As the year winds down... | stockbee


As the year winds down...

Santa Clause rally is in full swing with a large number of stocks leading the advance. The strength should continue in the year end.

The year has been largely dominated by don't fight the Fed theme. Every time there was even a minor correction in the market the Fed aggressively intervened either through policy or verbal intervention. That put a floor under the market and made life difficult for the short sellers.

As the year comes to end it is time to reflect on what really matters in the market. While Fed is important, at individual trader level it does not matter. What matters most is having a setup and well though out method and shutting out the macro noise like Fed and most of the BS that is written about the economy.

What you make money out of is a setup idea with ability to give you positive return over large number of trades. If setup works you make money. There are many possible setups a trader can trade. The most important thing is is your setup profitable.

Let us look at two setups ideas I traded this year: one was based on earnings breakout and the other is a breakout setup. The earnings breakout setup looks for stocks with neglect that had surprisingly good earnings and buys on day of earnings. This is a setup I have extensively described on this site and has been trading for over 13 years. The breakout based setup is primarily a swing trading setup that looks for momentum bursts of 3 to 5 days and 8 to 20% magnitude. The average holding period in this setup is 3 days.

Working People Setup

The earnings related setup has in hypothetical 100k account has 8.45:1 ratio of profitability. Or in simpler term average profitable trade has been $3417 and losing trade has been $404. Largest loss on any trade was 600 dollar and the largest profit was 24500 dollar. 73% of the trades were profitable. Only 17 trades were taken under this setup in the year. This is a very infrequently traded setup and has currently has open trade in FB from a price of around 33.4 and XIV from around 24.5 price, so final profitability ratio  might be much higher than 8.45:1.

The setup by year end given current prices on open positions would give returns upwards of 40% with extremely conservative position sizing. Those who risked higher per trade  have much higher returns for the same number of trades. If you risked say 25% of account on each trade you would have doubled your money using this setup. This setup is primarily focused on Working People who do not have time to do active trading. Most positions are held for months or weeks.

This is a setup idea which does not depend on Fed action or any other macro variables. Every year you will find stocks with months or years of neglect that will suddenly surprise the market and go on to make big move. If you understand the setup and develop process flow for trading this you can find a profitable method that you can exploit for years. If you are serious about making money in 2014 and beyond then a setup like this can offer you life long profitable opportunities.

The swing trading related setup based on momentum bursts is a frequently traded setup and produces hundreds of trades in a year. By its very nature it is a short term setup so its profitability per trade or profitability ratio reflects that.

Active Traders Setup

The ratio of Average Winner to /Average Loser in the setup was 2.26:1 for the year as of today no counting open trades. In dollar terms average winning trade produced profit of 818 dollars while losing trade produced loss of 362 dollars. Win/loss ratio was 50% (50% of trades were profitable). This kind of setup requires taking hundreds of trades. More trades you take in this kind of setups the better it is as that increases profitability through compounding. A setup like this can produce 500 to 1000 trades or more in a year.

None of these setups or many other setups used by profitable traders are complicated. They produce profit over sample of trades , in this kind of trading approach individual trade does not matter as long as you keep following your setup. Profit happens because the setup works.

If you are new to trading or struggling, the most important thing that will make you profitable is to shut off all noise like CNBC, Stocktwits, Twitter , Yahoo Finance message board, or newsletters and so on and just focus on mastering one or two setups. If you focus on setups you will have profitable 2014 , but more than that you will have many profitable years. Setups once mastered become your tool to extract money from the market for rest of your life.

If you are serious about making money then don't look for stocks picks and hot tips but look for profitable setup ideas. There are thousands of newsletters, gurus, blogs , and sites offering you hot stock tips, but what you need is a setup and not tips. Because once you learn setups you can generate your own hot picks.

Most important thing in trading is setup selection. ....

Have a Merry Christmas.....


Saurabh Shah said...

Have you ever tried position trading? (the longer term version of swing trading / trend following)

What has been your experience?

Is it a good idea to allocate a certain portion of the portfolio for position trading and rest for swing?

Pradeep Bonde said...

I like to trade setups that have extremely low draw downs. Position trading/trend following has large draw downs which does not suit my personality.

Jiang Bowei said...

The first EP looks to have much higher rewards/risk ratio than the 2nd one. Do you think it will be a good idea to put most of your potion to 1st setup? Only when you closed some potion due to profit or cut loss, use the cash to trade the 2nd setup before you find next EP candidate.

The other thing you mention, EP takes several weeks, 2nd trend intensity takes only 3-5 days. Although the profit is small, but should compound really quick. If you use a little bit margin, it will be speed up much faster than the EP.

Pradeep Bonde said...

Yes one can take very concentrated positions in first setups to further increase returns.

Yes margin can increase returns in swing trading , but it can also increase draw downs.

Personally I look for least amount of draw downs while looking for maximsing returns.

Jiang Bowei said...

Let's you have 100K account, it takes 5 days or 1 week to full invest in 10 stocks, 10K for each stock. You risk 0.5% on each one. 5 of them turn out to be winner, you have 10% or $1000 profit on each winner. The other 5 turn out to be stop loss out, you loss $500 on each loser (risk 0.5%). So after one week full investment, you account change is $2500 or 2.5% of your 100K account. Assuming 40 weeks out of 52 weeks is bull market to use this swing setup. Anuallized profit is: (1+2.5%)^40-1=1.68 or 168%

It will be hard to achive 100% efficiency. Let's say average 80% or you have 20% in cash by average. So with 100K, you invest 8 stocks in 5 days or 1 weeks. 4 of them is winner and 4 of them is loser. Your account change will be $2000 or 2%. Anuallize profit is: (1+2%)^40-1 = 1.21 or 121%. I think this is the peak performance for cash account using this strategy.

What will happen if using 20% margin or 40% margin. The weekly return will be 3% and 3.5% accounding. To summuarize, let us see the matrix below:

80% invest ---------- 121%
100% invest --------- 168%
120% (20% margin) --- (1+3%)^40-1= 226%
140% (40% margin) --- (1+3.5%)^40-1= 296%

Buy using this swing strategy, I think you account is rising consitantly with minor draw backs. Even use margin, the net ammount of darw backs does not increase (as you are still risk 0.5% for each trade). What happened is the rising curve is much sharper. From 80% investment to 120% investment, it is 50% more, but you almost double your profit annually.

Saurabh Shah said...

Hi Jiang,

The example assumes bull markets and a 50% win ratio. In even slightly bearish cases, that ratio can really drop to even 10-0% for a week or two (breakouts wont work). Having margin would just make the loss worse. Remember for example, a 25% loss on portfolio means you have to make 33% profits to get back to where you started from.

Rather than using margin, do you think its best to scale up risk when you are doing good and scale down when you are doing bad?
For example, go from 0.25% risk to a max of 1% when doing good and reverse if doing bad. That way you don't need to use margin.


Delwyn Wee said...

Thanks for sharing, Pradeep. A quick question, for breakout trades, what determines your cut loss exit? I would suppose a breakdown with a long reversal candle would be one. Would you mind sharing your exit?

Pradeep Bonde said...

Exits are based on stop getting hit or time based exit. My stop is low of the entry day.The time stop is 3 days. If a stock does not move in anticipated direction in 3 days I exit.

Pradeep Bonde said...

Jiang yes leverage increases returns. One of the ways to do that is using options if they are liquid options.

Also use of leverage depends on nature of accounts. Accounts like Solo 401k , SEP and IRA do not allow margin.

The position sizing assumptions you made are not the kind I use. My positions are based on risk so they can be much higher than 10% of account. It can take only 3 to 4 positions to get fully invested.

Jiang Bowei said...

Hi Saurabh, I know my modeling is over-simplified or far from the Guru's actual practice. For example, if cut loss is much faster than take profit. You do not really need up to 5 days to do one-round trading, average should be less. Also by risk same 0.5%, some stock will have much larger position than the other. I just want to use this simplified model to express my point: invest level is the key.

I agree with you, leverage should be only used in confirmed bull market. How much leverage you use is depend on your confort level. In my case, I am willing to use 20%-40% margin only in very bullish market (pass 20 trading get >70% success rate, etc. If 50% success in pass 20 trading, I am more will to use 100% or less invest).

Simply increase risk does not help. Let's say you still 80% invest. In my original example of 100K account, you risk 0.5%($500) to trading 8 stocks ( assuming 10K each). 4 winner and 4 loser, winer you win 1K, loser you lost $500. Your account change by one round is $2000 or 2% of total account. Now you risk 1%($1000), but only trading 4 stocks (20K each) to get 80% invest level, 2 winners and 2 losers. You win 2k on winner and lost 1k on loser. So your account change is still $2000 or 2% if total account. Your account is more violate than before.

What make sense to risk more is that, you have extra edge. Among the 8 stocks, you know 4 of them is better than the other 4 (for examle Trend Intensity value is obviously better). Otherwise you are hint by increase invest level by saying risk more.

Jiang Bowei said...

Hi guru, I am not familiar with options. The leverage on options is huge which is beyond my comfort level for now. I think it need very careful math modeling, also may need to use lower invest level to remove some leverage to maintain the risk. I saw some member and you are doing this. I may want to try when my skill improves and get that level.

ANS said...

Hello Pradeep,

Can you talk a little bit more about the Working People method? What sort of criteria are you using to find such stocks?


Pradeep Bonde said...

They are based on Stockbee Episodic Pivots method. I select those stocks based on significant earnings surprise or other game changing catalyst that can lead to 50% plus moves in few quarters.