The Gutsy Trade You Shouldn’t Try at Home

Girl counting Australian money
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Hollywood is home to the classic one-liners.

Some need no introduction. The likes of ‘I’ll be back’ and ‘Go ahead, make my day’ are two of the best known phrases on the planet.

Then there are the catchphrases which haven’t quite captivated audiences in the same manner. Lacking broad appeal, they resonate on a more individual level instead. They strike a chord, sticking in our minds long after the final credits, even if we’re the only ones to appreciate them.

I’ve drawn inspiration from many films over the years. But there was one that had an influence on my early years as a trader. The movie? Top Gun.

I first saw this film 30 years ago. And I still recall one particular scene vividly. Let me give you a quick rundown…

It’s set in the debriefing room, following a training mission. The head instructor is analysing the battle tactics of one of the pilots — Maverick, aka Tom Cruise.

You see, Maverick had won a dogfight. But his methods were far from textbook. Rather than praise his daring manoeuvres, the instructor criticises Maverick’s instinctive flying, calling it a gamble — an example of what NOT to do.

At that moment, a fellow pilot leans forwards and whispers: ‘gutsiest move I ever saw, Mav’.

Maverick’s flying was aggressive and unconventional…and I loved it.

As a young guy starting out, this type of fearless, seat-of-the-pants attitude was appealing. I thought to myself, ‘that’s how you get ahead’. And it’s with this mindset that I arrived at the Bankers Trust trading floor.

One of my early strategies was to pick turning points. I would swoop in and buy when I thought a market was about to bottom, selling when it appeared to be topping.

I wouldn’t wait for much confirmation — that was for cautious types. Fearless traders took the market head on. They were aggressive and instinctive, like Maverick.

But I had it all wrong — ‘gutsy’ and ‘trading’ are two words that don’t belong together.

You see, a gutsy call is against the odds. That’s what makes it gutsy. Successful trading, on the other hand, is about waiting until the odds are in your favour.

Alas, what works in Hollywood, stays in Hollywood.

Fortunately, I had excellent mentors. They let my youthful bravado take a hit, and then set about rescripting my ideas on trading.

What would you do?

You’ll remember I responded to an email in last week’s report. A member wrote in asking for information about performance statistics. He also had a request concerning a stock:

…I would be very interested to see the results from a trade in Paladin Energy [ASX:PDN] (buying Dec 2013) to see how Quant Trader handled this one.

Member, Neil

Now this is an interesting situation. It’s one that I think offers an excellent learning opportunity.

Let’s start by having a look at the chart…

This shows PDN’s share price from January 2011 to December 2013. It was clearly a rough time for this stock — the shares fell close to 92% from the high.

Now, let me ask you a question. I want you to go with your instincts. Would you rather buy this stock or sell it?

If you’re like many people, you’re a buyer. You’ll say the stock has lost so much value that it must be close to turning. And, if it does, it could be up 100% in no time.

I know that line of thinking. It’s how I began my career. The gutsy play is to call the turning point. You’ll potentially make a lot more money than by waiting cautiously.

But here’s the problem. You could have easily said the same thing near every ‘temporary’ low. And look what happened…the rallies failed, and the decline went on.

Many people get hooked on an idea. They’ll maintain a strong bullish conviction — even when prices are falling. This leads them to assume that every small rally is the start of the next BIG market surge.

A recent example of this is gold. I’ve been reading bullish analysis on gold since the metal’s 2011 peak. But with a few exceptions, the trend has remained resolutely down.

Big trends typically reverse at some point. But you can lose a fortune trying to pinpoint the turn.

Follow the lines

Now let me add a simple trend following indicator to Paladin’s chart.

Let’s have another look…

This is the same chart as before. The only difference here is that I’m including the 50 and 100 day moving averages. These are the respective red and blue lines.

A moving average is simply a stock’s average price over a set period. I use it as a quick and easy way to determine the trend. Quant Trader also uses this as its primary filter.

There’s nothing magic about 50 and 100 days. But I find this combination works well for medium term trading — it isn’t too slow, and it’s not overly sensitive.

Now, notice how the red line (50 day average) is below the blue line (100 day average). This means the trend is down. Quant Trader will not give a buy signal while this is the case.

Following this process can help you avoid many disasters. In the case of PDN, Quant Trader didn’t give any buy signals over the three years to December 2013. (If you’re wondering, the system went short in June 2011. But that’s a story for another day.)

Now let me show you how Quant Trader has traded PDN from October 2013 through to present day…

Member Neil asks about buying in December 2013. You’ll see I’ve circled this period on the chart. The shares were down over 90% and prices appeared to be turning higher.

But look at the moving averages. They never cross. This means Quant Trader was NOT a buyer. Many traders mistake a short term bounce for the real thing — it’s often an expensive mistake.

The averages finally cross in February 2015, and this leads to a short lived trade (see the red horizontal line — that’s the exit stop). But it’s a false break. PDN turns lower and continues to fall.

Quant Trader has a strategy for this possibility. It’s called a stop-loss. This gets you out when a trade isn’t working. The aim is to shield your capital from continuing losses.

PDN is down close to 50% since December 2013. With the exception of a brief trade last year, Quant Trader has been on the sidelines since the 2011 peak.

A system trading pioneer called Ed Seykota once said: ‘There are old traders, there are bold traders, but there are no old, bold traders’. It’s so true…I can’t think of any in all my years of trading.

So leave the bold plays for the silver screen. Your trading account should be all the better for it.

Until next week,

Jason

Editor’s note: Quant Trader has just signalled several new opportunities. One is a small resources play with 100% upside potential over the next 12 months. Jason says it’s starting to move higher after a long period of trading sideways. Similar situations have led to impressive gains. Jason says this setup is one of the best he’s seen. Click here to gain immediate access to all Quant Trader’s signals with a risk-free trial subscription.

*All graphics produced by Quant Trader unless otherwise noted*


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Jason McIntosh

Jason McIntosh

Jason is a professional quantitative analyst. Before he graduated in 1991 he joined Bankers Trust — a Wall Street investment bank — to be a trader. After Bankers Trust was taken over in 1999, Jason, already financially independent, co-founded a stock market advisory and funds management business called Fat Prophets. At 37 he sold his part of that business and retired. These days, he’s a private trader and system developer. In 2014 he launched the wildly successful trading service: Quant Trader.
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