Tradability vs Profitability

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Waiting seems so unnecessary these days. We live in a digital world with on-demand access to just about everything. There’s an expectation for things to move quickly.

The financial world is no different — our tolerance for waiting is rapidly shrinking.

Take the holding period of shares for instance.

The average trade length is a fraction of what it once was. Research shows it’s gone from seven years in the 1940s to just seven months in 2007. Some estimate the figure is even lower today.

There are a number of factors behind this shift. But I believe one of the biggest is the chase for performance. Quite simply, we want results…and we want them now.

I see this as a double-edged sword.

Impatience for performance can go one of two ways. It can get you out of losing trades early, which is good. Or, it can get you out of a good trade before it’s had time to get going. This isn’t so flash.

The Goldilocks principle says the best result is between two extremes. The trick is to strike a balance. Don’t stay in an unprofitable trade too long…but don’t jump out too soon.

Well that’s the theory. How should we manage this in real-time?

I’ll answer this in a minute. First, let me share an email with you.

I’m certain you’ve already factored in what I’m about to say something. But my philosophy in business is that it’s always better to hear something twice than never at all.

I wonder when it should be time to decide that a signal was a “false break”. You can do the analysis yourself, but there a number of trades that have been in place for 60 days or more and are currently in a negative position.

I’m not saying 60 days is the number, but it makes sense to me that if it hasn’t taken off after a certain period, it probably won’t.

Thus, one of your “exit” filters would be to look at the length of the trade, its more recent trend, and if the indicators were negative, get out at a small loss.

This is an excellent question. It’s the sort of logic that makes a good trader.

Time exits are interesting. I’ve done quite a bit of work with these.

I did some testing a while back with time-based profit taking. I wanted to see if there was a good time to exit a stock.

It didn’t take long to see it didn’t improve profitability. Letting winners run was by far the better strategy.

I came back to time exits when I was developing Quant Trader.

Part of the development process involves looking at lots of trades. I’m looking for patterns that could lead to system improvement.

I noticed some trades didn’t do much. They would trade sideways for months. Then eventually they would hit their stop loss.

This looked promising. So I put it to the test. I wanted to see if giving stocks a time limit to perform would boost performance.

Here’s what happened.

A number of underperformers left the portfolio early. There was a performance benefit in getting out before they hit their stop losses.

But there was an unintended consequence. The success rate took a big hit. Cutting slow starters saw the number of unsuccessful trades soar.

There was also a big increase in the number of trades. This was because many slow starts would eventually get moving and this would require a re-entry.

I did some more back-testing last week. The aim was to compare two versions of Quant Trader — one with the standard exit…the other with an early exit for slow starters.

I set the time limit at 60 trading days. Any stock not showing a profit after this time is cut — even if it hasn’t hit the stop loss.

The start date for the tests is 3 January 2000. It assumes placing $1,000 on each signal. And it doesn’t include costs or dividends.

Let have a look at what happens.

 

Quant Trader
Standard exit

Quant Trader
Early exit

Total profit

$246,732

$280,630

Average trades per year

111

204

Success rate

59.5%

44.3%

These are interesting numbers. They show that early exits can increase profitability. But look at the cost — a lot more trades, and a lower ratio of winners.

Now this might not be a problem. Some people will be comfortable with the trade-off for greater profits. There’s nothing wrong with this.

But low strike rate systems are emotionally harder to trade. You have to be able to easily shrug off a loss and move to the next trade. Many people find this difficult.

You see, humans like positive feedback. This can make it challenging to trade a lower strike rate system. It goes against our mental wiring.

This is why I’ve made tradability a priority. I want trading to be as easy as possible. It’s no good having the world’s most profitable system if it’s emotionally too hard to trade.

Until next week,

Jason McIntosh
Editor, Quant Trader

Editor’s note: Jason’s trading system — Quant Trader — has just identified an opportunity. It’s an emerging business in a growing sector. The company has a market cap of $78 million. So you probably won’t read about it in your broker’s reports. This could all change in the coming months. But the shares may be a lot higher by then.

This developing situation is getting interesting. The stock has been RISING during the recent sell-off. This could be just the start. Find out more here.

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The Daily Reckoning offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, The Daily Reckoning delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors. Founded in 1999, The Daily Reckoning is published in 7 countries with a worldwide readership of almost 1 million people.
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