Trading The 10-Bagger

KEEP IT SIMPLE
In the interest of full disclosure, I am not a fan of technical analysis. To me, it makes no sense. There is no cause and effect. Stock prices don't increase because they increased, and they don't fall because they fell. The cause of their movement is beyond the chart.

Of course, most technical analysts readily admit this. After all, they are not concerned with why a stock does what it does; they are only concerned with what it is doing. Since the prediction of 10-baggers is based on "the why" and not "the what," we might be tempted to discard technical analysis as an analytical tool. But we won't. There are two reasons why.

First, while the causal foundations of trading may be suspect, the fact is that 90% of stock market profits come from trading stocks. Thus, trading cannot be ignored. Second, trading provides an immediacy of observation. As I have observed in earlier articles, 10-baggers often move six to 12 months prior to a change in company performance. As investors, we are conditioned to wait for the change. As traders, we are conditioned to react to the move. When it comes to 10-baggers, time is money, and immediacy has its rewards. So we will not ignore trading, but we will also not elevate it beyond its worth.

In that regard, we will keep it simple. There will be no use of moving average convergence/divergence (MACD) or on-balance volume (OBV) or relative strength index (RSI). These are all just manipulations of the basic inputs of price and volume. They may clarify, but they do not enlighten. We will skip the manipulations and focus on the basic inputs — price and volume. I'll leave the technical analysis to the mathematically adept and the true believers.

We'll start our analysis by dividing the chart into four sections: the launch (or breakout), the path (or trend), the potholes (or corrections), and the destination (or reversal). These are all illustrated in Figure 1. The objective is to determine how the 10-baggers differ from the overall market with respect to price and volume. Unlike our fundamental comparison, we are not looking for cause and effect; we are looking for degrees of separation that identify that a 10-bagger has been set in motion as it is occurring.

FIGURE 1: FOUR SECTIONS OF A CHART. Here you see the launch (breakout), path (trend), potholes (corrections), and destination (reversal).

How can we distinguish between a real launch and a false start? There are several clues (but no guarantees).

The first clue is the sheer size of the price move. As illustrated in Figure 2, the median monthly price move for the overall market is 0.00%. The median launch price increase for a 10-bagger is 34.43%; thus, 10-baggers are in the top 3% of the overall market. Viewed another way, if a stock's price increases 34% or more in a month, there is a one in 10 chance that you are looking at a 10-bagger.

Another clue is volume. The median volume increase for 10-baggers at launch is 114%, which is in the top 4.5% of the overall market. Figure 3 shows the volume profile of a 10-bagger, and the increase stated is calculated by dividing the volume before the move into the volume at the move (5.77 / 2.69). When we combine both the price and the volume increases, we discover that only 1% of the overall market exhibits that level of positive activity. Your odds have just improved from one in 10 to one in three that a price move on volume is a 10-bagger.

The final clue comes after the launch. It is more of a confirmation than an immediate indicator. It is the 13-week price movement that occurs after the launch, which is illustrated in Figure 4. The median 13-week price increase of a 10-bagger is 39.06%, compared to the market increase of just 0.92%. It is clear four months into the move that these stocks are establishing a new price trend. If you couple this price observation with the observation that the volume of shares traded is maintaining the launch level (Figure 3, 5.77 at launch and 5.31 after launch), there is a strong sense that a 10-bagger may be in the making.

FIGURE 2: REAL LAUNCH OR FALSE START? If a stock's price increases 34% or more in a month, there is a 1 in 10 chance that you are looking at a 10-bagger.

THE PATH (TREND)
A 10-bagger is launched when it crosses its six-month moving average price line. After it launches, it typically remains above that average until it hits its peak price and reverses or, more accurately, falls back and settles at a new price level significantly higher than the launch price. With the exception of a few corrections (discussed in the next section), the price approximately doubles in the first year, doubles again in the second year, and doubles once more at its peak in the third year (Figure 1).

While this price rise is occurring, the volume of shares traded also increases. The volume increase is even more dramatic than the price increase. In some cases, 100% of the shares outstanding are traded in one month. The implications are intriguing, but that will have to be addressed for another time. What is clear from the chart (and illustrated in Figure 3) is that the percentage of the shares outstanding that are traded grows to far exceed the normal volume traded in the overall market. At its destination, the median level for the number of shares traded, as a percentage of the shares outstanding, is 29.45% compared to just 7.02% for the overall market. There is plenty of price and volume confirmation along the path of a 10-bagger chart.

THE POTHOLES (CORRECTIONS)
Very few price charts are perfectly linear. Dips and spurts can be found in even the strongest charts, and 10-baggers are no exception. The 30 studied here demonstrated a total of 193 corrections. (A correction is defined as a price decline of one or more months.) Of those 193 corrections, 74 dipped below the six-month MA, with seven of the 30 10-baggers having no corrections that dipped below the six-month MA.

For the trader, the goal is to distinguish between a correction and a reversal. In that regard, the six-month MA is of little value since 76.7% of the 10-baggers would trigger multiple sell signals prior to the stock's peak price. Unfortunately, adding the size of the price correction and the volume of the shares traded during the correction did not aid in the distinction. However (and here I am about to break my promise to keep it simple), the MACD did offer some insights. Only five of the 193 corrections (2.6%) triggered an MACD sell signal (monthly MACD). Thus, you have a 97% confidence level that a price decline that does not trigger the MACD is a correction rather than a reversal. This is a significant improvement over the 71.2% confidence level offered by a simple decline below the six-month MA.

FIGURE 4: THE CONFIRMATION. The median 13-week price increase of a 10-bagger is 39.06% compared to the market increase of just 0.92%.

THE DESTINATION (REVERSAL)
The time to sell a 10-bagger is when the run is over and it has peaked. Of course, we don't know that it has peaked until it reverses. And we don't know that it has reversed until we realize that the price decline is not a correction. And since corrections vary in size, volume, and duration, there is no simple distinction between a correction and a reversal. Thus, we turn to the MACD.

All reversals trigger a MACD sell signal, but not all MACD sells signs indicate a reversal. Previously, we have identified five MACD sell signs that were later determined to be simple corrections. So there is a risk that if we sell on the MACD, we will sell too early. What is that risk? It is 14.3%. This means you are more than 85% confident that you are making a correct sell decision. This is considerably higher than the reported success rate of top business executives. Their success rate is just 70%. Thus, when it comes to 10-baggers, selling on the monthly MACD appears to be good business.

CONCLUSION
Let's conclude by looking at the efficiency of a 10-bag trading strategy. We will buy after the 13-week confirmation and sell on the monthly MACD sell signal. Backtesting this strategy with our 30 10-baggers reveals the observations presented in Figure 5.

It is clear from Figure 5 that trading a 10-bagger is not efficient, but it is still very profitable. When the 23.6% efficiency number is applied to a typical 10-bagger, the annual rate of return on a 30-month trade is more than 50%. In other words, a $5,000 play will grow to $329,159 in 10 years. Compared to the average stock market return over the same period of just $14,197, trading 10-baggers is a lucrative business.

Yet, 23.6% leaves a lot of room for improvement. Could we do better? My trading experience indicates that any attempt to speed up the process to increase efficiency tends to have a negative impact on effectiveness. In essence, when we are right, we make more (efficiency), but we are right less often (effectiveness). A series of ineffective trades will ultimately reduce the overall efficiency of the strategy.

So where is the answer? Our analysis of the fundamentals demonstrated that the answer isn't there. They would be even slower to buy and slower to sell, which would reduce the efficiency further. And there is no evidence that they would be any more effective. That leaves us with just one player to turn to — the speculator. They may have the answer, but they will have to wait until the next installment.