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6,358 posts
msg #43164
Ignore TheRumpledOne
4/23/2006 8:13:45 PM

Creating New Trading Strategies Perspectives for the week ending April 23, 2006

Profitable investing requires the disciplined application of a proven strategy. You need to plan the trade and then trade the plan. When I am working to identify a new trading strategy, I go through a four phase process. Here is a summary of how I create and test a new trading strategy.

All good inventions start with an idea. Ideas can come from many places but it is important that the idea make some sense to you. The process of creating and testing a new strategy is time consuming and challenging so you have to believe in the concept to get you through the process. However, you must also accept that your trading idea may not work in real market conditions, making it necessary to abandon your great idea before you ever invest a dollar with it.

For this example, let's consider a strategy that looks to short sell stocks on a reversal of their long term upward trend. The Canadian markets have a lot of stocks that have done very well over the last couple of years and there are many people who think that there will be a correction in some of these stocks as valuations have come up too much. A strategy that is good for identifying the turn in the upward trend could generate a lot of profit when this general market reversal arrives.

Step two of the process is to identify the criteria for the strategy. In our example, we know we want to find stocks that are breaking their long term upward trends and turning in to a downward trend. With this set up, we can short sell these stocks when they shows the signs of a breakdown and profit from the fall.

When trying to identify the criteria for a strategy I like to look at charts of stocks that have already done what I am looking to find. In this case, I want to find stocks that have had strong sell offs after trending higher for some time.

This is where the Stockscores Market Scan can help. I can set up a scan to find stocks that have suffered losses recently and then look at those charts to see if there were recurring patterns that telegraphed the breakdowns from an upward trend in to a downward trend.

So, far our example, I might do a Market Scan for the following:

Gain/Loss < -20% over the last 60 days
Price > $5
Number of Trades > 500

Short selling is generally only possible on stocks over $5 and widely held, which is why I add the second two criteria to the scan. The first criteria seeks stocks that have fallen more than 20% in the last 60 days. Since a fall of -21% is actually less than a fall of -20%, we have to make sure that the operator sign is < -20%.

This scan produced 89 candidates on Friday. The next step in building the criteria is to look for charts that show a long term up trend broken and then reversing in a to a downward trend. When I see these kind of charts, I will note some of the technical criteria that existed on the trend reversal.

In going through one year charts using the Stockscores Slide Show chart viewer, I find a stock that shows what I am looking for. Dot Hill Systems (HILL) was in a strong upward trend until February when it slowed and reversed in to a downward trend.

On the day when the stock seemed to reverse, I notice a few things from the Stockscores chart:
- the Sentiment Stockscore was still above 60
- the Signal Stockscore spiked down to below 60
- a long term trendline drawn across the rising bottoms of the chart was broken
- the stock made an abnormal move to the downside

I now have a sense of what I may be looking for, so I continue to go through charts to see if there are more examples of the set up that I want. I come across QMED Inc (QMED) that did something very similar on Oct 11 2005. On that day, the stock's Sentiment Stockscore was above 60 and it Signal Stockscore jumped down to 59 as the stock made an abnormal move to the downside, breaking its upward trend line.

Once more example from my Market Scan results is Cerus Corp (CERS) which made an abnormal move to the downside on Feb 100, 2006, breaking its upward trend line. Again, the Sentiment Stockscore was above 60 (62) and the Signal Stockscore was below 60 (44). This was the start of a fall from $12.30 to its current price of $7.20.

I now have some criteria that I can work to test. Here are the Market Scan filters that I will use to find this set up:

Sentiment Stockscore > 60

Signal Stockscore < 60

Abnormal Activity = Abnormal Day Down

Price > $5

Number of Trades > 500

I enter these criteria in to the Stockscores Market Scan and save them with a Strategy name, Reversal of Fortunes. Now I can come back and apply these Market Scan Filters over and over without having to reenter them. I run the scan and it produces 24 candidates. I must now look through these charts to see if any meet my chart pattern criteria of a break of a long term upward trend line.

I now need to test this strategy for a while to see if it works. On a daily basis, I will scan the market and put charts that I like based on the criteria of this strategy in to a Watch List so I can come back and look at them in a few weeks and months to see how the trades have worked out.

As I go through the results of the Market Scan using the Chart Viewer, I will take any chart that I like for this strategy and add it to a Watch List which I have also called Reversal of Fortunes. For now, that is all I do. After about a month of doing this each day, I will start to look at the charts of the stocks that are in the Watch List and see how a potential short sale would have performed over time.

During this process, I also work to identify some risk management criteria. For example, where should I put my stop loss point to ensure that a incorrect trade does not produce a loss that is too large? It is through the Testing Phase that I develop all of the rules for the strategy.

If I find that the strategy consistently produces winning trades, I will go to the final step.

Now it is time to use real money to trade the new strategy. With established rules and the benefit of hindsight the process is easy through this paper trading phase. When we go to apply the Strategy we add a new dimension that complicates matters. Emotion is the factor that could make us break the rules of our new strategy and affect its ability to perform.

That is why I always start a new strategy very cautiously. It is important to build confidence in the strategy so that you have faith in the rules and a willingness to follow them. As you find success with a strategy, you can increase the amount you risk on each trade.

One thing that may make this strategy easier is the addition of a filter to only look for stocks that are optionable. That way, we purchase a Put option position which is easier to execute than a short sale and still profits if the stock goes down in price.

The market is always evolving and that makes it necessary to identify new strategies to leverage the opportunities that the market presents. Serious traders should try using the tools of to create and test new strategies.

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