There are two common approaches to trading: trading stocks that are breaking out (championed by
IBD among others) and trading stocks that are pulling back (championed by L. Connors among others).
As a professional statistician, I’ve long been interested in these two
approaches as they apply to fundamentally sound stocks, especially those with
remaining value in their price. My work over the years shows that this select
group is more profitably traded utilizing some sort of pullback
strategy. Let me share an eye-opening example.
The following chart shows the performance of the two investment strategies
over a 479 week period (9.2 years between 12/17/99 and 2/13/09) through both bullish and bearish times. The S&P 500's performance
is included as a benchmark (and the y-axis is a log scale). Each strategy begins with $10,000 and has
a one-week hold period. Over this period, the S&P's equity curve dropped to $5,587, while the first
strategy's equity curve rose to $2,096,347 and the second one dropped to $2,127. So what are these two
strategies that differ so drastically in their performance? Surprisingly, both are trading strategies
limited to fundamentally sound stocks.
Both begin by requiring their stock membership be limited to
those having a Zacks ranking of 1 or 2
(~850 stocks rated as either a strong buy or a buy). Both require their respective picks to be in the
top 50 percent in terms of price performance of this group over the past 24 weeks and, from that group,
the top 50 percent price performance over the past 12 weeks. The two then differ in their fourth
requirement: the strong performing strategy picked the worst 10 performers over the past week (often
those in strong pullback), while the weaker performing strategy picked the top 10 performers over the
past week (breakout and strong momentum risers). These are both sets of fundamentally sound stocks that
have performed well over the past three and six month periods then either pulled back for the last week or
continued their strong run higher.
Those ten exhibiting the worst pullback each week outperformed the next
week: taking their equity curve from $10,000 to $2,096,347. The second group, by contrast lost over 75 percent
of the original $10,000. No doubt, if you had stayed in the trade longer this second group might have performed
better, but I think this is clear evidence that entering on a pullback is far superior to entering on a breakout
for the short-term trader.
Larry Connors’ group has written much about the usefulness of the two-period RSI for qualifying stocks and
ETFs in pullback. Its formula simplifies to
RSI(2) = 100 * Adv(2) / (
Adv(2) + Dec(2) )
where Adv(2) and Dec(2)
are the average advance and declines in price change over the
two periods expressed as absolute values. After three price data, if price
advanced both times, RSI(2) = 100; if it declined both times, RSI(2) = 0;
and if it advanced once and declined once, RSI(2) = the percentage
advancement.
Thus, RSI(2), in calculating
the percentage price
advancement over the past two periods, is a measure of the extent of
breakout (high percentages) or the extent of pullback (low percentages).
Multiple, consecutive down or up trends in RSI(2) is a measure of the
extent of the pullback or breakout.
In this study, one to four consecutive daily RSI(2) values falling below 25 were used
as a trigger for a buy and, once the trade was entered, a RSI(2) value greater than 70
was used as an exit signal. All entries and exits were made at the close of the day.
Twenty stocks were chosen to demonstrate these strategies executed between January first
and July seventeenth of this year. The 20 were fundamentally sound stocks with value remaining
in their price, as determined by a series of fundamental screens and their, respective PEG ratios.
Each had been a TSM pick over the past month. In the 80 sets of results shown in Chart I (20 stocks
times four separate strategies), only once did a loss result and that was limited to -0.03 points.
Requiring RSI(2) to end the day once below 25, buying the close, then closing the position at the
close over the next few days when RSI(2) rose to 70 or beyond resulted in a 83.84% win rate for 229
trades with a total of 253.17 points earned (1.11 per trade). Requiring RSI(2) to end two consecutive
days below 25, then entering and closing the position as above, resulted in a 87.83% win rate for 115
trades with a total of 132.16 points earned (1.15 per trade). The win rated climbed to 91.67% for the
last set of data where four consecutive RSI(2) values below 25 were required for entry, and the number
of trades fell off to 36, but a similar 0.96 points per trade continued to be earned.
While each of these four strategies provided very good trade entry and exit points for
these quality stocks, I prefer the combination win rate to number of trades offered by the second strategy.
Finally, let’s consider how buying and selling pressure changes for a quality stock that
still has value at its current price. Simply put, once identified, everyone wants to own it (that’s you
and me as well as institutions) so buying pressure builds and drives price higher. Price is driven higher
to a point where it becomes overbought (often over a short period of time): investors stop buying; traders
sell their positions and short sellers even step in. Selling pressure is able to temporarily win out, and
price falls. The pullback begins, but all the while, these three groups (institutions, investors and traders)
look for a point to re-enter: at the support of a major moving average (20-, 50- or 200-day), at a prior
price reversal (earlier valley or hill) or at a major Fibonacci level (38.2, 50 or 61.8%). Though my work
has shown there’s something symmetrically pleasing about the Fib levels that causes people to react there,
these areas of support at not magical, just self-fulfilling because smart money reacts there. Trading (or
investing in) quality stocks in pullback presents a low-risk, high-profit opportunity for the individual as
well as the institutions.
More of my studies emphasizing the benefits of trading pullbacks:
How I Apply Connors' RSJ(2) to Trading Pullbacks
Trading Pullbacks for Fundamentally Sound Stocks
Pullbacks Versus 21-Days New Highs and 21-Day New Lows
Buying Pullbacks
The Hammer Candle, a High Probability Reversal Signal
Combining Fundamentals with Trading PowerRatings
Buying Weakness and Selling Strength
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