Evolve With the Market
Stockscores.com Perspectives for the week ending September 11, 2011
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In this week's issue:
The market is always changing and yet the more it changes, the more it stays the same. Market participants are still guided by fear and greed, some people still get better information than others and emotion still causes prices to behave irrationally.
However, as technology has allowed more and more people to be involved in the stock market I do think that much has changed. The market moves quicker and with much greater volatility than it has ever achieved before.
And so, while the basic principles that have guided my strategies over the last 20 years have not changed, I am always modifying and adapting those strategies to fit with the current market. This week, I want to provide some insight on how I go about creating a new trading strategy.
First comes the idea; it should be possible to explain a trading strategy in one or two sentences. In light of the current volatility amidst a lack of trend, I might seek to create a strategy that buys weakness and sells strength. As the market gyrates back and forth inside a trading range, this approach would buy when fear has caused people to accept to low of a price and sell when greed kicks in and prices run up too quickly. Watching the way that the market has traded over the past few weeks, I expect this would yield good results.
However, thinking that something will work and knowing that it will work are two very different things. So next, I must create some rules for my news strategy and test them. At this point, my rules will have some flexibility because I won't really know what variables are going to work best. I typically spend a few hours going through charts looking for patterns that seem to occur repeatedly and try to find common characteristics for money making moves.
I fine tune the rules for entry, risk management and exit as I work through this process and eventually have a set of criteria that appears to be sound. Next, I do some formal testing to put performance numbers to the strategy using historical data. I build an Excel spreadsheet and calculate the risk versus reward of entry signals that I find from the historical testing. What was the risk, what was the reward, how often did it work, how often it failed and at what point is it best to consider the trade a failure and exit at a loss are all questions I want to answer.
This formal testing will often further define the trading rules for the strategy, the rules will often change as the testing data shows weaknesses and strengths in the strategy. Some times this testing will just show that the strategy is not working and I have to throw out the idea and start over.
But, assuming the historical testing demonstrates that the strategy has a positive expected value, I will then go to paper trading the strategy. The problem with historical testing is that we have the benefit of hindsight and there is a bias, no matter how hard you try to avoid it, in how you judge information as you apply the rules of the strategy. When you are paper trading a strategy in real time, you have no idea of what will happen and so you have to really stick to the rules as you have defined them. Again, at this stage a strategy may show itself to be a loser and the process is stopped or at least the rules may be altered. However, if the strategy continues to work on paper then I can go to the final stage in testing which is to actually trade it with real money.
Paper trading has issues that tend to make the performance of a strategy better than they can ever be. With paper trading there is no emotion. With paper trading, there is no slippage. I have found that a successful paper trading strategy has to have an expected value that is much more positive than you think it would need to be because emotion and slippage hurts performance. A strategy that should yield 4 to 1 risk reward might only end up paying 2 or 3 to one in real market trading.
So, when I am testing a strategy with real money I only take a small amount of risk. So much of trading success relates to confidence and emotional control and I have found that putting too much risk in to a strategy in the beginning can often hinder my ability to make that strategy effective in the real market. By starting with a small amount of risk I can further develop the strategy at a lower cost. Mistakes are inevitable in the early stages of applying a new strategy.
If the strategy is working and making me money, I will begin to increase the amount that I risk on each trade. Confidence in the rules of the strategy makes it easier to apply the rules with discipline. The process of gathering momentum must be slow at first to avoid mental breakdowns that hurt performance.
There are many places in this process where a potential new strategy can fail and the idea tossed away. Most of my trading ideas never make it to be a strategy that I will use over the long run, but the work in building a new trading strategy is rewarded when I finally find something that is effective. I find it to be a fun process and hope that many of you will spend some time to work through it.
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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 should generate a good number of high probability position trading opportunities each week.
This week was a rough week for stocks in general but the mining sector has been able to escape the general market weakness. It was the only sector that produced stocks showing strength, and is the source of this week's feature stock.
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1. V.RIO
V.RIO traded abnormal volume on Friday and broke through some short term resistance. On a day when the market was down over 300 points, this stock was able to hold on to a gain. The move higher took the stock through short term resistance, it is not yet making a clear break through resistance but I think it is still worth considering. Support at $2.29, a close below that level would negate the positive message of Friday's breakout.
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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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