March 18 2009 10:36 PM EDT
The Method
Each of four factors is assigned a value from -1.00 to +1.00 for an aggregate score of +4.00 (buy/cover) to -4.00 (short/sell).
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-4 0 4
Trend is the only completely objective element. Price, Market, and Catalyst are dependent on research and quality of analysis. Ideally, when the evidence for a particular price movement is very strong the score moves to an extreme.
PRICE A judgement of the price relative to earnings, historical ranges, or future value. If it is extremely low, the value is +1 to indicate future prices could be strong. If the price is neither high nor low, 0 is appropriate.
TREND The trend is measured by moving averages on three separate time frames: 100-min EMA(200), daily EMA(200), and weekly EMA(200). Each is worth 0.33 points. If the price is below the moving average, count it -0.33. For example, if the price is below all three EMA's, score it -1.00. The weekly is given a value of 0.34 rather than 0.33 to even out the sum.
MARKET This is a subjective analysis of who is involved in the market and what their motives are. One class of participants could be the general public, for example. If retail investors are historically over invested in gold indicating a "mania" then a negative value such as -0.50 is justified. If it is also known that sovereign banks have copious amounts of gold to sell and intend to do it, then a negative value closer to -1.00 is appropriate.
CATALYST The catalyst is a specific event that can trigger market participants to react a certain way. The outcome must be predicted in advance and the score is reset after the event (or a portion of it) is resolved. If confidence is high that inflation will be more than expected, for example, this can be considered a short term catalyst in the price of gold. In the case of a stock, the catalyst could be the conjecture of an entire year of better than expected earnings (four quarterly earnings reports). If there is no catalyst, the value should be 0 at best or possibly an opposing value. Positive reinforcement in terms of news flow is important. If there is no news confirming the catalyst is currently at work, then the score should not be extreme.
Trade Design
Given a strong enough confidence score, a trade can be planned. Strict control of value at risk is as important as the research.
TIME How long will it take for the predicted price action to occur?
RISK How much will be dedicated to the idea? What percent of the account size?
STOP, TARGET, EXECUTION Determine a hard stop, target, and execution time in advance. 