How FindingThe Best Stocks is A Needle in The Haystack Problem

Finding the best stocks in certain ways is like finding a needle in the haystack. I don't mean with regards to difficulty necessarily but procedure. Awhile ago I was watching a show called Mythbusters: The Search in which they had contestants compete to become a part of the next generation's "Mythbuster's group". One of the problems that they had to solve for was how to find a needle in the haystack. Contestants invented ways of burning the hay that would not burn the needle, using magnates that would work on the needle but not the hay, using water in which the hay would float and the needle would sink and other ideas en route to attempting to filter out the noise.

One of the more eccentric contestants named Hackett suggested that this was a "signal and noise problem". He explained that you had a lot of noise (hay) and had to filter it out without also filtering out the signal (the needle).

I realized that stock picking methods involved mostly the same process. A lot of people like to look at only just the winners and seeing what they have in common. The problem with that is you might be very effective at identifying traits that are also true with losing stocks. Even if 75% of winning stocks have a certain characteristic, if 90% of all stocks share that trait then the trait in itself is not useful. Another problem is that even if you can compare it to the baseline and say that 90% of big winners paid no dividend and 75% of stocks that made big moves were under $10 per share and 60% of stocks that made big moves were under a $1B market cap--and even if you can also say that these big winners percentages are higher than the baseline rate for each stat---it is still possible in combination that this isn't the best match of filters. For example, perhaps although a small percentage of all stocks pay no dividend, 92% of $10 stocks with a small market cap pay no dividend. You'd have to decide which filter is more important.

Nevertheless, as long as you set up a way to objectively find out how to increase your hit rate of capturing big winners while reducing your chance of getting a non winner and still providing enough opportunities you are being productive in your methodology.

I want to focus on methods not stocks and not markets here. You could look at quarterly performance or yearly performance... but for an example I"m going to assume daily performance as you can run this every day and build a large sample size of what works and also plot some sort of measure of market condition in terms of trend, breadth and volatility just in case you notice certain scans work conclusively better in certain conditions.

So here is the method:
1)Develop a scan from a universe of stocks (say 5,500 stocks as an example)
2)Develop scan A to seek stocks up more than 1% and scan B to seek stocks up more than 4% in a single day (or 3% or 5% or whatever you prefer).
3)Either subtract the results or come up with a scan to seek stocks NOT up more than 1% and 4%.
4)Determine the baseline "hit rate" or percentage of all stocks that are up 1% vs up 4%.
This establishes a baseline. Let's imagine that out of 5,500 stocks 400 of them are up 1% or more and 150 of them are up 4%.

Eliminating The Noise And Burning The Hay

Now you are going to come up with a variety of scans you may like to use of what happened prior to today and not including today such as a stock was oversold 3 days ago or a stock was down 3 days in a row until today. Or perhaps you come up with a bollinger band squeeze or a scan that a stock over last several days prior to the breakout closed lower but not too much lower and never made a move more than 1%. Come up with at least a few methods between consolidating volatility, oversold, breakouts, trends, etc.


1)Develop these scans.
2)Scan them from all stocks to see the total number of stocks that pass the filter (say 500 stocks for a particular scan).
3)Add into a version of one of these scans that they pass this scan AND are up more than 1% and 4% or sort by today's change and count them (say 60 stocks in the scan are up 1% or more and 30 of them are up 4%)
4)Determine if randomly selecting a stock from this scan is better than randomly selecting from all stocks in terms of hit percentage and if so how much?
Example: In the example 400/5500 stocks or 7.27% are up 1%+. 150/5500 or 2.72% are up 4%+. In the example scan 60/500 are up 1% or 12%. And 30/500 or 6% are up 4% or more. This is a clear increase in your success rate over picking stocks randomly, so the filter added value today.

Repeat this process
I would run multiple scans and filters and even multiple "universes" from which you run the scan. Is scanning just the russel 3,000 going to produce a better hit rate than all stocks? What if you create a list of stocks that IPO'd in the last 5 years or less vs more than 5 years? What about stocks with positive earnings vs negative? What about stocks with accelerating earnings growth (growth % greater than last year) vs decelerating? What if you create a list of stocks that have been out of favor at one point or another and peaked in 2015 or earlier and are still down from their peak vs those within 15% of a prior peak in any year before 2015 (possible multiyear breakouts from ranges) or a list of stocks with positive uptrend or oversold on a longer term basis? This would be separate from the scan and it needs to have a pretty large number of names on that list to be statistically valid.  You can remove the results that would have stopped out if you want as well.

You can improve the results by identifying the samples most representative of the current market and sticking to methods that worked in the past under those EXACT same conditions.

This may seem like a lot of work but once it's done you can have confidence in the process and selection method's. Once you have collected samples over various periods and begin to determine the best scans to trade from, you may even develop the habit of reviewing the lists and developing your own personal skill or eye for identifying unique features that are hard to quantify in a scan or algorithm and begin to only focus on the best names from the list according to your experience.

If you'd like to shorten the time you have to wait to do this process you can set up the 4% movers for yesterday and just set up more scans and just keep running it for each day before today of how the scan would have came out. It's more work but you can do this all at once if you'd like. Or perhaps you'd like to do all of this over the weekend for each day of the week rather than once after close every day. Or perhaps you'd like to play for weekly moves or monthly moves of larger amounts rather than 1 day moves.

More Accurate Modeling

A more accurate way to model how your portfolio will result over a period assuming certain conditions is to actually look at 5 different distributions of outcome based upon the scan rather than just the success rate. You can sell at the stop, sell at the target, sell break even, sell below the stop or sell above the target. Using spreadsheets and getting a little app that runs monte carlo simulations on random numbers, you can set it up so that a range of random numbers between zero and one represents an outcome consistent with the actual results. For example if 40% of stocks stop out at the stop rather than gaping down or gaping down you'd set it up so that a number less than or equal to 0.40 results in a stop out and set up 5 different cells that determine 1 for the outcome and zero for no outcome and then translates that to a result for a single trade. Trying to plot simultaneous trades is more difficult particularly if your outcomes have any degree of correlation (they will) so modeling your entire portfolio of multiple trades with simultaneous holding periods and different entry and exit times that overlap is really hard to program for me. But you can do a simplified version of perhaps ALWAYS holding 10 stocks so that way your results over a period of 4 trade periods doesn't allow you to compound more than 4 times of the sum of all 10 results for each period.

This can be set up with rules such as if the result of a particular trading year or series of 100 or 1000 trades is over a certain amount to trigger a 1 otherwise a zero. Then a montecarlo simulation determining the average will give you the probability that that outcome is reached. SO you can determine a particular allocation and risk % how many series of trade results in obtaining your goal of minimum (what percentage of these periods are not down more than 20%) and maximum thresholds (what percentage of these periods are up more than 50%). Or you can look at the total distribution of all simulated outcomes at the end of a period.

I'm planning on trying to do a similar process at some point but I'm working on setting it up. This post serves as me getting the logic down so I have an idea of how to run it but now I actually have to set up the scans and process. I plan to track it on an excel spreadsheet which I have not yet build yet. I've attempted such a feat for quarterly results and some fundamentals, but those results were based upon recent data rather than the data BEFORE the stock made their move so it may not be accurate.

SNAP it up

Took these screenshots earlier today BABA and TWTR went through a similar process after IPO. It consolidated downward but fails to break down and soon the short sellers and bulls waiting for lower prices have to chase to get on and the short sellers get squeezed out.

THe psychology is also interesting. Conviction in the short run can be a weakness, and in a long run it may break and you may not be able to have it. The short sellers say "but I'm right" and add on or are forced out only to try again higher. Collectively it is the short sellers conviction that creats more selling than can be sustained in the short term and lower prices than can be sustained in the short term that allows for prices to be driven higher. And it is the short covering rally that creates buying that pushes stocks higher and forces shorts collectively to buy higher.

There are people underneath signalling to be patient and wait for lower prices to buy. That creates a potential bid should prices go lower and also a potential chase effect should they run out of patience if/when prices begin going green and shooting higher.

Pay attention to price action. If it breaks down and doesn't respond by reversing then perhaps the trade is over, but if it begins going higher and you see green shoots appearing, then beware a short squeeze ahead. Have a stop and manage risk, but remember that if more people short and more people sell that's more ammo for a greater short squeeze should it occur. Of course it may not so you have to be flexible, but what I see is a lot of conviction from bears and they have no other move left but to post on twitter and stocktwits about how obviously over priced it is and how the longs are "bagholders". IN order to be a bagholder you actually have to be willing to hold the bag as opposed to having a tight stop. But every stock in the late 90s was overpriced that doubled in price and so was TWTR when it went from $38 to $70. NFLX had nothing proprietary about it and Amazon has chronically been overpriced while it rallied from $50 to $850.

Again, I may be wrong, and it's also possible I'm right and the bears will eventually be right after it goes much higher. But to me this represents opportunity if you can manage the downside and keep a modest position size or modest risk overall.

If the idea begins to gain traction I may add to it, but be warned... the best performing stocks don't offer too many dips when they start moving while everyone waits on the sidelines wishing they were in as the green shoots push the stock higher.


edit:Using a time machine I was able to look at the intraday patterns

Full Blown Bull Market Not Yet Here?

One thing that dow theorists used to propose is that it isn't a bull market until all major indices are making new highs. However, due to the US coming off the gold standard in the 70s and the way currency exchanges and the increased global investing that is being done that may not be enough. One thing Martin Armstrong once said that always stuck with me is it's not a full blown bull market until its leading relative to all currencies. That works for different asset classes and in this case the Russel is only just about to approach new highs relative to the dollar index.

The last time that we were in a "full blown bull market" by this metric was in mid 2013 to 2014.
We can also look and see emerging markets aren't ready and that the all world index is not ready to take out its highs. This suggests a concentration into US stocks until proven otherwise.

The Russel is and all world index is pushing against resistance so it is possible we will stall here, but if/when we make it through to highs it is an all clear buying signal until it retraces the candle that takes out the high and fails its breakout (failed move and 2b sell signal) or until it creates another topping pattern after completing its rally.

For the record, Martin Armstrong has also suggested that the public average Joe investor won't as a group begin to pour into the market until if/when we get above 23000 and if that happens lookout we are headed towards a parabolic move or what he calls a "phase transition".

Risk Arbitrage And Options

Risk Arbitrage is identifying a deal of merger and aquisition that has been announced but has not gone through officially yet and in an all cash offer, buying the company to be acquired, and in an all stock deal buying the to be acquired company and selling the company doing the acquiring.

Risk Arbitrage with options is instead using calls and/or puts to accomplish the same thing, but with unique leveraged instruments.

In the early days, Warren Buffett used to participate in these until he met Charlie Munger and Munger convinced him of sticking with other methods.

Long Call Options and Risk Arbitrage

A call option gives the call owner the right to buy 100 shares of a stock (per contract) at a particular agreed upon price (the "strike price" is the term to define the agreed upon price). It forces the seller of the call option to sell the stock itself at that price should the call owner decide to "execute" your option rather than just sell it to someone else.

For example, if a stock is priced at $90 and there is a deal announced for $100 per share, you may decide to buy call options with a strike price of $95 and make the difference between the price at the close of the deal and this strike price (in this case $5 per share), and the cost of the option. If you can buy the option for $1.70 per share (or $170 per contract) and the deal goes through, you can sell the option for $5 and make $3.30 per share (or $330 per contract) if the deal of the stock closes at $100. However, if the deal fails, you'll likely lose 100% of what you risk. In fact, even if the deal is delayed and the stock goes up from $90 to $96.69 or less you will lose money, and if it doesn't go at least to $95.01 you will still lose all of it. With options you have to be right on timing, price, AND for out of the money options you need to be right on the magnitude of the move. This example allows a return of almost 3 times the risk, which means you can lose 3 times and nearly break even on the 4th. So to make money the deal has to go through more than 25.4% of the time. We actually should only plan to make this trade if the odds are much higher (like 35%) because of volatility, risk, and to pay for missed opportunity.

One variable I haven't mentioned yet is time. Eventually options expire and when they expire you either sell them, exercise them, or they expire worthless. Unless they are trading above the strike price for call options, (and sometimes if  you sell them before the end of the day on the final trading minute of the final trading day before options expiry) they will almost always expire worthless because no one else will want to buy the, knowing they will soon be worthless. The tricky thing about arbitrage deals is they can take longer than you initially expect.

One of the tricks of options is position sizing. Normally when you buy a stock you might put 10% in a stock and if it drops 10% you might sell. This is a 1% loss to your portfolio. But if you risk 10% on an option you have a 10% loss to your portfolio. Lose multiple times and you will have a hard time making it back. A 20% loss requires a 25% gain, a 50% loss requires a 100% gain. While options do allow leverage, making back those gains eventually It doesn't take too many losses for the position size to hurt you even with an edge. However, if you risk 1% per option, you only incur a 1% loss if you are wrong and you can lose 10 of those and be down 10% and only need an 11% portfolio gain to get back to even. The thing to realize about options is the problem is time PLUS price.

Options can work well for risk arbitrage plays because there usually is a clearly defined time frame and a clearly defined buy out price, so you can calculate your exact upside if the deal goes through, and your downside can be 100% as opposed to worrying about a stock that could easily gap down substantially before you could sell the stock itself.

So with this basic understanding we can look at other strategies for merger arbitrage plays.

Covered Calls And Risk Arbitrage

Rather than just buying call options on an all cash deal for risk arbitrage, you may attempt covered calls. Covered calls is where you buy the underlying stock and sell a call at a strike price against it.
For example, awhile ago RAD was selling at $5.60 with a deal that would either be $6.50 or $7.00. The FTC denied the initial deal at $9 for the entire company but after revising the deal downward and offering to divest from a certain number of stores to satisfy the FTC it could go through again at either price depending on how many stores required to divest from. The deal was expected to go through at the end of July.
The call options with expiration date of the 3rd week in July with a strike price of $6 were trading at $0.45 (per share or $45 per contract of 100 shares). That means that if you buy the option AND the deal goes through for $6.50, you'll only make 5cents and you're risking 45 cents per share if it doesn't. That means the deal has to go through 90% of the time to break even as a call buyer. Even if it goes through for $7. That's still $1 made on $.45 risked which is a little higher than I'd prefer. Also, I'd usually want to buy a couple months past when the deal is said to go through because it may get delayed again, this actually doesn't even finish out the month of July which means there's a good chance we can lose even if the deal goes through. If it's a bad situation for the call buyer, you should think about being the call seller.

Selling calls without owning the stock is dangerous. Although this would be the best possible situation a call seller who doesn't own the stock could be in with a likely capped upside, there is still a rare possibility of another bidder coming in (RAD would have probably already looked at all possible bidders and someone else would have probably come in by now), or something weird like the deal failing but the shares going up beyond $7. Plus, I think the deal still probably goes through more than 50% of the time so we want to own some of the exposure.

This is a perfect situation in my view for a covered call.

In other words, we buy the stock and for every 100 shares that we buy, we sell a July option with a $6 strike price. In the most likely situation given a buyout goes through before expiration, we keep $0.45 per share that we collected from the premium, we keep $1 that we make from the stock from $5 to $6, and we give up our stock at $6 per share and forfeit any additional gains, should they occur. In other words, when we are right, we make $1.45 per share. If the deal fails, we still collect $0.45, but we have to hang onto the stock until the option expires, unless we want to close on the option first and then sell the stock afterwards (but there's usually extra transaction fees for this).

The options are like a $0.45 insurance policy in exchange for giving up the gains beyond $6. It insures $0.45 of damages should the stock decline, but we'll still have to take the loss of the difference.
If we expect this deal to go through 2/3rds of the time, we'll make $1.45 each time or $2.90 for the two times, and on the 3rd we'll make $.45 more for the options or $3.35 for all 3 times including the one that failed. So when it fails the stock will have to drop less than $3.35 to make money (not including fees, transactions, and weird situations like a revision of the takeover price or early execution that can mess with the expectations) Since the price is $5.66, that means it would have to fall to $2.31 or lower when we're wrong to lose money (or we'd have to overestimated the chances that it goes through).

I don't know exactly what will happen if the deal fails, but it seems reasonable enough that this trade is profitable. Some people will look at the price a stock was trading at before it announced the deal and use that as the expected loss. I think the actual probability might be higher. Also, I think I'll probably collect the premium in July and that will possibly allow me to collect an extra $.50 to $1 when the deal goes through, or possibly sell August options, or if it's trading close to $6 I may even exit early rather than risk the possible deal failure.

Long Stock And Risk Arbitrage

There are plenty of situations which you would not wish to buy the option but would wish to own the stock without selling covered calls. One example is when the calls have such a wide spread between the bid and ask that you can't buy or sell them at any reasonable price. This happens more often than you might think. But if this happens, you still may wish to consider risk arbitrage if the deal seems good enough. You also may wish to do this if the stock is trading at $1 and the deal will go through at $2.50 or less and the only options available are $2.50 and they are only available for buying at $0.05 and sellers are unlikely to collect. In other words, if the strike price of the option doesn't make sense for either side. Not all stocks trade options so that's another reason you may not wish to play options.

The way options are priced usually make deals that have higher net profit better than shorter time frame. However, if you can get a deal that is expected to clsoe next week for only a 3% gain, and the loss is less than say a 9% loss if it fails, and you can make lots of these trades over a year, that can add up. This is a good reason to make long stock risk arbitrage. 

When selecting risk arbitrage, you have to realize that the highest percentage profit probably have the lowest chance of going through or will be delayed

The Baseline Odds of Risk Arbitrage Deals

According to insidearbitrage,  last year saw 225 deals closed. It also saw 20 deals that failed. It also saw 88 pending deals, some of which were probably delayed and may not close yet, and some of which may have been carry overs from 2015 that still haven't closed. We also don't know how many deals closed at a lower total than initially expected that could have resulted in a loss in options price, a much lower gain in the stock, and possibly even a loss overall in the deal (depending on where you bought). So let's just assume all pending deals are bad deals. We'll say 225/333 closed which is just over 2/3rds. I think this is a good number to use when planning a deal but with higher percentage deals you should expect lower probability of it going through.

I think using the pre-announcement price is a good price to plan on the stock going to if the deal fails.

How Much To Risk?

How much you should risk on these deals and on merger and arbitrage depends on your edge and instrument in general, but when Warren Buffett used arbitrage, he only used it as part of his portfolio. He would take a controlling interest in some and he would just find undervalued situations in others. 

One of the benefits of risk arbitrage is the low correlation to the market. The expectation of gain is not very high, but it also will tend to outperform in bear markets because of the low correlation to the market. Buffett would at times use margin to buy risk arbitrage names due to the high probability nature, and his measurable downside and measurable edge, but he would carefully weight the downside, and this was a time when risk arbitrage was not popular, and thus the opportunities were much better. He also was convinced that these were not the best way to play the market over time.

I like it due to the ability to outperform on the way down which can allow capital to buy if things go wrong. Buffett now almost always has some (usually large like 20%) percentage of capital in cash, buys insurance companies which have access to their float and now has access to the federal funds rate to borrow at lower interest than most, plus he has such a good reputation that he is unlikely to see a lot of capital leave his company just because the market sells off and he can also raise money by selling bonds. He also collects earnings directly from companies he owns privately that are relatively immune to the economy. Because of this, he doesn't have a shortage of means to buy when everyone else is selling and raise more capital should stocks sell off. 

However, for the average Joe experienced investor, this may be a good option if you do so intelligently. There's a book by Mary Buffett explaining how Warren did these deals if you want to learn more.

Trading System - Order Within Chaos

Stockbee has a good post out recently on how to organize your trading plan.
For some people, operating under chaos is how they're used to operating. These individuals may be able to manage the simultaneous chaos of the market and find setups. But even this type of individual would benefit from organization. There are too many tools available that can improve your efficiency and too many options out there for individuals to be able to optimize them all. This is where a trading plan can be structured to be more efficient.

Even having software that helps you with one particular process such as watchlist development or entrypoint isn't necessarily enough to tell you position size, asset management, decisions on how many to enter and which ones and how to prioritize entries, how aggressive to be given the conditions and so on.

A full trading plan has to quickly sort through the mess of multiple variables and manage the chaos. Many make the mistake of confusing chaos with randomness. The market is chaotic which means many properties such as distribution of outcomes and day to day predictability of moves may seem random, while operating with an order under the surface.

But chaos is sensitive to small changes and relationships between multiple variables may not be equal to the sum of its parts. So how do we operate in a multi-variable world?

Mohnish Pabrai has been using checklists to accomplish this task. It is the same process that airlines have implemented to reduce error and many medical arenas are now adapting to avoid mistakes.
Checklists should at least be designed with the most fatal mistakes in mind and make sure there aren't too many decisions on the checklist.

Develop the habit of reading through a checklist.

Make the checklist when you are out of the market or at least on a weekend when the market is closed so you can maintain some objectivity.
Backtest and forward test and/or model certain conditions and decisions to see if your assumptions about your decision make sense prior to implementing it into a working checklist. A checklist should have no more than 11 items and probably closer to 5-7.

Example checklist:
1)Check to make sure portfolio tracking data is updated
2)Check to see if any thresholds have been met that require action such as reducing size or limiting buying.
3)Check to see if your portfolio rules allow for the addition of stock and/or option purchases
4)If so, use breadth tracking and/or other methods like oscilators and indicators to determine if market is in a condition where taking the action is acceptable.
5)Check watchlist and risk/reward of potential entries and ensure they follow your purchase rules before purchasing.
6)Look for entry trigger.
7)If portfolio rules and market conditions and entry triggers permit, buy.
8)Track portfolio end of day just before close (5-15m before close) and sell anything below stop or beyond target that meets exit criteria.
9)Update watchlist after close consistently (perhaps once a week, twice a week or once per day).
10)Input watchlist data of possible stops and entries.
11)Update alerts for prices below stop or above target and also for any prices that may trigger a trade.

Optional:Update portfolio tracking data after close or after next open?

Condense this to:
1)Update and check portfolio tracking.
2)Check breadth and portfolio tracker to determine if you are possibly (or definitely) buying or selling today.
3)Check watchlist for possible entry, confirm with trigger.
4)Review positions before close.
5)Update watchlist, watchlist data and alerts

You may wish to set an alert or alarm to inform you when it's time for this. You might have a phone alarm and where it says "location" or "title" you can put the details for what that time of day signals. Example:
Alarm 9:35: portfolio tracking - determine today's possible actions. Update portfolio data
Alarm 10:35: check breadth and determine if buying or selling today.
Alarm 11:35, 12:35, 1:35: breadth + portfolio + watchlist
Alarm 2:35  Final period to consider buying
Alarm 3:50 Check portfolio tracking and look for trade exits.
Alarm 3:59 Market close, update watchlist.
Alarm 4:15 Update watchlist stop and targets in spreadsheet
Alarm 4:45 Update Portfolio data
Alarm 5:00 Update email alerts for trade triggers

Another way to organize it is perhaps that within each checklist you might have more details available as a reference if you need them, or you might try a checklist of checklists. Your first checklist tells you which order to view the checklists and how to use them to come to a decision. Your second goes through the steps of what specifically to do rather than generally and provides more details to avoid any mistakes within that particular process itself and gets you used to not trying to make any decision that isn't allowed by the process. This is a more in depth way to go about it but it keeps you organized to a particular procedure.

Checklist of Checklist example:
1)Portfolio tracking checklist
2)Breadth tracking checklist
3)Watchlist development checklist
4)Monitoring Watchlists for entries checklist
5)Entry checklist + Position size checklist
6)Management/exit checklist
7)Trade review checklist

-------------------------------------
1)I like updating portfolio and determining the plan for the day at the open (adding any trades from yesterday and updating the prices to set the tone for the rest of the day. I have no interest in trading the first hour or two after the open anyways so any time in the first two hours to do this is fine)
2)I like managing trades/exiting right before market close on an exit signal.
3)I like setting up a watchlist after the close and setting the targets and the stops if I were to take the trade after the close... or on the weekend
4)I like setting alerts just after that. Alerts let me know when trades I really want hit points where I'd consider an entry or when certain candlestick trades are triggered that I use when opportunity is scarce or when I'm trying to place a bearish trade.
5)After the first hour or longer of trading I like checking breadth throughout the day and I check that just before I look at my watchlist.


Setting a phone alarm with a note to go off Monday through Friday is a good system even as just a reminder. You may want to treat one or two days of the week differently and have different alarms.
Set it to go off once sometime during the open.
Have it go off once 5 or 10 or 15 minutes before the close depending on what you need
Set it to off after the first hour or two to go off once every hour and once every 15 or 30 minutes on Fridays (options expiry).

As you spot nuances you'd like to include, try to adapt your checklist to reflect those changes but make sure you don't get carried away. For example, perhaps you want to check the RSI(5) on the sector SPDR ETFs and check the breadth by sector and by some of the largest industry groups to determine where to focus your buy priorities or watchlist priority names. As you're building a watchlist rather than just being about risk/reward you probably want to highlight a few of the most quality names or those within themes and place emphasis on those

How To Avoid Embarassing, Costly Trading Mistakes

Everyone makes trading mistakes and some of the most costly include:
1)Trading too large in size.
2)Holding onto a stock against the strategy of stopping out.
3)Missing an exit.
4)Missing an entry point
5)Being Under or Over invested
6)Many others

One of the more important things I am working on is systematizing my trading and automating a trading strategy wherever possible. If you can learn how to simplify your trading strategies to a set of rules, you can set up safeguards and routines that keep you from making mistakes.

Money Management And Portfolio Management:

 

The ideal money management strategy is a complicated topic. I tried to approximate the "maximal growth" strategy for multiple correlated investments using a series of formulas and assumptions. This allowed me to come up with a maximum for a system I have.
It's something like:
No more than 20 "active" option positions
Standard 1% position size
max of 5 2% exceptions
max of 2 3% exceptions
max of 1 4% exception.
max 5 exceptions total.

max 10% per stock position
max 50% stock allocation.
10% income allocation. Only sell as needed to avoid margin, and repurchase as you can.
1-5% asset allocation (reviewed monthly)
A few more nuances than listed here.
Maximizing growth is probably way more aggressive than I want, so I may cut these in half. Still, it's very unlikely I'll be anywhere close to every single maximum all at once.

Trade Management:
I also have a few rules about trade management:
minimum 3:1 reward to risk prior to entry.
Clear entry trigger priority list.
Clearly defined stops and targets prior to trading
Exit near close if stock remains below your stop.
Don't sell short of target
After target have clear criteria for exiting that gives the stock a chance to run (such as selling on a close below the target or a close below the prior day low. or 3 day low or prior week low)

Using A Spreadsheet to track decisions:

You can set up formulas using excel to display a message if a stock is above or below a particular price. This can also allow you to also let you know if a stock has the minimum risk/reward to purchase. The idea is to input a watchlist into this list and have a way to automatically update prices (or to press a button or copy and paste a price quote) and not have to think too hard tracking your decisions.

The routine:
You should fall into a routine or habit rather than being emotional or thinking or worrying about your decision process.
1)Build watchlist. (I have a separate spreadsheet to mostly automate this)
2)Input watchlist plus add stops and targets
3)Check portfolio rules to determine how much of a particular position you can accumulate according to rules.
4)Look for confirmed buys if you can do so within established guidelines/rules of both portfolio and following buy checklist.
5)Purchase.
6)Input purchases in spreadsheet with stops and targets.
7)Review positions near the end of the day

You shouldn't really need to check your own positions more than once a day and the process of buying should only require you check your watchlist 5 times for a couple minutes per time. Perhaps once an hour after the first 2 hours of trading is over plus the last 5 minutes of trading.

One exception to checking your position might be on the Friday if you have any options that expire. You should probably use a 30m chart and check once per hour. Look for a close below in either of the prior 30m candles or a failure to take out the prior high in 2 candles... Otherwise sell or roll the option over to a later expiration date an hour before expiry.

If you need a checklist to remind you of this process and/or a timer system to alert you to make the checks that's fine.

Watchlist Creation:
As I've said, I've mostly automated the process. I have a much more complicated set of formulas that allow me to quickly categorize the stock and rank them and I'll go through maybe 400 stocks just glancing at the charts for a particular visual look I'm looking for and I'll come up with a watchlist of maybe 20-60 names from that list. It only takes me maybe 15 minutes. I could probably come up with more strict formulas to only look at 100 names and still get 1-2 dozen names for the watchlist but I like looking for the best setups. I can do this after market close and use the list the following day.

Watchlist importing:
This also is probably best done after the close. List the stock, identify approximate stop and target (I use measure rule to measure the pattern) and repeat for all. This may be a little more time consuming but will probably enhance my decision making and makes sure I don't miss anything obvious.

Options Tracking:
Probably the most challenging thing to automate is options tracking. it's not easy to automatically get option quotes for every price and have formulas based upon your stock target to convert it to a risk and reward. You may be able to approximate the option cost if you know the implied volatility and days left or come up with a formula that calculates it... but the implied volatility varies too often between stock and even among a stock it varies over time. However, if you list a strike price and target price, you can have a calculation of what the intrinsic value of the option at expiration is. There may be an extrinsic value added on if you buy more time than you need which can complicate the strategy if you are planning on rolling the option well before expiry.

You can also reverse engineer so you have the required price to give you the 3:1 reward to risk based upon the intrinsic value at expiration at the target price. You might just pick a strike price or 3 for a stock and check the quote early on and see the risk reward and where it needs to be and then set a limit order based upon what it should be at the price. That would take an options calculator or you approximating it (you can develop this skill over time). I'm not sure what the best way is to quickly optimize strike price selection and options selection. This function needs work. For now I'm just using the stock's risk/reward as a proxy and I'll go down the line of those on my watchlist and make sure the option trade also has a 3:1 reward to risk.

Tracking the option once you trade it should be tracking the intrinsic value only which isn't too difficult as long as you input the strike price. The "stop" for an option should probably be zero but you may try to salvage half in certain circumstances when you use options as stock replacement, but that's another topic.

So for now this is a system that you can use to have a spreadsheet literally tell you in words what to do with an option, a checklist you go through before you buy, monitoring key metrics as they occur and so on.

Another thing you may want to do is avoid trading earnings. as long as you have data inputs coming in when earnings are you can set up a formula what today's date is and then one to alert you if a stock is within X days of earnings date.

All of this can help you avoid virtually every mistake you can think of ahead of time as long as you create a plan and rule for it and method to ensure you avoid it.

How To Identify Exact Entries: Trading Triggers

Certain classic bullish chart patterns can be traded. I like to buy before the move is confirmed. I am basically playing volatility compression since volatility expansion tends to follow but I'm not waiting for the initial move to signal range expansion.

I have designed a spreadsheet to spot a list of opportunities. From that I manually create a watchlist off of my own manual filter scanning for visual setups.

The watchlist contains setups that I may consider trading if I have some sort of entry point. To find these I'm looking for a "trigger".

Trading triggers can help you narrow down your watchlist into actionable entry points. I like using a 5 period RSI because it tests well. You can use the same 5 period RSI on an intraday chart like a 5 minute or 1 minute if you really want to narrow down the buy trigger within the buy trigger and be extra precise. Backtests of buying a cross below 20 and selling a cross above 50 provides a compound annual growth rate of over 24% if you ignore transaction fees.

Another triggers include an inside day or cluster of a few days trading in a narrow range or multiple days where the open and close are inside one of the prior day or days.  Yet another trigger is a bullish hammer candlestick pattern or a break above a prior candlestick high. Or perhaps just buying at support of the pattern or looking for an intraday pattern within the pattern. I like to have numerous triggers because I'm looking to add multiple stocks and stock options and I use small 0.50-1% positions (and occasionally 2 or even 3% in certain exceptions) out of the money options to gain control over many price movements.

Some of these triggers have been backtested to beat the market. A hammer candlestick pattern with fixed time exit like 5 day hold or 10 day hold provides about a 15% compound annual growth rate(CAGR). The 5 day RSI has 24%. Others have not been tested, but I believe from experience it provides an edge. The inside day seems to work well.

Learn to fine tune classic chart pattern anticipatory entries or even breakout entries by looking for the right triggers. You can try backtesting methods but I have several potential concerns with this that I'll cover later..

Solar Setting Up

Solar is setting up for a move longer term. Look at the consolidation.