Trading Rules

Levels of Risk

Risk is everywhere. There is, in reality, nowhere without risk. Every thought can trigger risk. Every act can be risky. Every result, happy or sad, is a balance between risk and reward.

Keeping risk in mind, I have divided my holdings into three levels: No risk, low risk, mid-risk, and high risk. See the About page for more.

For any trade, low risk to high risk, there are two rules that rule them all:

  1. Have a defined rule for entering a position.
  2. Have a defined rule for exiting a position.

I’ve traded outside of those universal rules on occasion, and have always regretted it.

Outside of the two universal rules, only the mid-risk and high-risk positions have formal rulesets, and those are what I shall discuss here:

  1. High Risk: Options Contracts
  2. Mid-Risk: Momentum Trades of Shares
  3. Mid-Risk: Managed Shares

 

High Risk: Options Contracts

My options trading rules are straight out of research conducted by Tom Sosnoff‘s Tastytrade financial network, with the exception of the exits rules, where I’ve expanded on his methods. The rules are intended for smaller accounts, and has the goal of many base hits rather than the occasional home run amid a lot of strikeouts.


Trading Rules

Positions: Short vertical or iron condor spread.

  • Set the short leg or legs at delta 20 to 30. The higher the delta, the greater the risk.
  • Select an Implied Volatility Rank (IVR) of 30% or greater. (This is similar to the IV Percentile found on many trading platforms.)

Entry timing: As close as possible to 45 days prior to expiration, giving preference to monthly options. Generally, I won’t enter after 43 days prior to expiration.

Due diligence before entry:

  • Avoid earnings announcements
  • Avoid ex-dividend days

Exit rules:

  • Up to 21 days prior to the options expiration
    • Profitable trades:
      • Exit at 50% of maximum potential profit, calculated as this way:
        • (credit_received – current_debit) / credit_received
        • where credit received is maximum potential profit and current debit is the cost of exiting the position. If it’s negative, the position is a losing one at present.
  • 21 days or fewer prior to the options’ expiration
      • Exit if the position is profitable, even if minimally so
      • Hold an unprofitable position until
        • It becomes profitable, even minimally so, or
        • It expires unprofitably.

 

Mid-Risk: Momentum Trades of Shares

This strategy relies on momentum for the selection of stocks and on a 20% trailing stop/loss for the exit signal.

Select high momentum symbols based on the criteria of your choice. I discuss my criteria in the “In Practice” section below.

In selecting trades, give preference to

  1. Higher rates of change.
  2. Expansionary periods while avoiding recessionary periods, as signalled by the Sahm Rule Recession Indicator, published on the Federal Reserve’s FRED tool.

Upon buying the stock, set a trailing stop/loss for 20% below the fill price as the condition for exit. 

If a position ceases to meet my criteria for entry, exit upon a downtrend signal from the Fisher Transform on a chart with monthly bars.

Funds from closed positions will be placed in a government or corporate bond fund, such as TLT or HYG, until required for a new stock position.

In practice

There are many ways to define momentum. The Han et al. study referenced below took a universe of stocks and defined those with the highest six-month change as being suitable for momentum trading.

I have chosen to use the Zacks screen for momentum called Zacks #1 Rank Uptrends, which has the following parameters:

  • A Zacks Rank of 1, meaning the strongest buy recommendation.
  • A 10% price change over the past 12 weeks.
  • A 5% price change over the past 4 weeks.
  • A positive price change over the past week.
  • A positive price change since the beginning of the year.
  • A price of 70% or higher of the 52-week high-low range.

The Zacks query also includes a couple of house-keeping items: A minimum price of $5 and average volume of at least 100,000.

I’ve retained those but lowered the minimum average volume to 10,000 and the minimum price to $1.

The so far has produced results ranging from about a dozen symbols to around 20.

Rather than trying to rank the results of the screen from best trade down to least best, I’ve chosen to use a random number to select the trade. The positions are on the small side, taking advantage of the new commission-free rule of my brokerage in order to achieve equity diversification. I add one trade a week, selecting the trade day by random number, in order to achieve time diversity.

Appendix: The Fisher Transform

The Fisher Transform, created by John F. Ehlers, converts prices into a Gaussian normal distribution, highlighting when the prices are at an extreme based on their recent range. The goal of the conversion is to spot potential turning points.

An article in Investopedia (“Fisher Transform Indicator“, April 19, 2019) describes the steps in calculating the Fisher Transform:

  1. Choose a look-back period, such as nine periods. This is how many periods the Fisher Transform is applied to.
  2. Convert the prices of these periods to values to between -1 and +1 and input for X, completing the calculations within the formula’s brackets.
  3. Multiply by the natural log.
  4. Multiply the result by 0.5.
  5. Repeat the calculation as each near period ends, converting the most recent price to a value between -1 and +1 based on the most recent nine-period prices.
  6. Calculated values are added/subtracted from the prior calculated value.

I use a derivative metric, the FTtrend, that I coded using the ThinkOrSwim programming language, ThinkScript. It returns a 1 for a buy signal and a -1 for a sell signal. Here is the code:

declare lower;

plot status = if(reference FisherTransform().FT > reference FisherTransform().FTOneBarBack,1,-1);

status.setDefaultColor(color.ORANGE);

———

Three research papers were used in constructing the ruleset:

Han, Yufeng and Zhou, Guofu and Zhu, Yingzi, Taming Momentum Crashes: A Simple Stop-Loss Strategy (September 24, 2016). Available at SSRN: https://ssrn.com/abstract=2407199 or http://dx.doi.org/10.2139/ssrn.2407199

Yusupov, Garib and Shorrason, Bergsveinn, Performance of Stop-Loss Rules vs. Buy-and-Hold Strategy (2009). Available at Lund University: https://www.lunduniversity.lu.se/lup/publication/1474565

Kaminski, Kathryn and Lo, Andrew W., When Do Stop-Loss Rules Stop Losses? (January 3, 2007). EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=968338 or http://dx.doi.org/10.2139/ssrn.968338

 

Mid-Risk: Managed Shares

What to do with in an era when falling interest rates make less risky trades insufficiently profitable to be worth the trouble? Robinhood came to the rescue. Robinhood Markets Inc. is a brokerage founded in 2013 with the goal of easy trading online without trading fees. I underlined the no trading fees part because that change overturns the long-standing preference most private traders have to holding stocks for the long term. In traditional brokerages, each trade into a position produces fees, and each trade out produces fees. Stocks generally aren’t leveraged, and trade in and out enough, the trader will find his exits have been eroded away.

Robinhood, by eliminating trading fees, liberates the trader from the buy-and-hold  restriction, making it possible to follow trading signals closely, even if it turns out to be a buy signal on Wednesday and a sell signal on Thursday. It puts an end to the two ancient laments, “Well, if I had bought Amazon back in the day, I’d be a millionaire today,” and “I know the markets down 10%, but if I just hold on long enough, it’s sure to come back.”

Adherence to trading signals in Robinhood’s first advantage.

By allowing quick trading without a financial penalty, Robinhood also allows for diversification over a period of time rather than static diversification. Exchange traded funds provide diversity in a holding, but under a buy-and-hold scenario the diversification is limited to the holdings of that fund. If I hold fund A for a week (during a buy signal), and then switch it for fund B for three weeks (during a buy signal), and so forth with funds C, D, E and F, then I’ve achieved a higher degree of diversification than a single fund will allow.

Diversification over time is Robinhood’s second advantage.

By allowing quick trading without a financial penalty, Robinhood also allows for diversification over a period of time rather than static diversification. Exchange traded funds provide diversity in a holding, but under a buy-and-hold scenario the diversification is limited to the holdings of that fund. If I hold fund A for a week (during a buy signal), and then switch it for fund B for three weeks (during a buy signal), and so forth with funds C, D, E and F, then I’ve achieved a higher degree of diversification than a single fund will allow.

Diversification over time is Robinhood’s second advantage.

And so I came up with a plan, and trading rules, for managing stocks by closely adhering to trading signals on exchange-traded funds, providing diversification both statically and over time.

Here, the, are my trading rules for a self-managed alternative to the robo advisors.


Stock Trading Rules: Mid-Risk

Introduction

The goal of this rule set is to create a highly diversified mid-risk portfolio of exchange-traded funds, managed daily  according to crossovers in the Directional Movement Indicator (DMI) technical analysis tool that signals trend changes. A buy signal is generated when the DMI+ (uptrending) crosses above the DMI- (downtrending). A sell signal is when the DMI- crosses below the DMI+.  Investopedia gives an explanation of the DMI system, here.

This sort of strategy is possible solely because of the emergence of no-free brokerages. I use Robinhood — Robinhood Markets Inc. — a brokerage founded in 2013 with the goal of easy trading online without trading fees. I underlined the no trading fees part because that change overturns the long-standing preference most private traders have to holding stocks for the long term. In traditional brokerages, each trade into a position produces fees, and each trade out produces fees. Stocks generally aren’t leveraged, and trade in and out enough, the trader will find his exits have been eroded away.

Robinhood, by eliminating trading fees, liberates the trader from the buy-and-hold  restriction, making it possible to follow trading signals closely, even if it turns out to be a buy signal on Wednesday and a sell signal on Thursday. It puts an end to the two ancient laments, “Well, if I had bought Amazon back in the day, I’d be a millionaire today,” and “I know the markets down 10%, but if I just hold on long enough, it’s sure to come back.”

Adherence to trading signals in Robinhood’s first advantage.

By allowing quick trading without a financial penalty, Robinhood also allows for diversification over a period of time rather than static diversification. Exchange traded funds provide diversity in a holding, but under a buy-and-hold scenario the diversification is limited to the holdings of that fund. If I hold fund A for a week (during a buy signal), and then switch it for fund B for three weeks (during a buy signal), and so forth with funds C, D, E and F, then I’ve achieved a higher degree of diversification than a single fund will allow.

Diversification over time is Robinhood’s second advantage.

Method

My holdings consist of a portfolio of five exchange-traded funds picked from a pool of funds. For signaling, I use the DMI applied to a daily chart.

I use a large pool of more than 90 exchange traded funds, including U.S. general index funds, sector funds, international global and country-specific funds, and a few futures-oriented funds in metals and agriculture.

When I have exited a position, I select a replacement that meets the following criteria.

  1. The DMI is showing a buy signal.
  2. The most recent date that the signal for each symbol switched from sell to buy is preferred over earlier signal dates. If the number of symbols on the most recent signal date is insufficient fill out the portfolio, use the next most recent date. For any selection date where there’s a choice of symbols to use, make each selection using a random number.
  3. Each fund in the portfolio, wherever possible, represents a unique sector compared to the others.

More briefly, the selection criteria for my five positions:

1) Buy signal. 2) Newest trend. 3) Unique sector.

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

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Based on a work at www.timbovee.com.