'High Probability ETF Trading' - A Good Place to Start

I know many people who trade stocks frequently but shouldn't. If you look at the most active stocks, they include many ProShares stocks that give you two, even three times the leverage of the regular stock market. Thus, the risk minimization from diversification implicit in indices is removed via leverage. Unfortunately, this does not amplify the 'equity risk premium' because the high amount of trading in these vehicles generates significantly drag longer term: being long the UltraPro S&P500 (UPRO) gives you three times the leverage against the S&P500 daily, but over the long run, a worse performance.

If you are going to invest this way, the best thing you can do is work out a system. Develop rules, test them, write them down, and at the end of the year, evaluate your results. If you fail, perhaps give it another year. But after a few years, if you underperform standard benchmarks (eg, the SPY ETF), then either get out of the market, or stop trading, and simply invest in the SPY.

A book like Larry Connors' High Probability ETF Trading is a good place to start. The author presents straightforward technical trading strategies, mainly based on momentum over longer periods (eg, 200 days), and mean reversion over shorter horizons (eg, 3 days). There's a lot of empirical research that suggests these trends generally exist, in that momentum is one of the famous equity risk factors (from Jegadeesh and Titman), while mean reversion underlies a lot of 'stat arb' strategies. The issue is, can you use these facts to add alpha to a naive strategy of going long and forgetting about it.

In trying to be clever, there are two things going against you at all times. First, there are many nuances to any actual implementation, and if you play around enough something will work if only by chance. Thus, you have to be disciplined when testing these strategies because it is easy to find something if you try hard enough--torture the data enough and it will confess. Second, there are transaction costs. For a retail investor, I would assume a one-way cost of 2 cents a share. Make sure this cost is included in your performance results.

So, Connors' book walks through several such rules (buy if these 5 conditions are true, exit if this one condition holds). You can learn how to test strategies downloading daily Open-High-Low-Close from Yahoo!, and set up a spreadsheet to apply it to the past 5 or even 50 years of daily data. You may not like his specific rules, but it clues one in on what kinds of things people find useful, and if you can test his strategies, you are then in position to create your own, similar strategies.

Most importantly, if you plan on trading more than once a year, you should have a testable system. Maybe it's based on fundamentals, but at least you should have a written record of what you were thinking, and when. The main thing to avoid is investing ad hoc every year and not learning that you are wasting money and time. Most people are wasting their time at anything innovative: your average poet, screenwriter, trader. The key is to discover if you are in the 'talented tenth' ASAP, because sampling alpha is costly.

So, if you must actively invest, evaluate not just a particular tactic (buy after 2 up days when price is above the 200 day moving average), but the strategy: should you even be actively trading at all? Remember, odds are you will fail as demonstrated by the fact that most retail investors do not outperform the market, and neither do professional money managers. Do not assume that simply trying hard, or wanting it, are sufficient, because every money manager really wants to outperform, and most work quite hard. Don't take it poorly, no one is good at everything, and very few are very good at more than a few things. The key is to find what you are good at so you can do it again and again, and this takes some courageous sampling, a good effort, and then a hardheaded evaluation.

Comments

[isaac the t...:]

One of the best articles I have read on this site!

Nov 11 10:04 PM

[John Doe2:]

Excellent article.

Couple of other points: 1) As an individual investor, you are competing against professionals who have more sources of information than you do and who can complete trades in a matter of seconds when unexpected news hits the market; and 2) to the extent that the trading strategies described in the book are successful, the more they will be copied and applied--thus any advantage that the strategies have will eventually disappear because too many traders are using them.

Nov 12 12:44 PM

[Maxe Paul:]

Stop trading ETF's would be your best bet to make money. It's a losers game.

Nov 14 05:03 AM

[American in...:]

Except for the extremely risk averse, the optimal portfolio leverage is greater than one (positive debt is optimal). So the question becomes how do you achieve optimal leverage in a world where most brokerage accounts are charging in excess of 4% annual margin rates and where US tax protected accounts forbid margin.

Leveraged ETFs, particularly of broad market indices, can be used as a long term investment by periodically rebalancing. The challenge there is to keep transaction costs low.

Nov 14 08:00 AM

[bobbybutte:]

as a person who has achieved financial independence solely from allocating capital let me comment

I like the authors article but I would trade options or individual stocks more than ETFs

Nov 15 11:11 AM

[jjp:]

I have had some very good luck with the Larry Connors system on stocks. He has a site that costs 79 a month and does all the math and trend research. I would never go solely by his system - the fundamentals are still very important. Sometimes a stock price goes down and no matter what the past performance, because business conditions have changed, will never go back up again. That said, the $79 has been an excellent investment for me. Last week a 3000 investment brought me 490 in 5 days. This system is also geared at shorter term turnarounds, 5 to 10 days, not months or a year. Out of the top picks he has, I usually only find one or two safe enough - i.e. a stock I would be willing to hold more than two weeks - to not worry if I need to hold it longer if the short kill does not happen.

Nov 15 03:38 PM

[Igor Shumovich:]

>>>>>&g... after a few years, if you underperform standard benchmarks (eg, the SPY ETF), then either get out of the market, or stop trading, and simply invest in the SPY. >>>>>&g...

"Why so serious?.." Seriously, isn't that too extreme? You can keep 90% of your portfolio in indexes, but if you need exitement - go ahead, trade 10% remaining. Well, you still need to be smart about it and use strategy for your trading, for example IBD's rules of investment:

millionairenowbook.blo...

Nov 15 09:47 PM