The Glory of Edge

What is an Edge? 

I used to believe that it an edge was the advantage you could develop over other traders.  In other words, the edge necessary to be profitable was likely some highly complicated strategies that the hedge funds might use with various correlations.  But if this was the "edge" then the retail investor stands no chance. 

As I progressed in my development, I came to realize that you do not need to have a complicated strategy, an edge can be developed by understudying your trading setups inside and out and applying them consistently.   While this certainly was closer to being correct, it is a methodology and not really an answer. I've since come to the realization that "edge" is the edge your system has over randomness.  

Fooled By Randomness

If markets are random, there is no edge. Nothing will make you money, not psychology, technical analysis, trading systems, discipline, or expert money managment.  Thus, it becomes imperative to ask whether markets are random or are they non-random.  

Humans are trained to see patterns in data that does not exist. We can find "bull flags" "head & Shoulders" patterns in completely random generated data. Consequently, I do not believe that training yourself in these chart patterns is especially helpful in developing an edge.

Certainly, much of the market action appears to be random. But given that every trade likely has a strategy behind it, can it be said that the market is truly random?  I  picture the market as a school of fish, every individual movement does not appear significant, but some times, the entire school turns in one direction. 

If your the system does not provide more edge than over a random market, then your system is the same same thing as trading a random market.  It is impossible to make money. 

In other words, if we do not understand the market action, or if our system does not know how to trade it, then the signal is no better than random.  

To make money in the market:

1. There must be a non-random pattern
2. the pattern must be recognized
3. The strategy must be executed properly

There is however, certain times when non-random signals appear. The objective is to separate random from non-random movements and to create a trading strategy that allows you to capture the signal. The difficulty is that randomness hides non-randomness  (signals).

Thus, the question we should ask ourselves is how do we develop this edge?  How do we avoid just trading the noise and ensure that we are not only trading legit signals but doing so profitably.  Given that  some of the best traders often have win rates in the mid 50s%, it is not easy to do. 

Some of my observations that I've built my trading strategies around  are that

1. Stocks rests in periods of consolidation

2.  Volatility leads to more volatility

3. A stock that trends into consolidation will often continue the trend after a volatility expansion.

4. If a stock makes massive move on high volume and the pull back is shallow, the next higher move can be very explosive. 

I've turned these observations into strategies and defined them in my playbook. 

My continuation anticipation setup buys strong stocks in periods of consolidation.

My momentum burst setup buys stocks that have consolidated and have shown their first range expansion -- (volatility leads to more volatility. )

My Fishhook setup looks to capitalize on big volume movers that pull back and then resume the move. 

Confidence

My playbook only works because I have confidence in those setups, Ive detailed.  If someone were to show me a set up, it would do me no good until I have researched it and believe in the setups take advantage of a non-random pattern that I can execute properly.  Until that point, the setup is no better than trading random markets... There is no edge.

 For example, I was able to reverse engineer the Powertrigger Setup. But so what?  I don't have confidence in it, so it is no better to me than a random signal. 

What a Pump Looks Like

I've recently taken a short position in OBCI, which has rallied after it paid to be interviewed by CEO LIVE.  OBCI has now issued  more press releases from the interview in a transparent attempt to inflate the company's stock price.  The headline reads:

"Ocean Bio-Chem, Inc. Ceo In Interview Sees Excellent Prospects For 2015"

In the press release, the company's "excellent prospects" are due to the drop in  gas prices . OBCI reasons that  people will use their boats and R.V.'s  more frequently and thus, purchase more of the company's marine cleaning products:

The drop in gasoline prices means that boats and RVs are more affordable to use. We have expanded our sales and marketing departments to take advantage of prospects for 2015

  The company's reasoning is pretty attenuated and certainly not justification to issue a press release-- unless of course you are attempting to drive the stock price up. This appears to be the case after the news comes out, we see the company being bid up: look at that volume.  2 shares. Someone wanted a higher print and was willing to pay $9.34 for that print. 

Market Monitor

One of the tools that is used to get a sense of the market conditions is StockBee's  Market Monitor.  The market monitor seeks to ascertain what phase the market is in by looking at a number of indicators to gauge the health of the market.

Primary indicators:

• Stocks up 4%
• Up to 300 normal buying pressure
• 300-500 high buying pressure
• 500-1000 very high  (beginning of a bullish turn from a bearish phase)
• 1000 extreme buying pressure 
• 300 plus days are common in bear markets as short squeezes

Very High buying pressure

End of year 877 followed by 952 4% moves: over a 9% move on the Russell in 3 days. 

Extreme Buying

1000 extreme buying pressure -- most likely to come during a bear market  -- November 13, 2008    2242!  over an 8.5% day on the russell   

But this move did not stick as it made new lows -- see chart 1. It reversed the next day. 

DOWN:
up to 300 Normal selling pressure
300-500 high selling pressure
500 to 1000 very high selling
1000 plus extreme selling

Its been suggested that bear market rallies after a 1000 -- so a down day of that level would be bullish But is it? Consider 2010 there were a number of 1000 stock down days

5 day Breadth Ratio 
# of stocks up > 4% in last 5 days/#of stocks down > 4% in last 5 days

10- day Breadth Ratio
# of stocks up > 4% in last 10 days/#of stocks down > 4% in last 10 days
When market is in bearish phase first time ratio is  2 plus signals start of a bull move. 
Ratio below .50 signals start of a bearish move after a bull move has been in progress.

 2 plus readings are good for swing trading on long side.
.5 or less readings are good for swing trading on short side.

Number of Stocks Up 25% in a quarter
Market is in bullish phase while the # of stocks up>25% in a quarter is greater than # of stocks down>25% in a quarter.When this number goes below 200 it is extremely bullish. It indicates extreme bearishness. Rallies which start from readings below 200 are extremely powerful. 
EOD readings of below 200 are rare, most of the time 200 readings are reached intra day for few hours or minutes and market rebounds.

So when EOD readings drop to below 500 be on watch out for a reversal of bearish trend.

Number of Stocks down 25% in a quarter

Market is in bullish phase while the # of stocks up>25% in a quarter is greater than # of stocks down>25% in a quarter.
When this number goes below 200 it is bearish. It indicates extreme bullishness.
Readings below 200 are rare and happen only intra day. 
So watch for EOD readings of below 400.
Unlike end of bear market in bull market, markets do not turn immediately after such high readings.

There is a delay of 2 to 6 weeks before real selling might start and a top is formed.

50% in a month
This indicator tells you intermediate term extreme bullish phases and likely pullback/correction points
Readings above 20 are bearish 
They indicate high bullishness and tend to lead to correction.
Market resumes its bullish move once such high readings drop below 10.
Readings of below 3 are bullish.

I've noticed that fishhooks set ups in low priced stocks start working well between 15-25

SD 50

Here my notes on the Stochastic dynamite off a rising 50MA created by CKBergin.

Money never sleeps. SD 50 is a pullback set up from an oversold condition. The  SD50 setup, i.e. stochastics dynamite off a rising 50 day ma after the 14/3 stochastics or CCI drops below 20 and -100 respectively.  

Here are the setup conditions.

1. Market is in a confirmed uptrend,
2. Strong IBD type stock 
3. 50 day ma is moving up, 
4. The 14/3 stochastic or 20 day CCI is below 20 and -100 respectively, 
5.  Price is at a support level either horizontal, gap, Fibonacci or 50 day MA level,  
6. The last price bar is either a higher close than the open (white candle) or a pause day(higher low than the low of the lowest low day in the pullback. and 
7. On the close the stochastic cross over above 20 or the CCI closes above -100. If all conditions are met place an order .05 cents above the high of the prior day with a stop loss .10 cents below the last swing low. 
8.  Look for a change of direction day, which is a close above the high of the lowest day high in the lowest bar of the pullback. 
9. Buy the close or the next day open without waiting for the stochastic to close above 20.
10. Position size should not exceed a risk of more than 1% of trading capital. 

Managing the Trade:

Initial target is 20% so you hold until that happens or your initial stop on close is hit. DO NOT MICROMANAGE THESE TRADES. Let the market take you out. Once 20% target price is hit you now stop out on any close below the low of the last high close bar, but sell any key reversal day. By doing this you can catch some 25% to 30% trades, and at worse your 20% intra day gain might only stop on close at 18%.

 If you get a take off like GPRO with only one day red bars that are ignored the next day ride the sucker and after 50% use a three point point and figure chart reversal the exit. These are the kind of home run trades that can make your year. 

Target

Shoot for 20% gain or you can take off 1/2 at 10% and trail the rest at a three day low stop. In any event sell all reversal days on volume. he high of the of the prior day being exceeded by .05 cents

EXAMPLES:

GPRO.  The low day was 8/8 with a high of 39.18. It traded sideways in a tight narrow range with the 14/3 stochastic going under 20. Although we had no 50 day MA yet the trend was rising as prices were higher than the IPO day. On 8/14 we had a higher close on better volume than the prior day at 38.49 a 3.8% gain and a dollar breakout.

8/14/14:

Observations: Volume increased, Dollar Break out w/3 move

CCI coming off oversold

8/15/14 Trade entered @39.50

RESULT

BABA?

1. Market in an uptrend: Check--but not exactly strong
2. IBD type of stock, Check
3. The 14/3 stochastic or 20 day CCI is below 20 and -100 respectively? CCI below 100
4. Support level, Check Bounced right at 50 MA.  
5. The last price bar is either a higher close than the open (white candle) or a pause day(higher low than the low of the lowest low day in the pullback?  Not fulfilled, High of low day was 107.95 , thus would need to clear above 108 and CCI above 100.

Conclusion: BABA is close to triggering an SD 50 trade but is not fulfilled yet. 

"If You don't know who you are, the market is an expensive place to learn."

I'm taking Adam Grimes' online course. It's free and can be found here.  As an opener, Grimes cites the market adage I have in the title and asks "who are you? 

Who Am I?

In my past reflections and market musings, I've come to the conclusion that trading  is a game we play against ourselves.  It's now time to size up my opponent.

Background

My initial interest to the markets was during the go-go period of 1998-2000. I was in college.  I have a distinct recollection of a 60 Minute episode that portrayed day traders.  The gist of the program was that  people were quitting their jobs in masses to trade the markets and they were making fortunes--except the ones that lost fortunes. I was making $7 bucks an hour and I was hearing about people making 10K in a day. I thought that sounded like the coolest job ever.

 I was still risk adverse and had no plans to day trade.  Nonetheless, I convinced my parents to let me open an investment account at E-trade and I put some of my college funds in the account.  

My First Trades

 Shortly after opening my trade account, I read a Money magazine article about stock picks and Knight Trimark (NITE) was  one of the recommendations as they were a market maker who would make money on every online trade. In addition, I picked Etrade as I figured I would now be using their services so I might as well be an investor. Call it beginner's luck because these trades were absolute home runs. NITE, which I had bought in the 40s would run upwards of $150 and split 4/1.  Etrade made a similar parabolic move. 

Of course, that was not entirely unusual during the period, stocks like AMZN, EBAY, CSCO, JDSU, JNPR were going parabolic.  And then there was QCOM.  One of my college buddies had bought 300 shares when it was a $15 stock.  He was up over a hundred grand, when he told me about it.  I didn't buy but I did buy his next recommendation RMBS.   

I was doing a lot of reading mostly on yahoo messages boards. It was all half-hazard approach but it all worked.  Everything worked back then.  Anyway RMBS looked like it was at support (or at least what I had believed was support) I bought 100 shares at 60.  I would sell it 3 months later for over $200-- (it ran to $470 and split 4/1. )

At that point, I started getting into swing trading.  I came across a guy called "TraderMike." (He now has a site called Wallstreetwindow.)  This was really my first foray into swing trading.  Trader Mike had a free newsletter or email list in which, he would send out a watch list.  These stocks were usually hitting 52week highs. The day after doing so, they would nearly always gap up.  10-50%.  I was making money with this method but I never really understood position sizing or risk management and those types of things.  I had some big winners a $6000 1 day winner in JMAR on a 50% gap up comes to mind.  

Bubbles pop and the internet bubble popped magnificently. All things considered, I came out relatively unscathed.  I gave back some profits, I big losses on a stock called InfoSpace, but I had sizable profits that I had retained.

Tradermike made a call that Gold wold be the next thing...and it would be.  But when gold was still $400 an ounce there were no ETFs.   You had to buy the miners.  While this could have been the trade of the decade, I lost money.  As I look back on it, I had no idea on how to buy a set up. I was constantly shaken out of stocks like NEM, GG, RGLD and became discouraged despite the parabolic rise in gold over the next decade.

CBOE

I was serious about being a trader and coming out of college I landed at an option market maker as a junior trader.  My job responsibilities included placing trades on other exchanges to spread risk for our traders to spread and basically learning how to trade.  I was to go  through an intensive 6 month training program.  Mock trading, option theory, strategy.  After that time, I was to get a badge and begin trading.  It didn't work out that way. 

The market popped in a big way, After 9-11, the market got a huge surge in volatility then the volatility dried up.  When volatility dried up, market maker profits go down.  Everyone on the floor was hemorrhaging money.  The firm was not anxious to put new traders on the floor as it, and every other firm, were firing their existing traders.  It became a very depressing place to work as our mentors were being let go.  I never got my badge and a year after starting the trainee program was discontinued and I was out of a job. 

I became very jaded on trading in general but one good thing about taking the job at the CBOE was that trading in personal accounts was strongly discouraged due to conflicts of interests, etc.   After I was let go, I went on to more schooling.  My trading profits were spent on tuition.  As I worked towards my new career, life got in the way and my trading fell mostly by the wayside.

The Next Chapter--Discouragement 

Most traders go through the discouragement when they first start to trade. I got mine a decade later after I attempted to trade again.  I tried  to keep up on the market and would read seeking alpha articles on various stocks.  I wanted to get back to trading but I had convinced myself that it is now too difficult.  I read about the complexity of the various hedge fund strategies, paired trading, high frequency trading, automated trading and all that good stuff. I was convinced that trading again was beyond my capabilities and it would be a fool's game to try.

In 2011, I placed some long term trades after the market sold off very large.  I bought MO, DIA, JNJ.  I did well, but as I attempted to move towards shorter term strategies my results were not that impressive. I would win on most of my trades but then shit like an elephant when I lost.  I had no concept of proper money management.

Fortunately, I then came across "Step Into My Trading Room" by Alexander Elder. I learned the importance of the 2% rule--- no trade risks more than 2% of your equity and the importance of keeping a trading journal.

I would like to say that everything suddenly made sense and I started following all these rules and became a profitable trader at that point, but that's not what happened. Here's what really happened:

I was initially hindered by positions I had that were not really trading positions.  But I didn't want to simply sell them because I had read a few books.  My trade selection was poor, It was a difficult time in the market and I fared poorly and lost interest. 

In 2013, I took a look at some beaten down stocks that I thought could make comebacks.  I bought NOK and BAC.  Both stocks made come backs over the course of the year but my returns lagged the market badly.  But I made a strong charge at the end of the year. 

It was this move, that revitalized my interest in trading again.  NOK sold out its handset division to MSFT.  I then did a few more profitable swing trades and my account had recovered. 

2014- My Breakout Year?

  I've eventually learned to define my setups, find profitable setups, and make money.  This was not exactly a smooth year. I've had numerous relapses into past bad habits  but I am now confident I can succeed and I've done so:

Self Assessment

Here's where I am at this point in my development as a trader.  It is an honest assessment and a transparent assessment.

Strengths:

• I have defined my setups.
• I have defined my risk tolerance
• No hesitation to take a trade.
• No regret about missing a trade
• Not usually afraid to re-enter a stock at higher prices if the setup warrants 
• I go into a trade with the mainframe how much will I lose.  This frame of mind has allowed me to properly position trades and to avoid hype
• I still have confidence in my setups even after multiple losses in a row.
• I can overcome multiple losses in a row with 1 or 2 profitable trades.
• For the most part, I have been  able to immediately take losses.
• I've been able to consistently find profitable setups. 
• I've made some very good counter-trend trades. 
• I've bought well for the most part.
• I've avoided significant drawdowns. 
• I can research stocks for profitable shorts. 
• Transparency -- 
• My trade journal remains an open book. By keeping it open to the public, I force myself to be accountable. It helps me follow my rules and my setups.  It is also a very helpful tool to see how stocks I've traded in the past acted on past trades.

Weaknesses:

• I occasionally take impulsive trades that do not always fit my set up criteria
• I'm too influenced by trade recommendations of people I respect.
• I take profits too early on many breakout trades.  
• I am uncomfortable when a stock Rips in my favor.
• I am uncomfortable when a breakout buy fades -even if just a small amount so I sell
• On a handful of occasions, I've froze and not taken a loss when I should have and I have broke my 2% rule.
• I've fallen prey to the sirens call of massive profits and have traded too big at times. 
• I've not been able to consistently stay in trends.  I captured only 1 big trend this year.  
• My selling criteria are not as well defined as my buying criteria. 
• I have little conviction in any particular trade.
• I migrated from strategy to strategy a little too haphazardly.

Year Highlights

• I caught a 50%+ trend trade in HCLP

• I developed a setup to trade low price momentum stocks profitably, which has delivered gains over 50% on a few stockss

• I've traded continuation anticipation setups well 
• I have found a trading community that I very much enjoy.
• Having the resolve to recovering from a trade that took 9% of my equity.

Goals

• Catching a superstock / EP early 
• Staying in stocks that are moving in my favor longer
• Gaining conviction in individual trades.
• Fewer mistakes. 

A Darvas Study

Nicholas Darvas was the author of the famous trading book, "How I Made $2,000,000 in the Stock Market. 

The idea was to pick strong stocks, which he wanted to have doubled from their lows.   Darvas drew boxes around those stock charts while they were in consolidation. These boxes are now called Darvas boxes.  The Darvas method works just as well today as it did in his day. It has has attracted a large following. 

Some have suggested that the Darvas method may be summed up as follows: 

D – Direction of the Market
A – Accelerated Earnings and Sales
R – Relative Price Strength (and Return on Equity)
V – Volume Increasing
A – Aggressive Growth Group
S – Sound Base Pattern

 In any event, I wanted to run through what a Darvas stock might look like.  I came across PLNR.

Here's PLNR which got a big move after earnings.  It has now setup as it has formed a nice base after these earnings..  I drew the "Darvas box" around the highs.  But we also want to see earnings growth, a volume surge, and a low cap /  float.   PLNR meets all these requirements in my opinion.