Newsletter
January 5, 2008
Investing in Stocks, Not Ideas
In Search of Nirvana - Developing an Edge
Largest Changes In Raw Numbers (21 Days)
Investing in Stocks, Not Ideas
Trading the markets is a challenging enterprise. It takes time and effort to find a trading idea that will make you a profit. Traders differ in terms of how they find such ideas. Some may utilize technical data until they find a strategy that will make them a profit in future trades. Others may read stacks of financial reports, research, or magazines, in an attempt to find under-valued companies that may shoot up in the near future. To the extent that you put your effort and energy into finding a trading idea, you are psychologically invested. And even though it's just an idea in the end, if you aren't careful, a big psychological investment in an idea can be your undoing.
Show a healthy detachment to your ideas. A trading idea is nothing more than a working thesis. It may be right or it may be wrong. Sometimes even a great idea can produce loser after loser, if market conditions are not correct. A winning trader remembers that the bottom line is making a profit, and nothing else matters. But when you've spent hours in search of a winning idea, it may be hard to just throw out the idea when it isn't working the way you had planned.
What is over-invested in your trading idea? Part of it may be ego. If you view yourself as a brilliant trader who has a special talent for analyzing the markets, you may start to get too wrapped up in proving your superiority. People equate the ability to discern astute trading ideas with innate intelligence; it's human nature. When you work under this assumption, though, you'll associate a losing trading idea with a lack of intelligence. It's better to take things a little more lightly. It's better to be a more flexible trader than an "intelligent" trader.
When you execute a trade based on your own cherished ideas, it's vital to continually entertain the possibility that you may be wrong. You might even want to monitor your self-talk. It is useful to practice changing your internal dialog from, "I need to be right. If I'm wrong, it shows that I'm too dumb" to something like, "I don't need to be right. Being wrong has nothing to do with my abilities. It's better to admit I'm wrong and avoid a big loss than stubbornly stick with a bad idea and feel sorry for it later."
It's easy to invest too much of your self-esteem into a trading idea. At that point, not only is money on the line, but the value you place on your talents. And when that happens, you may lose your ability to objectively evaluate your ideas. You must stay flexible. You aren't investing in ideas. You are trying to make a profit by investing in stocks.
In Search of Nirvana - Developing an Edge
In this authors' humble opinion one of the biggest failings of traders is attempting to pick tops and bottoms rather than learning to play in the middle. In an interview, when asked how he made all his money in the stock market, Bernard Baruch stated: "I leave the first 20% of a move to another and the final 20% to someone else, I'm perfectly happy with the middle 60 percent". Another of his famous quotes: "Don't try to buy at the bottom and sell at the top. It can't be done except by liars". Makes one wonder why so many pundits on CNBC and the financial press are so intent on picking bottoms in many financials doesn't it?
Being right is more important than being a genius. I think one reason why so many people try to pick tops and bottoms is that they want to prove to the world how smart they are. Think about winning rather than being a hero. Forget trying to judge trading success by how close you can come to picking major tops and bottoms, but rather by how well you can pick individual trades with merit based on favorable risk / return situations and a good percentage of winners. Go for consistency on a trade-to-trade basis, not perfect trades. - Jack Schwager
With the above two paragraphs in mind as well as the old Wall Street cliché - "there is always a bull market somewhere", we begin our search for an asset allocation and trading model. Step one therefore is to find an advantageous way to define the long term trend in order to keep our trading in alignment with that trend, not opposed to it, i.e. if the long term trend of a stock, market, or sector is up we trade that stock, market, or sector only from the long side. The backtesting work utilized, to begin with, the Dow Jones Industrial Average from the end of World War II through 12/21/07. Why the DJIA? Simply because data exists back far enough to take in several bull and bear markets.
This testing involves the process of finding a definition. Such things as the trading returns, Sharpe ratios, or k ratios are of no concern as this is not a system in and of itself. It is a means of determining when we should consider being in and when we should stand aside. It is the definitions that a methodology will be built around. For instance if the long term trend, per definition, turns from down to up it merely means we are allowed to trade from the long side, it is the point at which you apply other criteria or indicators to tell you to buy now or wait.
The question is simply does the definition arrived at provide us with an edge from which to build? Testing involved many methodologies such as simple and/or exponential moving averages, linear regressions, linear regression slopes, and rates of change to mention a few. The three summaries below involve two linear regression analysis criteria and one simple moving average crossover; all involve relatively long time frames which are necessary for each to become affective. Limited optimization of criteria was utilized.
In terms of annual rates of return the difference between each is insignificant. Definition A has the distinct advantage of very low turnover, on average about 1.3 year holding periods while B and C show higher degrees of turnover. Both A and B show a relatively high degree of reliability with 70% of the signals being correct, i.e. 7 of 10 entries will show, on average, a positive favorable excursion. C has a much higher degree of turnover and a lower degree of reliability but it too shows a positive favorable excursion on average. In other words an advantage to each of these definitions exist and that is the purpose of this weeks exercise. Can better definitions be found? Perhaps and testing continues.
Definition C also contains a good deal of short term whipsaw and therefore it would be better to utilize C within the context of A and B. The reason for it's inclusion at this time is simply the understanding that many choose to trade shorter time frames although my personal preference will wind up with either A or B. Remember this is not a system in and of itself; it is a definition where methodologies will be worked on within.
As mentioned in previous newsletters it is advisable to have more than one methodology, in order to switch from one to the other during times when one is apparently not working, and two to give you a time frame of consideration and a way of confirming one with the other. In all probability all plus a few more will be included.
The exercise and the signals generated are meant to be guidelines and not mechanically based order entry. Although in time there will be suggested entry and pyramid areas. Since there are so many markets, so many sectors, and so many categories of funds it will be a means of directing your attention to the correct areas to be invested and the worst areas which should be avoided, plus perhaps a few model portfolio's.
The following graph is Definition A in and out of the market. Nothing is perfect, it does not buy bottoms or sell tops, that is not the intent. The intent is to define favorable and unfavorable periods. On that score this does a very good job overall.
Although this particular definition was long into the crash of '87, it did an excellent job of avoiding the bear markets of the 70's and 2000 through 2002. Even though we show a number of whipsaws during some previous trend changes they may not mean a thing simply because a signal only allows us to trade on the long side it does not mean there will be a tertiary signal during those times. The '87 crash may also have been avoided due to the tertiary signals, lack thereof, stops, and risk assessments but more on that in the future.
The big question; are these signal definitions unique to the Dow Jones Industrial Average or do they apply elsewhere? Interestingly in random back testing utilizing the above criteria against other indexes, ETF's, and individual stocks, while certainly not identical, in some cases quite different, but overall yielded similar results. This is important because it tells me the definitions which are long term in nature have some important characteristics which can be carried over into other markets.
The key to this week's newsletter is utilizing any of the above definitions: an advantage exists. Whether or not we can make and take increasing advantage will be the subject of future newsletters. When all is finally said and done the key will be the methodology within the definitions as well as the diversity amongst sectors, groups, and markets that Exchange Traded Funds provide. I.e. we look to the markets that are in uptrends and we trade those markets from the long side, other markets are traded from the short side or avoided until conditions change.
Anyone wishing a Microsoft Excel spreadsheet containing entry and exit dates, DJ value, and percent changes, simply send an email to: admin@prudenttrader.com and I'll happily forward the information.
Largest Changes In Raw Numbers (21 Days)
NOTE: The presentation of this report has now been changed to an excel spreadsheet format containing all Industry Groups, ETF's, and Indexes, allowing you to sort all from best to worst. In addition each weeks report will appear next to the last weeks report and so on, allowing I believe much easier research on your part.
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Have A Great Week!
Bill
Prudent Trader.com
Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.
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