William O’Neil is one of the most influential traders of the 20th century. His lessons are been derived from master traders like Jesse Livermore, Nicolas Darvas, and Richard Wyckoff. His CAN SLIM trading method not only made him very successful but influenced many successful traders until today.
The CAN SLIM Method
William O’Neil, after his extensive research, concluded that every top-performing stock shares some common characteristics. The CAN SLIM abbreviation has summed up these characteristics. Each of these numbers is used as stock searching criteria in a stock screening application.
The earnings of a company, as you are about to find out, is, according to O’Neil, one of the most important things when trying to pick a winner stock. The Earnings Per Share (EPS) is calculated by taking a company’s after-tax profits (net income) and dividing that number by the common share outstanding.
The letters mean..
- Current Quarterly Earnings = The Earnings Per Share (EPS) indicator should have increased at least 18% or 20% from the same quarter a year prior to avoid temporary distortions in the numbers. It would be also helpful to compare a company’s earnings as a trend in a logarithmic chart. If the trend keeps going up, then is a good indication of a strong company. Another indicator is comparing earnings upward movement to sales upward movement for at least the last quarter or relative increase in other company earnings in the same industry.
- Annual Earnings Growth = The earnings of the stock must be increased at least 25% for the last 3 years. This isthe first thingthat William O’Neil would look for in a stock. This number can also be seen with a strong Return On Equity number (ROE). ROE can be measured by taking the net income of a company and dividing it by the Shareholder’s Equity number. Contrary to the value investment mentality, a high Price to Earnings ratio (PE) doesn’t make a company overvalued, and vice versa.
- New Product, Service, Management, or New Price Highs = Past winning stocks are correlated with their new game-changing product or service. Management plays, of course, also a key role in a company. Technical Traders might look for new price highs for the stock.
- Supply and Demand = This term includes stocks with limited share supply (shares outstanding) and volume accumulation.Companies with fewer shares outstanding would require less accumulated volume for their price to move.Companies with more shares outstanding would, on the other side, require way more volume for the same purpose. On the other side, companies with fewer shares outstanding are more likely to fall with reducing volume, that’s why these stocks require more tight risk management. Combining this factor with the previous one, a smaller company with a great product is more likely to move since the product account for a bigger percentage of this company’s overall portfolio. The company’s overall Debt to Equity ratio (D/E), is derived from the division of the total assets by the total liabilities and shows how leveraged a company is. Small but highly leveraged companies might now be in a great position but it will worsen as interest rates rise.
- Leader or Laggard = The basic premise is that if one cannot end up with positive trades with a leading stock in a sector, he or she cannot win with any other stock in this particular sector. The proprietary Relative Strength indicator of IBD is an indicator to check if a stock is a leader or laggard. Leader’s have a Relative Strength Index of more than 60.
- Institutional Sponsorship =Top investment institutions need to account for 70% or more of a stock’s activity. A trader needs to “follow the money”. Too much institutional ownership though might mean that the stock might rapidly change its trend due to an institutional selloff.
- Market Direction = Market trend needs to be in sync with a winning stock’s trend. This variable is the most important of them all. If the market direction is supported with fundamentals, though, as Nicolas Darvas would say, then the chances of the move being a speculating one are minimized. The main method of determining how the market is doing is to check the S&P 500 (SPX) index, the Nasdaq index (NDX), the Dow Jones index (DJI), and the New York Stock Exchange composite (TVC). These indices should be studied every day. On bear days, a trader should sell his or her leveraged positions, and on bull days, he or she needs to open positions. When an index experiences an increase in volume but not in price, then this might be a sign of a topping index. When it is clear that the index tries to move forward, but despite the increased volume its price action doesn’t move upward, it is time to sell. William O’Neil suggests a sell-off if the price moves 8% down from the initial entry point when opening a position.
CAN SLIM is a part of a technofundamental trend-following swing trading technique.
Chart Formations“Flat Base” and “Square Box”
These chart patterns are maybe easier to understand, even without visualizations. The “Flat-Base” chart pattern is created when the price creates candlesticks around the same price and moves sideways. The “Square Box” formation is the same as the “Flat Base,” but the price makes some upward and some downward moves around that price. This chart formation can also be called “Darvas Boxes” or simply “consolidation area.
Double Bottom
In the double bottom chart pattern formation, the price tests the same support area twice before it moves upward. The pivotal point is the sort term high point inside the “W”-like formation.
The “double bottom” chart pattern. The “Cup With Handle”
The formation of this pattern can three to six months in general, but it can take from 7 to 65 weeks until completion.
This pattern starts with raising volume and an at least 30% upward trend prior to the cup.
The formation of a handle gives the pattern more chances to continue the upward trend. The handle usually forms on the upper right side of the structure and above the 50-day moving average. The price in the handle area should retrace 12% at max.
Overview of the “Cup with Handle” chart formation.
The“saucer with handle” chart pattern is similar to the “cup with handle” formation, only shallower.
Indicators
William O’Neil doesn’t use many indicators on his charts. The signals that he is looking for come from price action, chart patterns, volume, and some moving averages.
Moving Averages
The are many mentions in William O’Neil’s books about moving averages. He would use the following:
- 10-Day Simple Moving Average
- 20-Day Simple Moving Average
- 50-Day Simple Moving Average
- 200-Day Simple Moving Average
Volume
The volume bars on a price chart show the supply and demand of the asset. Abnormal spikes in specific prices indicate that big institutions/market participants do recognize that this particular asset has value, and thus they enter the market. A great volume indicator is the visualization of a simple moving average on volume so that the identification of the average volume as well as the spikes are clearly visible.
Volume with simple moving averages on buys and sell. Selling Short
Selling short is a way in which a trader can make profits during bear markets. William O’Neil specifically mentioned that selling short is more difficult than going long and requires experience and specialized skills.
At its core, short selling is recognizing a trend reversal from bullish to bearish and entering a position to profit from the new downward trend.
The basic mechanics of the trade involves selling a stock that one doesn’t own, but borrows from his or her broker, with the obligation to buy it back at a later point in time and earning proceeds from this full circle, meaning selling it higher and buying it lower. As it is implied, a stock can move downwards to zero and upwards to theoretical infinity and thus the trade has limited gain and infinite loss.
Needless to say that when shorting, any dividends earned are been owned by the broker and thus they must be repaid by the short seller. Of course, short selling requires a margin account.
The image has been taken from “How to Make Money Selling Stocks” by William O’Neil, and Gil Morales, Page 39Head and Shoulders
The Head and Shoulders (H&S) chart pattern can help identify short sales. Although my example doesn’t have the “perfect” setup, it's a good approximation.
Overview of the head and shoulders pattern. Double Top
Rising volume initially drives the price to new highs, but poor later volume and moving average stagnation show signs of price top. After the price tests the top level, it collapses due to poor volume.
Double top chart formation. Teachings General
- Companies with growing quarterly and annual earnings, the highest return on equity and lowest debt ratio, wide profit margins, and a small number of common stocks in the market, are the ones that a trader needs to focus on.
- Inside an investment portfolio, one should constantly sell his or her worst performers, and keep the best performers.
- William O’Neil would analyze a daily and weekly chart.
- Price action plays a huge role. If for example a price is overextended without any proper base formation, or maybe with a gap at the end, or simply bigger than average volume with no price action, then the trader needs to close his or her position. The same goes for a big run after a stock split or after a big rally with 3 to 4 base formations in between, or even when the stock is the only one who advances from its industry.
- William O’Neil always believed that money in the markets is not made just by buying the right stocks but by handling them correctly.
“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.”
— William J. O’Neil
Psychology
- William O’Neil follows the rule of “lose small and win big” as his predecessors did. He expanded on this notion by saying “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”.
- The brand of a company doesn't play a role in the CAN SLIM method. Many of the companies CAN SLIM traders buy are unknown to them.
“What seems too high in price and risky to the majority usually goes higher eventually, and what seems low and cheap usually goes lower”
— William J. O’Neil
Fundamentals
- Total profits after tax, divided by common share outstanding, also known as Earnings Per Share (EPS) is one of the most important fundamental indicators. The vast majority of former stock market winners had evergrowing earnings.
Risk Management
- Good entry points will be after the price of a stock breaks a price consolidation area. If the price has moved up for 5% or more from the buy area then an entry at this point would be in an overextended area.
- When a market enters a correction phase, the stocks that went down the least might be the best choices for the new bull run.
- Not all stocks recover after a bear market. A trader must close his or her position in these periods and open new when markets are turning bullish again. In these bear markets, one should use market order in order to save as much of his or her previous profits as possible.
- William O’Neil suggests that entering a stop-loss order is the equivalent of showing your card to the broker in a card game. Instead, one should set his or her stop-loss mentally (or with a red line on the chart) and have the discipline to execute that target. When, of course, this option is not available, a stop-loss order is the second-best option.
- When opening a position, one should have a STRICT loss set and allow a 7% to 6% downward move. After that, the position should be closed, no questions asked, and the trader should admit that he or she was wrong. When on profit, the stock should get more room for fluctuations and set the stop-loss at a 10% to 15% downward move from its current on-profit top level.
- As Jesse Livermore did, so William O’Neil would followpyramidingand will build up his position on his winning stocks.
- A trader should also take some profits when his or her position has run in his or her favor for up to 20% or even 30%.
- In an overall bear market, cut down your stop losses to 3% and take profits to 15%. William O’Neil’s main strategy works on bullish markets.
- William O’Neil was against buying a stock when falling to its average down in price.
- Loser stocks must be sold immediately, and winning stocks must be held longer.
- A position should be open when a stock reaches at or near its 52-week high.
“Sell when there is an overabundance of optimism. When everyone is bubbling over with optimism and running around trying to get everyone else to buy, they are fully invested. At this point, all they can do is talk. They can’t push the market up anymore. It takes buying power to
do that.”
— Jack Dreyfus, from How to Make Money in Stocks by William J. O’Neil
Shorting
- In his book “How to Make Money in Stocks,” William O’Neil suggests that short trading is just for a few traders, and even then, a small amount of the entire portfolio should be used for short selling.
- O’Neil is mainly a trend follower, and thus he suggests never to short on an overall bull market for short-term profits.
- When one finally takes the decision on shorting a stock, he or she needs to make sure that the stock has at least 5 to 10 million shares outstanding in order to minimize the possibility of a short squeeze.
- Short-selling formations, according to O’Neil, can occur after a new high accompanied by low volume, and when moving averages make little to no upwards movement in some time (a sign of market top).
Options
- When a trader, instead of stocks, wants to apply the CAN SLIM method on options, the risk must be no more than 10% to 15% price move. If the option price fluctuation is three times more than its underlined asset, then a maximum of 25% must be applied.
- William O’Neil uses option buys only will the best setups.
Conclusion
The first thing that one would notice when reading William O’Neil’s books is the plethora of price charts included in them.
Regarding his strategy, one can describe this in a small sentence. When a company shows a strong foundation, market participants see this, and they invest in it, imposing their beliefs on the stock and making its price go higher. In other words, the market is always right, and this trading strategy confirms that when a company makes constantly new highs, is because market participants see this. Timing the market, in that sense, means three simple words, follow… the… money.
$S&P 500(.SPX)$ $NASDAQ(.IXIC)$ $DJIA(.DJI)$
Follow me to learn more about analysis!!
Comments