How do I Increase My Odds of Success?

The focus of the Seasonal Forecaster newsletter is on high probability trading, which is more of a philosophy than a specific strategy. It involves trying to increase the odds of success, and the overall returns over time, on the whole process from trade selection through trade closure.

Sometimes in the newsletter I go through the whole thought process, sometimes I abbreviate it so I don't send out a mini-novel three times a week. But like a good professor who repeats, repeats, and repeats until the students can't possibly forget the lesson, it is time for me to once again go through the whole process on a trade candidate.

Short trades are an occasional necessary evil, but since stock markets in general have an upward bias, I concentrate on identifying top quality stocks, ideal for bullish trades, that are good for short-term trades. Over the years, I've developed a large watchlist (about 600 stocks) of quality stocks, picked from Investor's Business Daily articles and lists, Mergent's Handbook of Dividend Achievers, and other sources. I've gotten to know the characteristics of most of my watchlist stocks, and that is one of the biggest common denominators you'll find when reading about very successful traders – they get to know the stocks they trade inside and out, and they trade the same ones over and over.

While I make and maintain smaller, more focused watchlists, I try to regularly look at the charts of all of my large watchlist stocks, but especially the ones that I've had multiple successful trades on in the past.

This weekend, one stock that I've written about a few times recently caught my attention – Harley Davidson, symbol HOG (see the 3/3/2014 and 5/5/2014 Seasonal Forecaster newsletters). Sometimes I start with fundamentals or earnings-related news, sometimes with charts, and sometimes with seasonal analysis, but no matter what initially catches my attention, the investigative process is the same.

This time, it was HOG's daily chart that jumped out at me. Harley-Davidson's January earnings report was in line with expectations, and the April announcement was 12% higher than expectations. HOG has since drifted sideways, a not unusual situation after previous earnings announcements. But HOG stayed above the 50-day moving average, and on Friday closed above a two-week tight trading range.

So technically, this is a higher probability chart setup. A stock with good fundamentals has gently pulled back to its 50-day MA and is starting to rebound. No setup though is ever perfect. It would be preferable to see more volume on Friday's rebound. If the overall market heads south, this (and most other) stocks will likely follow. But given a chance, this setup alone should slightly increase the odds of success.

The next consideration is whether there is any indication of current institutional interest in this stock. Stocks don't move upwards if there isn't an imbalance between buying and selling, and the biggest imbalances come from institutional trading. Is there any evidence this stock is being ‘accumulated'?

One way to determine this is to use the On Balance Volume (OBV) chart indicator. A quick check of HOG shows OBV has been rising steadily since February, an indication of net buying in the stock. Investor's Business Daily has two ratings it assigns stocks – the Accumulation/Distribution rating, and the Up/Down Volume Ratio indicator. IBD's Acc/Dis rating is currently a C- on the stock. But I usually follow their other indicator, the Up/Down Volume Ratio, calculated from the volume on up-close days divided by the volume on down-close days. From experience I have found that an U/D Volume Ratio of 1.3 or greater often accompanies stocks that are under accumulation by institutions.

IBD prints just the current value of the U/D Vol Ratio. But I keep track of and chart it over time and look for patterns. For example, like OBV, HOG's U/D Vol Ratio has been increasing since February is now at 1.3.

Now what if the stock has a seasonal pattern? Why would it? The company may be in a line of business sensitive to weather cycles, or it may be in a business sensitive to the time of year, like retailers that sell back-to-school items or holiday gifts. This company, Harley-Davidson, sells a product (motorcycles) that at least in North America, do not ‘fly off the shelves' in winter months. So smart institutional traders will ‘trade the sales cycle', meaning they regularly buy the stock each spring in anticipation of increasing earnings for the summer and fall reporting periods. We don't want to trade against a strong historical tendency of institutions to sell off the stock. In this case, we expect a strong positive seasonal pattern, which would be in line with our expectations for the stock movement.

We are not disappointed. Looking at the seasonal table for the next several months, we see that is doesn't appear to matter much if we enter a long HOG position now, or sometime within the next few weeks. But after that, the historical tendency is for gains, especially over the next 8 weeks:

From experience, and common sense, I find the highest success rates for new trades is when the historical track records shows the highest success rates. If we are thinking of an 8-week trade, we'd of course like to see a track record of gains in 100% of the previous years over that same period. Of course, very seldom do you come across a 100% track record. I look for a minimum of 12 years of track record, and the percentage of years with gains over a certain time period should be 70-75% or higher.

With HOG, the 9-week period looks interesting, as the best near-term combination of average annual return and success rate. Let's look at the variability of the track record. If there is wide variability of individual years, the track record becomes suspect.

HOG's 9-week track record is not as consistent as I would like. But overall, the average gains have been higher than the losses.

The implications of the above seasonal analysis may not be immediately obvious. So let me state it a different way. Say you figured out, 27 years ago, that this new stock, HOG, would likely be sensitive to the time of year, and you decided to buy the stock starting at the 2nd week of June, and sell it 9 weeks later. You were so confident of this system, you decided you would use a 20% stop-loss, basically a ‘catastrophic' stop-loss – you wanted to give the stock some room to move, but not be ‘stopped-out'  due to minor movements. This would show the overall tendency of the stock. The theoretical results of your ‘HOG trading system', after 27 years, would be:

Now look at the above results and compare them with other ‘systems' you have tried in the past. The average gain was 15.6%, the average loss was 9%, but with the 2-to-1 success rate, the average gain per trade was 7.4% (remember these trades last only 9 weeks, so that is a 48% annualized rate-of-return). You would have a 199% return from the original amount you risked (without compounding). More importantly, there were never 2 or more consecutive losses. The worst drawdown was 20%.

In practice, a prudent trader would use a tighter stop-loss, as well as a ‘filtering' of trade entries and exits, depending on current conditions. But the above analysis shows the underlying stock is an appropriate vehicle for a bullish trade this time of year. Picking a stock with a historical track record like this is another step towards increasing the odds of success.

At this point I'm thinking that buying the stock or entering one of several possible option strategies makes sense. But I can still increase the odds of success on this trade even more by picking the right trade-management strategy. I can buy the stock (or enter a bullish option position) and implement a stop-loss strategy. That will limit the losses if the trade doesn't work, but give the stock enough ‘wiggle room' to prove itself first, if the stop-loss level picked is appropriate for the current volatility of the stock. I can enter a covered-call trade to lower the cost basis, again allowing the stock some wiggle room.

The next step to increase the odds is to decide on an exit strategy before entering the trade. I could just let the position ‘ride' and see what happens. Once the stock starts moving upwards, and the profits are increasing, I could implement a trailing-stop strategy where I will sell the stock if it falls back some percentage from the highest high since entering the trade. Again, the appropriate trailing-stop should be matched to the volatility of the stock.

But if I pick a profit target, a price level or percentage gain based on chart analysis or seasonal/historical track record, it is likely that more of my stock trades will turn out winners. Yes, I may give up some profit that I could have made, if I was able to see into the future and know exactly when to exit a trade. But often, traders allow a profitable position to turn into a loss because they stay in the trade too long. Like meat and dairy products on supermarket shelves, think of every trade as having an expiration date. Stocks cycle up and down. At some point the trade will go bad. We need to aim to be out of every trade before the odds increase that it will go bad.

We've all heard the point made that if you suffer a 50% loss in a trade, you will need to make 100% on the next trade just to get back to even on your account. How likely are you to make 100% on a trade? Well, how often have you done it in the past? It is far better to prevent as many losses to begin with, even if that means not making maximum possible profit. So picking a reasonable profit target is another way how to increase the odds of success of the trade.

The chart pattern may have an obvious resistance level that would make a good profit target. In the HOG chart above, we see that HOG set a new all-time high after breaking upwards from the April earnings announcement. But the stock twice tried to extend above 74 and could not. That is now a resistance level and could be a reasonable profit target. But it would be only a 2.9% gain for HOG to reach 74. The seasonal track record shows this stock is quite likely to do better than 2.9%, so it might make sense to aim for a 6-10% target. Looking over the past year or two of HOG's daily chart, I find that when HOG rebounds off a short-term low, it often is advancing 10% or more. An initial profit target of 8% is somewhat arbitrary, but makes sense. I can always adjust it in the future as the stock moves and I get an indication of how strong it currently is.

Back to the expiration date comment above, I can also implement a ‘time stop' on the trade. This is especially important with option trades, which are sensitive to the time remaining before expiration of the component option contracts. In essence, I will say to myself, “if this trade doesn't prove itself by making at least 3% over the next 3 weeks, then this isn't the right time for this trade”. So a time stop is another way to increase the odds of success on a trade. It tends to weed out the non-performers and allow recycling non-producing funds into possibly profitable new positions.

There are still more ways to increase the odds of success once in a trade. I can add to a position if the stock is moving up strongly and steadily from consistent buying (analysis of the chart and volume patterns helps with this). For a better picture of how this works, read my article Trading High Price Stocks And New Highs.

Summary

The point is that you should think about how to increase the odds of success of each and every trade you make, every step of the trade. I will save you a lot of time by doing the initial analysis of trade candidates for you in the newsletter. And I will propose trade strategies that will increase your chances of success. But you need to be diligent about following through on each trade you enter. Watch every position closely and follow your original plan for the trade.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, please click on the following link: www.markettamer.com/seasonal

(Note: There is an important qualification on the potential HOG trade in today's newsletter)

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2014 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com with extensive experience in the financial sector.

Gregg started out as an Engineer and brings a rigorous thinking to his financial research. Gregg's passion for finance resulted in the creation of a real-time quote system and his work has been featured nationally in publications, such as the Investment Guide magazine.

As an avid researcher, Gregg concentrates on leveraging what institutional and big money players are doing to move the market and create seasonal trend patterns. Using custom research tools, Gregg identifies stocks that are optimal for stock and options traders to exploit these trends and find the tailwinds that can propel stocks to levels that are hidden to the average trader.

The content on any of Market Tamer websites, products, or communication is for educational purposes only. Nothing in its products, services, or communications shall be construed as a solicitation and/or recommendation to buy or sell a security. Trading stocks, options, and other securities involve risk. The risk of loss in trading securities can be substantial. The risk involved with trading stocks, options and other securities are not suitable for all investors. Prior to buying or selling an option, an investor must evaluate his/her own personal financial situation and consider all relevant risk factors. See: Characteristics and Risks of Standardized Options (http://www.optionsclearing.com/publications/risks/riskstoc.pdf). The www.MarketTamer.com educational training program and software services are provided to improve financial understanding.

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