How to Gauge a Stock's Trading Potential

I get many questions from readers about how to calculate the potential of a trade, since I always say I will not enter a trade unless it offers enough to make it worth the risk of exposing my capital on the market. So how do I figure out how much one stock will oscillate compared with another?

To answer that question, first take a look at these charts:

From my tracking I know that on an average day, when Microsoft (MSFT Quote) moves 75 cents, Intel (INTC Quote) will move about 20 cents to 30 cents and Cisco (CSCO Quote) will move about 20 cents. This is "relative volatility" given no special news on each individual stock.

Often, I will see a climb in Microsoft, Qualcomm (QCOM Quote) or Intel, and based on the amounts that these stocks move, I determine how much potential there is built into stocks like Ciena (CIEN Quote), Cisco, Juniper (JNPR Quote), Sun Microsystems (SUNW Quote) and WorldCom (WCOM Quote).

Many times these "indicator" stocks lead the market with "follower" stocks sometimes minutes behind. So when I see Microsoft move up 75 cents and stocks like Ciena, Cisco, Juniper or any of the other "follower" stocks starting to bottom, I enter. I then watch Microsoft to see when it tops out and how much it goes up. If I entered Cisco and Microsoft climbed 75 cents before reversing, I would expect Cisco to climb approximately 20 cents before it reversed. So as Cisco approaches the plus 20-cent mark, I am poised and ready for a quick exit should it show signs of a reversal (i.e., buying slows, stops, pauses and then the selling begins).

I don't just look at one stock like Microsoft to judge the entire market, though -- I take the average of "indicator" stocks in Microsoft's peer group. I consider the average before I consider the individual stock. This eliminates or lessens the effect of a rogue stock that is not typical of the general market.

The same thing holds true for reading market gaps and their effect on the market. Let's say Microsoft gapped up 21 cents, Intel 11 cents and Qualcomm 28 cents as they did the morning of Sept. 26. The average gap up is about 20 cents. What does this tell me? It says we are not strong, nor weak, but "potentially" recovering. There are many moving parts to reading the market, and this is just one piece.

I also look at several other factors, such as the premarket buying and selling, the historical market both short and long term, and trader interest. On the morning of Sept. 26, all of these were negative. Premarket buying was weak, with very few rally bounces. The historical market long term was down, and short term was a mixed bag of selling and buying at the open. Daytrader interest was cautious at best, judging by the action of smaller-priced stocks in the premarket. Putting all this together, I felt the market would climb a bit at the open then drop fairly hard as traders took short-term profits from the gap up. Given these indicators, the proper action was to short at the open or first highs.

As you can see from the Nasdaq chart above, this is what happened. Does this always work? Heck no! Sometimes the market just does what the market wants to do completely contrary to what the indicators are telling me. But I play the percentages, and a good percentage of the time these indicators work and give me great insight into what the market is about to do at the open. When the indicators are wrong, I exit with the smallest loss possible, take my lumps and move on to the next trade.

By taking into consideration all these factors on the morning of Sept. 26, I was given a sneak peek into what was about to happen. It enabled me to prepare for what I expected to happen, instead of spending time figuring out what was happening and then simply reacting to it.