The following day, before the market opens, we place a limit order of 4 percent below the current day’s close.That is because if there is intraday movement in which the stock moves further down, that simply means there is more fear.
That makes our trade stronger, because fear is good. We want fear in our stocks. There is a significant edge if we buy lower than we could have at the beginning of the day.
At the end of the day, we look at which orders were filled.
If we wanted to use a stop loss on the first day, we would need to watch the market the whole day in order to place a stop. Since we only want to work thirty minutes a day, we don’t place stops on the first day. We could, but it’s too much work and doesn’t fit with our objectives. It also would make virtually no difference on your bottom line.Test results are similar whether or not we use stops on the first day, as shown in the examples.
Exit Rules
When an order gets filled, we place a stop loss after that day’s close. The stop loss is 2.5- times the ten-day ATR. That’s wide, because we need to give the trades room. We are buying falling stocks, and for mean reversion, these stocks need space to develop.It’s important to know that these trades must have a large stop loss. If we trade with small stops, this strategy doesn’t work. The trade needs room to develop.This can be difficult on a psychological basis, because many positions will first show a loss after entry.
We stay in the trade until any of the following conditions is met:
Stop Loss: The trade gets stopped out.
Profit Target: When the position has earned a profit of 3 percent or more, we exit the following day, market on open.
Time Exit: When four days have passed without A or B occurring, we exit market on close.
Here’s an explanation of the statistics used in the previous chart.
R-squared measures the slope of the equity curve—it goes from 0 to 1, so 0.96 is excellent.
R-cubed is a measure of the relationship between the CAGR, the maximum drawdown, and its duration. The higher the measure, the better.
The Ulcer index measures how many ulcers you might get while trading—clearly, the lower the index, the better. In the world of trading, a 2.92 ulcer index is very low. It factors in the size and duration of drawdowns.
As you can see, this strategy has a great CAGR, reasonable drawdown—but contrary to the Weekly Rotation strategy, our win rate is extremely high. This is great for people who struggle to handle losses and don’t like strategies with low win rates. The reason for this is because we have a very short-term profit target of 3 percent. Many trades reach that 3 percent and are exited with a profit. Mean reversion strategies are good for people who want higher win rates.
Also, the average exposure of 10 percent is very low. You may be 100 percent invested at times, but overall, your equity will be unexposed. We only trade when the time is right.
This strategy destroys the benchmark in all aspects, without correlating to it, as you can see.
The strategy would have turned $100,000 into more than $7 million, if you had traded it since 1995.
This chart shows the equity curve, juxtaposed with drawdowns. With this strategy, it’s normal to be in drawdowns, but your winnings make up for it.
Before the largest drawdown, in 2000, there were significant gains. The drawdown occurred because of large accrued profits. Therefore, it’s easier to stomach. It’s expected.
The one negative year was very small. With mean reversion, the more volatility, the more trades we get. The mediocre years are a result of low volatility.
As you can see, there are far more dark grey months (making money) than light grey ones (losing money).
Performance has been mediocre in the last few years, but that is simply due to low volatility. In 2016, performance has picked up.
With mean reversion, the more volatility, the more trades we get. If there isn’t a lot of volatility in the markets, we don’t see a lot of setups, and our trade frequency is too low. I’m certain that as soon as the volatility picks back up, this strategy will perform exceptionally, as it has in previous high-volatility environments.
Example 1
Entry: Long at 26.64
Initial Stop Loss: 23.91
Exit: Two days later on open (slippage included)
We see a clear uptrend lasting for a while, then before we enter, you could see a lot of fear. We like fear—we buy when there is a short-term pullback that implies there is a lot of fear. We put in a wide stop loss, which in this case wasn’t reached, and we closed out the next day, with a solid gain. We hit our profit target and got out.
Example 2
Entry: Long at 3.21
Stop Loss: 2.29 (not shown)
Exit: Two days later at open, slippage included at 3.57
Again, we see a stock that was on a huge uptrend, when panic intervened, showing a pullback. That’s our time to pounce. Our automated strategy tells us to buy while everyone is panicking. It’s not easy for most people to buy at these points—there’s probably a big, negative event in the news. People can’t help but sell off at the sight of bad news, and that helps us. We love that fear—the more fear, the better.
Example 3 (Losing Trade)
Entry: Long at 7.25
Stop Loss: 6.60
Exit: Time exit after four days, market on close 6.94
We entered on the same path here—uptrend, pullback due to fear, and then we pounce. The difference here was the stock never reached its profit target, nor was it stopped out. After four days, we accepted our loss (with a time stop) and sold. If we had stayed in, we would have lost more. This is why we always put in a time stop. A time stop tells us that this is not a good stock to be in, so we can then look for a better opportunity.
Example 4
Entry: Long at 29.82
Initial Stop Loss: 27.74
Exit: After profit target has been reached, third day market on open
Here we see the same story again. Uptrend, panic, buy, large stop loss, and the stock shot up soon after. We got out the next day, market on open.
Summary
As you can see in the previous examples, the strategy is simple.
Look for an uptrend.
Look for significant volatility.
When the stock shows fear through a pullback, we buy even lower the next day.
We get out on a small target profit—we have a stop loss and a time stop.
The key to trading this strategy profitably is to have a large number of trades. The average profit per trade is not very high, so we need a large trade frequency to ensure large overall profits.
Most people don’t want to be involved in short trading, because they’re unfamiliar with it. However, it’s a great way to capture profit in the markets. For people who are comfortable trading against the herd, won’t have trouble ignoring the news, but want a different strategy than mean-reversion long, this is a great strategy.
This strategy is designed to make money when the market goes down. That’s its biggest advantage, especially when used in concert with the mean-reversion long, or Weekly Rotation strategies. That’s the ideal way to trade this strategy. They all work in perfect harmony, as I’ll discuss in part 5.
Short strategies are a little less reliable than long strategies because shares to short are less available, and occasionally the government will ban selling stocks short. That has happened in big market panics—the government will say, “You can’t short stocks right now.” We have to be aware that could happen.
Also, there is no guarantee your broker will have the shares you need available to short.
More than 96 percent of my short trades in the past five years have been executed, so this isn’t a huge issue, but you should be aware of it.
Objectives
Trade short only on a large universe of stocks, taking advantage of overbought conditions by short selling the best stocks, and buying each back when it reverts to its mean.
Execute in
less than thirty minutes a day.
Take advantage of stocks that have significant volatility and are on the shorter term overbought. By short selling these stocks, we get a strategy that performs well in bear markets and sideways markets.
Beat the benchmarks, especially in bear markets.
Beliefs
This strategy is similar to the long mean-reversion strategy, but now we’re looking for overbought situations, rather than oversold situations. Before we were buying short-term fear—now we’re selling short-term greed.
When markets have shown irrational, fear-and-greed-based behavior, there is a statistically larger than normal probability that we will see a reaction in the opposite direction.
Markets are driven by fear and greed. To take advantage of this on the short side, we need to find greed-based situations. These stocks have been high-flying stocks, mostly in favor with amateurs that have jumped on the fast-riding train. This typically is accompanied by large volatility.
In these situations, there will come a time when professional traders will start to take profits. Statistically, there is an edge in selling greed and buying it back when it has reverted or shown some downward movement.
This kind of trading goes against human nature and is trading against the herd. It is not easy to be a seller when everybody is buying and when all news messages show panic, but it is exactly what makes it a profitable strategy.
Since we are looking for shorter-term trades (a couple of days), we need a large trade frequency. This is both done by scanning over a large stock universe and creating exit rules in which we get out fast.
Trading Universe (Same as Mean-Reversion Long)
We trade all US stocks from AMEX, NASDAQ, and NYSE.
We do not trade ETFs, pink sheets, or bulletin board stocks.
For testing, this means that we take into account all listed and delisted stocks. Since 1995, this list consists of forty thousand stocks.
Filters
Minimum Average Volume of the last twenty days is above 500,000 shares.
Minimum price is 10 USD.
Position Sizing
Fixed fractional risk: 2 percent
Maximum size: 10 percent
Entry Rules
It’s essentially a mirror of the long strategy. The main difference is that we do not use an SMA filter. That’s because we want to make sure this strategy assists our long strategies—this ensures that they work in harmony. Often the long strategy starts to lose money when the market is in an uptrend that starts to trend down, and this protects against both strategies losing money.
7-day ADX: above 50
ATR% of past ten days: above 5 percent
The last two days were up days
3-day RSI: above 85This, combined with rule 3, is a measure of greed in the stock. That’s what we’re looking for. As the character Gordon Gecko said in the movie Wall Street, “Greed is good.” There will come a moment when people sell, and that’s when we’ll profit.
When rules 1–4 apply, we place a maximum of ten orders.
We rank the orders by the highest three-day RSI.The most overbought stocks indicate the most greed.
The following day, before the market opens, we place a limit order to sell short at an equal of the today’s close.
At the end of the day, we look at which orders were filled.
If we want to use a stop loss on the first day, we need to watch the market the whole day and place the stop as explained in the previous example. Since we only want to work thirty minutes a day, we don’t place stops on the days on which we trade the stock.Test results are similar, whether or not a stop loss is used on the first day.
Exit Rules
When an order gets filled, we place a stop loss after the close. The stop loss is 2.5 times the ten-day ATR, above the entry price. It is so wide because we sell fast-rising stocks, and mean reversion trades need space to develop.
We stay in the trade until any of the following conditions is met:
Stop Loss: The trade gets stopped out.
Profit Target: When the position has a profit of 4 percent or more, we exit next day, market on open.
Time Exit: When two days have passed without A or B occurring, we exit market on close.
Here we see the same characteristics as the long strategy—a high win rate, low exposure, low trade duration, and also a low ulcer index. The results are superb.
Again, if you compare with the long strategy, they are perfect complements. The short strategy is great in bear markets (2000–2002, 2008), as you can see. In times of poor performance (2012–2013), the long strategy did great.
Example 1
Entry: Sell short at 15.00.
Initial Stop Loss: 17.27
Exit: 14.31
The story is simple. We see a lot of greed, sell short, with a large stop loss, and capture a quick profit. This was a significant win.
Example 2
Entry: Sell short at 63.50.
Initial Stop Loss: 81.12 (not shown)
Exit: The following day, at 57.91
In about a week, the stock moved from 45 USD to 65 USD, which signaled greed. Again, we saw that greed, and we captured gains. There was a fast reaction downward, as expected.
Example 3 (Loss)
Entry: Sell short at 35.02.
Initial Stop Loss: 40.05
Close: 37.37
This was closed with a loss, but as you can see, we did not come near getting stopped out. The time stop closed out this position.
We sold a lot of greed again, but it turned out greed hadn’t yet hit its peak. Our time stop saved us.
Example 4
Entry: Sell short at 12.22.
Stop Loss: 14.84 (not shown)
Exit: Close at 10.79.
Here’s one more example of selling greed, and its paying off.
If you like trend following, but can’t handle the large drawdowns paired with it, this is a good strategy for you.
The idea is to combine lots of open, long positions with short-term mean reversion strategies. By doing that, our drawdowns are lower. Trend following alone saw a 30 percent drawdown; now we’re at 23 percent. In addition, CAGR increased from 19 percent to 26 percent.
We’re combining two directions (long and short) with two styles (trend following and mean reversion).
Here’s a chart comparing them when used alone, versus in concert.
As you can see, they work incredibly well together. By adding the mean-reversion short strategy to the Weekly Rotation, the CAGR increased almost 7 percent, while the maximum drawdown decreased 7 percent, and its duration was cut from thirty-eight months to sixteen. That’s a tremendous improvement.
The strategy beats the benchmark quite easily. Drawdowns are shorter than with the uncombined strategies, and their magnitude is lower. The win rate is lower than the combined long and short mean reversion strategy, but that’s expected—because trend following strategies have a lower win rate, but larger win-loss ratio.
Most importantly, this strategy beats the benchmark by a large magnitude, with low correlation.
Again, when one strategy is down, the other is up, and vice versa. In the bear markets of 2000–2003, when the trend-following strategy was flat, this strategy continued to make money.
There are some sharp drawdowns—that’s what happens when the long-term trend following strategy was making a lot of money beforehand. We have to give money back, because we’ve profited handsomely. That’s a consequence of trend following. However, by combining strategies, these drawdowns are much smaller than they were with trend following only.
When one is flat, the other makes money. In 2008, the Weekly Rotation was losing, then flat—but the short strategy was making great money. Since 2012, the short strategy hasn’t done much, but the Weekly Rotation has skyrocketed. In the beginning of 2015, the Weekly Rotation started to give back profits—and the short strategy started to make profits again. They balance each other out perfectly.
In 1999, the strategy made over 100 percent! As expected, it gave money back afterward (the consequence of trend following), but not nearly as much as if we had been only long invested. It wound up making a profit in 2000—this is a great combination.
In 2008, that horrid year for the index, the strategy was a slight minus, but destroyed the benchmark.
By combining long-term trend following and short-term mean reversion, we make money in bull markets, bear markets, and sideways markets. We make money in all markets.
This strategy is great when you want to make big gains in bull years, but you still want protection for when the market goes down. It’s a phenomenal combo.
This strategy combines both the mean-reversion long strategy and the mean-reversion short. We trade them simultaneously. The result, as you’ll see, is that the CAGR increases significantly, and the max drawdown is significantly lower. That means you lower the risk, while gaining upside!
When one strategy starts to lose money, the other makes up for it. The long position starts to lose money, but the short positions recover those losses. It balances things out, and performance is exponentially better than using either one alone. We trade both strategies at 100 percent equity, when possible. I don’t mind trading 100 percent both when I can, because by being 100 percent long and 100 percent short, I’m basically market neutral. Sometimes we will be more directionally invested—say, 70 percent long or 70 percent short instead—and that’s fine, too.
The 30-Minute Stock Trader Page 10
