Investing with the Moon

Posts Tagged ‘method’

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, 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:

apple trades 2015-16

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:

apple trades 2015-16

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% over the considered period. 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. And asking questions is always allowed.

Good luck.

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What a trading method can do for you – Part 2

Posted by Danny on December 9, 2015

Several readers have been asking for back test performance results of my reversal levels. I am not a fan of putting out back test results, not because the results are bad but because I don’t want to look like so many other sites that sell a poor system with good marketing. I prefer to offer a good system with poor marketing.
Also, I think it is far more important to look at forward testing rather than back testing. Back test result showing hand picked examples of great winners may be good for marketing, but it can also distort readers’ expectations and that sets them up for disappointment.
That’s why I put out a lot of weekly and daily reversal tables every morning before markets open. It allows people to verify for themselves, develop confidence in the method, get a feel for what it can and cannot do, and get realistic expectations. Profits do not come on a silver platter in the market, there is some home work to do for traders who want to succeed. Forward testing is an important part of that home work.

Back test results have several known shortcomings. We can test methods with historic data, but we don’t know if our orders would have been filled at the given prices. There is also no guarantee whatsoever that similar results will continue into the future. The structure of the market may change, possibly rendering a method useless after some time. With those shortcomings in mind I am giving back test results of weekly reversal levels for S&P 500 and Crude Oil in this post. This is for educational purposes only.

The back test simulates long only trading using the standard buy and sell signals from the weekly reversal levels. I generally avoid shorting because it is more risky and has its own specifics. And there is always a bull market somewhere. Trading is done at the weekly Close for this test. For the S&P 500 I use data from 1950, which gives us 87 trades. The list with trades is here: Reversal levels back test for S&P 500

The result:
* 44 winners and 43 losers (with one trade still open).
* The average win is 14.1% in 47 weeks, the average loss is -3.4% in 9 weeks.
* The system was in the market 68.7% of the time, giving a risk adjusted annualized return of 9.1% (versus a 7.5% rar for buy and hold S&P 500 over this period).
* The max drawdown was -31.9% (versus a max drawdown of -56.2% for buy and hold S&P 500)
* The biggest win was 77.5%. The worst loss was -9.8%

So the method succeeds in its aim to get and stay in big profitable moves while keeping losses small. The profit distribution looks like this:

profit distribution

Most of the losses (34) are smaller than 5%, only 9 losses where 5-10%. The method gives some big winners of 15% and more, which easily takes care of the small losses. All we need to do is wait for those big moves to come along and not get distracted or discouraged by the small losses. Most investors do not have that kind of patience and tend to give up just before another big move starts…

Keeping the drawdowns small is important too because it is a good measure of how much risk is being taken. Looking at the list of trades we can see that it just sits out the big bear markets and gets back in on the next buy signal. So big drawdowns are rare. This is the drawdown chart:


Only 4 drawdowns were bigger than 20%. A buy and hold S&P 500 strategy went through a 20% drawdown 9 times over this period.

Some readers will probably think that S&P 500 has been in a long term bull market, making it easier to have this kind of gains. What happens in a sideways market? So, I took Oil, for which I have data going back to 1984 when WTI crude traded at $31. As of today oil costs around $37, so it has been roughly flat over this period with some huge ups and downs. How did the weekly reversal levels do trading long only?
There are 48 trades, here is the list: Reversal levels back test for Crude Oil

The result:
* 21 winners and 27 losers. All trades closed.
* The average win is 15.6% in 31 weeks, the average loss is -7.4% in 10 weeks.
* The system was in the market 50.2% of the time, giving a risk adjusted annualized return of 3.6% (versus a 0.8% rar for buy and hold Oil over this period).
* The max drawdown was -63% (versus a drawdown of -74.2% for buy and hold Oil)
* The biggest win was 88.3%. The worst loss was -15.3%

So even in a sideways market the method did a good job of staying in big moves while keeping losses small. We see bigger losses and a bigger drawdown than for S&P 500, but that’s of course because oil has been more volatile. The profit distribution looks like this:

profits distribution

Most of the losses are in the 5-10% category. They are compensated for a good deal by the 5-20% winners. But the method comes out ahead thanks to picking some big winners while staying out of big losers. Two winners of around 80% and two winners of 30% make all the difference here. If we miss out on those big moves then we are not going to make the cut in a stock or commodity that is in a long term sideways range. The patience to keep trying after a string of small losses is crucial if we don’t want to miss the next big rally.

This is the drawdown chart:


Clearly the drawdowns are more significant here. Oil has seen huge spikes and sudden crashes over the last 30 years. It is not possible for a weekly trading method to sidestep such violent moves completely. Oil is of course a risky commodity play that should not be more than a small part of the overall portfolio. An index like the S&P 500 has diversification and that means smaller drawdowns.

I hope this gives you a better idea of what kind of results you can expect with the reversal levels. In part 3 of this series I will show how the daily reversal levels work out when you use them to trade a common stock like Apple (AAPL).

For part 1 of this article: What a trading method can do for you.

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What a trading method can do for you

Posted by Danny on November 27, 2015

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 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):

reversal level profits

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):

reversal levels losses

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.


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