Basics Trading Strategy

Before description of the Basics Trading Strategy let us tell a few words about some fundamental principles of stock trading theory.

Basics of Stock Trading

We consider short-term (2 - 5 days) stock trading strategies. All profitable strategies are based on the following golden rules:

• Develop a winning strategy and trade often. A small daily profit can provide a large annual return.
  Example: if the average daily return is equal to 0.3%,  it will provide an annual return of 113%.    (1.003 ^ 252 = 2.13)
  
  
• Trade only stocks with the highest growth probabilities. Do not hold stocks when their probabilities of growth are close to the average value. Switch to more profitable stocks. 
  
  
• Be sure that expected return is larger than the transaction cost (bid-ask spread + brokerage commissions).
  
  
• Avoid risk as much as possible. Do not put all your trading capital in one stock. Diversification is the only way to survive in the market.
  
  
• Winning strategy is a strategy with the lowest risk/return ratio.

Risk and Return

You cannot be a winner in every trade you make. Any trading strategy must leave room for some losses. Your returns may be positive or negative. Figure 1 shows returns per trade for one of our trading strategies for the year 1996.

Figure 1.  Returns per trade (in %) in 1996 for the first stock selected using the Basic Trading Strategy. 
 The dashed line shows the average return per trade (3.64%).

You can see from this figure that returns were mostly positive. However, 29% of trades had negative returns. This number reflects the risk of trading. Risk of returns is the standard deviation of the set of returns for given period of time.

You can calculate the standard deviation by using any spreadsheet program. To illustrate the definition of risk let us show the distribution of returns.

This Figure presents the distribution (histogram) of returns per trade for data from Figure 1.  These returns are pure returns - no transaction costs have been considered. The standard deviation is a characteristic of the distribution width and is equal to 6.9%. It is clear that the larger the standard deviation, the larger the probability of losing money. This is why the standard deviation of the set of returns is considered as risk.

As we mentioned before a good trading strategy must have a small risk/return ratio. We found some strategies with small values of this ratio. One of the best is the Basic Trading Strategy.

Basics Trading Strategy

Short Description
Every day after market closing  (day #0) we perform market analysis and prepare a list of Potentially Bullish Stocks which are oversold within various time frames. Before market closing on the next day (day #1) we select two stocks from the list with maximum price drop (in %) and buy these stocks. We hold these stocks for two days, and sell them at the market opening on day #4. 

More Details
1. Every day after the market closing we perform the market analysis to generate the list of potentially bullish stocks. Let us call the day of analysis day #0. Tomorrow will be day #1 and so on.

Ope1, Clo1, Ope2, Clo2, ... are the stock prices at market opening and market closing on the corresponding days.

These stocks are partially oversold in the 16 - 32 day time frames.  The stocks from the list may not be oversold on the day of analysis for all possible time frames. We have not taken into account the behavior of these stocks during the last few days. This is why we call these stocks potentially bullish stocks. You can find more details about our stock selection method in E-Book Short-Term Trading Analysis.

2.   Before market closing on day #1 one should check the prices of all stocks from the list and buy two stocks with maximal  %  price drop during day #1. Mathematically, this can be written as

       Clo1/Clo0  ----->  minimal                                             (*)

This condition substantially increases the probability that the selected stocks will be oversold in all important time frames (from 4 days to 32 days).

Note that in this strategy the stocks may rise during trading day #1. The only important thing in this case: their rises should be minimal among the stocks from the list. The equation (*) describes this statement. 

3.   During the next two days (#2 and #3) one should hold the stocks.  At the market opening on day #4 these stocks should be sold.

We have performed computer analysis of this strategy and found a high profitability using this method. An important part of this strategy is dividing the trading capital between stocks.

Days #2 and #3 are the days of holding stocks which were bought on day #1. If we do not buy other stocks during these days we will lose possible profits. So as to be able to buy stocks every day the trading capital should be divided into three equal parts. Every part of the capital should be used to buy two stocks. 

Practical using the Basic Strategy

Please check how a daily trading file looks like. EXAMPLE

Visit our Help and FAQ page to see description of this file. On this page you can also find many tips how to use this file.

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