Playing Follow the Leader

In the short term, most stocks tend to follow the market; here's how to use that information to your advantage.
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Ever watch a flock of birds flying together across the sky? It's a thing of beauty! One bird has the "lead," and all the others follow without question. The birds that follow know who is king of the hill, and whenever the lead bird changes direction, they follow because they know that the lead bird will bring them to food and safety.

Trading would be easy if all we had to do was pick out the lead stock and play the ones that are about to follow. Unfortunately, it isn't that easy. Stocks do follow leaders, but it's like watching 100 different flocks of birds, all following their own leaders. If you sit back and look at the market from a macro aspect, however, you can see that even though different groups of stocks seem to be moving in different directions the majority of the groups are, in fact, moving in the same general direction.

One of the techniques I use to determine and play stocks based on the general movement of the market is to put a basket of stocks on my screen that historically has moved with the general trend of the market. I track the stocks day after day to see if they participate in opening trends, such as a buying spike or selling dip right after the open, and then watch whether they follow the general market up or down.

One would expect stocks to be independent and move to the beat of their own financial reports and fundamental analysis. For the most part, though, in the short term stocks move with the tide of the market regardless of the company fundamentals, unless some sort of news forces them against the trend, such as poor or outstanding earnings, new products, Food and Drug Administration approvals, etc.

The stocks in my "basket" tend to mirror the general movement of the market very closely in the few minutes after the bell, then slowly migrate away from its exact moves as the day goes on. I pick one that is lagging slightly behind the leader stock, but has more potential (e.g., better news or more explosive momentum), and play it just after the leader stock moves in one direction.

Here is an example of one stock following the general direction of the market. On Thursday, Aug. 23, I was watching

Synopsys

(SNPS) - Get Report

because I identified it as one of my basket stocks that was following the general trend of the market.

If you take a look at the

Nasdaq and Synopsys charts above, you can see that Synopsys followed the Nasdaq move very closely in the first 30 minutes during the market spike just after the open. Then the two slowly migrated apart, making their own independent spikes and dips, but the whole time moving in the same general direction and even ending up at about the same levels.

Take a look at an expanded view of Synopsys and the Nasdaq at the open in the charts above, and you will see the correlation of the moves in the first 30 minutes.

So what does this mean to us momentum traders? Well, because I identified Synopsys as a stock that was moving hand-in-hand with the basket stocks that were following the general move of the market, I used this information to pick solid entry and exit points. I was watching my basket stocks in the premarket and noticed a large surge of buying just prior to the opening bell. Because Synopsys was moving with them, I entered a long position at the first uptick after the opening bell at $44.75. I then stepped back and watched all my basket stocks at once, looking for them to change direction as a "flock" and ignoring any minor deviations.

At 09:58 EDT I noticed signs that the buying momentum of a few of my basket stocks was starting to slow down. By 09:59 EDT it was obvious the flock was about to abruptly change direction, as the majority of my basket stocks started to cascade, first, one by one, then all together. I missed the top by 35 cents and exited at $47 for a $2.25 profit.

Had I simply concentrated on the movement of just Synopsys alone, I would have been shaken out of the trade three minutes into it, due to a momentary pause and slight dip. By stepping back and looking at this trade from a macro aspect instead of micro, I was able to identify very profitable entry and exit points instead of being shaken out of yet another trade.

This market is tough, and to make consistent profits you have to watch what's happening around you and not just the trade you are in.

Ken Wolff is founder and chief executive officer of Paradise, Calif.-based MTrader.com, a daytrading and swingtrading Web site. This column provides general information about momentum trading. TheStreet.com has no affiliation with MTrader.com, and no endorsement of MTrader.com or momentum trading is intended. While Wolff cannot provide investment advice or recommendations here, he invites you to send your feedback to

Ken Wolff.