The Profit From Being Wrong
Stockscores.com Perspectives for the week ending February 15, 2008
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In this week's issue:
Do you feel you have to be mostly right when trading in the stock market?
Do you think that picking the right stock and avoiding losses are key elements to your long term success as a trader?
Do you avoid taking losses when trading?
If you answered yes to these questions then you are like most people. Unfortunately, it also means that you have been trained to fail as an investor. I want you to be a successful trader and with that goal in mind, I have to change the way you think about investing.
The truth is, the most successful traders are probably wrong more than they are right. It is what they do when they are wrong versus what they do when they are right that allows them to take more money out of the market.
To illustrate this point, I want to go through the process and results of a test I did on one of the strategies that is taught in the StockSchool Pro course. This strategy, called the Superheroes, is a day trading strategy that focuses on the hot stocks of the day and looks for a specific chart pattern set up. Since it is part of the StockSchool Pro course I won't go in to the specific rules. I want to focus on the results of the test and what it means for how you should approach the market. (The StockSchool Pro course, including all of the strategies can be bought from Stockscores.com for $2995. Canadian residents can get the StockSchool Pro course for free if they are a brokerage client of DisnatDirect, go to www.disnatdirect.com/stockscores for more information on this offer).
For my test, I identified all of the trading opportunities that this strategy produced this week. I have some software that automates a lot of this work so that I remove the research bias and don't have to spend quite so much time doing the analysis. I only applied the strategy to the NYSE and NASDAQ markets.
From Monday to Friday, this strategy found 43 trade set ups. 20 of them were purchases and 23 of them were short sells. I used the rules of the Superheroes strategy for entry but rather than exit on a set of rules, I chose to exit based on the risk reward ratio for each trade.
Here some explanation is required. The risk of a trade is the difference between the entry price and the stop loss price. The reward of the trade is the difference between the exit price and the entry price, assuming the trade is profitable. For example, a stock that is bought at $10 with a stop loss point at $9 and is then sold at $13 would have a risk reward ratio of 1 to 3.
For each trade, I calculated the profit based on risk reward ratios of 0.5, 1, 1.5 … all the way up to 10. So, there were 20 possible risk reward ratios. A stock that was stopped out before getting to a risk reward level shows up in the study as a loss. If a stock does not hit a risk reward ratio level and does not get stopped out is simply exited at the close of trading.
So, the stock that is bought at $10 with a stop at $9 and which hits a high of $13 before closing at $12 (without ever falling to $9) would have a risk reward of $3 if the target ratio was 1:3. If the target ratio was 1:4 then the ultimate risk reward of the trade would be 2 since the stock never achieved the $4 move necessary to be sold at a risk reward of 1 to 4 and was then exited at the close where the risk reward was 1 to 2. I know it is bit confusing, but these facts are not all that important to understanding the results of the study.
So, suppose that my target risk reward was 1 to 4. That means that I am planning to exit when the stock has moved four times the risk amount. I will either be stopped out at a loss, I will hit my target price of 1 to 4 risk reward or I will exit at the close at whatever the price at the close represents in terms of risk reward.
For most traders, the hardest thing to do is exit the trade at the right time. The tendency is to exit too early and the result is that their profitable trades don't make enough to pay for their losses. This method of exiting a trade takes much of the emotion out of the decision making process; you simply plan to exit when the stock has achieved its risk reward ratio target.
I consider a trade a success if it achieves its risk reward target. Failures fall in to two categories. Those that are stopped out at a loss and those that are exited at the market close at whatever the prevailing price is.
The signals that the Superheroes strategy generated will have different success rates based on the target risk reward ratio. If the target was a risk reward of 1 to 1, the results this week found that 15 out of 20 trades were successful, four trades were stopped out for a loss and one trade made a profit that was less than 1 to 1. Basically, a 75% success ratio.
On the short trades, 16 out of 23 hit the 1 to 1 target, 6 were stopped out for a loss and one was exited at the close for a slight loss.
In the StockSchool Pro course I teach that you should size a position based on your risk tolerance. If a trade has $1 in risk (the difference between the entry and the stop loss) and you have a $500 risk tolerance then you would take a 500 share position. In this study, with a $500 risk tolerance and a target of 1 to 1 risk reward, the buy signals earned a profit of $5400 and the shorts a profit of $4900 which appears to be pretty good.
At this point, I want to ask you a question. Would you rather be right or would you rather make money?
Consider this when answering that question. If I set the risk reward ratio target to 1 to 5, I get very different results. For the buys, I only hit the target 3 out of 20 times. 5 out of 20 are stopped out and the rest are exited at the close, some at a loss and others at a profit.
On the shorts, the results are even worse because the trades only hit their target 3 out of 23 times with six stopped out and the rest exited at the close.
However, what should be most important is how much money was made. On the buys, the total profit over the 20 trades has gone up to $11,100 and the total profit on the short sells rose to $16,300. Despite a losing record, total profit was almost 3 times as much as the performance of exiting at a 1 to 1 risk reward ratio.
The reality is, most traders can't execute with this in mind. We are so worried about being right and avoiding losses that we lose sight of what is really important - making money!
For this week's trades, the ideal risk reward ratio for the buys was 7.5 and for the shorts it was 5. Most traders never let their stock profits run like that because we are afraid of losing.
What this example should motivate you to do is test your trading strategy and calculate what is the ideal target risk reward ratio. It should show you the importance of judging success over a large number of trades, not one trade at a time as we tend to do.
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Chart patterns that predict upward trends are often characterized by abnormal breaks through resistance from periods of low price volatility, typically from a period of rising bottoms. The Stockscores Simple Strategy and Market Scan combines the Sentiment and Signal Stockscores with other Market Scan filters to find these chart pattern set ups. The result is a scan that will generate a good number of high probability position trading opportunities each week.Back To Top
1. V.BDO
V.BDO has been trading sideways for about 4 and a half months after gapping down in September. The stock has tried to make a few up moves over that time but each time it found some strong selling pressure that kept it down. Friday brought some more good interest from the buyers and that took it through resistance on higher than normal volume. The chart pattern is not ideal, but I think it has a 65% chance of moving higher from here and if it does, will probably not get stuck until around $0.40. With support now at $0.13 that gives it $0.07 of downside for $0.20 of upside, not a bad trade off.
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References
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Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
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Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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