About Trading Methods
In tennis wins the one who makes less mistakes.
Trading is like tennis.
Trading is like tennis.
Successful traders build simple trading methods that are:
- Easy to follow;
- based on proven market anomaly;
- bring profits consistently;
- minimize losses.
A good trading method is like a set of driving instructions which when followed, will bring you to your final destination. Nothing great in this world has been achieved without a plan and trading isn't any different.
Everything starts with the goal you want to achieve. The well stated problem is a half solved problem. Let’s say, for example that you aim to achieve 10% return on a monthly basis. Then you have to screen for stocks that rose 25% + in a month and study carefully their common characteristics, before they went to make such an impressive move in a compressed time frame. This will help you to build at least several trading methods. The different methods require different time devotion, capital requirements, risk exposure, investing horizon. You should choose the one that suits best your personal needs and way of living.
To create a working trading method, you need to answer 3 basic questions.
1. Why is it working? What's the logic behind the method?
If you are able to explain in simple words, why a method is working, then you will feel much more comfortable trading it. It will save you time and it will decrease the noise coming from so many different sources of information. Nowadays lack of information is not a problem. The plenty of the information is a problem. A well defined trading method will help you to focus on the really important things.
There are three main market anomalies on the long side that are incorporated in most institutions' investing strategies:
a) Earnings' surprise: companies that report better than expected earnings tend to outperform the market average. This is especially true, if it is first major earnings’ surprise. The market reaction to earnings is indicative for the size of the surprise and foretells the future price behavior of a stock. Earnings’ growth is one of the major variables followed by big institutions. For their reaction to earnings, we may judge by the price and volume action. When there is a 10%+ one day increase on at least triple the average volume, there is a clear sign of institutional interest. Such reactions usually follow major earnings surprise. That is why we conclude that institutions like to buy after major earnings’ surprise.
b) Long-term RS: stocks that outperformed the market during the last 6 months, tend to outperform the market during the next 6 months.
c) New 52 week highs: all top performing stocks during the year are frequent visitors of the new 52 week high list. Substantial research reveals that a portfolio of stocks within 5% of their 52 week highs tend to beat the market average, assuming frequent stocks’ rotation and profit taking.
One variable is defined as anomaly, when basket of stocks, possessing this variable, outperforms the market averages during at least 70% of the cases. (70% of the years since market opened doors for first time). The above mentioned anomalies work not because there is a special kind of magic behind them. They work, because they are the variables that institutions follow. And institutions are the ones that define the market trends. People tend to believe that anomalies cease to exist once they become known to wider group of people. Those people don't understand the power of conditioning. Until institutions react to those variables, money will flow into stocks that possess one or more of those variables.
Anomalies exist in every market. We just have to find a way to incorporate them in a market strategy that corresponds to our personal investing horizon and risk zone.
2. When is it working best? Under what circumstances this particular method bring optimum results?
There are three main market anomalies on the long side that are incorporated in most institutions' investing strategies:
a) Earnings' surprise: companies that report better than expected earnings tend to outperform the market average. This is especially true, if it is first major earnings’ surprise. The market reaction to earnings is indicative for the size of the surprise and foretells the future price behavior of a stock. Earnings’ growth is one of the major variables followed by big institutions. For their reaction to earnings, we may judge by the price and volume action. When there is a 10%+ one day increase on at least triple the average volume, there is a clear sign of institutional interest. Such reactions usually follow major earnings surprise. That is why we conclude that institutions like to buy after major earnings’ surprise.
b) Long-term RS: stocks that outperformed the market during the last 6 months, tend to outperform the market during the next 6 months.
c) New 52 week highs: all top performing stocks during the year are frequent visitors of the new 52 week high list. Substantial research reveals that a portfolio of stocks within 5% of their 52 week highs tend to beat the market average, assuming frequent stocks’ rotation and profit taking.
One variable is defined as anomaly, when basket of stocks, possessing this variable, outperforms the market averages during at least 70% of the cases. (70% of the years since market opened doors for first time). The above mentioned anomalies work not because there is a special kind of magic behind them. They work, because they are the variables that institutions follow. And institutions are the ones that define the market trends. People tend to believe that anomalies cease to exist once they become known to wider group of people. Those people don't understand the power of conditioning. Until institutions react to those variables, money will flow into stocks that possess one or more of those variables.
Anomalies exist in every market. We just have to find a way to incorporate them in a market strategy that corresponds to our personal investing horizon and risk zone.
2. When is it working best? Under what circumstances this particular method bring optimum results?
There are times when market will favors one more aggressive applying of your trading method. You should know when that time is. There are times when your method won’t provide you with good opportunities and you should decrease your trading activity. You should know when that time is. For example IBD recommend full exposure during confirmed market rallies and cash positions during corrections.
3. What are your money management' rules?
Prudent investors don't risk more than 1-2% of their capital at every single trade. This means that if your trading capital is $ 100,000, you won't risk more than $2000 on any single trade. ($100,000 x 2% = $ 2,000). To illustrate how to define how many shares to buy, I will analyze a hypothetical stock with symbol YYY.
3. What are your money management' rules?
Prudent investors don't risk more than 1-2% of their capital at every single trade. This means that if your trading capital is $ 100,000, you won't risk more than $2000 on any single trade. ($100,000 x 2% = $ 2,000). To illustrate how to define how many shares to buy, I will analyze a hypothetical stock with symbol YYY.
current price = $ 46.00
stop loss = $ 42,50 (there are various ways to define a stop loss spot. the most frequently used is taking 50 cents off the last price of major support)
time stop = 10 days
profit taking = selling half of the position between $50.00 and $54.00, depending on the velocity of the move and the current market environment.
The difference between the current price of the stock we are looking at, is $3.50, which means that we are not willing to risk more than 3.50 for every single share.
total amount at risk (2% of the trading capital) divided on single amount at risk ( in this case 3.50) will give the number of stocks you should buy.
2000 : 3.50 = 571 shares (approximately)
571 shares x the current price of $46 = $26,266.
The rest of the capital is $73,734 and you may follow the same rules for defining the size of your next position.
Following this consequence, you'd be able to create a portfolio of 5-6 stocks.
-About the stop loss: its purpose is to minimize losses in such a manner that they never harm significantly the overall portfolio return.
- About the time stop: a successful trade is profitable from the very beginning. It's all about optimization. You don't want to put money in temporarily "dead" stocks. Frequent stock rotation is essential for achieving outstanding returns.
You should know what it takes to trade a certain method and create a comprehensive plan to follow rigorously. Which websites are you going to visit, why, how much time are you going to spend there, what kind of information are you looking for? Which scans are you going to run, at what time during the day and why? How are you going to choose your trading candidates from the list your scan has created?
When you build your own trading method:
-About the stop loss: its purpose is to minimize losses in such a manner that they never harm significantly the overall portfolio return.
- About the time stop: a successful trade is profitable from the very beginning. It's all about optimization. You don't want to put money in temporarily "dead" stocks. Frequent stock rotation is essential for achieving outstanding returns.
You should know what it takes to trade a certain method and create a comprehensive plan to follow rigorously. Which websites are you going to visit, why, how much time are you going to spend there, what kind of information are you looking for? Which scans are you going to run, at what time during the day and why? How are you going to choose your trading candidates from the list your scan has created?
When you build your own trading method:
- you'll gain an edge against other market participants;
- it will provide you with new trading ideas consistently;
- you'll learn to think for yourself instead of relying in other people' personal opinions;
- it will saves you time;
- you will make money.
6 Comments:
Excellent post! Very helpful! Thank you!
So how do you know where to set the stops?
From this post of Ivanhoff's, he says:
"there are various ways to define a stop loss spot. the most frequently used is taking 50 cents off the last price of major support"
How are you doing btw?
IBD recommends as a general rule to close your position, if it drops 8% below your purchase price. This is a general rule and it's not very suitable for the different stocks, investing horizon and trading methods.
If you prefer to buy in strength,you might put your stop loss as 10 cents below the previous 2 days' lowest price.
Most people use as a stop a major area of support - such as a 50 day MA, 200 MA, long-term trading range that was broken on the upside. Market makers are aware of such spots and know where the majority of the people have put their stop losses. That's why they often intentionally bring the the price of stock 20-30 cents below major area of support in order to shake out individual investors. That's why you should be more flexible when defining your stop loss and have others (not only technical) reasons to buy.
Ivanoff - do you have a soft stop for Maria?
there are some things in life that have to be hold forever.
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