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Watchlist Criteria

April 1, 2007

In rebuilding our watchlist, I want to clarify the criteria I think we should stick to for a good and all-purpose watchlist. The aim should be to have a list of highly rated and leading stocks from a broad range of industry groups.

Most basic criteria for consideration to be on our list:

  • F/E score of 3.25.
  • Price Pattern score of 2.5
  • Average daily volume = 1 Million or more

These scores for F/E and Price Pattern are far from a crystal ball. Indeed there will be plenty of high scoring stocks that don’t perform well. But at the very least, this is a simple way to begin the process of narrowing our sights from the vast sea of stocks that one could watch. With so many stocks out there, why look at any other than the ones with the strongest fundamentals?

The volume requirement brings a few benefits. It is true that a stock trading a minimum of 100 to 250 thousand shares a day is probably liquid enough to safely trade and invest in. But when a stock is traded as heavy as 1 million shares a day, we know that a few players will not be able to push this stock around and we can trust more of a “fair” market in the stock and its price. The more people there are haggling for something, the more likely it is to sell for the most appropriate price given all factors at any given time. In turn, it seems to me that a more heavily traded stock should have a chart that is more likely to provide us with more reliable material for technical analysis of the chart. Think about it like watching a bunch of people finding their way through a maze. If you watched 20 people trying to find their way, you’d probably have a harder time predicting their next move than if you saw 2000 people moving together. Does that make sense or is that just an image that works for me only? I suppose the simple message is that it is easier to observe and predict the behavior of a big mass of people than a small few.

But perhaps the most important reason for requiring that higher degree of liquidity is that the heavily traded stock is much more likely to also have heavy trading in its options chain. (I know that some people may not be trading options, but for those that are we should keep this list appropriate for all purposes.) The more people trading the options, the more open interest there will be on each option contract throughout the chain of months and strike prices, and the tighter the bid/ask spreads will be. We want to be very careful with options that have wide spreads. Basically, the wider the spread, the bigger the instant loss you have to make up. If an options has a bid of 3.50 and an ask of 3.90, you buy at the ask and instantly show a .40 loss if you wanted to sell it quickly. If this kind of situation would be the norm in your options trading, you would have to have a higher ratio of success to compensate for the toll the wide spreads would take on your profits.

For an extreme example, look at the options chain for the QQQQ. The ETF is trading somewhere around 130 million shares a day and the options chain has amazing levels of open interest. As a result, the bid/ask spreads in the options chain are .05 or even less with the new penny price increments.
(click image to see it bigger)

In contrast, look at a stock like VPRT. I have watched and really liked this stock for quite some time. It has an F/E score of 3.75 and trades an average 400,000 shares daily. While that is enough volume to comfortably trade the stock, the options chain is a bit dicey. There are contracts here with high levels of open interest, but there are also some that are lacking. As a result we see a nice bid/ask spread on the contracts with high open interest and a less favorable spread on those with lower open interest. Look at the front month(April) 35 and 40 calls. .20 spread on one, .40 spread on the other. .40 is more than I want to pay. We won’t find much better than .20 on options spreads for stock, but if we stick to stocks that have heavy volume, there is a greater likelihood of high open interest throughout the options chain and therefore attractive spreads. Also, there will likely be a greater choice for months and strike prices available. (Keep in mind that these snapshots were taken over the weekend when the market is not open, so the pricing is probably a bit off of where it is during open hours. But the basic principle still holds.)

Back to the list! Even with these basic requirements, we’ll still have plenty of stocks to choose from. Now it’s up to our discretion. Here are some factors I think should be used to consider the strongest of the strong and narrow down the potential candidates.

  • Because it represents the forwarding looking expectations for the company, we would prefer that the Estimates score is stronger than the Financials score.
  • Sales and earnings growth are perhaps the most influential factor in a stock’s performance. Annual sales and earnings growth of 25% or better for the trailing year is important. Ideally, the earnings growth will be higher than the sales growth as a sign of efficiency. Estimated 20% annual growth or better for the next 5 years is important.
  • A PEG of 2 or higher is a sign of a potentially overvalued stock. You can find this piece of information on the “Valuation Analysis” page found in the left hand column of your Investools “Corporate Snapshot” page.
  • A strong stock should be a group leader both fundamentally and technically. For a technical comparison, click on the “Industry Comparison” link also in the left hand column near the bottom on the Corporate Snapshot page.

I don’t think we should worry so much about ranking on the big chart as this is meant to be a longer term list to watch and not one to change every 3 weeks as groups heat up and cool down. Of course, you can do that at home with your own list, but for the sake of simplicity for the group, let’s keep it about the individual stocks and not the hot groups. The bonus is that if one of our hot stocks in a cold group begins to climb on the big chart, we’ll be there to ride it on up with the rest of the group as it should be a leader.

Well, I think that covers my basic thinking behind the watchlist. Please chime in with any questions or comments.

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