Friday, October 12, 2012

WFC: Broken Turtle

Passionate advocates of the Turtle Trading system (you can read about it here) make it sound so simple:

1) Get the signal.

2) Make the trade.

3) Set the stops.

4) Wait for either a small loss or a big profit.

Real life is rarely that simple.

The original Turtles back in the 1980s were futures traders. Most private traders nowadays deal in stocks and their options.

And stocks are far more complex that futures. You've got earnings announcements and the quantum price jumps they cause. You've got ex-dividend dates and the price drops they cause. You've got thousands of potential trades, far too many to understand with any degree of thoroughness.

Corn or coffee futures, by comparison, are a snap: No earnings, no dividends, a fundamental environment that can be grasped.

So for traders who have adapted Turtle methods to stock and option trading, there's always the question of how far to modify the original rule set.

Wells Fargo Co. (WFC), the national bank, is a case in point. It broke above the 55-day high on Sept. 6.

The breakout point was $34.76, and in subsequent days the price dropped a bit and then rose some more, to a swing high of $36.60 on Sept. 14. From there it dropped, never again to rise above the 55-day (or even the 20-day) high.

Yet it also stayed above both the initial stop/loss -- double the average trading range below the entry price -- and also above the 10-day low. Either point would have triggered an exit.

The exit came at the open today, in the form of a 5.1% downside gap following the company's earnings announcement before the open. Wells Fargo's profit rose by 22%, but its profit margin and take from mortgage banking were less than analysts liked.

The gap moved WFC below the 10-day low, triggering closure of the position for a loss, and below the 20-day low, $34.29, triggering a Turtle bear signal.

I won't go through the company's financials again. You can read them in my write-up from September -- you'll find it here -- in which I quite wisely label WFC as a potential head fake. And so it proved to be.

I'll focus instead on trading methodology. The Turtle system has been tried by many, and it works, although by its nature it produces a lot of outs at first and makes up for them with a couple of home runs into the grandstands.

But when I look at WFC, I feel as though I'm looking at a broken Turtle, a methodology that isn't being all that it can be.

The only possible solution to the problem, short of throwing out the Turtle with the bathwater, is to use filtering rules that have the effect of tossing out some potential trades, despite the bull or bear signal.

One rule that I've used with my traditional trend trading is to not take a trade within 30 days of an earnings announcement. That wouldn't have helped with WFC -- I opened the position 36 days ahead of earnings. But it seems like a reasonably good rule, even so, since it is in that last month that many traders position themselves for the next earnings publication.

A rule that many traders adhere to is to never hold a position across an earnings announcement. That would have prevented part of the loss, and in fact would have made the position a wash. I've not gone with that practice because it excludes both good and bad surprises, and since Turtle trading relies on big moves for its success, it seems to me that excluding surprises is a bad practice.

At the time WFC gave its bull signal on Sept. 6, the 55-day high and the 20-day high were identical. This is what happens on a chart with the stock has been on a rise for some time. One possible rule would be to take breakouts beyond the 20-day high or low, but only when they differ from the 55-day high or low. Breakouts when the nearer and further out levels are merged would be ignored. In the case of WFC, that would have disallowed the Sept. 6 signal.

The stop/loss rules for Turtle Trading is to get out at a level double the average trading range (I use the 20-day Wilder version of the ATR), or at a drop below the 10-day price extreme in the opposite direction from the position. Either of these would have produced losing trades in the case of WFC.

An alternative would be to use a trailing stop that's double the average trading range. That sort of stop rises (in a bull position) along with the price, but doesn't fall. In the cae of WFC, the trailing stop/loss would have been double the range below the peak price,m or $35.36. That level was hit on Sept. 26, and it would have produced a loss similar to the one that actually happened.

I've been using the relative strength index as an entry filter, and it would have allowed the WFC trade. What about using it for exits, as well? The RSI moved above the 70% level on Sept. 14, producing and overbought signal, and the next day dropped below, producing an exit signal. That would have closed the position for a 1.6% profit or better.

In my September analysis of WFC, I called it a potential head-fake because it kept breakout above the 55-day high and then retreating. It had done it twice since August when the September signal came. Is there a way to use that false breakout information to construct a filter? I don't know the answer to that, but I'll be looking at it going forward.

Finally, I've been using a time filter in opening a position. When I get a Turtle bull or bear signal, I wait half an hour before trading. If the price has retraced back across the breakout point, I skip the trade. That wouldn't have barred the WFC trade. But what I lengthen the waiting period, for a rule that says, for example, if the price retraces and closes back past the breakout level  within the next two (or three?) days after breakout, then the position must be closed. A three-day period would have worked with WFC, but it would have missed the swing high.

Here's what I plan to do for now:

I'll retain my ban on taking trades with 30 days of earnings.

I shall take breakouts produced by earnings announcements.

I'll disallow Turtle bear signals produced by ex-dividend dates.

I'll retain my 30-minute waiting period.

I'll retain the Turtle trading stop/loss scheme.

I'll continue to use the RSI as an entry filter -- it must be moving in the direction of the trade.

I'll start using the RSi as an exit signal. In the case of bull plays, if the RSI crosses the 70% line in a downward direction, I'll take that as a signal to close. Likewise, in bear plays if the RSI crosses the 30% line in an upward direction.

That's it for now. I'll also be studying two other possibilities: Using a trailing stop at double the average daily trading range (which, in addition to potentially mitigating losses, would simplify my trading logistics), and somehow using a history of failed breakouts in determining whether or not to take a trade.

By the way, the WFC bear signal meets my criteria: It is below the breakout level a half hour after breakout, and the RSI is dropping. True, the price is up intra-day, and that can be a cause for concern. But, the drop did cause a lower low following a lower high, meaning that WFC is in a bear trend according to traditional analysis.

Implied volatility stands at 22% and has been dropping since Oct. 10. Options are pricing in confidence that 68.2% of trades will fall between $31.98 and $36.32 over the next month, for a potential profit or loss of 6%.

Options are active, running 181% above their five-day average volume. Puts lead slightly at 192% above average, compared to 174% above for calls.

Today's fair-price zone on the half-hour chart runs from $33.90 to $34.19, encompassing 68.2% of transactions surrounding the most-traded price, $34.04. With 90 minutes before the close, WFC is trading near the top of the zone.

Decision for my account: I'm not taking the trade because my trading funds are fully committed under my rules. But if I had funds available, then I would take the trade, structuring it as  January puts with a $36 strike price, for 8x leverage.

Good trading!

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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