Morpheus Stock Trading Strategy
We run a trend-following system using pattern recognition to identify setups with favorable reward to risk ratios. As trend followers, we trade with the trend, whether up or down, through longs, shorts, and inverse ETFs (for RIA accounts to profit in a bear market) when necessary.
When analyzing potential candidates, we prefer to keep it simple, using mainly price, volume, and moving averages. For long setups, strong quarterly earnings and revenue growth play a major role in stock selection. Priority is given to stocks that have gone public within the past 10 years with new and exciting products that are trading within 20% of a 52-week high.
We manage risk through proper position sizing and stop placement. However, one should develop their own risk profile before trading. A good start is to define an average and maximum risk per trade of account equity.
When market conditions are ideal and our timing model is on a buy signal, the model portfolio looks to be 100% invested in high quality growth names. These stocks have the potential to run 20% to 50% higher or more within a few weeks to months. Some may run 70% to 100% higher in as little as two to three months, but these are extreme moves.
With any good trading system, a consistent screening process is needed to produce ideal candidates. We use the Marketsmith platform by Investors Business Daily to run weekly and daily screens that narrow our trading universe from several thousand stocks to several hundred. From there it is just a matter of creating a watchlist of names and monitoring that list for ideal, low-risk buy points.
Entry Management - How do we know when to buy?
Almost all of our entries on the long side will come from one of the following setups:
- Breakout buy or pre-breakout buy (building a position) in a stock that has formed a valid basing pattern.
- Breakaway gap up. Generally in reaction to news, a stock makes a new 52-week high on the open, gapping up above the highs of a valid basing pattern (on big volume).
- IPO breakout. Stocks that breakout from a short base after going public.
- Major gap up within a base but not a new high. Not a breakaway gap up, but still a significant gap up that if holds is a very strong buy signal.
- Pullback buys after a strong breakout from a valid basing pattern. This is generally the first pullback to the 10, 20, or 50-day moving average after a breakout from a valid basing pattern.
Chart Examples
Typical BASE BREAKOUT
MAJOR GAP UP(though not breakaway gap to new highs)
CUP WITH HANDLE or CUP WITH NO HANDLE
FLAT BASE PATTERN
IPO BREAKOUT
Who is this system for?
Since this report is based on a trend-following system, swing, intermediate-term and longer-term position traders will find value in our trade setups.
For the more true swing trader operating with a 3 to 20 day holding period, selling once a stock is up 10-20% is probably a good idea, as this will generally equate to exiting a winner once up 2 to 3x trade risk depending on stop width.
The intermediate-term trade is our focus in the report, as we look for gains of 20-50% or more within 1 to 6 months. If a stock rips higher after an entry and shows exceptional strength, then we will play for a +40% gain as long as the price and volume action remain bullish.
Longer-term traders may hold on to trades for 6 - 18 months, depending on the strength of the trend. This is the case if a stock runs 50-100% higher without breaking the rising 10-week moving average on a weekly chart.
What about selling short?
When market conditions turn bearish, and broad market averages are unable to hold the 200-day moving average on a daily chart, we then turn to short setups to generate profits.
We will trade individual stocks as well as inverse ETFs so that all accounts can participate on the downside.
Most short setups will originate from a classic topping pattern, such as a head and shoulders top or a failed late staged base breakout to new highs. In general, these stocks are at least 20% or more off the 52-week high and are trading below the 50-day moving average on a daily chart. Unless we are in a prolonged bear market, most short setups will consist of former leaders that have broken down after a significant advance and are now under heavy distribution. What goes up must come down!
A detailed look at the type of stocks we focus on
Our style of trading can be characterized as momentum growth. The overwhelming majority of buys will come from stocks that are in a strong uptrend, with many trading 100% or more above the 52-week low when purchased.
Our system is designed to identify stocks that are in a position to run significantly higher during the next three to eight weeks. When conditions are ideal, all positions initiated will carry a minimum target of 20%, but just how far they move will depend on the strength of the trend. When conditions are less than ideal, targets may be lowered to the 10-15% range.
Below are some of the specific traits we look for in a setup:
- Valid basing pattern (see primer) and proper buy point in a stock with a relative strength rating from IBD of 80 or higher (unless IPO).
- 9 out of 10 trades will be above $15 and trade with an average volume of 200,000 shares per day or more. Fast-moving stocks with great liquidity are ideal situations.
- Ideal candidates will be part of an industry group that is leading the market higher. Several stocks within the group should be strong
- Best candidates will have ramping quarterly earnings and revenue growth of +15% or more over the last three quarters. Preference is given to stocks with quarterly earnings and revenue growth of +25% or more.
- When earnings are not present, strong revenues may take its place.
- Small, mid, and large-cap stocks are traded, with an emphasis on small and mid-cap. However, our preference is to trade anything that moves with liquidity.
Trade Management
As mentioned above, our minimum target for all buys under strong market conditions is 20%. However, we do not set concrete targets because we can never tell in advance just far a stock will run. As such, we rely on price and volume action along with moving averages to guide us along the way.
Risk Management
We manage risk by proper position sizing and stop placement. All traders have different risk profiles, but for profitable swing and position trading, we believe one should risk no more than 1% to 3% of account equity per trade.
In the model portfolio, which is a mock $50,000 trading portfolio our maximum trade risk is 1.5% of account equity, or $750. At a full position size, the average trade risk is around 1%. A half position is 0.5% risk.
Most positions will be sized in the 5% to 15% area of account equity, with stops generally 4-8% away from the entry. With cheaper stocks, stops may be as wide as 10%, then we would cut our share size back to keep risk in line.
An example of how to calculate position size using a 10% position in a $50,000 account with a buy stop entry at $25.
formula: ( portfolio value x % position ) / entry price = share size
( 50,000 x .10 ) / 25 = 200 shares
To calculate the trade risk in terms of dollars: ( entry - stop ) * share size
Other risk management guidelines:
- Although a concentration of positions is needed to outperform, exposure to any industry group should be limited to 30-40% of portfolio value.
- Averaging down is not recommended when it is an emotional decision to enter just to lower the cost basis after a stock has sold off more than one expected. If one bought a small position with the expectation of adding more size on slight weakness and the stock was still trading in a fairly tight range, then averaging down is possible.
- Intermediate-term traders should have rules in place for holding a stock through earnings. Our rules are simple. If we have a profit buffer of 10% or more, then we will likely hold all or most of the position through earnings. In the event of a worst-case scenario such as a 20% gap down, our loss will be contained to 10%, which isn't great but only 2% more than an average-sized loss. The smaller the buffer, the smaller the position. If there is no buffer, then we will likely sell the full position.
Trading Psychology
When a trader has a well-defined system in place and has some experience running that system, trade psychology becomes very important.
Once we are no longer newbies, we should operate as a professional. Below are a few general guidelines for maintaining a winning mindset.
- Plan the trade and then trade the plan. Identifying a proper buy point and establishing a new position is fairly easy once we have experience. However, following through on the initial game plan while reacting to new information daily is a challenge.
- Worry about the trade before it is placed. Once the trade is live, keep positive and follow the plan. Adjust stops accordingly if needed, but avoid spur of the moment decisions to cut a position ahead of the stop just to save some money. A stock may come within 10 cents of our stop before reversing and then running 20% higher during the next few weeks. We have seen this happen before!
- Learn how to deal with losses. Think of stopping out as an opportunity to put money to work in a better situation. Do not become negative. Also, keep an open mind with regard to price action, especially if stopped out and the chart is still bullish. The first entry may have been a day or two early, but keep the stock on a watchlist as it may be ready to explode higher next week.
- Try to operate from a position of strength as much as possible…...do not chase price action. If a stock moves out from a buy pattern without us, so be it. On to the next. If we lose discipline and buy late, we may get lucky, but chances are that we will struggle to manage the trade properly at the first signs of weakness due to the stress of a higher cost basis. This is often referred to as buying a position in no man's land. Buying right prevents this.
