The Stockscores TradeScore
Stockscores.com Perspectives for the week ending July 10, 2009
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In this week's issue:
How do you judge your success or failure in the market? Most people look at how much money they make or lose and let that determine their performance. They may look at how they have done on one trade or what their overall profitability is over a period of time on their portfolio. But there are problems with looking at performance in such a simplistic way. This week, I introduce a new performance measure and demonstrate how it was applied to a trade idea that I presented in the daily newsletter a couple of weeks ago.
I call this new measure of trade performance the Stockscores TradeScore. There are three components which must first be explained before I give the formula for the TradeScore:
1. Percentage gain on the position - this is the profit divided by the position size. A $500 profit on a $10,000 position would show a 5% gain. A $500 profit on a $5000 position would show a 10% gain. So, it is better to make a profit with less capital.
2. Reward for Risk - the amount of reward for the amount of risk taken. Risk is the difference between the entry price and the stop loss price. You can define your stop loss point as low as $0 but in doing so, you lower the reward for risk ratio. It is better to plan that price point where you will take a loss on a trade. If you buy a stock at $10, with a stop loss point at $9 and you exit the trade at $13, you have earned a reward for risk ratio of 3. The higher the reward for risk ratio, the better the trade.
3. Annualized Hold Period - the number of trading days in a trading year divided by the number of trading days the position is held. Making the same profit in a shorter time is better so the TradeScore should increase for the same profit with a shorter hold period.
Now, the formula for the Stockscores TradeScore:
Profit / Position Size * Absolute Value of the Reward for Risk Ratio * Number of Trading Days in a Year / Number of Trading Days Held * 100
An application of the TradeScore is best shown from a trade idea that I discussed in the daily newsletter on June 10, 2009.
I had a feeling the market would be going down soon, the S&P was coming in to resistance and the intraday, 15 minute chart was building a rising wedge pattern. There was a breakdown 45 minutes after the open today, giving the signal to short the S&P. The question is, how do you best play it?
There are a number of options, you can short the S&P 500 Index ETF (SPY), buy the ProShares Short (SH), buy the double beta short fund on the S&P (SDS), or buy a Put option on the S&P 500. The question is, which gives the best bang for the dollar?
To answer that question, we need to figure out what dollar value position size each has for the same amount of risk and whether each returns the same amount of reward for the risk taken. So, I looked at the entry price and stop loss price for each and the resulting position size in dollar terms
SPY - enter short at $92.35, stop loss point at $93.06, risk per share of $0.71
SH - enter at $65.38, stop loss point at $64.90, risk per share of $0.48
SDS - enter at $54.86, stop loss point at 54.05, risk per share of $0.81
July $92 Put Option - enter at $1.69, stop loss point at $1.37, risk per share of $0.32*
* the stop loss point is not really comparable to that of the stock since the option will suffer value decay daily and could go through support even if the S&P 500 does not give a signal to exit the trade at a loss.
To have $1000 of risk on the trade, you would need to hold the following position sizes:
SPY - $130,070
SH - $136,208
SDS - $67,728
Option - $5,281**
** this is probably way too risky if you only want to take $1000 of risk since time value decay will eat in to the option quickly and you are likely to see the value of the option fall below support on the option price chart before the S&P broke resistance as a signal to cover the short. Therefore, your probability of success is lower with the option.
I should have included the TSX listed S&P 500 Bear ETF for our Canadian readers and I would have liked to see how an out of the money and deeper in the money option would perform too. For this analysis, I included them as follows:
T.HSD - enter at $23.76, stop loss point at $23.43, risk per share of $0.33, position of $72,000
July $87 Put Option - enter at $0.48, stop loss point at $0.38, risk per share of $0.10, position of $4,800
July $97 Put Option - enter at $5.17, stop loss point at $4.35, risk per share of $0.82, position of $6304
Finally, let's calculate the TradeScore for each of these trades using Friday's closing price as the exit, although an exit signal has not really come yet:
SPY - Profit of $6338 and a TradeScore of 849
SH - Profit of $6812 and a TradeScore of 937
SDS - Profit of $6827 and a TradeScore of 1892
T.HSD - Profit of $7242 and a TradeScore of 2003
$92 Put Option - Profit of $7843 and a TradeScore of 32036
$87 Put Option - Profit of $4400 and a TradeScore of 11091
$97 Put Option - Profit of $4865 and a TradeScore of 10327
I used 220 trading days in a year for this calculation and only looked for a close below the stop loss price as a signal to exit at a loss.
SPY and SH use no leverage which is why they have a lower TradeScore. During this time period, they earned a 5% gain. The SDS and T.HSD are leveraged to the index two to one so they enjoyed a 10% gain. So, it took less capital to make the same amount of profit.
The options are very leveraged so they get a very high percentage return and a decent risk reward ratio. The out of the money and in the money options have a lower risk reward ratio than the at the money option and that is why their TradeScores are lower than the $92 Put Option.
While it may seem obvious that it is best to trade the at the money option on a trade set up like this, be careful about drawing that conclusion. This trade worked well for the options because the trade did as I expected it would with a couple of days. However, if the trade had languished it is quite likely that the options would have been stopped out since their value decays over time. So, even if the S&P 500 did not close below support, it is possible for the options to do so. Thus, the option trades have a lower probability of success but a higher reward with less capital for when they do work.
I was interested to see how the TradeScores for the options changed if you set the stop loss point to zero. In other words, how much did the TradeScore go down if you were willing to hold the option to expiry when they could be worthless. The result was the $92 Put had a TradeScore of 6066, the $87 was 2310 and the $97 was 1637. Without the risk of being stopped out, they still performed better than most of the other trade vehicles.
This Fall, Stockscores will be launching a new tool that will calculate your TradeScores for any trade that you do and will calculate an overall rating for you as a trader (TraderScore?). In choosing this method, I hope that our users realize the importance of getting reward in consideration of risk taken, capital required and hold period.
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I continue to think that this market favors the short seller, the overall market looks more likely to go lower than higher. This week, I ran a Market Scan that looked for stocks that traded abnormal volume, broke below 15 day support and traded at least 500 times a day. It produced a few stocks that I think are good short selling candidates.Back To Top
1. ANDE
ANDE is breaking down from a double top pattern, the stock should retrace 50% of the gains it has made since April. Resistance, and the stop loss point, at $31.60.
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2. HE
HE has broken its upward trend line after making a double top, resistance and the stop loss point at $19.45.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
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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