What a trading method can do for you

When I started investing in stocks in the 1980s I first bought some household names and was doing OK. But it didn’t generate the kind of above average returns I was hoping for. So I started subscribing to a few newsletters, which gave me fresh stock ideas every month. Soon I was buying stock of companies that were supposedly embarking on significant new growth or turning around after a difficult period. Some of those picks did well, but there were also a lot of stocks that went nowhere and several positions that showed 30% losses rather quickly. At the end of the year the winners had barely taken care of the losers, so listening to newsletter stock picks was not an easy road to riches either.

I noticed that many of my stocks had gone up 10% or more at some point, before falling back. So it looked like a logical idea to take profit as soon as a stock was up 10%. That’s what I tried next. I did have more winning trades as a result, but there were always a few stocks that never reached my 10% profit target. Those stocks would be down 30% or even 50% by the end of the year as I kept waiting for their turn around. Once again the winners were barely taking care of the losers, because it now took 3 to 5 winning trades to compensate for just one of those losers.

My journey went on trying with options and then commodity futures, but that wasn’t any easier. Technical analysis became a hobby, but it seemed to work just as often as not. Eventually I came to the conclusion that investing is a lot more difficult than it looks at first sight. What I had lacked all the time was a clear method.

An investor needs two things: he needs an edge and he needs a method to translate that edge into real profits. His edge can come from many directions: it can be as simple as having a good intuition about future trends, or an ability to determine a stock’s valuation based on fundamental data, or having the right insider connections, or knowing about lunar cycles,…
Edges in the market are usually small and very fallible, so he still needs a method to take advantage. Basically the method should be designed to get him out whenever the assumed “edge” has put him on the wrong track, and to keep him in as long as things go in the right direction. There are no perfect edges and no perfect methods, so the job of an investor is to aim for a good batting average.

The readers of this blog know that I post about “reversal levels” from time to time. The reversal levels do not predict anything, they are just a method of trading. You can now find them on the sister site at http://www.reversallevels.com/ every day. If you have any kind of edge that tells you which markets or stocks are ready for a nice trending move then you can use the reversal levels to exploit your edge. The reversal levels are designed to keep you in trending moves while keeping losses small. As a thanksgiving special you can pick up the daily reversal levels for free today. Just how well the method stays in trending moves can be seen by sorting the tables on basis of P/L%. For S&P 500 stocks this are the 25 most profitable trades at the moment (click image to enlarge it):

We see 20% to 40% gainers, often in less than 50 days. Now, let’s take a look at the 25 worst losing positions in the S&P 500 (click image to enlarge it):

The largest loss is 7% and most are around 2 or 3%. Why? Because the reversal levels will typically get out before the loss can get any bigger. The only way a bigger loss can happen is when a stock crashes overnight, which is fortunately not happening very often.

So, this is what a method can do for you. If you have a few 20% gainers from time to time it will take care of many small 2% losses and that’s how you can get to a good batting average.
It looks easy, so why is not everybody using this? The reason is simple: most people are looking for quick and spectacular returns and don’t have the stamina to cope with a string of small losses. What happens when you make 5 trades and all of them close out with a 2% loss? What if you get a string of 10 small losses? Too depressing? Most people just give up on such a method and usually move on to try something more heavily advertised. Only a few will keep trying. And I consider that a good thing because it means this method will remain underused. Overused methods tend to lose their effectiveness.

In a next article I will show how the reversal levels would have done for a major index like the S&P 500, based on backtested results.

Danny