Stockscores.com Perspectives for the week ending May 21, 2010

In this week’s issue:

Weekly Commentary
Strategy of the Week
Stocks That Meet The Featured Strategy

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. Continued…….

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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.

Another big week to the downside but there are signs that the market is likely to bounce back from oversold conditions. Traders who can be nimble and make quick trades can take advantage of this bounce but I recommend that more conservative traders stay on the sidelines. The price volatility should continue as investor uncertainty remains high.

The reasons I think the market is likely to bounce back are as follows. First, the downward price action has taken stocks far below their downward trend line. Consider the chart of SPY below. If you draw a line from the high of April across the peak from about May 12th, you can see that prices have fallen away from that line. Markets tend to regress back to their trend line.

Second, the S&P 500 (SPY chart below) hit support from the lows of early February.

Finally, the markets opened weak on Friday but rallied back to close up for the day and above the open. That is a strong signal of a bounce, something I call a Dead Cat Bounce.

The issue from a trading perspective is whether the reward of the trade justifies the risk. To buy at Friday’s close has support at the low of the day. The reward potential up to resistance at that downward trend line that I drew is about the same distance as the distance down to support. That means the reward potential for the risk is about one to one. I like to take trades that have reward for risk of two to one.

I entered this trade early on Friday morning before the market had really made a comeback from weakness so the distance to support was much less and the distance to resistance was much greater. That gave a better reward for risk profile and made the trade worth taking.

Looking ahead to next week, I recommend traders watch the SSO, UCO, QLD, DDM and T.HXU for intraday pattern set ups that have good reward for risk profile. By watching the intraday, 15 minute charts, you can enter on a predictive pattern with a much tighter stop to have a good reward for risk outlook.

1. SPY

2. SSO

3. QLD

4. DDM

5. T.HXU

References
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Tyler Bollhorn started trading the stock market with $3,000 in capital, some borrowed from his credit card, when he was just 19 years old. As he worked through the Business program at the University of Calgary, he constantly followed the market and traded stocks. Upon graduation, he could not shake his addiction to the market, and so he continued to trade and study the market by day, while working as a DJ at night. From his 600 square foot basement suite that he shared with his brother, Mr. Bollhorn pursued his dream of making his living buying and selling stocks.

Much of Mr Bollhorn’s work was pioneering, so he had to create his own tools to identify opportunities. With a vision of making the research process simpler and more effective, he created the Stockscores Approach to trading, and partnered with Stockgroup in the creation of the Stockscores.com web site. He found that he enjoyed teaching others how the market works almost as much as trading it, and he has since taught hundreds of traders how to apply the Stockscores Approach to the market.

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.