Thursday, February 9, 2012

Long-term Trading

After reading my essay "Chart Granularity", posted Wednesday, a reader asked: "Wouldn't the charts depend somewhat on the type of investment you're looking at making? Say, long term vs. short term?"

A fair point, and one that deserves consideration at length.

Most people want to hold positions for the long term.

Most people have wives, partners, significant others, children, grand-children, cousins, nieces and nephews, great-nieces and great-nephews, aging parents, best friends, buds, jobs, commutes, hobbies, places to go and people to see.

Most people have lives, and are unwilling to see those lives disrupted by the need to watch the markets with the hawk-like devotion required by short-term trading.

Most people simply don't have the time.

Momentum Trading

In my opinion, as a momentum trader, charts with fine granularity are the best way to decide whether to ENTER a position. The question of long-term positions vs. short-term positions is a matter of EXIT strategy.

Here is my reasoning:

A momentum trader's strategy relies upon finding a price trend and riding it until it falters. For example, if I'm looking for a bullish position, I want to find a stock whose price is rising now, so I can jump aboard the trend.

If the trend lasts for six months, then it will be a long-term position. If the trend falters next week, then it will be a short-term position.

What matters is what the stock does, not what my intentions were at the time of entry.

A long-term chart might show that the price has been on the rise, with corrections, since 2009. In my experience, that has no more to do with my trade than do the hieroglyphics of ancient Egypt. For a momentum trader, what counts is now.

In a market where events like the Flash Crash happen and computers dominate trading, long-ago support and resistance levels have melted away to irrelevance.

Of course, I have some control over the length of the position that allows me to stretch it out. It all depends upon how I define "falter".

An uptrend is a series of higher high prices and higher low prices. If I define "falter" to mean the first lower high and lower low after I buy, then I'll generally be getting out pretty quick.

If I define "falter" as a decline of 3% or more from the most recent highest high, then I'll be holding positions longer. The latter definition filters out small corrections in the trend.

You might call it a falter filter.

When I'm determined to enter a long-term position, I abandon momentum trading based on the price trend and go to other methods.

Moving Average Crosses

One method is to rely on two moving averages (MA) -- a shorter term MA and and a longer-term MA.

When the shorter-term MA crosses above the longer-term MA, I buy. When it crosses below, I sell.

A moving average is an average of closing prices for the past however-many trading days. Each day the oldest closing price is dropped, the newest one is added, and the average is recalculated.

One standard trading method is to use the 200-day MA for the longer term and the 50-day MA for the shorter term. This produces positions that can last for a year or more. It is eminently suited for the mutual funds required by so many 401(k) accounts offered by employers, since the mutual fund companies often limit the number of trades allowed each year.

It's also suitable for dividend-paying stocks, where holding for the long term avoids frittering away dividend income in trading fees.

Moving averages come in two flavors: Simple and exponential. A simple moving average is calculated by adding all the closing prices and then dividing them by however many there are. An exponential moving average gives greater weight to more recent closing prices.

As an example, I'll apply the 200-day/50-day exponential moving averages to SPY, an exchange-traded fund that tracks the S&P 500.

SPY hit a peak of $157.52 per share on Oct. 11, 2007. Let's assume that I, unwisely, bought that day. The worst-case scenario.

The 50-day crossed below the 200-day on Jan. 8, 2008. The close that day was $138.91, and I'll take that as my exit point, and my loss was $18.61 per share.

Ouch!, I say with some feeling. But, most long-term investors don't sell. They simply hold their position through thick and thin. As it turns out, things got pretty thin for SPY.

The decline reached its low of $67.10 on March 6, 2009. People who held their positions were down by $90.42, making that $18.61 loss for traders look pretty good.

The 50-day MA crossed back above the 200-day MA on Aug. 11, 2009. Long-term traders entered at the close, $99.73. At that point, the buy-and-hold crowd was down $57.79, and traders were down $18.61.

There was a sideways period in the summer of 2010 when the moving averages crossed several times. They would have been pretty much of a wash, no matter what strategy was used, so I'll ignore it.

The short-term MA next crossed below the long-term MA on Aug. 17, 2011. The close that day was $118.72. Traders exited at that point, taking an $18.99 profit. The buy-and-hold folk were down $38.80, and  traders had a net profit of 38 cents per share.

By getting out, traders avoided riding the stock down to its most recent low of $107.43 on Oct. 4, 2011. They re-entered at the next MA upside cross on Jan. 6 of this year, at $127.71.

Since then, the price has risen to today's high of $135.59, giving traders a gain on this leg of $7.88.

If everyone in this thought experiment sold their positions today, the buy-and-hold crowd would have a loss of $21.93 per share, and traders would have a gain $8.26 per share.

Assume that you have $40,000 in your account -- not unreasonable for someone who has been diligent in putting money in their 401(k). That means that way back in 2007, you would have bought 250 shares of SPY, at the peak.

At 250 shares, the buy-and-hold strategy produced a $5,483 LOSS. The moving-average-cross trading strategy produced a $2,065 PROFIT.

That is how the methods compare during the worst recession since the 1930s and one of the worst market crashes ever.

Which strategy do you wish you had used?

Fixed-Term Positions

But if watching moving averages is just too time consuming, here is another strategy, somewhat akin to Warren Buffet's value trading.

Now, Warren Buffett never likes to sell his holdings. In 1996, he wrote that a shareholder should "...visualize yourself  as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family."

Personally, I'm not comfortable with that approach. Indefinitely is a very long time, and the world moves on and changes more quickly now that it ever has before.

Here is a compromise between next week and forever.

Find a company whose business prospects you like. You might follow Warren Buffett, whose holdings are listed publicly on several websites. Or you might pick some stocks from Jim Cramer's charitable trust.

Or use some other method to find a stock that you like for the long term, preferably one with high volume so you have a narrow bid/ask spread and large capitalization. Large cap companies tend to be more stable. They don't go bankrupt as often as smaller companies.

Buy the shares a month before an earnings announcement. (It must be shares, not options, for this strategy to work well.)

Go to Google news and set up an alert for the stock's ticker symbol and the word "bankruptcy", and another alert with the symbol and the term "Chapter 11".

If you get an alert in your email and discover the company is on the verge of bankruptcy, then sell.

Otherwise, five months after buying -- one month after the next earnings announcement -- take a look at the stock price.

If it is above what you paid for the stock -- the base price -- then check out the reasons you liked the company before. If you still like it, then hang on to your shares for another quarter, setting a new base price at the current level.

If the price is below what you paid for the stock, then sell it and find another stock to trade.

And of course, there's no need to go as short as a quarter. Holding a stock for more than a year means you get a huge tax break, just like the 1%.

This strategy works best in a rising market. To determine if the market is rising, take a look at the SPY moving average cross chart, discussed above.

If the stock price is above the 200-day moving average,  then odds are good that the market is rising. But don't rely entirely on the moving average. If your eye tells you that the price is falling toward the moving average, then don't take the trade.

As always, the first rule of trading is use common sense.

(The second rule of trading is that I must trade to make money. So I always try to make fast decisions about taking opportunities rather agonizing at great length over whether I should enter a trade or not.)

Closing Thought

There are as many ways of trading as there are traders. I find short-term trading works best for me. But I'm retired and I'm 66 years old. My family for the most part lives far away. I rely in part on the capital gains from trading to pay for necessities, as well as such fun stuff as my season ticket for the opera.

That means have I lots of time for studying the market and trading, and  not as much long-term ahead of me as a 40- or 50-year-old does. And I'm motivated to harvest the money sooner rather than later, to pay my bills.

A younger person, with heavy family responsibilities and steady income from work, will need to look at different strategies. A younger trader's major cash drain may be decades in the future, when the kids to go college. And decades further down from that, to support retirement.

A younger trader can profitably adopt a longer-term strategy because the investment funds aren't being used to produce current income.

Whatever strategy a trader picks, it must, above all, fit the needs of the trader. Ultimately, life is way too much fun to waste on ill-fitting strategies.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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