Toward an Active Trading Strategy

Earlier this year one of my favorite investment research firms, Stansberry & Associates, created an open house product: for $99 you could get access to all the research, newsletters and trading services the firm offers.

Until this point, I had only dabbled in any sort of technical analysis or momentum trading.  I had read one book about systematically owning the top 100 stocks based on momentum and another about picking value stocks quantitatively and started trying to figure out a way to combine the two strategies.  Thinking being the key word, as nothing had really come of it.

So I eagerly purchased the one-month open house, excited to read all about distressed debt investing, natural resource stocks and their ‘Extreme Value’ publication.  Surprisingly, I found myself hooked on their day trading service within hours.

The Stansberry Short Report sends out a bi-weekly missive with some idea or another, typically based on technical analysis done by Jeff Clark, a 30-year wall St. veteran.  The best part, though, is Clark’s “Direct Line” which he updates almost hourly throughout the day, evaluating the S&P technically as well as sharing any ideas he comes up with.

After downloading the Direct Line app, I became addicted.  I was constantly checking my phone while at work, while walking to lunch, before I got out of bed, in the shower – it was like a money-making version of Pokémon Go.

During the month of the open house (February 2016) my portfolio increased by 15% thanks to my new found trading partner and all the ideas that were funneling in from the other services.

After the month ended and I recovered from the resulting depression, I got a lot busier in my day job and stopped trading for a while. However, when I started up again in June, right after Brexit, I managed to get my portfolio value to go up another 15% in just over a month.

At this point, I decided it would be best to get a trading plan down on paper both to share with readers and to keep myself disciplined going forward.

The trading plan has three parts:  first, we look for assets with a lot of potential energy, or the ability to quickly rise tens of percent; then, we try to figure out when this potential energy will convert into kinetic energy for an entry point; and finally, we utilize deep in the money call options to leverage each trade.

Potential Energy

Potential energy is the field where I am used to playing.  To use it, look for situations in which the market has mispriced a security for some reason or the security just likes to jump into huge trends, gaining tens of percent in a matter of months or even weeks.

We’ll start with the more boring of those two scenarios, value investing.

Undervalued Stocks

Value investing is self-explanatory. You buy stocks that are valuable because they have room to run and when they revert to the mean you will see some good gains.  Here are some good spots to find ideas:

  • The Magic Formula is sort of the original ultra back tested value screen. Joel Greenblatt made 50% a year for ten years with special situations in his hedge fund and then decided to shift into an easier quantitative strategy.  The one he came up with pairs high earning yield (value) with high return on capital (quality).
  • Quantitative Value took the Magic Formula further, adding all sorts of fun bankruptcy and fraud screens to improve the results even more.
  • Morningstar subscribes to the same value ethos, but adds a little subjectivity, employing tons of analysts to analyze their universe of bigger companies to pinpoint those that are undervalued with economic moats, good stewardship and low uncertainty. I like to run the 5-star and highest discount to intrinsic values screens weekly.
  • Gurufocus follows the professional value investors with the best historical returns and pulls out their holdings from SEC filings. I prefer to pick specific gurus and look at their newer holdings, but you can also look for the stocks owned by the most gurus.
  • The big movers or new low list isn’t as easy to name or link here. Many of my better performing trades have come from buying calls when a good company sees its stock cut an unreasonable amount for some reason or another.  In late 2015, Wal-Mart was killed in the markets after a bad quarter and I was able to evaluate the situation, buy calls and then exit up 50% within a few months.
  • Special Situations I wrote a whole book about these so I will leave it to that. Check out the current portfolio for moves I like now.

Assets prone to intense up and down trends

Here’s the strategy that’s lost me shitloads of money at times. I have made more than ten commodity-related speculations that have lost >90%.  I have also made more than ten speculations in commodities that have at least doubled.

  • Gold & Silver Miners are the big one. This year alone I have had six or seven gold miners calls close out over 100% and two or three over 200%.  If you time the trend well, you can make a lot of money really fast.  If you time it poorly and are a slave to long-term macro-economic trends and other gold buggy things, you can lose a lot of money.  For now, focus on learning where to find and evaluate the plays (I like the Stansberry Resource Report) and risk management.
  • ‘Undervalued’ Commodities are full of fits and starts. In my newest book, I have a whole chapter on gauging whether commodities and other asset classes are mispriced and how to time investing in them.  Basically look for a commodity that cannot be produced profitably at current prices.  I used this method to make over 400% on Chesapeake Energy and over 200% on Freeport-McMoran earlier this year.  I also have a legacy position in Cameco from before I used stop losses that is down 90% so pay attention to risk management.

Kinetic Energy

Alright.  This is the part of the equation I was missing for over ten years of my investment life.  If I could get back all the dollars I invested in cash rich but behind-the-times shoe retailers or biotech companies that want to inject bubbles into peoples’ arteries or overpriced (the product and the stock) donut stores, I would have at least, like, $1,000 more than I do now.

Anyway, what we’re looking to do here is read charts to try to figure out when a stock is going to go up for long enough to profit on it.  Many billionaires think this doesn’t work, but billionaires also sometimes consider playing only four men on defense in basketball or sign Greg Hardy.

The theory behind why technical analysis works, as far as I understand it, has to do with psychology.  Assets in a trend tend to stay in a trend.  People like to buy what’s working for them and like to tell everyone about it.

Determining if the stock is trending

We are really only concerned with trending stocks for this strategy.  There are traders who make a living trading in channels.  I actually know a guy who used to pay his rent by buying out of the money calls in big bank stocks when they were two standard deviations below their average price over a period of time, but that’s for another article.  All of the strategies above look for companies with a lot of potential energy and to juice out returns for weeks and months from that potential energy we need the stock to be trending up.

The way I gauge the strength of a trend is the Average Directional Index (ADX).  I’ll admit I don’t entirely understand the math behind the ADX and I’m not particularly worried about ever understanding it.  The developer back in the 70’s looked at the average true range of the stock over a period as well as the distance between the highs and the lows over the period.  When the ADX is over 30 a security is trending.

Alternatively, the old-fashioned way to determine if a stock is trending is by hooking together several highs and lows in a row (at least three.) If the line is up, it’s trending up. If it’s down, it’s trending down.

Determining if it’s an Uptrend

Really it should be obvious if the stock is trending up, but we can make it a little more objective using moving averages.

We will use the 200-day and 50-day moving averages (200 dma and 50 dma), which represent a year and a quarter of trading days.  And if you want to get really fancy, you can use the 20 and 9-day exponential moving averages (20 ema and 9 ema); exponential moving averages weigh the more recent days higher.

For a stock to be in an uptrend, you want the shorter period average to be higher than the longer.  So if you set up a chart to show the 200 and 50 dma and the 20 ema, you’d want the 200 to be lower than the 50 which was lower than the 20 which was lower than the market price.

The logic behind this is fairly simple: if the more recent prices are higher than the older prices, it means the stock has been going up.

Finding an Entry Point

Here are the three main ways we will look for an entry point:

  • The slope of the moving average should always be positive. You want the stock price growth to be accelerating.  When the slope changes form flat or negative to positive this signals the stock will be moving up even faster shortly.
  • Moving Average Crossovers are when (for our purposes) a more recent moving average crosses over a longer one. So when the 50 dma price moves above the 200 dma price.  This signals to the market that the stock is ready to trend upwards.
  • MACD Crossovers. The Moving Average Convergence Divergence (MACD) plots the difference between the 12 ema and the 26 ema along with a ‘signal line,’ that is the 9 ema of that line.  When the MACD line crosses over either the 0 or the signal line it is a bullish signal.  The MACD is just a derivative of the MA crossovers with a shorter time-horizon.

The Instrument We Will Use

Many of these moves offer fairly high risk. To attempt to mitigate that risk with leverage (no one has ever said that before) we will use stock options to trade.

Stock options (specifically calls, which for now is all we will use) give the holder the right but not the obligation to buy a stock at a certain price before a certain date.  For example, if I wanted to buy calls for PayPal (current price of $38) to get the option to buy it at $34 before October 21, 2016 (it is August 9 as I write this) I would have to pay $4.60.  This price is made up of the intrinsic value of the stock, or what you would get if you exercised it today ($38-$34), and time value, which is the remaining 60 cents.  The time value is the value the market gives to the potential for the stock to rise above the current price between now and the maturity date.

You have to buy 100 options at once so the above call would set you back $460.  To break even you need PayPal to hit $38.60 ($34 strike plus $4.60 option price) in the next two and a half months; just a 1.6% return.  If PayPal announces amazing news and jumps 21% to $44, your option would be worth at least the new intrinsic value of $14, turning your $460 into $1,400.  Nice.

Deep in the money calls

Options can be one of three things: in the money, out of the money or at the money.  With calls, in the money means the market price is above the strike price (so there is an intrinsic value), at the money means at the strike price and out of the money means below the strike price (no intrinsic value).  The presence of intrinsic value lowers the leverage in the option.  This seems like a negative at first but with options we will get fairly high leverage no matter what. We are looking for an option that will move about as much as the stock price.  If we bake in too much leverage, a 1% move in the stock will send the option down 25% and we’ll hit out stop loss.

Luckily, there is a way to estimate how much the option price will move as a percent of the stock price. It’s called delta.  We will target a delta north of 0.80 (which means the option price will move 80% of the stock price) and won’t put on a trade without a delta of at least 0.70.  The PayPal options we looked at above have a delta of 0.86.

Another fun way to look at delta is to calculate what is called the position delta.  Because every contract contains 100 options you can multiply the 0.86 delta by 100 to see that you are, in effect, controlling 86 shares of the stock with your option.  This is where the risk management through leverage comes in.  If you wanted to actually buy the 86 shares you would need to commit $3,268 (86*38).

The full-of-potential-energy opportunities we are targeting with this strategy are prone to quick falls and even my four-page investing plan is to enough to be right every single time.  Using an option allows you to reduce your initial outlay and your total potential capital loss while participating in the same amount of potential return.

Risk Management

Stop Losses & Position Sizing

Back to the billionaires.  The business section of the bookstore is full of stories about guys who invested their entire net worth plus some into their business and stuck with it even as the stock price fell 99.9% and they had to write trading tutorials at night to get by.  If you’re Eddie Lampert or Wilbur Ross or even some random laundromat owner, doing those two things can make sense.

If you’re using a leverage derivative to try to get quick returns in the market, you should use stop losses and position sizing.

Position sizing is the easy one.  You should rarely, if ever, risk more than 5% on any of these trades.  Because options will usually have binary outcomes (that is they go up or they go to zero) you should only trade the amount of money you are fully willing to lose forever in that position.  And look at your trading portfolio as a percent of your total, too.  I have something like 70% of my portfolio in cash and long-term value investments.

Stop losses take a little explanation but are also easy.  The most straightforward way to use them is to pick a percent and sell the stock if it ever falls that percent from the highest point it’s been since you purchased it. I like 30%, so if you buy an option at $5 and it shoots up to $8 your stop loss is now at $5.60.

You can also use what is called a free ride and loosen up your stop after.  In a free ride you sell half the position when it doubles.  This means no matter what happens, you get your initial outlay back.

Watching the Bid/Ask spread

When you buy an option you aren’t really buying it from the person who owns the stock.  That person likely sold it to a third party called a market maker who will then sell it to you.  The market maker makes money based on a bid/ask spread.  The ask is the price you have to pay for the option and the bid is the price the seller gets.  So if the bid on a contract is $2.00 and the ask is $2.50, then the bid/ask spread is $0.50.

This one has killed me a couple times even when I may have made a good decision.  I bought puts (opposite of a call) on Brazil a few weeks ago because I read an article saying country stock markets historically peak right before an Olympics.  The market has since risen 6% and my options have fallen 30%.

I don’t remember the exact numbers but the bid/ask on this trade was something like 2.05/2.65.  This meant after buying the option I was immediately down 23%.  We use the market price for our stop losses, which is equidistant from the bid and the ask most of the time, but even then the position opened down 12% (even more when you count the commission) which was too much of a hurdle for the flimsy reasoning I employed on my buy.

Putting It All Together

Even though you’ve read this treatise, I wouldn’t suggest going out tomorrow and filling your portfolio with options.  The first thing you should do is explore all the potential energy sources and make a watch list of 10-20 stocks.  First, find names that you know (stores where you shop, websites you use, firewalls that thwart your hacking, etc.) and track their charts.  When they hit a potential entry point, find a deep in the money call and write the price down.  Over the next few months pay close attention to the price of the option and figure out what your return would’ve been had it been a live trade.

Some Books to Read

Quantitative Value

I spoke about this book earlier.  Suffice it to say it’s easily the best $85 (only $54 on amazon through this link!) investing book I’ve ever read.

Trading by Numbers

Luckily, I found this one at the library, as it is also irrationally expensive ($75 list or $41.60 on amazon through this link).

Swing Trading for Dummies

Just reviewed this one!

Intelligent Option Investor

The Intelligent Option Investor may be my favorite book of 2015.  The author has two tiers to his strategy: finding value and using option strategies to profit from the reversion to that value.  Sound familiar?  There are also a lot of cool charts you can make to use the volatility implied in option prices to see where the market thinks a stock will be in the near future and then compare that to your value.  If you don’t think that sounds like a great Friday night, then I guess you’re not interested in being rich.

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