What a trading method can do for you – Part 3
Posted by Danny on January 8, 2016
In part 1 of this series I tried to explain why having a trading method is important. Somebody may have the body and the talent to be a top tennis player, but if he steps on the court without a clear game plan then he is not likely to win Wimbledon. An investor may have good ideas when it comes to picking winning stocks or sectors before others do so, but without a good game plan he may still fail to translate that knowledge into above average profits.
In part 2 I showed how using the reversal levels for S&P 500 and Oil does a few % better than simple buy and hold, while also reducing risk as evidenced by smaller drawdowns. But I have never been a great fan of back tested results, because even with the worst of methods it is usually possible to find a few examples where it “would have worked” well.
A real live test is always better than a back test and in this part 3 we are going to take a look what would have been your experience if you had traded Apple (AAPL) based on the daily reversal levels I have been sharing via reversallevels.com, Twitter and Scutify every day. I use AAPL because it is one of the most widely watched stock and has been a challenging stock for the investors who owned it in 2015. Apple started the year near $111 and as of yesterday it trades at $96.45, or down about 15% for a buy and hold investor over the last 12 months. Somebody who used my reversal levels to trade AAPL long only would have done these trades from January 2015 until now:
There were eleven trades and only three were profitable. There are eight small losses and the overall result over this period is an 8.25% loss. That may not look very good at first sight, but let’s not forget that a buy and hold investor in AAPL has lost 15% since January 2015. And that’s what makes this a good example to learn from. Apple has not been a good stock to trade long only because it has been sliding down for the better part of 2015. But of course, we only know that with the benefit of hindsight. No matter which method we use, our results will always depend on which stocks we trade. If we are trading long only in a stock that goes sideways or down, then we should be happy if we end the year somewhere near break even because it means we have kept our losses small.
There is more we can learn from this series of trades. The method was invested only 135 days, so only half of the time. This means there was a significantly reduced risk. The biggest draw down for the reversal levels trader was 12.8% with the series of 6 small losses from March until September. A buy and hold investor went through a much larger 31.6% drawdown as Apple dropped from a high of $134.5 to a low of $92 in August.
If we study the exit and entry prices, then we can see that the new entry is sometimes higher and sometimes lower than the preceding sell. E.g. on 4/20 there was a sell at $125.55 only to buy back on 4/21 at $128.1, so $2 higher. Then there was another sell on 5/1 at $126.1 and two weeks later on 5/15 the method was buying back at $129.07, or $3 higher. This is the most difficult hurdle to take for most investors who start using the reversal levels, because people tend to get frustrated about buying back more expensive just days after they sold a stock for a small loss. But the rewards come in the longer term. On 7/23 the method sold at $126.2, again at a small loss, and then it stayed out until 9/15 when it reentered at $115.93, more than $10 cheaper. Right now the same is happening again. AAPL was last sold on 12/10 at $116.04 and we keep waiting for the next buy signal with AAPL currently trading at $96, so $20 cheaper than our most recent sell. The risk reduction of getting out at every sell signal is significant, but many traders hate to reenter at a price that is higher than they just sold a few days or weeks before. Almost every good method of investing has one or more characteristics that make it really uncomfortable to follow, and this is what makes reversal levels hard to stick to. If you can’t bite that bullet you will never benefit from using reversal levels.
To finalize this article I also want to show what happens when we start including the weekly trend (“Tr” in the reversal level tables) into our approach. The weekly trend is based on the reversal levels on the weekly charts, and posted for free every weekend. The more conservative and safe method of trading is to take the buy signals only when the stock is bullish (green or light green) in the weekly trend. That’s why “Tr” is included in the daily reversal level tables. AAPL was weekly bullish at the start of 2015, but turned weekly bearish on July 31st. Even though AAPL briefly turned weekly bullish again for a few weeks in early November, there were no daily buy signals over that period. So, for the more conservative reversal levels trader who takes “double green” buy signals only the list of Apple trades since January 2015 looks like this:
Only seven trades, as we stopped taking the buy signals when AAPL went in weekly bearish trend in late July. Two winners and five small losses for a total gain of 1.4%. Number of days in the market: 81.
Sure, a 1.4% gain is nothing to get very excited about. But I would never complain about making a small profit trading the long side in a stock that goes down 15%. A trader who uses this conservative method is now waiting for AAPL to turn into weekly bullish trend again, and only then he will start taking the daily buy signals that come along. Meanwhile he will of course be using his capital in other stocks that are in a weekly bullish trend (there is always a bull market somewhere..). This is a safer way to trade, as we keep away from any stocks that are in a down trend. Trading in the direction of the weekly trend puts the odds in our favor, but it also requires a lot of patience. This method also never has us buy anywhere near a bottom, and it can be psychologically difficult to buy a stock at $50 if it traded at $38 just weeks before. That’s the discomfort that comes with buying “double green”, some people can never get themselves into buying stocks that are up a lot already and that’s what we are doing with this more conservative approach.
I hope this series of articles is giving a better idea of what can and cannot be done with the daily reversal levels. There are many different strategies that can be used based on those simple tables and I plan to share more of them in the future. But I am not the kind of person that brings everything on a silver platter. I think in the stock market nothing comes on a silver platter and it is important to test and try and do some work. There are no magic formulas that produce easy profits. The profits come to those who have a method AND put in the needed work. I can even tell that one is likely to do better with a mediocre method and above average work than with a very good method and mediocre work. It is the work that gives the trader the necessary “grounding” into his method, he learns the ins and outs of it. There is no easy substitute for that work.
That’s why I put out reversal levels for a number of stocks every day. Traders can use them for testing and finding their way with them. Maybe they will not find a way with them. That’s OK, personalities differ.
Final note: Not everybody is in a position to pay $20 per month for a subscription and there are also people in third world countries that try to get into stock trading. They deserve a chance too, so I will keep posting some reversal levels for free as long as I keep doing this. If readers have good or bad experiences with them, I am always happy to hear about it, either as a comment on the blog or as a private mail. User experiences allow me to improve the algos in ways that I couldn’t do if I kept it all to myself.