Wednesday, June 29, 2011
Investopedia Explains Straddle
Straddles are a good strategy to pursue if an investor believes that a stock's price will move significantly, but is unsure as to which direction. The stock price must move significantly if the investor is to make a profit. As shown in the diagram above, should only a small movement in price occur in either direction, the investor will experience a loss. As a result, a straddle is extremely risky to perform. Additionally, on stocks that are expected to jump, the market tends to price options at a higher premium, which ultimately reduces the expected payoff should the stock move significantly.
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Tuesday, June 28, 2011
Can the Fed and Economists Forecast the Future? See This Startling Chart.
Elliott Wave Financial Forecast Editors Kendall and Hochberg on economists, the Fed and forecasting.
Business Talk Radio host Gabriel Wisdom recently spoke with Pete Kendall, Co-Editor of EWI's Elliott Wave Financial Forecast. Their discussion included a crucial but rarely asked question about economists and the Federal Reserve. Here's the relevant excerpt:
Gabriel Wisdom: "Ben Bernanke, the chairman of the Federal Reserve, says the economy is slowing but there's faster growth ahead. Is he wrong?"
Pete Kendall: "Economists are extrapolationists. They tend to look at what's happening in the economy and extrapolate that forward. So here we have a situation where not just Bernanke but economists in general are looking at... what they call the 'soft patch' and somehow contorting that into growth later in the year.
Pete's startling reply flatly contradicts conventional wisdom. Most people believe that the Fed really is able to anticipate the economic future. After all, they're the most "qualified." But what do the facts say?
Pete's Elliott Wave Financial Forecast Co-Editor Steve Hochberg recently included this eye-opening chart (from Societe Generale Equity Research) in his new subscriber-exclusive video, "Buy and Hold, or Sell and Fold: Where Are The Markets Headed in 2011?
The red line in the chart is the S&P earnings, and the black line shows economists' forecasts relative to those earnings. Here's what James Montier, head of equity research for Societe Generale, said about it:
"The chart makes it transparently obvious that analysts lag reality. They only change their minds when there is irrefutable proof they were wrong, and then only change their minds very slowly." (emphasis added)
That comment is spot-on. In 2002-2003, as you can see, earnings turned up despite economists' forecasts for earning declines. It took them a while to "turn the ship around" and play catch-up with the trend.
Yet in 2007-2008, earnings turned down -- despite the forecast by economists for continued increases. The devastating truth is that earnings did more than fall in the first quarter of 2008: they had their first negative quarter in the history of the S&P. As Steve said in his subscriber video, "Economists were wrong to a record degree" -- and investors felt the pain.
So what's the point? Economists do extrapolate the trend. That approach works fine, until it doesn't -- and you're on the hook.
Elliott wave analysis never extrapolates trends -- it anticipates them. The Wave Principle recognizes that markets must rise and fall -- and that they unfold according to changes in investor psychology, in a way that is patterned and recognizable.
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Monday, June 27, 2011
Scanning for Market Opportunities
There’s been continued stock selling since the beginning of May. Is the market heading lower near term, or will there be a rebound? I suggest caution on the long side right now, and have a short sell stock pick this week on Nordstroms Department Stores. If you don’t like short selling stocks I recommend commodity or currency trading with the large liquidity in those markets currently.
Click Here for a Commodities Profit Boom Free Video
Zacks Investment Research reports one of the leading fashion specialty retailers in the U.S., Nordstrom Inc. has entered into a new five-year unsecured revolving credit agreement with a consortium of world's leading investment bankers for optimizing its capital structure.
Bank of America Merrill Lynch Wells Fargo Securities, LLC are offering the total amount of $600.0 million to the new revolving credit line facility maturing in June 2016. The company would have to pay an interest of LIBOR plus a margin of 1.125% on the outstanding amount and a commitment fee of 0.125% on the total capacity. The new credit facility will replace the company's prior unsecured revolving credit facility of $650.0 million, which was schedule to mature in August 2012.
Under a revolving credit facility, a company can borrow again once it repays all dues under the old credit facility. The company may utilize this fund for general corporate purposes, which includes repayment of outstanding commercial papers, working capital and capital investment or acquisitions.
Nordstrom has also notified that it has terminated the $650.0 million credit facility entered on August 14, 2009, effective from June 23, 2011, as there were no outstanding borrowings under the credit facility. Under this credit facility, the company has paid a variable rate of interest of LIBOR plus a margin of 1.750% on the outstanding balance and a commitment fee of 0.250% on the total capacity.
Based in Seattle, Washington, Nordstrom is a leading fashion specialty retailer in the U.S., offering high quality apparel, shoes, cosmetics and accessories for men, women and kids. The company offers both branded and private label merchandise, as well as a private label card, two Nordstrom VISA credit cards and debit cards to be purchased from Nordstrom stores.
The company operates in a highly fragmented specialty retail sector and faces intense competition from other well-established players, such as Gap Inc. (NYSE: GPS - News) and Abercrombie & Fitch (NYSE: ANF - News).
Nordstrom currently holds Zacks #3 Rank, implying a short-term Hold rating. We retain our long-term Neutral recommendation on the company.
Sell Short Nordstrom – Ticker JWN
Sell Entry: 47.06 to 44.56
Take Profit Areas: 41.50 to 40.91, 39.30 to 38.68, 34.67 to 34.13, 28.61 to 28.16
Nordstrom, Inc., a fashion specialty retailer, offers apparel, shoes, cosmetics, and accessories for women, men, and children in the United States. The company offers a selection of brand name and private label merchandise. It sells its products through various channels, including Nordstrom full-line stores, off-price Nordstrom Rack stores, Jeffrey’ boutiques, and Last Chance clearance stores; and its online store, nordstrom.com, as well as through catalog. Nordstrom, Inc. also provides a private label card, two Nordstrom VISA credit cards, and a debit card for Nordstrom purchases. The company’s credit and debit cards feature a shopping-based loyalty program. As of June 02, 2011, it operated 214 stores located in 29 states. The company was founded in 1901 and is based in Seattle, Washington.
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Click the Nordstroms stock chart below for a larger view.
Friday, June 24, 2011
How to Set Protective Stops Using the Wave Principle
The 3 simple rules of Elliott wave analysis can help traders manage risk, ride market trends and spot price reversals
The 3 simple rules of Elliott wave analysis can help traders manage risk, ride market trends and spot price reversals.
EWI's Chief Commodities Analyst Jeffrey Kennedy values the Wave Principle not only as an analytical tool, but also as a real-time trading tool. In this excerpt from Jeffrey's free Best of Trader's Classroom eBook, he shows you how the Wave Principle's built-in rules can help you set your protective stops when trading.
Over the years that I've worked with Elliott wave analysis, I've learned that you can glean much of the information you require as a trader - such as where to place protective or trailing stops - from the three cardinal rules of the Wave Principle:
1. Wave two can never retrace more than 100% of wave one.
2. Wave four may never end in the price territory of wave one.
3. Wave three may never be the shortest impulse wave of waves one, three and five.
Let's begin with rule No. 1: Wave two will never retrace more than 100% of wave one. In Figure 4-1, we have a five wave advance followed by a three-wave decline, which we will call waves (1) and (2). An important thing to remember about second waves is that they usually retrace more than half of wave one, most often making a .618 Fibonacci retracement of wave one. So in anticipation of a third-wave rally - which is where prices normally travel the farthest in the shortest amount of time - you should look to buy at or near the .618 retracement of wave one.
Where to place the stop: Once a long position is initiated, a protective stop can be placed one tick below the origin of wave (1). If wave two retraces more than 100% of wave one, the move can no longer be labeled wave two.
Now let's examine rule No. 2: Wave four will never end in the price territory of wave one. This rule is useful because it can help you set protective stops in anticipation of catching a fifth-wave move to new highs. The most common Fibonacci retracement for fourth waves is .382 retracement of wave three.
Where to place the stop: As shown in Figure 4-2, the protective stop should go one tick below the extreme of wave (1). Something is wrong with the wave count if what you have labeled as wave four heads into the price territory of wave one.
And, finally, rule No. 3: Wave three will never be the shortest impulse wave of waves one, three and five. Typically, wave three is the wave that travels the farthest in an impulse wave or five-wave move, but not always. In certain situations (such as within a Diagonal Triangle), wave one travels farther than wave three.
Where to place the stop: When this happens, you consider a short position with a protective stop one tick above the point where wave (5) becomes longer than wave (3) (see Figure 4-3). Why? If you have labeled price action correctly, wave five will not surpass wave three in length; when wave three is already shorter than wave one, it cannot also be shorter than wave five. So if wave five does cover more distance in terms of price than wave three - thus breaking Elliott's third cardinal rule - then it's time to re-think your wave count.
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Tuesday, June 21, 2011
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Monday, June 20, 2011
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Are you still a bull after this 6 week selloff? Do you think the markets oversold, and it’s time to start buying again? Do you think the selling is over with? Or do you think the selling has just begun and may continue?
The Dow SP500 and Nasdaq
Chance favors the prepared mind so this week, I don’t have a specific stock pick to buy or sell but index analysis to see the big picture of the markets possible future direction, because for the most part, most stocks follow the broad market. So much for fundamental analysis huh.
Big Wave Riding
Notice the index charts below. Notice the recent 1 2 3 on the charts. These are Elliott Wave patterns. Important Note: The analysis in this article are Minor Waves. There are also longer term intermediate and major waves. Elliott Wave analysis is based on the following. The Wave Principle is governed by man’s social nature, and since he has such a nature, its expression generates forms. As the forms are repetitive, they have predictive value.
The 3rd Wave Is Like a Profit Tsunami If Your Right
3rd waves of the 5 wave Elliott Wave sequence are the strongest, longest, most profitable, and if you’re going against them, have the ability to wipe out your account very quickly. God help you going against a 3rd wave in either direction. 3rd waves are so strong, you never know when they’re over until they have shown the 4th wave. Riding 3rd wave trends in either direction can put more money in your account faster than most other trading methods with the lowest risk and highest reward. 3rd waves are the truest “the trend is your friend”.
Where’s the Support Now?
Notice the charts again. Notice how the index prices have touched or surpassed the orange support areas. Notice the light blue, and dark green support areas on the charts. Remember 3rd waves are the strongest and longest in the Elliott Wave sequence. Where do you think support will be once the 3rd wave is done? Is it where prices are right now in the orange areas or is it lower in the light blue or dark green areas? Notice the STF indicator. The STF is showing the indicator below and outside its normal band line range. As long the STF indicator is below the lower band line of its normal range shown, consider the downtrend intact and prices going lower. If the STF indicator moves above the lower band line, a reversal may be in the works heading up into a 4th wave. Once the 4th wave is formed, then prices should normally head back down into an ending 5th wave which can be one point to many points above or in this case below Wave 3.
Fast Profiting from 5th Wave Completions
Normally once the 5th wave is complete, it normally retraces most all of the advance or decline in this case, to about the area where Wave 1 was formed. After that the market could move up or go back into a reversal again and head downward again. In my opinion, I’m looking for a longer term downtrend for various reasons. Once this 5th wave downtrend is complete, normally the potential exists for a low-risk high-reward buy long for a quick short term pop. I do it all the time with forex on 15 minute chart day trades and sometimes 1 hour chart swing trades. In short ending 5th waves can provide quick fast profitable reversal moves, providing you can successfully analyze a 5th wave ending. Analyzing Elliott Waves manually is one way, but using Elliott Wave trading software is much easier in my experience where you can cross check everything quickly with the help of other confirming indicators.
Elliott Wave Analysis or Other
Whether you believe in the Elliott Wave trading investing method or not, one look at these charts can still tell you a lot. There has been a downtrend for the last 6 weeks. The “sell in May and go away” cliché came true this year again. When and where is support now for buying long? Or when and where is it a good time to short-sell if you want to? How can you profit with as lowest risk and highest reward as possible? My analysis above will help you with those questions. I’ll leave the final analysis up to you since it’s your money, and provide you some additional Elliott Wave analysis links at the bottom of the page for your review.
Click the chart images for a larger view.
DJIA Support – Current Price and 11662.24 to 11623.50 and 11138.68 to 11129.64
SP500 Support – Current Price and 1257.28 to 1253.87 and 1212.15 to 1209.60
Nasdaq Support – Current Price and 2492.18 to 2479.61 and 2384.10 to 2371.53
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Friday, June 17, 2011
Six Straight Weeks of Decline Take DJIA Below 12,000: What Now?
Before blaming falling stocks on the most recent weak economic reports, let's check some dates
As of June 10, the Dow has suffered the "longest losing streak since the fall of 2002. The market's last seven-week stretch of losses began in May 2001, as the dot-com bubble deflated," reports The Associated Press.
As for why stocks are falling, most observers agree: Blame "weaker hiring, industrial output, and a moribund housing market." The economic reports from the past two weeks made that clear.
But wait a minute. The DJIA didn't top in the past two weeks -- it topped on April 29. At the time:
U.S. unemployment benefit applications had been trending down/flattening. In fact, "The unemployment rate fell last month in more than 80% of the nation's largest metro areas," said an April 27 AP report.
U.S. industrial output was up. In fact, "both the Philly and N.Y. Fed reports show[ed] improving manufacturing and business conditions." (Reuters, April 15)
As for the U.S. housing market, it officially entered the "double-dip recession" zone only on May 31, a month after the Dow's April 29 peak.
This is not to say that unemployment, manufacturing and real estate were peachy in April. But the worst of the reports from those areas of the economy only came after the stock market had already entered the decline. The most recent weak economic reports hardly explain why stocks topped when they did.
If you're looking for a better explanation, consider an Elliott wave perspective: The economy doesn't lead the stock market -- it's the stock market that leads the economy.
Skeptical? Then think back to 2007. "Goldilocks economy," strong corporate earnings, unemployment at 4.4% -- nothing but blue skies ahead. The Dow rallies to an all-time high above 14,000 in October 2007 -- and over the next 18 months goes on its biggest losing streak in 70+ years, falling 54% and ushering in "the Great Recession."
Now fast forward to March 2009. The Dow has crashed below 6,500; unemployment has more than doubled; the desperate Fed has dropped interest rates to 0%; foreclosures; bailouts; consumer confidence at an all-time low; general state of near-panic. The Dow bottoms on March 6, 2009, and stages a powerful two-year rally above 12,000.
By conventional logic, you'd have to agree that, paradoxically, "the good economy" of 2007 prompted the deflationary crash, while "the bad economy" of 2009 sent stocks flying.
But here's an explanation that actually makes sense: Broad market trends are not created by the economic conditions -- social mood is what creates them. Social mood doesn't depend on what Ben Bernanke had for breakfast -- it changes for endogenous reasons, and those changes follow the Elliott wave model. Stocks lead the economy because they are quicker to register changes in social mood.
For the latest on that, see the just-published, June 10 issue of our Monday-Wednesday-Friday Short Term Update. And don't miss the longer-term analysis in the new Elliott Wave Financial Forecast and Bob Prechter's Elliott Wave Theorist. All three can be on your screen in seconds via a risk-free subscription to this comprehensive package. Details >>
Before you make investment decisions based on the latest economic report, be sure to read the 2011 edition of The Independent Investor eBook by Elliott Wave International. You will see example after example of the fallacy to the belief that economic conditions direct the moves in the stock market.
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Tuesday, June 14, 2011
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Monday, June 13, 2011
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The market has been due to head lower for quite some time now, and now it has happened. Now we will see if it continues lower long-term or not. There’s lots of debate on that topic whether this is a correction or a larger double dip coming. In my opinion, the upside looks to be much more risky than the downside right now. This week I've got a short sell on AutoNation.
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Near Term Index Support Levels
Dow Jones – 11666.13 to 11625.70, 11170.87 to 11130.44
SP500 – 1257.34 to 1254.27, 1212.49 to 1209.63
Nasdaq – 2637.84 to 2624.74, 2493.68 to 2480.24, 2386.18 to 2372.74
According to Zacks Investment Research AutoNation Inc Ticker AN reported a 15% fall in new vehicle sales to 16,347 vehicles in May due to shortages in supply of vehicles, especially from Japan that accounts for 52% of its sales. The Japanese automotive industry has been hit hard by the earthquake and tsunami on March 11 that damaged many parts supplying companies’ plants, leading to a parts shortage.
Sales of the Domestic brands, which comprise of stores that sell vehicles manufactured by General Motors, Ford Motor Co., and Chrysler LLC, inched up 3% to 5,995 units.
Sales of the Import brands, comprising stores that sell vehicles manufactured primarily by Toyota Motor Corp., Honda Motor Co. and Nissan Motor Co., slashed 30% to 7,110 units. The twin disaster in Japan led many automakers to suspend or cut back production at their plants on the back of parts shortages, leading to dearth of vehicles supplied by them.
Meanwhile, sales of the Premium Luxurybrands, comprising stores that sell vehicles including Daimler AG’s Mercedes Benz, BMW and Toyota Lexus, increased 1% to 3,242 units.
AutoNation’s sales decrease was more pronounced than the overall sales decline in the U.S. during the month under study. Last month, auto sales in the U.S. dipped 3.7% on a year-over-year basis to 1.06 million vehicles. It has touched the lowest rate in 8 months since 11.76 million vehicles recorded in September 2010.
AutoNation, a Zacks #3 Rank (Hold) stock, posted a profit of $70.3 million or 46 cents per share in the first quarter of 2011, compared with $58.8 million or 34 cents in the year-ago period. With this, the company exceeded the Zacks Consensus Estimate of 43 cents per share.
Total revenues amounted to $3.31 billion, up 16.5% from $2.84 billion last year led by massive rise in new and used retail vehicle sales. Reported revenues also surpassed the Zacks Consensus Estimate of $3.23 billion. Operating income improved to $140.0 million from $115.1 million a year ago.
New vehicles added $1.79 billion to total revenues, up 22.6% from last year’s $1.46 billion. The retailer’s new vehicle sales rose 22.8% to 55,710 units, transforming into revenues of $32,043 per vehicle, a marginal decrease from last year’s $32,209. However, the company expects new vehicle sales of 12 million units for full year 2011, given the supply constraints from Japan.
Sell Short AutoNation – Ticker AN
Sell Entry: 35.79 to 33.00
Take Profit Areas: 31.97 to 31.62, 31.17 to 30.82, 28.67 to 28.32, 23.89 to 23.58
AutoNation, Inc., through its subsidiaries, operates as an automotive retailer in the United States. It offers various automotive products and services, including new vehicles, used vehicles, parts, automotive repair and maintenance services, and automotive finance and insurance products. The company also provides a range of vehicle maintenance, repair, paint, and collision repair services, such as warranty work. In addition, it arranges financing for vehicle purchases through third-party finance sources. Further, the company offers various vehicle protection products, including extended service contracts, maintenance programs, guaranteed auto protection, tire and wheel protection, and theft protection products. As of December 31, 2010, it owned and operated 242 new vehicle franchises from 206 stores located in metropolitan markets, primarily in the Sunbelt region of the United States. The company was founded in 1991 and is headquartered in Fort Lauderdale, Florida.
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Monday, June 06, 2011
Friday, June 03, 2011
Market Sentiment and Volume Reach Extreme Panic Levels
It was a crazy session as the stock market slid over 2% on heavy volume. This type of price action means fear has taken control of masses and they are unloading (selling their stocks) in anticipation of much lower prices.
Trading off extreme levels of fear can be very rewarding if done right. That’s because fear is the most powerful reaction we as humans have and it’s somewhat predictable. Fear can make people do crazy and or stupid things and it’s these extreme reaction which investors do in the market that lead to great trading opportunities. Buying into fear and selling into greed is what I focus on.
Gold and Silver Showing Greed and Fear
For example, if we take a look at the 4 hour chart of gold and silver you will see how investments which have a large amount of speculation like Silver move the opposite to what other related investments like gold are doing.
The first chart which is gold, shows how today’s fear had investors moving into this shiny safe haven. Silver on the other hand has been the investment of choice for every Tom, Dick and Harry trying to play the popular headline investment. So on a day like today when prices start to slide in the stock market these speculative holders of silver get scared and dump (sell) their position in stocks and silver. The problem with silver is that the market is still small and its does not take many people hitting the sell button to send it 5% lower which is what took place today. This is one sign which is telling me traders are getting scared of a market selloff.
Evidence #2 Showing Signs Of Fear
These data points below clearly show sellers were in control today. I like to look at the NYSE because it holds all the big brand name stocks which the masses like to buy when they feel lucky. So when I see this many traders selling and so few buying I know the masses are dumping shares and going to a cash.
The NASDAQ had 10 shares being sold to every one share being bought which is half the fear level of what the NYSE and that makes good sense. The NASDAQ has many smaller companies which the masses just don’t know about or own so there was not as much selling taking place on that exchange. So brand name stocks getting dumped all at once is another sign of extreme fear hitting the market.
Evidence #3 Showing Signs Of Fear
This chart below provides the momentum of the market. I think of it as the rubber band effect. If the market selling momentum is strong enough then it pulls this indicator down to a level which it cannot go much further before it gives way and moves back a neutral or positive extreme level. This little hidden gem of an indicator can help time entry and exit points with ease once you understand it. Currently its telling us that a pause or bounce is likely to happen tomorrow.
Evidence #4 Showing Signs of Fear and an Oversold Market Condition
Take a look at the 10 minute SPY (SP500) chart below. Simple visual analysis shows that today’s strong selling which has brought the market down into a support zone should provide a pause or a bounce very soon. The question is how big will the bounce or rally be?
Given all the confirming is looking ready for a bounce and I feel we could be nearing not a bounce but an intermediate bottom and higher prices going forward. But if we break strongly below this support level then all bets are off and much lower prices should occur.
In short, the sharp move lower has put the market in a short term oversold condition. Meaning, a bounce is very likely to take place within the next 1-3 sessions. With the masses selling all their positions in stocks and commodities it generally takes 1-3 days after a day like this for the selling pressure to dissipate and for value buyers to step back into the market providing support.
I think both stocks and commodities will strengthen in the next few days and we will see if the market can get some traction and start a new rally. But until everyone has sold out of the market giving their shares to the big money (smart money) at a sharp discount I feel we have a rough road ahead.
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Thursday, June 02, 2011
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Elliott Wave International (EWI) has just released a free 10-page trading eBook: How You Can Find High-Probability Trading Opportunities Using Moving Averages, by Senior Analyst Jeffrey Kennedy.
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Founded in 1979 by Robert R. Prechter Jr., Elliott Wave International (EWI) is the world's largest market forecasting firm. Its staff of full-time analysts provides 24-hour-a-day market analysis to institutional and private around the world.
Wednesday, June 01, 2011
The Power of Back Testing
by Ken Long of Van Tharp International Institute of Trading Mastery
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Traders typically have some firm beliefs on back-testing. Some believe it’s required, others think it’s useful, and there’s a group that thinks back-testing is a way to fool yourself. I’ll give you some of my thoughts on why I believe that back-testing is a crucially important aspect of understanding your system. Even an experienced trader should carefully consider the results of a detailed back-test when taking on a new strategy or operating in a new time frame so that he or she is not misled. I’ll also provide some of my views on the limitations of back-testing because they are significant and not to be overlooked.
Back-testing can take many forms: on trading platforms, in back-testing software, on paper, over long periods of time or only in specific market types. Rather than spending time considering the types of back-testing, however, I think your level of back-testing is a more important consideration.
In some cases, experienced traders may only need minimal back-testing to be convinced that an idea is worth trading with live money at a reduced risk level if it is similar to systems previously traded that were reliable. In other cases, they may want to fully check out a new idea before trying to trade it live—even with small position sizes.
Properly constructed, back-testing will identify whether or not an idea has a persistent edge and under what conditions that edge will manifest. By properly controlling different parameters, we can isolate the ones that add the most value to this particular proposition. We can test for robustness and see how sensitive the edge is to changing parameters.
We may be able to identify specific market conditions where the edge is significant and tradable. We may be able to identify a subset of the total market trading targets in which this idea works best.
A particular edge may not convince some people unless they see it work over multiple time frames, in multiple markets and in all different market conditions. Others are satisfied that an idea only has to work within the definable set of parameters to be tradable. This is a matter of beliefs and personal taste as back-testing is not an academic exercise in the pursuit of the absolute truth. We’re traders, we want to make money.
What Back-testing Can Tell Us
Back-testing should tell us the likely win rate percentage, the importance of slippage and commissions, the trading frequency, the maximum adverse excursion, the longest normal winning and losing streaks, and the maximum and average figures for both wins and losses.
One of the most important result sets for analysis is the distribution of results in the form of a frequency histogram. We would like to see a somewhat normal distribution that has most of the trades clustered around the mean with an orderly profit tail to the right that suggests we have the possibility of large winning trades. We would also like to see a carefully controlled left tail of losses, which suggests that we are able to engineer our risk carefully.
Under these kinds of conditions and looking for this kind of information, back-testing is an important part of the trader’s repertoire. Having robust back-test data in hand allows us to determine where, when and under what conditions this idea is tradable and the expected results. When we proceed into live market trading as a prototype system with reduced real risk, we can then compare actual results with live money to see if the trade can be managed as intended.
Limitations of Back-Testing
As much as back-testing can reveal, it can also fail to reveal that one overlooked truth can be mortally dangerous for traders. Back-testing results provide historical performance but they do not forecast how a system will perform now. This is perhaps the biggest challenge with back-testing.
Even if a trader performs a rigorous back-test with full knowledge of the limits of its ability to forecast into the future, it's common to see a large discrepancy between back-test results and actual results from live trading. This phenomenon has several potential sources. Sometimes, back-tests are conducted in isolation and not as part of a full portfolio of strategies. Often back-tests may use optimistic values (though they may have seemed realistic at the time) for slippage and commissions. Many times back-tests are simply unable to integrate the human dimension of executing a set of trading rules. Experience shows me that this is perhaps one of the most important aspects overlooked when evaluating back-testing results.
Regardless of the reasons, some traders place so much reliance on their back-testing that very different live trading results fail to convince them they missed something important in their back-test. They might persist in trading a system that will simply not work in the real world. This situation illustrates the combination of an overconfidence bias and the need to be right.
Professional engineers and doctors are especially prone to this problem because of their belief systems and testing experiences from their previous professions. Those professions place a premium on being right to be successful. Yet in trading, the ability to act with incomplete knowledge and the willingness to be wrong can lead to excellent trading results.
Also, there is always a real danger of curve fitting and data mining to find a perfect system that would have worked with an exact set of market conditions in the past. The obvious predicament that thinking poses is that those conditions can never occur again in the future. Perfect fit system thinking neglects the reality of the market as a complex adaptive system that never shows you the same face twice. It also exposes the problem of over reliance upon the power of computation.
Back-testing offers many powerful advantages to the professional trader. At the same time, it must be undertaken with full recognition of the limits of its usefulness. The professional trader will take back-testing results into consideration as a way to select particular systems to prototype. In the prototype phase, the trader fully engages real money, real markets and the human factors where you can generate real world results. If the real world results prove attractive, then you can commit the system to full position sizing methods or “full production mode.”
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