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Trading
Spoilt for choice - when there are too many stocks to buy and sell
Jeff Cartridge - August 07, 2008
 One of the key problems with any signal to buy or sell is that there are too many opportunities available. In the markets we are spoilt for choice. It does not matter whether the signal is a candlestick pattern, an indicator or a chart pattern that is used to make your entry and exit decisions. How does a trader determine the signals to follow and those to avoid?
With BHP in the chart below there is an inside day or bearish harami pattern at both of the recent peaks. This would appear to be a strong signal to exit from the share as substantial drops occurred each time after this signal. It is important to understand that just because an idea works once or twice does not make it the perfect trading strategy.
 Van Tharp talks about the idea of the well chosen example where a chart is chosen to illustrate a point. It is always possible to find these charts in hindsight and could involve searching through hundreds of charts to find the one example that illustrates what the writer or the presenter wants to put across. To overcome this bias it is important to search for false positives, i.e. examples of when the pattern was present and the outcome was not what you expected.
The same signal appeared 23 times in BHP during the last 12 months and we can now assess the signal and its usefulness as a trading strategy on BHP. Some of these appearances will have delivered profit and some will have been false positives. Does this signal provide a profitable trading opportunity?
When we look at each of the trades we find that of the 23 possible trades 13 of the trades resulted in BHP going lower and 10 resulted in BHP going higher. The false positives occurred 10 times when the signal was followed by BHP climbing higher. The success rate of following all the signals is 57% which is slightly better than random, but not significantly so.
During the next seven days from the signal BHP dropped, on average, to a low of $1.76 below the entry point with the largest drop in seven days being $4.51 and the smallest drop being just $0.99 cents. The risk reward of the trade stands at 3.9:1 which certainly shows a clear downside bias.
If we were to short sell BHP every time we got an inside day signal and exit at the lowest point in the next seven days (an impossibility) we would be right almost six out of ten times and make 3.9 times the amount at risk. Overall this would be a profitable trading strategy; however we could not execute it as we do not know in real time what the lowest price will be in the next seven days. It does however show that there is a clear bias for BHP to fall after an inside day signal.
Developing this idea further what if we only took the trades where BHP broke down the day after the inside day. The low of the next day must be lower than the low of the inside day. This would ensure that we only took short trades when the trend did actually change and would improve the results of our strategy dramatically. The number of trades is now reduced from 23 down to just 11 trades.  We also will need to apply an exit signal to complete our trading strategy. Consider a very simple exit; buy at the close 3 days after we enter the trade. Now our success rate jumps dramatically. This simple trading strategy is profitable on 82% of the trades and has a risk reward of 1.51 and an average profit of 0.78%. No stop loss has been employed in obtaining these results, but this confirms the bias that we found earlier that BHP tends to drop after an inside day. Adding a stop loss at 3.5% to cover an extreme move against the position would not be triggered by any of these trades and the results remain the same as shown. A stop loss of 2.5% maintains the same win% and reduces the profitability of the strategy. 
An alternative exit that could be used is the bail out exit from Larry Williams. This exit takes the first profitable open as the exit signal and hence locks in any profit that is achieved. Applying the same entry criteria as above we will get the same number of trades, however the results will look different. All trades will be exited for a profit if no stop loss is used. The average gain increases to 0.93% and the risk reward cannot be calculated as no losses occur. A stop at 3.5% would allow a trader to get these results, but tightening the stop to 2.5% reduces the win% back to 82% and the risk reward down to just 0.82.
Based on the data we have analysed there is a potentially profitable trading strategy utilising the inside day as a sell signal for a short trade. When this signal is coupled with a breakout in the direction of the trade this becomes a high probability trading strategy and delivers good returns utilising either of the two simple exit strategies outlined above. Couple this strategy with sound risk management and you have a trading idea that is likely to deliver you profitable results.
To effectively trade this strategy it would be easiest to use a CFD to short sell BHP and the leverage would make the most of the small gains you are taking. Alternatively a different exit strategy could be used to allow you to hold the position for a longer period of time. And always remember a signal on its own or a well chosen example does not make a profitable trading strategy.
Jeff Cartridge is the author of Supercharge Your Trading with CFDs. For more information go to www.superchargedreturns.com.au. Please note that the views expressed here are those of the author, not of CompareShares. Although all investing has some form of risk, CFD trading strategies are only for experienced traders and risk management strategies must be considered.
Whatever your views, you can discuss this article - or any of Jeff's articles - on our message board Your 2 Cents.
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Ask the expert – Share Trading: Top 5 pointers to being a successful trader and how to avoid stuffing up
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