 2nd ed. (New York: McGraw-Hill, 1995), 34

This the essential premise of O’Neil methodologies: They are in no way, shape, or form intended as a panacea for making money in the market. Human beings are complex organisms, and so represent the greatest variable in the implementation of any investment methodology, whether of “O’Neilian” origin or otherwise. This is why O’Neil insists that one must put in the time, effort, and work required if one intends to become a successful stock market investor: “Human nature being what it is, 90 percent of the people in the stock market, professionals and amateurs alike, simply haven’t done enough homework.”

O’Neil laments the fact that so many investors are looking for some magic formula that enables them to produce an optimal result in the stock market with little or no effort. In The Successful Investor, he laments the “rise of the individual investor” during the dot-com bubble market of 1999. “Most people, both investors and advisors, got hurt in the 2000 to 2002 downturn because they never took the time to learn sound investment rules and principles. In the 90s they thought they’d found a way to make money without doing much homework. They just bought tips, touts, and stories” (William J. O’Neil, The Successful Investor [New York: McGraw-Hill, 2004], xii).

While most investors do not hesitate to dabble in the markets, they would rarely dabble in medical or legal practice, or even in playing professional baseball. O’Neil reminds us, however, “Outstanding stockbrokers or advisory services are no more frequent than are outstanding doctors, lawyers, or baseball players” (William O’Neil, How to Make Money in Stocks, 2nd ed. [New York: McGraw-Hill, 1995], 256). This is not too far off from Richard Wyckoff’s astute observation that “A person becomes competent in other fields because he has generally gone through a long period of practice and preparation. A physician, for example, goes to college, attends medical clinics, rides in an ambulance, serves in hospitals, and after some years of preparatory work, hangs out a sign. In Wall Street, the same M.D. would hang his sign first; then proceed to practice” (Richard Wyckoff, How I Trade and Invest in Stocks & Bonds [New York: The Magazine of Wall Street, 1924], 159-160).

Investing is hard work, and an investor requires no less preparation and expertise than any other white shoe professionals practicing their craft, whether it be law, medicine, software design, moviemaking, or otherwise. Jesse Livermore became annoyed when he was approached by friends or acquaintances who would ask him how they, too, could make money in the market. Biting his tongue, Livermore’s answer eventually evolved into a curt, “I don’t know,” as he found it difficult “to exercise patience with such people. In the first place, the inquiry is not a compliment to a man who has made a scientific study of investment and speculation. It would be as fair for the layman to ask an attorney or a surgeon: ‘How can I make some quick money in law or surgery?”’ (Jesse Livermore, How to Trade in Stocks [Greenville: Traders Press, 1991], 15).

While reminding investors that success can only be achieved by hard work and persistence, O’Neil, always the optimist, makes it plain that success is within the reach of anyone willing to make the effort, and in his book, How to Make Money in Stocks (2009, 9), he urges us all on with a touch of self-sufficient idealism, “The American dream can be yours if you have the drive and desire and make up your mind to never give up on yourself.” But O’Neil insists from the start that, as Wyckoff wrote, “. . . anybody who thinks he knows of a short-cut that will not involve ‘sweat of the brow’ is sadly mistaken” (How I Trade and Invest in Stocks & Bonds [New York: The Magazine of Wall Street, 1924], 93).

BUY EXPENSIVE—NOT CHEAP—STOCKS

Like Livermore, O’Neil despises a lazy approach to the market because it results in one trying to take what is perceived as the easy route to stock market riches. Nowhere else is this more embodied than in the idea of buying stocks that are “cheap.” This age-old trap is easy to fall into, since most novice investors approach the market with an incorrigibly ingrained consumer mentality that views anything selling today at a lower price than it was yesterday as a “bargain.” This is perhaps because the individual investor views herself as a consumer endpoint, when in fact the investor should act like a business that purchases raw or finished goods and intends to turn around and sell them at a higher price. Hence, O’Neil’s story about red dresses and yellow dresses, where the slower-selling yellow dresses are marked down by the store owner to get them out of the “portfolio,” otherwise known as the store inventory, so that more of the hotter-selling red dresses can be purchased and resold at higher prices.

O’Neil advocates buying stocks that are “red dresses” selling “like hotcakes” at all-time high prices. The reason for this is simple: “. . . real leaders start their big moves by selling at new price highs, not near new lows or off a good amount from their highs” (How to Make Money in Stocks, 4th ed. [New York: McGraw-Hill, 2009], 426). In a contrarian sense, this is what makes the concept of buying stocks at new highs so effective. It is simply not obvious to the crowd, who fear buying a stock that looks to be selling at such a high price, because, as O’Neil points outs, “What seems too high in price and risky to the majority usually goes higher eventually, and what seems low and cheap usually goes lower” (2009, 174). The market tries to fool the majority of investors the majority of the time, so if new high prices in a particular stock make the crowd timid about buying it, then that is likely the precise time to be buying the stock.

Like O’Neil, Jesse Livermore appreciated higher-priced stocks far more than “cheap” stocks, advising, “One should never sell a stock, because it seems high-priced.... Conversely, never buy a stock because it has had a big decline from its previous high. The likelihood is that the decline is based on a very good reason. That stock may still be selling at an extremely high price relative to its value—even if the current level seems low” (Jesse Livermore, How to Trade in Stocks [Greenville: Traders Press, 1991], 25).

AVERAGING DOWN

Trying to buy cheap stocks is but one frequent sin committed by novice or lazy investors. Another lazy man’s sin eschewed by O’Neil and his predecessors is the concept of “averaging down.” Richard Wyckoff observed, “A great deal of money is lost or tied up by people who make a practice of averaging. Their theory is that if they buy a security at 100 and it goes to 90, it is that much cheaper, and the lower it goes the cheaper it grows.”

Retail stock brokers, when in need of a way to avoid taking responsibility for a bad recommendation, often try to use “averaging down” as a way to justify the initial decision to purchase a stock at higher prices. To some extent, this evolved as a convenient corollary to the retail investment concept of “dollar-cost averaging” when purchasing mutual funds, about which we’re sure many readers are only too familiar. To O’Neil, this is shameful: “About the only thing that’s worse is for brokers to take themselves off the hook by advising customers to ‘average down.’ If I were advised to do this, I’d close my account and look for a smarter broker” (How to Make Money in Stocks, 4th ed. [New York: McGraw-Hill, 2009], 247).

Jesse Livermore was no less harsh in his assessment of the averaging-down technique when he said, “It is foolhardy to make a second trade, if your first trade shows you a loss. Never average losses. Let that thought be written indelibly upon your mind” (How to Trade in Stocks [Greenville: Traders Press, 1991], 26). Richard Wyckoff took the concept just a little bit further by adding, “It is better to ‘average up’ than to ‘average down”’ (Stock Market Technique Number 1 [New York: Richard D. Wyckoff, 1933], 50). And as we know, O’Neil contrasts his sermons against averaging down by strongly advocating “averaging up” on one’s winning stocks.

CUTTING LOSSES QUICKLY

Jesse Livermore wrote in How to Trade in Stocks, “You should have a clear target where to sell if the market moves against you. And you must obey your rules! Never sustain a loss of more than 10 percent of your capital. Losses are twice as expensive to make up. I always established a stop before making a trade” (How to Trade in Stocks [Greenville: Traders Press, 1991], 171). O’Neil advises a 7 to 8 percent automatic stop-loss policy on all stock purchases, and the main reason for this is to keep oneself out of danger. Huge losses in the market can be debilitating, and O’Neil views a strict stop-loss policy, whether at his threshold of 6 to 7 percent or Livermore’s 10 percent, as absolutely necessary for survival in the stock market. Livermore observed, “Taking the first small loss is wise . . .profits take care of themselves but losses never do” (1991, 7).

Richard Wyckoff in Stock Market Technique Number 1 advised: “Your first line of defense is a stop order—placed when you make the trade, or immediately thereafter. If you fail to limit your risk at inception, make a practice of looking over your commitments every day, or twice every week and selling out, at the market, all showing a loss. That will keep your sheet clean and allow your profitable trades to run until the time comes to close them out” (1933, 96). This concept of using a stop-loss as a “line of defense” runs parallel to O’Neil’s thinking that “letting your losses run is the most serious mistake made by almost all investors” (How to Make Money in Stocks, 2nd ed. [New York: McGraw-Hill, 1995], 93) simply because “[i]f you don’t sell to cut your losses when you get into trouble, you can easily lose the confidence you’ll need to make buy and sell decisions in the future” (1995, 252). Not only do losses cut into the capital an investor has available to capitalize on potential opportunities in the stock market, they also take their toll on an investor’s psychological capital, their all-important self-confidence.

To O’Neil, Livermore, and Wyckoff, losses are just part of the process, and it is always better to take a little pain now rather than a lot of pain later, because, as O’Neil reveals, “The whole secret to winning big in the stock market is not to be right all the time, but to lose the least amount possible when you’re wrong” (1995, 240).

TAKING PROFITS TOO SOON—LETTING YOUR WINNERS RUN

The O’Neil methodology is essentially a trend-following system—you want to be in the market when the trend is in your favor, and you want to capture a large portion of any trend by riding with it for as long as possible. To O’Neil, buying a winning stock is only half the problem, because the key to capitalizing on a big price move in any potential, big, winning stock is in how you handle the stock once you have bought it. As Livermore said, it is the uncommon man who can “sit tight and be right,” so sitting with and properly handling a meaningful position in a big, winning stock through the bulk of its upside price move is a big part of how O’Neil makes big money in the stock market. This necessitates adhering to a basic principle that Livermore stipulated when he said, “As long as a stock is acting right, and the market is right, do not be in a hurry to take a profit” (How to Trade in Stocks [Greenville: Traders Press, 1991], 21). You can’t make big money in stocks if you don’t give them a chance to make big money for you.

O’Neil recommends “take your losses quickly and your profits slowly,” because “your objective is not just to be right but to make big money when you are right” (How to Make Money in Stocks, 4th ed. [New York: McGraw-Hill, 2009], 247-272). Trading for quick profits requires that one be constantly active and thinking about the next trade. It is a notoriously busy way to approach the market, and is entirely out of sync with the ideal that O’Neil-style investing tends toward. In our experience, there is nothing easier than making big money in the market once you have latched onto a big winner, because at that point all you are doing is sitting more and thinking less. When your stocks are trending nicely to the upside and you are fully invested, there is, from a practical standpoint, very little to do. You are simply letting your winners run. This is what we like to call “being in the zone,” a mental space that derives from Livermore’s principle: “It never is your thinking that makes big money. It’s the sitting” (Edwin Lefèvre, Reminiscences of a Stock Operator [New York: John Wiley & Sons, 1994], 68).

Richard Wyckoff had his own unique perspective on the idea of cutting losses quickly and letting winners run when he wrote in Stock Market Technique Number 1, “Are you getting rich backwards? Then you are taking two points profit on your speculative trades and letting your losses run. Why not reverse this rule? Limit your risk to one, two or three points and let your profits run” (1933, 52).

POSITION CONCENTRATION

A big part of handling a winning stock correctly is properly scaling one’s position size. If you only want to make average market returns, then scale your positions to a very small size, and your portfolio will act very much like a market index. Having scores of positions is nothing more than “closet indexing.” Most mutual fund managers take positions that make up 1 to 2 percent of their portfolio equity or less, and they may have 100 to 200 positions or more. To O’Neil, this is anathema. If you want to make big returns, then you absolute...