Episode 11: Further Trading Styles

In this episode I’ll be talking about some of the different styles of trading that our more advanced members use.

Transcript: 

'Successful Trading' - Episode 11: Further Trading Styles

Presented by Jeff Bryant, HomeTrader.

Hello - and welcome to Episode 11 in our series our series on successful trading.
   
Last episode we started to look at some of the more advanced aspects of trading – short selling and using CFDs.  In this episode I’ll be talking about some of the different styles of trading that our more advanced members use.

These are styles that allow our members to broaden their opportunities: Specifically - Mean Reversion and Rotational  Trading.

To recap on trend following - it’s what we call the basic approach. We want to be trading with the trend; with the weight of market opinion. So, on the long side of the market we want the trend to be up. And on the short side when prices are dropping, we look for downtrends.
   
Let’s now move on to Mean Reversion trading. In this style of trading we are looking for stocks that have mean trundling along, one way or the other and then suddenly find themselves pulled away from their normal trend.

For trades on the long side, consider the analogy of the rubber band.  It’s now stretched downwards. That in itself is not enough for us in this style of trading.  We are looking for a further downward stretch of the band.  Given we get this further move down, we then consider the stock has been sufficiently displaced downwards that we can expect it to rebound…  the rubber band snaps back, the price bounces back up.

The price reverts back up towards its mean. Hence the name of this style of trading: Mean Reversion. We’re looking to capture the reversion back up. Mean reversion trading has a number of quite specific characteristics. The trades tend to be very short term – averaging around 4 or 5 days in length. While we are not looking for large profits in these trades, we have seen some very high win rates. 

One of our NSW members commenced his mean reversion trading back in 2008 and started with 16 consecutive winners! Obviously that’s not the norm – but still… expectations for winning trades in mean reversion trading are very high – ranging from 70-80%.

Another feature of this style of trading is that we set profit targets. This is in apparent contradiction to trend following where we find that setting profit targets tends to be detrimental.  This is because in that style of trading we want to let our profits run.

In mean reversion trading, it’s much more ‘smash and grab’, and the profit target is the primary means of exit. Let’s look at an example. Here we have IMF showing clear downward displacement.  All we need from here is that further stretch of the rubber band.  We want he price to drop to the black line.  Should that happen, we will buy the stock.

In our example we do get entry the next day at $1.40. The red indicator above the price shows us where we would take profit.  In this case at $1.62. The next day we get a bounce to $1.49 – not enough for our profit target, but a step in the right direction.At this point we adjust our target.  The red line comes down to $1.59.

The following day, another move up to $1.54 but not quite an exit.  And again, that night we have a minor adjustment to our target.  Day 4 and another move up sees us out at $1.58, gaining us 18 cents – a profit of nearly 13% in 4 days – not bad. That’s Mean Reversion on the long side – buying into the dip, and looking for the rebound.

Mean Reversion on the short side is just the reverse.  Selling into a strong rally, where the displacement is suddenly positive – the rubber band is stretched up.  We then look for profit from the pull-back, or reversion back down towards the mean.

Another style we use is called “Rotational” trading. On the long side of the market, the concept is almost blindingly simple – having defined our  universe of eligible stocks - we want to own the best. We define ‘best’ in terms of the velocity of the stocks.  We want the stocks that have the strongest trend.

We then manage the stocks on a regular basis, periodically reviewing our portfolio.  The ‘rotation’ as we call it, is the interval between reviews. This varies but is mainly weekly, fortnightly or monthly, but can be as short as daily or as long as quarterly or even longer.

In operation, at each rotation, we check the velocity, and if a stock has fallen out of the top bunch (usually 5-10 stocks) we sell it and replace it with what has moved up. The converse applies on the short side where we want to be short the stocks with the lowest trends.

In summary – broadening your ability to trade different styles of trading with different instruments in both directions will significantly improve your ability to increase you returns and smooth out your profit curve.   

As always, if you’d like further information, you can visit our website at hometrader.com.au, and book in to one of our free 2-hour information seminars.