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Tharp's Thoughts Weekly Newsletter

January 09, 2008 — Issue #354
  
Education

Something for Everyone in March

Article

What Is an Efficient Stock? by Van K. Tharp

Workshops

Van Is Teaching Workshops in Singapore and Australia

Trading Tip

A Look at the Markets by D.R. Barton, Jr.

Melita's Corner

The Feeling Cycle by Melita Hunt

Trading Education

March 2008--Something for Everyone, Everywhere!

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Feature

Tharp’s Thoughts

What Is an Efficient Stock?

by Van K. Tharp

A number of times, I’ve looked at efficient stocks and found that buying such stocks long produces a very good trading system. For example, from July 2006 through July 2007, during a quiet up market, 23 such trades produced a System Quality Number ™ of 4.08. That’s a better record than any of the newsletters I tracked in the 2nd Edition of Trade Your Way to Financial Freedom.  As a result, we started a series here in which I was looking at trading efficient stocks within the S&P 500. The initial results looked quite good, but the results got much poorer as we began to filter out various errors and assumptions that we were making. The results were acceptable, but not as good as the two times that I’ve publicly traded such stocks through my newsletters, (i.e., see Tharp’s Thoughts July 18, 2007 and in Market Mastery, issue # 111).

However, before we do any more research on the topic of efficient stocks, we needed to know if we were actually trading efficient stocks. I asked for volunteers to find charts and review them to see if these were actually stocks that met my criteria. First, the efficiency was calculated and we only looked at stocks with a composite efficiency over +8 in the S&P 500 on the first trading day of the month. We then looked at two sorting algorithms based upon smoothness and only bought the top 10%, based upon those algorithms. The first was the standard deviation of the daily change in the close (close minus close) over 180 days. This gave us great results, but was biased toward low priced stocks.  As a result, we also looked at the standard deviation of the daily close divided by close over the 180 days as a smoothing function. 

I’ve now had three volunteers (thank you, guys!) look at nearly 200 stocks from both smoothing functions to tell me whether not they were efficient. One volunteer did 191 of the close minus close smoothing functions and concluded that only 49.2% were efficient. Two volunteers worked on the smoothing function: one concluded that 33% were efficient and the other concluded that 35% of them were efficient. Those results basically told me that we were probably not looking at stocks that I wanted to trade and that I needed to go back to the drawing board with our algorithms.

However, I then started to look at the charts. I’d told my volunteers to look at the price for the six month period prior to the entry to determine whether or not the stocks were efficient or not. But when I started to look at what they were defining as “efficient and not efficient,” it was clear to me that everyone had a slightly different interpretation.

I’ve always thought that my definition of efficiency was fairly subjective – the stock is going up in a fairly smooth line. But this exercise told me that my criteria are a lot more detailed than I thought.

So let me give you some new ideas that typically describe what I thought was a fairly subjective decision. 

First, the risk-reward ratio is important to me. Thus, if I’m using a 25% trailing stop, I’d like something that I believe has the potential to go up 75 to 100%. Thus, the first thing I’d like to do is eliminate those stocks that don’t have that potential. I believe I have two criteria here. First, I don’t want to trade something that is approaching a prior high that could provide a strong resistance point. Thus, the stock might have been going up for six months in a straight line, but if it’s right at an old high for say six months or a year ago, I’m not interested in trading it. Figure 1, illustrates this sort of stock, which is approaching some potential resistance at around 39 and 47. Neither support area, with a 25% trailing stop, gives me a good reward to risk ratio.

Figure 1: No Good Reward to Risk Ratio

Next, the stock doesn’t necessarily have to be at an all time high (or at an all time high with a slight retracement), but if it had much higher highs (i.e., say in 1999 to 2000), then I want it to have the potential of at least a 3R move before it reaches those highs. Figure 2 gives a good example of a stock that I’d avoid based upon these criteria. Here QCOM looks very efficient, but it is approaching its 2001 highs. 

Figure 2:  Avoid These Stocks Because They Are too Close to Old Highs

Next, I believe that something that is starting to become parabolic is probably nearly the end of its potential move. Now that was not necessarily true in 1999 when stocks could easily move 5% each day and have the potential to go up another 100 to 200%, but the stocks that did that also tended to fall 25% or more in a single day when the move was over. As a result, I tend to avoid stocks when the upline gets too steep. Figure 3 is an example of something that I’d probably avoid simply because the line is too steep.

Figure 3: Avoid These Stocks Because They Are Parabolic

With these three criteria as a background, let’s look at the kind of chart I’m looking for. First, although I’m looking for six month efficiencies (i.e., I’d like something that’s been going up for six months), I’m fine with something  that’s been going up for three of the last six months as long as it is higher than it was six months ago. In fact, I looked at one example that was up for four months, flat for four months, and then up again for another month (BMS in early 1981). That is illustrated in Figure 4.

Figure 4: Efficient Stocks That is In a 9 Month Uptrend but Only Recently Started to Go Up Again

Stocks I’d trade, however, do not need to be at new six month highs. In fact, I’d generally prefer something that’s done a slight retracement. These stocks are often great buying candidates.  And, although I’m using 25% trailing stocks, simply because I want to hold them a long time, others could do well trading these stocks by using the retracement amount (i.e., once the trend resumes) as the potential stop. However, these could produce very short term trades, so I don’t trade them.

However, overriding the retracement is one very important criterion. The current up movement is usually defined by some sort of trendline. I am not interested in buying anything in which the trendline has been broken. Will it keep going down? I  have no idea, but I think the chances are much better when the trendline is broken, so I no longer call them efficient stocks.

Figure 5 shows an example of a stock that I’d trade even though it is not making new highs. The overall trendline is still intact and thus I’m fine with it.  Figure 6, in contrast, shows something that I’d avoid, at least temporarily.

Figure 5: Efficient Stock with an Intact Trendline

Figure 6:  An Efficient Stock That’s Broken Its Trendline

As I said, I’d avoid the stock in figure 6, but it could be a great trading stock if it goes on to make new highs. I also wouldn't trade Figure 7 because it's too volatile. 

Figure 7: Going Up But Too Volatile

These criteria pretty much determine what I look for visually in a stock when I do my efficiency trades. As a result, I looked at the charts I’ve been sent based upon these criteria. In some cases, I did not have enough data to determine if the stock was close to old highs. If that was the case, I just assumed that it wasn’t. As a result, I’m being conservative in the amount of stocks that I’m assuming that I’d trade from each of the smoothing algorithms. 

Close Divided by Close Algorithm

I’d probably accept about 53% of the trades that the computer took. This is considerably above the 33-35% taken by the reviewers, but it still suggests that the computer algorithm is taking too many trades that I would not normally take. I’d need to see at least a 75 to 80% agreement to even consider using the algorithm.

Close Minus Close Algorithm

With the close minus close smoothing filter, I estimated that I’d take about 62.6% of the trades that our algorithm took.  Our volunteer estimated that 49.2% were efficient using his interpretation of efficiency. With these trades, however, I couldn’t see far into the past to see if we were approaching any old highs. With that information added, my guess is that I would have taken less than half of the trades.

Conclusion

Our efficiency algorithm, despite acceptable results, does not resemble the kind of trading that I want to do. As a result, our new plan is to modify the criteria and the repeat some of the research we’ve been doing.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

Workshops

Van Tharp is coming to Singapore and Sydney

(Note date change in Sydney Workshops from February to March)

March 1-2-3

Peak Performance 101

SINGAPORE

March 7-8-9

How to Develop a Winning Trading System That Fits You

SINGAPORE
March 14-15-16

Blueprint for Trading Success

SYDNEY   

Australia   

March 28-29-30

How to Develop a Winning Trading System That Fits You

SYDNEY   

Australia   

Click Here for a Full Schedule and to Register Now

 

Trading Tip

A Look at the Markets

by D.R. Barton, Jr.

The market action is so interesting this week that we’ll take a break from our series on uncertainty to take a look at a couple of points that are worth noting.

We’ll pick up our series on uncertainty next week.  Thanks for all of your correspondence on that intriguing topic.  Please keep those e-mails coming to “drbarton” at “iitm.com”.

The market is a bundle of uncertainty right now.  Gold prices just hit ALL-TIME highs this week.  I have to pause for a moment to let that sink in.  Gold is widely considered a good indication of fear in the markets, as well as an inflation hedge.  With the crude hitting its all time highs (though not on an inflation-adjusted basis), inflation concerns are very real, and so is fear about the health of the economy.  Many folks are just starting to gain an appreciation for the credit market problems that we still face.  Most research tells us that the credit crunch will get significantly worse before it gets better.

The strange thing here is that many sentiment indicators are at a place that analysts call the sentiment environment complacent.  A “Goldilocks feeling” – not too soft and not too hard.

Add to this technical indicators that are overwhelmingly oversold – the major indexes are extremely oversold on daily and weekly charts.  And interestingly, weekly rate of change indicators (like ROC, Momentum, MACD, etc.) are at their lowest levels since 2002!! This means that the current move has gone faster as measured on a weekly chart than any move since 2002.

The final piece of data is that some value investors are getting blown up right now.  Newsletters that I watch have been getting hit for 30, 40 and 50% losses (some value investors don’t believe in using stops, but rather trust in the intrinsic value of their stocks).

What’s a Trader or Investor to Do?

The markets are very sloppy on short term time frames. 

Short Term Traders.  I have seen few markets that are tougher to ride for profits.  Take Tuesday’s trading for example (01/08).  In hindsight it would be easy to say, “Just jump in short and you would have been paid well”.  But the S&P 500 started by moving up seven points, then dropped 20 points, back up 15, down 32, up 12 then down 20.  Wow – that was tough to ride through unless you had a specific point of view!  Point-to-point trading offers some help and guidance, but this is tough sledding! 

During midday Wednesday (1/9) as I finish this article, the S&P 500 market is making a series of new lows by going down 6 then up 5 then down 6 and up 3… Wider stops and smaller positions are almost required revisions.

Intermediate or Swing Traders.  Nothing is more frustrating than having the direction right and getting stopped out on intraday swings.  That is probably the experience of some swing traders in this market.  Wider stops and smaller positions are called for if you’re getting whip-sawed.

Long Term and Value Investors.  Your plan dictates where you protect yourself.  If you don’t have stops in place, make a decision on where you should get out.  It’s tough to say where value investors should start looking to pick up some values.  Our book Safe Strategies for Financial Freedom, we suggest only entering once the stock has been heading up decisively.

Next week, we will continue to delve into uncertainty as we look at quantifying it, ignoring it, transferring it and living with it.  And I would love to hear your stories on dealing with uncertainty.  If you’ve had an experience dealing with uncertainty that provided a great learning, a vexing question, or just a good belly laugh, please forward it to me:  “drbarton” at “iitm.com”.  Let me know if I can use the story (either anonymously or credited) in a future article.

Great Trading!

D. R.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena where he is one of the most widely read and followed traders and analysts in the world.

He is a regularly featured guest analyst on both Report on Business TV,  and WTOP News Radio in Washington, D. C., and has been a guest analyst on Bloomberg Radio.  His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  “drbarton” at “iitm.com”. 

 

Melita's Inspirational Corner

The Feeling Cycle

by Melita Hunt

Those of you that read my article last week would have known that I was not feeling up to writing at that particular time. I was sitting at the computer, trying to force myself to come up with something and I eventually just wrote a very simple article after four attempts of coming up with nothing. This “writers block” you may call it, led me into a further discussion with a trader about one of Van’s ten tasks of trading. One of the simplest tasks that Van recommends that you do, is to check in with yourself each morning and give yourself a rating on a one to ten scale (with ten being “feeling great”). This is to help you determine whether you are in the right mental state to trade effectively that day.

Yet how many people do this simple exercise? It is so easy to do yet we don’t take the time to actually do it. Or worse still, we do the exercise, get a low score and trade anyway. Do we feel like we’re going to miss out on some special event in the market on that particular day?

If you are feeling like a “2” then perhaps it would be a good idea not to trade, but instead, we push ourselves to do something that we think we should be doing and our bad mental state subsequently shows up in our trading. We then have a bad or even horrendous trading day and kick ourselves at the end of the day because we knew we shouldn’t have traded. What a cycle to be stuck in!

And it isn’t just trading, it happens in all aspects of life. We force ourselves to do something against clear signals that we shouldn’t, and then get frustrated at the results at the end of our day. If I’d thought this through last week on my writing day, I would have recognized that I was in a “2” mental state before I started.

This isn’t about judging ourselves either. I had every right to feel like a “2.” I had undergone a CT scan earlier that day, was concerned about results, had back pain and ten other things on my mind that needed my attention. Imagine if I had decided to sit down and trade that day? Ouch.

Another recent example for me was the drive to Florida on the weekend (I am writing this article from the Florida Keys). I had incorrectly made the assumption that a 915 mile drive wasn’t a big deal and in my mind I had just equated it to a drive from Sydney to the Gold Coast (just under 1000 kilometers and about 11 hours), yet my body knew better. In my current medical condition, a long drive is not a good move. I awoke on the day that we were leaving and rated myself at about a “3”. Every sign pointed to flying. And it was still possible, but I just couldn’t be bothered making new arrangements because I had already made preparations to drive. And so I did. I ignored my mental state (and intuition). And my mental state came with me in the car…

A quarter way into the drive, my car started to smoke (Thankfully it turned out to be nothing serious – just air conditioning condensation) and it was at that point that I knew I had made the wrong decision and the universe was just giving me a little shove to make sure that I knew. We went through fog, torrential rain, road work and two long, long days of driving and I was just the passenger! I hurt like hell all over, didn’t really enjoy myself as much as I could have and the first two days of relaxation that I had planned, subsequently flew out the window. It really could have been so much easier. Lesson learned (I hope).

I know about the ten tasks of trading, I know about mental states and being in the right frame of mind to complete tasks, yet I too, forget to do it sometimes or I know it, and ignore it. Isn’t that “not to know it?”

Hopefully, by sharing some of my experiences with you, it will help me to remember to do this simple exercise more readily. I will be more conscience about checking in to see where I am ranked on the “feeling cycle” at any given time and plan accordingly. Then I can make an informed decision as to whether to go about my business, have some down time or what the best course of action is likely to be.

I hope that it is also a reminder to you. 

Next week, I’m going to talk more about using your feelings as a guide.

So where do you stand on the 1 to 10 scale right now?

Melita Hunt is the CEO of the Van Tharp Institute. If you would like to keep up with Melita’s progress regarding her recently diagnosed lung cancer (she is a never-smoker). Please feel free to read her blog at www.myleftlung.com.

You can contact Melita at mel@iitm.com

Feedback

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