August 3rd watchlist & poll

First, a poll:

Watchlist

USCN (OTC BB) – Potential short, absolute crap financials and it has been pumped endlessly. This should be a great short on green/red action although there likely won’t be any shares available to short when the time comes.

VHC – they did not win a patent ruling, only got a preliminary ruling that increases the odds of them winning. The fade after the brief spike following the news last Friday indicates that this will likely fall more, and it closed the day up about 100% so there is plenty of room for a 20% fade. I would look to short on green/red action. It may also be a decent buy if it shows strength but considering I got burned buying it Friday I will not play it that way. Friday it was shortable at IB.

INO – after PIPE financing news Thursday it fell 50% (from the insane price of $3.40 it closed at Wednesday from $0.80 on Tuesday). That move was overdone and it bounced Friday. I am not looking to play this as its next moves will be less predictable.

Reader Watchlists

I am perfectly happy to give my thoughts on stocks my readers mention. Keep in mind that I give only my  opinion and what I write is never personalized investment advice and should not be taken as advice to buy or sell particular securities. Preston mentioned a few in a comment on my last post. He said:

I know your not a fan of these but here is my watchlist.
I like AEM after Cramer pumped them and they had decent news, short above 58 and cover under 55.
MCD, long under 55 and sell over 58.
I also like ACH for a long term play on CHina but would like to see a pullback first, I bought this first around 12 and sold at 16 and of course it flew after that.

AEM & MCD just do not interest me. Their charts are too choppy and I have no insight into their fundamentals or why people would want to buy or sell them. ACH has a great chart and might be a buy over $30, but its average daily range (ADR) is very low. I am not a swing-trader so it doesn’t interest me.

One point I will make over and over again is that stock trading is like baseball with no called strikes. If you choose to not make a trade you cannot lose. So the best traders only trade when they have a clear edge. Stock trading is one of the few ‘jobs’ when you can show up drunk for a week and do nothing and you won’t get fired or suffer any harm (as long as you avoid trading). If you ask me my opinion on 99% of stocks I will say that I have no opinion. I can make plenty of money only if I have an edge in trading a few stocks on any given day.

Disclosure: No positions. I have a disclosure policy.

July 31st trading recap

As I wrote last night, I have some house-guests, so this is a short post.

Here are today’s trades, with little comment:

  • +    BOT    200    GGC    false    Stock    16.410    USD    SMART    09:31:38        1.00
    +    SLD    200    GGC    false    Stock    17.610    USD    SMART    09:41:51        1.00

GGC was negative in pre-market. I bought it just a minute after open after it jumped green. I had incredible patience for me, selling 10 minutes later after it twice failed to take out big offers at $18.10. This turned out just like I thought it would.

  • +    BOT    800    IBNK    false    Stock (NMS)    1.829    USD    BATS    10:01:47        4.00
    +    SLD    800    IBNK    false    Stock (NMS)    1.760    USD    SMART    10:16:04        4.00

Pre-leader long on breakout to new high. Small trade. My winning ratio on this type of trade is poor and I net about breakeven overall.

  • BOT    200    GERN    false    Stock (NMS)    8.8397    USD    SMART    11:12:34        1.00
    +    SLD    200    GERN    false    Stock (NMS)    8.970    USD    ARCA    11:13:50        1.00

Bought on red/green (a bit slow). Halfway decent trade.

  • BOT    500    INO    false    Stock    2.01    USD    BATS    11:21:02    BookTrader    2.50
    +    SLD    500    INO    false    Stock    2.040    USD    ISLAND    11:22:18    BookTrader    2.50

Pre-leader long. If I had given it more room to run I wold’ve had an easy 30 cent profit.

  • BOT    500    VHC    false    Stock    4.38    USD    SMART    14:26:39        2.50
    +    SLD    500    VHC    false    Stock    3.898    USD    AMEX    14:27:50        2.50

Dumb play on VHC, I had the right idea but I was slow to sell and buy. I am generally bad at quick-moving plays like this that can go either way.

  • +    SLD    3,000    PAL    false    Stock    3.110    USD    SMART    14:25:52        15.00
    +    SLD    3,000    PAL    false    Stock    3.088    USD    ISLAND    14:28:29        15.00
    +    BOT    3,000    PAL    false    Stock    3.020    USD    ARCA    14:59:31        15.00
    +    BOT    3,000    PAL    false    Stock    3.030    USD    SMART    14:59:48        15.00

PAL was what I call a fat-fingered short. I don’t mind going reasonably large in these; risk/reward is good although this strategy leads to occasional big losses. In this case it was CNBC pumping it. 40 cents (18%) vertical moves in 30 seconds are in general good shorts unless there is real news. It didn’t turn out as I predicted but I still had a halfway-decent profit.

For your reference, here are my year-to-date profits for the above-mentioned trading strategies:

Fat-fingered shorts:

Total Profit $2,889.99
Avg Profit % 0.55%
Wtd Avg Profit 0.86%

Pre-leaders longs:

Total Profit $67.89
Avg Profit % 0.66%
Wtd Avg Profit 0.26%

Today I netted +$348.39.

Disclosure: No positions.

More evidence on how most traders lose money

CXO Advisory Group did a study using data from Collective2, a website that lets users auto-trade off of public trading systems submitted by ‘expert traders’.

Here is some of what they found:

the typical stock trading system available on Collective2 substantially underperformed the broad U.S. stock market over the past few months. Over the past 30 days, only about 18% of these trading systems matched or beat the S&P 500 Index.

Note further the following from the Collective2 disclaimer: “All performance claims on this web site must be regarded as hypothetical. …Commissions, fees, or trading system leases/subscription fees are not included in any of the results you see here. There is often a vast difference between hypothetical results and real-life trading results achievable in a real brokerage account, and real-life results are almost always vastly worse than hypothetical results.”

If this Collective2 data is representative of the short-term trading of expert individual investors, then short-term trading generally does not work well.

Check out the full article for more details and charts.

Disclosure: I read the CXOAG blog and you should too.

Watch list for July 31 & daily recap

Sorry this won’t be the most organized or prettiest post: I’ve got house-guests coming tomorrow and need to clean up! First up, review of today’s trades.

INO – Arggh!!!!!!

It was shortable at Sogo. It was shortable at Sogo. Arrgh. I really should’ve shorted this, even after the 15% gap down. But no, I was too busy losing money on this next stock:

OHB – TimAlert trade

Readers of my twitter feed know I got back in that this morning. I should never have even gotten in considering it held up pretty well yesterday and closed green. My entry sucked ($2.87) and I made the mistake of not covering when Tim Sykes covered. If you trade illiquid stocks and you know a bunch of people are going to buy / cover, it pays to buy before they do. So that was two mistakes. My third mistake was tripling my original position on the spike caused by Sykes’ followers covering but getting bad fills. If I could have gotten filled at $3.50 or even $3.40 that would’ve been okay. Instead I got filled at $3.17 and $3.30. I later covered when it spiked back to $3.50; that was the only thing I did right in this trade. Total damage: -$1552. Annoying, but for someone with a big account like me, not huge. The loss didn’t even wipe out all of this week’s profits.

GGC

I saw this alerted in the IU stock chat. But, because I am horrible at buying breakouts, I did not buy at $8 or $9, I bought at $13. I scalped it twice quickly with 200 shares each time and made a respectable $121.34. Things I did right: kept my position small and actually tried buying a breakout that has run well previously.

DDRX – TimAlert Trade

TimAlert comes out: “Bought 300 DDRX On Probable Breakout At $24.83” I of course bought quickly, partly to get a few cents from slow TimAlert subscribers. Below are my actual trades copied from IB.

+ BOT 961 DDRX false Stock (SCM) 24.905 USD ARCA 14:44:04 4.80
+ BOT 6,000 DDRX false Stock (SCM) 24.950 USD SMART 14:44:07 30.00
+ SLD 5,468 DDRX false Stock (SCM) 25.033 USD ARCA 14:47:20 27.34
+ SLD 893 DDRX false Stock (SCM) 25.000 USD BATS 14:48:20 4.46
+ SLD 200 DDRX false Stock (SCM) 25.110 USD ISLAND 14:48:41 1.00

I held onto 400 shares long because I agreed with Tim’s thesis.

TimAlert comes out: “Sold 300 DDRX at $24.98, Looks Toppy”

+ SLD 400 DDRX false Stock (SCM) 24.958 USD ARCA 15:32:39 2.00
+ SLD 500 DDRX false Stock (SCM) 24.802 USD ARCA 15:34:45 BookTrader 2.50

I quickly sold (learning my lesson from OHB this morning) and went short a tiny bit. Holy crap that thing tanked quick.

+ BOT 500 DDRX false Stock (SCM) 24.680 USD ISLAND 15:35:01 BookTrader 2.50

Wait, it tanked over $2 and I covered my short for a lousy 14 cents??!!? Oyvey. I’m not gonna cry about this though. It is a garden variety mistake and the tank was not caused purely by Tim Alert subscribers; there was some big stop loss sellers. As it fell more I was incredulous that it would fall so quickly. I thought to play for a bounce but did not want to get burned.  So I placed a low-ball bid. Most of my 1000 share order was filled.

+ BOT 900 DDRX false Stock (SCM) 22.662 USD BATS 15:38:29 4.50

The bounce looked weak so I decided to take profits around $23

+ SLD 900 DDRX false Stock (SCM) 22.977 USD ARCA 15:46:31 4.50

Overall on DDRX, +$838.98 today. It helped to make up for my horrid $1552 loss on OHB. Some halfway decent trading on that and GGC helped keep this day from really sucking.

Watchlist

The only thing really interesting on my watchlist is GGC. They had financing news that looks like it will keep them out of bankruptcy. This is a low-volume stock; it was up 112% today on only 2.6 million shares. Back in March the stock was up 200% in one day, and the following day the stock went from $32 to a high of $50 and then closed at $42. Oh, and this company is heavily shorted. So I think this may be a great buy tomorrow. We’ll see if I actually play it. I would wait to see how it looks in the few minutes after the open before buying.

Wait — this was supposed to be a hurried post. Oops.

Disclosure: No positions. I am a customer of Tim Sykes and InvestorsUnderground and an affiliate of both of them. I have a disclosure policy that gives details on those relationships.

How I Stopped Stockpreacher’s Alanco (ALAN) Bull Raid

This is a classic trading post from 5/16/2009 originally published on my investment blog GoodeValue.com. This is the last such post I will re-post here on Reaper Trades.

A lot can be said about short sellers.  One undeniable fact is that short sellers are the sellers of last resort. When everyone else wants to buy, the only ones who wish to sell are often short sellers. In fact, while many fear the depredations of short sellers manipulating the market with bear raids (of which there is little evidence), short sellers are the ones who protect the market from pump & dump schemes and bull raids (a bull raid being a concerted promotion of a stock when the promoter is not being compensated; certain stock pumpers will engage in these from time to time to enhance their credibility). It is worth noting that pump & dump schemes are common in OTC and Pinksheets stocks that usually trade for less than a dime per share, but there are almost none in higher-priced listed stocks. The reason for this is that margin rules and difficulties borrowing shares to short prevent short sellers from being the sellers of last resort for penny stocks. For listed securities they are more easily able to sell. It is the fear of short sellers that causes most stock pumpers to avoid stocks trading for over $1 per share on exchanges like the NYSE and Nasdaq.

Sometimes pumpers get a little cocky or a short seller gets lucky and a pump & dump runs headlong into the brick wall that is a motivated and well-funded short seller. Whatever the reason, this short seller was able to find plenty of shares to borrow of last Thursday’s pump of Alanco Technologies (ALAN). This pump (or in this case a bull raid, as the pumper reported having received no money to promote the company) came from stock tout Stockpreacher (about which I have written previously). Stockpreacher released its ‘report’ on the company just as the market opened and ALAN jumped 100% from an opening price of $0.49 to over $1.00 in less than a minute (this was no doubt caused by Stockpreacher’s idiot subscribers buying with market orders). The stock touched a high of $1.30 but very few shares traded hands above $1.05.

ALAN Daily Stock Chart (pump and dump day highlighted; click to enlarge)

Seeing that the stock was up an insane amount for no reason other than a bull raid and that there were shares available to short, I quickly started selling large blocks of shares. I knew that the only reason the stock was up was a bull raid and I knew from past experience that previous Stockpreacher bull raids dropped quickly from their highs. I quickly exhausted all 12,550 shares of ALAN available to short at my main brokerage, Interactive Brokers (see a screen shot of my trades there). I then moved on to another brokerage account that had shares available and sold short another 34,500 shares. I had an average short price of $1.01. My fusillade of short sales (I sold over 2% of that day’s volume in the span of a couple minutes) helped to keep the stock from hitting more outrageous highs than the already outrageous $1.30 it briefly hit. How do I know? Stockpreacher’s bull raid on BOSC from the previous week (for which no shares were available to short at any of my four brokerages) had driven the stock price from $0.60 to an intra-day high of $5.80.

ALAN Intraday Stock Chart (click image to enlarge)

About an hour and fifteen minutes after I first sold short, I covered my short position at prices between $0.60 and $0.65. I netted $17,322 for a few minutes’ work and I got the satisfaction of helping to counter the manipulation of a notorious stock tout. It was indeed a good day.

How You Can Profit from Pump & Dumps

Some fellow stock traders were impressed with my courage in short selling a stock that was up 100% on manipulation without even waiting for the buying pressure to ease up. My response  was simple: manipulation has its limits. I am now nearly an expert on manipulation and hype, having learned from Tim Sykes how to short sell manipulated stocks.  I knew from observing the previous Stockpreacher bull raids that the stocks always dropped quickly from their intraday highs. There are no easier trades than short selling a stock that has been manipulated 100% higher when you know the manipulation is going to cease (Stockpreacher does not keep pumping the stocks it selects for bull raids after the initial day). That being said, it is scary to quickly take a large short position in a volatile stock. To do so requires both understanding hype and manipulation and confidence in being right. Unfortunately, until the last couple weeks (during which I have made several great trades), my confidence has been poor (like my trading) this year.

As I have mentioned repeatedly in my articles on becoming a stock trader (Part 1, Part 2) and in my Introduction to Evidence-Based Investing, the bane of any trader (or investor) is emotion. Fear and greed are both anathema to successful trading; a trader should be confident but not overconfident. Trading involves implementation of a specific plan; emotion will distract from the plan and lead to poor decisions. I have struggled with my trading this year, suffering from a large draw-down in my secret super-awesome trading strategy, suffering from meager profits in my pennystocking trading strategy (Tim Sykes’ strategy), and even messing up my arbitrage trades.

As a result of the above troubles, my account dipped into negative territory and I was feeling horrible. While I gained 5.13% in January and gained 5.32% in February, I lost 3.81% in March and lost 9.90% in April. I resolved to dial down my risk a bit and focus on fixing my trading errors. I revised my super-secret trading strategy (which had been responsible for 80% of my profits and losses) in a way that only slightly reduces returns while greatly reducing risk. For my pennystocking trades, I focused on getting my confidence back. The best way to do that is to focus on the easiest trades. So, knowing how easy it would be to profit from short selling a Stockpreacher pump, I followed each one and did not let my fears keep me from taking a huge short position in ALAN. It helped that I follow Tim Sykes and he kept reiterating the ease of profiting from stocks up on hype alone. That strategy seems to be working as I am now up 12.14% so far this month (and May is only half-over!).

Now I have my confidence back and will look to improve my performance in more difficult trades. Of course, there is no reason for me to abandon the easiest trades! If possible, I will gladly sell short 100,000 shares of the next Stockpreacher pump!

Chart of my cumulative profit trading Tim Sykes’ strategy
Cumulative Profits from Tim Sykes Trading Strategy

Disclosure: No Positions. I am an affilliate of Tim Sykes as well as a customer, having purchased multiple of his DVDs (I recommend Pennystocking Part Deux; it is by far the best) and being a Lifetime TimAlerts member. I have a disclosure policy.

Watchlist for July 30 and Today's Recap

ELRN on watch for long, had some good drug news (though not huge). ELRN might be a good buy on early morning strength, particularly on the cross of $7. It was nice today when it hit $7 and popped above $8. On second thought, ELRN probably will not be a buy, considering that it faded gradually all day today after its morning spike.

INO is on watch, I am not bullish or bearish, but considering its huge move today and strong close, it will likely move a lot tomorrow.

OHB remains on short watch. Today I shorted OHB following a certain famous trader’s alert service. I had been watching it all day but missed the entry at $3; my average price ended up being $2.86 on 3,000 shares. I covered at the end of the day for a $390 loss when the stock popped back green. As Yngvai noted on the Tim Alerts blog, I should not have been so concerned about that little spike because small spikes into the close are not necessarily meaningful with illiquid stocks.

I made a couple mistakes: I got in a little too large (a habit I seem to have*) and then my mental stop was too tight. With an illiquid stock like OHB it is smarter to have a looser stop, especially considering how much downside remains.

*I remember I took a multi-thousand-dollar loss last September when shorting WRSP. I had had a huge winning streak and got cocky; my position was something like 5% of the daily volume; I drove the stock up 10% by myself while trying to cover during a short squeeze. I took little comfort from the fact that one month later the company was bankrupt and the stock worthless.

Disclosure: No positions. I am a customer of Tim Sykes and an affiliate of his. I have a disclosure policy that gives details on those relationships.

Followup on Cannabis Science (CBIS)

Trading penny stocks is easy. My call on CBIS was dead on: on green/red action yesterday it fell straight from 1.13 to .83. Take a look at its chart:

cbis

My call on CERS was good too:

cers

Unfortunately CERS gapped down at the open yesterday and there were no shares of CBIS to short that I could find.

How did I predict what would happen to CERS and CBIS? I have carefully studied similar stocks and chart patterns and I must say I learned from the best trader of these stocks, Tim Sykes. If you want to learn I suggest buying his disclosure policy that gives details on those relationships.

Watchlist for July 29

Not too much here. In this market it has been a lot easier to buy than to short, and I am a specialist in short selling.

ohb

OHB is a prime short as a Supernova with no news. I know this company from a fundamental perspective and they will be bankrupt within a year. Volume is very low and shares are not easy to borrow. IB had none today, SogoTrade had some.

china

I am short 3,000 shares of CHINA overnight, following a certain trader who shall remain nameless (although I would have thought of shorting anyway as it was a great afternoon fade and there is still plenty of room for this to fall tomorrow). This is a classic play to short, up only on hype-filled press releases since $1.50. Unfortunately the price action has been choppy. I will look to cover right after the open tomorrow and I will hope for a morning panic.

Disclosure: Short CHINA and I will likely cover the position early on 7/29/09. I have a disclosure policy.

StockPreacher.com puts the pizzazz back in pump & dumps

This is a classic trading post from my investment blog GoodeValue.com.

I would congratulate Stockpreacher.com on the skill with which they have in consecutive weeks sent Candela Corp (CLZR) up 100% and on April 20, NetSol Technologies (NTWK) up 60% (from $0.45 to a high of $0.72). However, their pump of NetSol attracted so much interest that it crashed their website. On the day it was pumped over 5 million shares were traded versus an average of 400,000 shares per day in the prior week. I can only guess that 1 million more shares would have been traded if StockPreacher’s website had not crashed.

NTWK 4-20-09 stockpreacher pump-dump

Of course, like most pumped stocks, NetSol and Candela both fell after the pump and I profited from short selling both of them (I also profited from buying NetSol into the pump). Tim Sykes also has a post on this pump and how he (and I) profited from trading it. Do you want to learn how I have made $2577.30 in 2009 and $50,801.90 since last June by following Tim Sykes’ trading system? Buy some of Tim’s stuff (like his Pennystocking Part 2 DVD set … but skip Part 1) and find out.

For those who must know, I bought NTWK at $0.47 (because their website was down and my email was slow I found out which stock they were pumping from a post in the InvestorsUnderground Chatroom, which is a great place for day-traders), sold at $0.61, went short at $0.65, covered at $0.58, went short again at $0.64 (all on 4/20) and covered at $0.57 on 4/21. I made over $1500 in under 24 hours with no more than $4300 at risk at any time. Not bad, eh?

Disclosure: No positions in any stock mentioned. I am an affiliate of  InvestorsUnderground and Tim Sykes and will make a commission if you buy junk using my links. I am a subscriber to InvestorsUnderground and a customer of Tim Sykes. I have a disclosure policy that gives details on those relationships.

So you want to be a stock trader? Finding a trading system & dealing with emotion (Part two of many)

This article will address the emotional requirements, discipline, and risk controls necessary to be successful at trading. I will then address how to find a trading strategy that works. This is the second article in a series. I suggest reading the first article (on the extreme difficulty of trading profitably).

Types of Trading

There are a few different types of trading (as opposed to investing) that distinguish traders. My definitions are not going to be the same as others’ definitions, and I will make some broad generalizations that are not always true–keep that in mind. There is daytrading (rapid trading intra-day, usually not holding positions overnight), swing trading (buying stocks based on longer-term charts and news), and fundamental speculation. Day-trading can be subdivided into scalping (going for small 10 cent stock moves), trend following, and dip buying (counter-trend trading). Day traders typically do not trade on news (although they may adjust stop losses or profit targets if there is particularly good / bad news). Day traders do not care about fundamentals; all they care about is a stock’s price movement. I do a decent amount of day-trading. Swing trading, on the other hand, is a longer-term trading style. The classic example is Bill O’Neil’s CANSLIM system. Most swing traders I know like to hold stocks for a few weeks or months at the longest. They often use a combination of fundamental and technical analysis. I have never swing-traded. The last kind of trading I will address is fundamental speculation. This involves taking a directional bet on some security for some fundamental reason. My profitable short sale of Silver State Bancorp from $2.00 to $0.09 (in bankruptcy) was a fundamental speculation.

There are other types of trading but they are not particularly relevant or they fall within one of the above classifications. Most fake arbitrage (merger arbitrage, pairs trading, statistical arbitrage, and anything else called arbitrage that involves risk) is simply a type of fundamental speculation.

Disclipline is the Key

No matter what kind of trading you are trying to do, you need to be disciplined. Ego, greed, fear, and any other emotions only get in the way. When a trader is undisciplined or trades based on emotion, he will make costly errors and lose money. In the book of Chuang-tzu there is a story about a discussion the philosopher had with a student. Master Chuang stated that a man who could not swim would make a poor fisherman, a man who could swim would make a decent fisherman, and a man who is as much at home in the water as on land would be an excellent fisherman.  That last man would be free to concentrate on fishing because he would have neither fear nor excitement at the prospect of being out on the lake.  So it is with trading: the best traders are emotionally detached from trading and the prospect of winning or losing large sums of money.  This emotional detachment allows them to focus solely on carrying out their trading plan. It may sound odd, but I have gotten very excited about a small $100 gain (because I had made a perfect trade albeit using little capital) and I have become despondent after a $6000 gain (because I had failed to implement my trading strategy correctly, missing out on far larger profits on what was a perfect trade setup).

Anything that will prevent a trader from being detached, calm, and focused will lead almost certainly to losses.  Stress in other aspects of a trader’s life will distract a trader and likely cause losses.  Outside stressors that cause a trader to focus on money are the worst.  Whether it is a need to make money to impress a girlfriend, sustain a lavish lifestyle, or provide for the family, the need for money will cause the trader to lose focus and will almost certainly lead to losses.

Discipline Requires A Plan

Dictionary.com defines discipline in the following ways:

1.     training to act in accordance with rules; drill: military discipline.
2.     activity, exercise, or a regimen that develops or improves a skill; training: A daily stint at the typewriter is excellent discipline for a writer.

The first definition perfectly captures what discipline should mean for a neophyte.  Discipline means sticking to rules.  That is why chess students study famous games and strategies and first learn to implement classic strategies whole cloth before trying to mix and match bits of different strategies.  Likewise young doctors learn to follow a clear diagnostic protocol when diagnosing a disease.  Only with much practice will a doctor, chess player, or trader reach a level of knowledge and skill that they do not have to consciously implement a set of rules.

How Not to Trade

In my previous article I discussed several trading strategies that I believe to be very poor.  Simply put, any trading strategy that relies upon the trader implementing that strategy being smarter, better, or faster than other traders is a poor strategy.  When analyzing potential trading strategies, the key is to identify niches that besides offering opportunity for profit, exist for some reason, will likely continue to exist for some time, and do not suffer from a lot of competition from other (potentially better) traders.

A great example of a trading strategy that does not meet any of the above criteria is trying to swing-trade the stock market.  There is little evidence that any one can predict where the stock market will go in the next week, month, or year. The CXO Advisory Group has a good analysis of various stock market commentators, none of whom show any evidence of being able to reliably predict the direction of the market. The best among them was accurate only 63% of the time, while the group average was 48%. Mark Hulbert, who tracks many stock-investing newsletters, agrees that market-timing does not work (this is compounded by market timing becoming more popular during market lows and less popular at market highs). If predicting the market were possible, there would be a lot more smart traders (such as hedge funds) that time the market. Instead, the traders who try hardest to time the market are small retail traders (suckers). (I should add that I believe that sometimes it is possible to beat the market by making fundamental calls, such as betting that housing was going to cause a recession, but past experience shows that the people who bet correctly on the current market downturn have no more ability than you or I to predict where the stock market will be in a year. John Paulson, for example, has been sitting on his bearish bets on mortgages for a couple years.)

Now, for an example of a trading strategy that works and that meets all the above criteria.  This is my strategy for arbitraging the differences in value between Berkshire Hathaway share classes.  While this has made me money, it is niche trading strategy; the strategy produces bond-like returns, requires that I pay close attention at all times, requires a minimum of $200,000 to trade, and cannot be scaled up past maybe a few million dollars because the shares are relatively illiquid.  The problems with this strategy preclude all of the following types of traders from competing with me in this niche: hedge funds, part time traders, traders with little capital, and traders who have enough capital and time but use their capital all of the time for other trades.  In essence, the very problems with this strategy are its strengths for me–its problems keep other traders away, meaning that I will likely be able to continue profitably trading this strategy far into the future. (Disclosure: I am currently short BRK-A and long BRK-B.)

The Characteristics of a Good Trading System

Most people believe that the only thing that matters about the trading system is how profitable it is.  This is incorrect.  There are many different aspects of trading systems to which a trader must pay attention.  Profitability per se is actually not one of them.  Instead, profitability is best thought of subdivided into its component parts: percentage of winning trades vs. losing trades and the average profit per winning trade / loss per losing trade.  Many good trading systems will produce about the same number of winning and losing trades, but they produce much greater profits on winning trades than losses on losing trades.  It is a rare trading system indeed that produces both a large percentage of winning trades and significantly larger profits on winning trades than losses on losing trades.

Besides these measures of profitability, there are many other important aspects of trading systems.  The frequency of trading opportunities is one of the more important; the trading system that produces three trade opportunities per week will be three times as profitable as the system that produces only one trade opportunity per week.  Conversely, anything that makes the trading system more profitable can be tweaked to make it that much less risky instead.  So if a trading system produces many trades, the trader can devote less capital to each trade, reducing the probability of losing large sums of money on any one trade.  Another benefit to a trading system that produces many trades is that allows for quicker evaluation of a system and higher statistical certainty that a trading system actually works (given equivalent profitability profiles, we can be more statistically sure that the trading strategy with thousands of trades is not due to chance than we can of the trading strategy with just 50 trades).

Another important facet of a trading system is its scalability.  It is a lot easier to devise a trading strategy that generates 100% annual profits with $100,000 in capital than it is to generate such profits with $10,000,000 in trading capital.  If you’re reading this article, you are likely not a hedge fund manager with over $50,000,000 or $10,000,000,000 in capital.  You should use your size to your advantage by pursuing non-scalable strategies.  Pursuing non-scalable strategies also guarantees that you will not be competing against the best and brightest traders.  A good example of this is my recent arbitrage trade in KV Therapeutics stock.  Over the last week, my trading was over 2% of the trading volume in KV B shares (KV-B); on the days I actually traded the stock, my trades accounted for up to 10% of the volume!  A hedge fund with even $50,000,000 (tiny for a hedge fund) that does the same type of arbitrage trading I do would not be able to build up a meaningful position in such an illiquid stock, forcing it to trade other pairs of securities that offer much less profit potential.

How to Find or Design a Trading System

There are many different ways to trade stocks profitably.  These do not generally include common trading systems that you find advertised everywhere.  There are multiple problems with these systems.  The main problem is that there is no way to know if these trading systems work.  I have not heard of one trading guru whose returns are not only audited but also can display the great audited returns of a random sample of their followers.  The only trading guru of whom I am aware that has great audited returns is Timothy Sykes (who has plenty of educational materials to sell you).  He has the website Covestor.com tap into his brokerage account automatically to verify all his trades.  So at the very least you know that the trades he has been reporting are trades that he has actually made. If you run into any trading guru selling some system, ask them why they don’t use Covestor (it is free) or have a well-known auditor audit their trades. The evasive answers will likely be amusing.

So with anyone selling a trading system (or with just random trading bloggers) it is impossible to know if they are telling the truth or not.  There was actually a recent case where a trader I am acquainted with exposed a  generally respected trader/blogger who had blatantly lied about a trade he said that he made.  While that blogger was not selling anything, I am sure people have lost money following his free advice. If there is not a reputable source that has verified the trades of a trading guru or system, I would recommend following trades in real time (for a long period, such as a few months) to see if a system actually works before committing money to trading the system or paying the guru.

Other than fraud, the main problem with using someone else’s trading system is that it is easy to mess it up.  In any probabilistic endeavor, whether shooting a basketball or trading stocks, there will be long streaks of hits and misses.  If a person is shooting a basketball and knows that on average he hits 60% of his shots, he will not give up in disgust and quit basketball when he misses seven shots in row (which should happen by chance alone 0.16% of the time, although much more frequently in games due to variation in a defender’s skills).  (I should also point out that there is no statistical evidence that such a thing as a hot hand exists in basketball; people simply misinterpret the chance occurrence of a long string of good shots; the same is probably true for stock traders).  If a person is confident in a trading system that she has developed (or that she has rigorously tested and understands) and is confident that the trading system will continue to work, she will not abandon it.  A trader who uses another person’s trading system without fully understanding it and testing it will be prone to abandoning it when by chance alone the system produces a string of losses.

Another important caveat for those who would consider purchasing a trading system from some guru is that the best trading systems will never be sold.  Take me, for example: I use four main trading systems; my most profitable trading system I will never disclose to anyone (unless they wish to pay me $500,000 right now) because I can make far more money trading that system than by selling it.  On the other hand, I’m perfectly willing to discuss my other trading systems because they are far more limited (as I have done above with my share class arbitrage trading strategy).

Designing Your Own Trading System

By now it should be obvious that I believe it is much better for a new stock trader to design her own trading system, or at least plan on adapting an existing trading system to her own personality and style.  If you are interested in designing swing-trading systems based partly on technicals and fundamentals, I would recommend Portfolio123.com.  I successfully used Portfolio123 to design trading systems that have helped my IRA outperform the stock market by 20 percentage points over the last 18 months (when I stopped using Portfolio123 last July and switched my IRA to other stocks I was outperforming by 40 percentage points!).  If you are interested in purely technical trading, I recommend Stockfetcher.com. I use Stockfetcher to
scan for my day-trading stocks.  As far as books go, I think most trading books are utter crap; I recommend James Altucher’s “Trade Like a Hedge Fund“. It encourages the right kind of critical thinking in designing a trading system.

One last note: as far as technical analysis goes, 99% of it is crap. I only use the simplest kinds, all of which I can justify by understanding the psychology of traders. No happy prime Fibonacci retracement levels for me!

Note: I have not yet published a followup to this article, although I will eventually.

Disclosure: Short BRK-A and long BRK-B. This article was originally posted on my investing blog on 2/7/2009. I have paid Tim Sykes money, have successfully used his system, and am an affiliate of his. See my disclosure policy for details.