I have a problem.
My capital gains are all over the short term, and every April, the Taxman comes and takes away a huge chunk of my profits at the full tax rate, because the positions that earned the profits were held for under a year. So it goes with the U.S. income tax system. My tax rate would go down significantly if my profits were on positions that I held for more than a year.
Moreover, I keep going through periods when it's hard to find trades under my short-term rules, which are very exacting, since the positions must earn money right away. Such periods leave a large portion of my funds in cash, which produces losses to inflation.
My French protestant ancestors were firm believe that idleness is a sin, no more so than when the idler is money. I do believe they were right.
Last October I posted an essay called "The I Hate Stocks Trading Plan", intended for people who had money invested but who, for whatever reason, take the time to manage their positions intensively.
I followed it up with a formal set of rules for long-term trading and wrote about them in an essay titled, less puckishly than the first, "Long-term Trading Rules".
The old rules were based on 12-month moving average crossovers. When the price closed a month above the moving average after having been below it, that was a buy signal. When the price closed the month back below the average, it produced a sell signal.
The system worked after a fashion, but given the slow-moving nature of the system, whipsaws could be quite costly. Also, the need to wait for the moving average crossover month before entering made it difficult to find trades. And the reliance on the average as a signalling device meant that there was no guarantee that a position would last for a year.
The problem, I concluded, could be solved by retaining the 12-month moving average as a stock selection tool, but not as a signalling device.
That meant that I could enter into a stock at any time, as long as the price was above the 12-month moving average. The stock selection criteria could be anything, from rigorous fundamental analysis to a high dividend yield, a newsletter recommendation or a even whisper from a friend. Or even from the roll of the dice or on a whim.
That changes opens up a much wider range of trades. I included one criterion: Any stock that I bought had to be in an uptrend, as determined by the same chart analysis methods that I use in my short-term trading. Under my current practices, that means every trade must be declared to be in a bullish uptrend by means of Elliott wave analysis.
Also, without signals, there can be no forced sale of a position before a year is up.
How, then, to deal with the inevitable downturns?
I've decided that a hedging scheme was the only answer. Under the revised plan, I retain the bullish shares even if the price goes down, but I open a bear hedge position to offset or, best case, entirely eliminate any losses. A hedge would typically be an options spread of some sort.
Basically, then, a long-term position was long shares of stock held for at least a year, with short-term bearish option spreads as offsets to declines in the share price.
That decision, in turn, brought me back to trade selection. I added a second criterion: I can only trade shares that have liquid options with open interest running to three figures near the money and with bid/ask spreads of under 10%, the same rules I use in my short-term bear trades, which also are built from options.
After that, the only part missing was the entry and exit rules for the short-term hedging bear plays. Happily, I already have a rule set in place to cover it, the entry and exit rules used in my short-term trades.
The result has been a chimera, and it is in the nature of a chimera that its parts operate somewhat separately; they are not a unitary beast.
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| An Etruscan statue of a chimera found in Arezzo, Italy, ca. 400 BCE |
Or a sudden decline, producing large losses in the shares, followed by a long period of sideways movement, would also make a profitable hedge impossible to create.
Good chart analysis can mitigate those risks, but never eliminate them.
The new trading rules may be read here, as a Google doc. My intent is to post analyses for long-term positions going forward, much as I do for my short-term positions.
References
My shorter-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.
Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading.
Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.
Disclaimer
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 decisions for his or her own account, and take responsibility for the consequences.
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