Yesterday we gave rules for developing a successful technical trading system. Today we will describe one possible system. Tomorrow we will look at how the system stacks up against the rules. This example is given for educational purposes only and is not meant to be a recommendation or endorsement. You should make your own investment decisions after careful study of the risks and rewards of any opportunity.
Before I describe the system, I need to define a few terms. A bar in a technical trading graph represents a consistent period of time and includes the opening and closing prices and the high and the low price of the period. The bar could represent 5 minutes, one day (most familiar), a week, month or other period. A 5 minute bar would have the price at the beginning and end of the five minute period and the high and low prices for that period.
An envelope is some fixed percentage above and below a moving average. If you had a 3% envelope and a moving average of 10, the envelope would be at 13 and 7. When you use standard deviations, the upper and lower limits are referred to as Bollinger Bands instead of an envelope. Bollinger Bands widen and narrow with changes in volatility unlike envelopes which are always at a fixed percentage.
A standard deviation is a statistical tool that is measured as the probability that an observation will be within a certain distance from the mean (average) of the data being measured. One standard deviation above and below the mean will encompass 68.26% of all data points for a normally distributed set of data. 1.5 standard deviations should include 86.64% of the data.
So, here is the system. Set up a 5 bar system. For our purposes we will use one day as the period represented by the bar. So, your 5 bars would represent the last 5 days of trading in the security you are looking at. Find the mid-point of the opening and closing prices for each of those days. Take the average of those mid-points. Each day you will calculate a new 5 bar simple moving average of the opening and closing prices.
From the average mid-price, calculate your Bollinger Bands (envelope) by calculating 1.5 standard deviations above and below that point. These two prices are your look-ahead edges (for an envelope) or bands for standard deviations.
If during the next day's trading the price touches or goes through the band that gives you a signal. You enter a limit order to buy the security if it touches the bottom band or a limit order to sell the security if it touches the top band. The limit order is set at the look-ahead band price on the same side as the touch was made. The next time that price is reached you will buy or sell the security. The touches do not have to be on consecutive bars.
If the touches are on consecutive bars, buy double the units of your last "bet" to your position. If last time (or the first time) you buy 100 shares, and you got this stronger signal, you would buy 200 shares this time. Since your bet was 200 shares this time, if it happened again you would buy 400 shares (your last bet) not 600 shares (your new position).
Exit ALL positions at the FIRST touch or pass through of the opposite band from where you entered.
I'm out of room, so I'll discuss some nuances tomorrow and do the comparison the next day.
NAVIGATING THROUGH TREACHEROUS WATERS
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NAVIGATION BASICS (AN INTRODUCTION)
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You must know where you are at any given time if you expect to get anywhere. And where ever you are, well... there you go!
Would you go out to sea in a boat without a compass? Probably not! Would you start on a big job without any tools? I certainly hope not!
Every business has overhead. You can't run a business without paying for the costs to keep the business open. There is rent, insurance, wages, etc. Some months your revenue exceeds overhead and you have a profit. Other months revenue does not cover overhead and you post a loss.
Trading stocks IS A BUSINESS. You MUST expect to pay for some overhead expenses to keep yourself in business. You must buy your tools, and use them frequently. You must spend some time planning your business. You can't expect someone else to run your business for you. It is YOUR MONEY, and ultimately YOU are responsible for all decisions made.
If you are too CHEAP to pay for your tools, and other vital overhead expenses, the results are very certainly predictable. I can predict that you will lose more than what you would have spent for the proper tools in the first place.
It doesn't take much time to properly manage this business. On average, I might normally spend only about an hour each weekend keeping track of things. I know that if I don't spend that hour, I will get myself into trouble. I can predict that you too will get into trouble, if you don't spend some time managing your business.
MAKING MONEY TAKES WORK. THIS IS ESPECIALLY TRUE IN THE STOCK MARKET. I HAVE NEVER MADE MONEY WITHOUT WORKING HARD FOR IT! Is it difficult for you to believe that the harder you work, the more money you will likely make?
It doesn't take much money to buy your tools. Some friends over the years have been doubting Thomases, and have never invested in the tools of the trade. Now they regret it. They have "missed the boat," or so they think. A principal reason that I have made money and they have not is because I armed myself with (and utilized) the tools of the trade, and they didn't bother.
Tools of the trade:
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Chartbooks, Media, Experts, Advisory Services, Stock Brokers, and Market Makers. Since some of these tools are far more important than others (in my opinion), this posting will address those tools which I think are most critical to you as your best potential trading resources. You may be shocked again.
YOUR MOST VALUABLE TOOLS: Long Term Chartbooks
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Although past performance is no guarantee of future performance, I still prefer to buy stocks with a proven track record of earnings and growth. I like long-term chart books, such as the SRC BLUE BOOK Cycligraphs: 12 Year Charts. The "Long Term Values" provides 15 year charts. I like both because the charts are LOGARITHMIC. REMEMBER that stocks move in percentages of the current price, and not in points. Chartbooks that are not logarithmic distort (expand) prices as they go up, and compress prices as they go down. If I have a 100% profit in a stock, I want it to look like 100% on the charts. Arithmetic scale charts are so distorted that they make a 10% move from $50 look the same as a 300% move from $3.
Both chart books also plot earnings along with the price. Remember the CARDINAL RULE: Stock prices follow earnings of the company over time. These chart books give you a feel for how true the cardinal rule really is. You can see the deviations from the norm. You can experience thousands of years of history without risking a single penny! You can SEE THE MARKET CYCLES AT WORK. You will become a true believer in what I told you in an earlier posting: A cheap stock at $100 will double faster than an expensive $10 stock!
Market history is visible. If you are not aware of the history of stocks and of the market, then you are doomed to repeat old historical mistakes. My trading account was fully invested for the start of the "Gulf War." Why? I looked into my old charts to see what REALLY HAPPENED during previous wars. It took just a few minutes to conclude that wars ALWAYS drive stocks straight up! The news media, on the other hand, was consistently negative from August 1990 through the actual start of the war. The media pushed short sales to record all time highs, as can be seen in your market-timing software. The media pushed the public into panic selling during October and November of 1990, as can easily be seen in your market-timing software's 10 week oscillator, and stocks to new lows! I was an active and aggressive buyer that November! Chartbooks and historical data are the BEST investments that you will EVER make.
Bargain stocks stick out like a sore thumb. I once purchased a stock immediately upon seeing it in the Blue Book. It had sharply rising earnings and was into a giant 3 year apex (triangle) formation. The price was right at the apex the day I bought it. This was such a fantastic stock that I went on margin to buy a large position. Its PE multiple was only 7. For those who have old collections of chart books, the company's name was Genstar. Within 3 months it was taken over at twice the price I paid. My profits on this single trade would pay for all my chart books for the rest of my life. There were many others. I owned Carnation before it was taken over by Nestle. I owned Nabisco before it was taken over by RJ Reynolds. I bought up RJ Reynolds with teh profit and it became RJR Nabisco. All of these decisions were made with the help of chartbooks. The chartbooks were screaming at me: BUY THESE STOCKS!
I don't like daily chartbooks. You can't see the forest for the trees! I would have completely missed out on the Genstar trade if I were using daily chart books. In my humble opinion, daily charts are just confusing NOISE to be ignored. Chart formations that take but a few days to complete are meaningless noise, as well. If you want a GOOD SOLID chart formation that you can depend upon, it must take many months, or many years to form. The longer the chart formation is in progress, the better. Even so, they are not 100% trustworthy, and major moves still follow earnings, regardless of what a chart formation "says."
As regards all the different kinds of chart formations, I am not going to get into this subject in my postings here. There are hundreds or perhaps thousands of books that go into every little squiggle that chart formations can possibly make. I ignore most of the chart formations, unless they coincide with earnings or my market-timing software signals.
Market Makers
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I am not going to be negative about these guys. We need their services. We need more of them, and they earn every penny they get! I wish them well. If I were to be reincarnated, I would wish to become a market maker!
Here are my own viewpoints of the market makers: When you call your broker to place an order, he usually calls the market maker to actually perform the trade. Most brokers are just middle men passing the trade on to the market-maker. In some cases, your broker makes his own market in a stock. The market maker is charged with the responsibility of keeping "orderly markets." When there are more buyers than sellers, the market maker supplies the stock. When there are more sellers than buyers, the market maker is buying.
Since the general public is always selling low and buying high, then the market makers must properly buy low and sell high. If you want to make money in the market, you must read between the lines in the news media to see what the market makers are doing. If the news is extremely negative, it follows that the public is selling in fear. What is the market maker doing? I'm not saying that the market makers are responsible for the bad news, but they are just responding to the public selling. If the market is high, and headed higher, the news is always great. The public is buying. What is the market maker doing? That's right, he's keeping thye market orderly, which is his job; he is selling into the public demand for buying.
The market maker operates his business like a grocery store. He buys stock at wholesale prices, and sells it at retail prices (according to Richard Ney). When his shelves are empty, and he has no more stock to sell, he must move the stocks he supports down to get people to sell. When his shelves are overflowing, he moves prices up to get the public to buy.
His major tool is short selling. He sells borrowed stock to move prices lower. When the price is low enough, he buys back the borrowed stock at a profit, and uses that profit to stock his shelves with low-priced stock.
You will discover that in most major moves in a stock, there is always a frightening decline first! He clears out the trailing stops, fills his shelves, and away the stock goes. Learn the market maker's tactics well! Hang onto his coat-tails and try to get your buying and selling in sync with his. Your market-timing software is an excellent tool to get your act to closely follow the market makers. (Their operations are secret, so your market-timing software and the Media News are your major tools for this trade.)
Stock Brokers
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At the peak of my former stock trading activities, I maintained accounts at four different stock brokers. I have several good reasons for that practice.
RISK NOT THY WHOLE WAD
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My major reason was to never have all of my eggs in just one broker's basket. If my broker went out of business, as some did from time to time, I wanted to stay in business. Even if your broker has SIPC insurance, your funds and your stocks could be frozen for months or worse, until the mess gets untangled. If one of my brokers should have gone under, I still had 75% of my capital available for action somewhere else.
A broker does not have to go out of business to hurt you! For example, right after the crash of 1987, I was a buyer. Two of my four brokers were simply incapacitated! Their phones were perpetually busy, and for the entire week following the crash, I could not do business with them. My policy paid off in spades that week!
I kept two discount brokers, and two full service brokers. A full service broker is good to have. He can do valuable work for you that you just don't have time to do. A perfect example of this occurred during 1987. I wanted to take a large position in Borland International stock. It was not available in the United States yet. It was traded on the London Unlisted Market. I called one of my two full service brokers (my guy at what is today known as Smith Barney Citicorp), and asked him to track the availability of Borland, and to let me know when I could take a position. He agreed, and within a few months, I was among the FIRST to buy Borland. Borland International has been one of my most profitable positions ever. Was the full service broker worth it? Of course. My full service broker is always rewarded with an order for his good work and timely help.
A full service broker can give excellent advice on what to buy, as well. He can be a valuable resource that you should be prepared to pay for. Be aware that there are some very bad brokers out there, as well as some good ones. Don't be talked into excessive trading, or CHURNING of your account. I will be devoting a forthcoming posting on this blog to the proper rules for buying and selling stocks.
Your broker makes his money by buying and selling. Make certain that the trading is in your best interest, and not his. Verify all recommendations in your own chart books, or ask him to send you a photocopy of the required charts BEFORE you place an order with him.
MY NEXT COMMENT TO BE POSTED ON THIS BLOG SHALL ADDRESS STOCK SELECTION FUNDAMENTALS.
Posted by: Bob Hansell | March 22, 2006 1:09 AM | Permalink to Comment