Basics Trading Strategy

Before description of the Basics Trading Strategy let us tell a few words about some fundamental principles of
stock trading theory.

Basics of Stock Trading

We consider short-term (2 - 5 days) stock trading strategies. All profitable strategies are based on the following
golden rules:

• Develop a winning strategy and trade often. A small daily profit can provide a large annual return.
Example: if the average daily return is equal to 0.3%, it will provide an annual return of 113%. (1.003 ^
252 = 2.13)

• Trade only stocks with the highest growth probabilities. Do not hold stocks when their probabilities of
growth are close to the average value. Switch to more profitable stocks.

• Be sure that expected return is larger than the transaction cost (bid-ask spread + brokerage
commissions).

• Avoid risk as much as possible. Do not put all your trading capital in one stock. Diversification is the only
way to survive in the market.

• Winning strategy is a strategy with the lowest risk/return ratio.

Risk and Return

You cannot be a winner in every trade you make. Any trading strategy must leave room for some losses. Your
returns may be positive or negative. Figure 1 shows returns per trade for one of our trading strategies for the year
1996.

Figure 1. Returns per trade (in %) in 1996 for the first stock selected using the Basic Trading Strategy.
The dashed line shows the average return per trade (3.64%).

You can see from this figure that returns were mostly positive. However, 29% of trades had negative returns. This
number reflects the risk of trading. Risk of returns is the standard deviation of the set of returns for given
period of time.

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You can calculate the standard deviation by using any spreadsheet program. To illustrate the definition of risk let
us show the distribution of returns.

This Figure presents the distribution (histogram) of returns per trade for data from Figure 1. These returns are
pure returns - no transaction costs have been considered. The standard deviation is a characteristic of the
distribution width and is equal to 6.9%. It is clear that the larger the standard deviation, the larger the probability of
losing money. This is why the standard deviation of the set of returns is considered as risk.

As we mentioned before a good trading strategy must have a small risk/return ratio. We found some strategies
with small values of this ratio. One of the best is the Basic Trading Strategy.

Basics Trading Strategy

Short Description
Every day after market closing (day #0) we perform market analysis and prepare a list of Potentially Bullish
Stocks which are oversold within various time frames. Before market closing on the next day (day #1) we select
two stocks from the list with maximum price drop (in %) and buy these stocks. We hold these stocks for two days,
and sell them at the market opening on day #4.

More Details
1. Every day after the market closing we perform the market analysis to generate the list of potentially bullish
stocks. Let us call the day of analysis day #0. Tomorrow will be day #1 and so on.

Ope1, Clo1, Ope2, Clo2, ... are the stock prices at market opening and market closing on the corresponding days.

These stocks are partially oversold in the 16 - 32 day time frames. The stocks from the list may not be oversold
on the day of analysis for all possible time frames. We have not taken into account the behavior of these stocks
during the last few days. This is why we call these stocks potentially bullish stocks. You can find more details
about our stock selection method in E-Book Short-Term Trading Analysis.

2. Before market closing on day #1 one should check the prices of all stocks from the list and buy two stocks
with maximal % price drop during day #1. Mathematically, this can be written as

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 Clo1/Clo0 -----> minimal (*)

This condition substantially increases the probability that the selected stocks will be oversold in all important time
frames (from 4 days to 32 days).

Note that in this strategy the stocks may rise during trading day #1. The only important thing in this case: their
rises should be minimal among the stocks from the list. The equation (*) describes this statement.

3. During the next two days (#2 and #3) one should hold the stocks. At the market opening on day #4 these
stocks should be sold.

We have performed computer analysis of this strategy and found a high profitability using this method. An
important part of this strategy is dividing the trading capital between stocks.

Days #2 and #3 are the days of holding stocks which were bought on day #1. If we do not buy other stocks during
these days we will lose possible profits. So as to be able to buy stocks every day the trading capital should be
divided into three equal parts. Every part of the capital should be used to buy two stocks.

Low Risk Trading Strategy

Short Description
This strategy is similar to the Basic Trading Strategy, but we buy two stocks from the list with maximum price drop
(in %) only if their prices dropped more than 5% during day #1. (Bullish Level in the list of Potentially Bullish
Stocks).

More details
To reduce risk one should be very selective choosing stocks to buy. The simplest idea is to buy stocks with some
level of price drop during day #1. In the Basic Trading Strategy one buys stocks with maximum price decline
during the day #1. Sometimes the maximum price drop is not large. Usually this is an indication of strong market
growth during day #1. You can avoid buying stocks if they do not decline significantly. For the Low Risk Trading
Strategies, you should consider only stocks with a price decline of more than 5% (Low Risk Strategy-1) or 10%
(Low Risk Strategy-2). This method can be illustrated by the following scheme.

Before market closing on the day following the analysis check, the stocks in the potentially bullish stock list.

Find two stocks with maximum price (in %) decline during day #1, i.e., the ratio CLO1/CLO0 should be
minimal.

If the price decline of both stocks is more than 5 - 10%, buy these stocks. Percentage of decline we will call
the level of selection.

Hold these stocks for two days.

Sell the stocks at the market opening on day #4.

Let us show some statistical data for the Low Risk Trading Strategies. The computer analysis was performed
during the period from January, 1996 to July, 1999.

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 Low Risk Trading Low Risk Trading
Parameter Basic Trading Strategy
Strategy-1 Strategy-2
# of days when 2 stocks for
873 419 116
trading have been found
Average 3 Day Return +3.4% +4.8% +7.1%
Standard deviation 8.3 9.6 10.5
Risk/Return 2.4 2.0 1.5
Probability of positive
69% 73% 78%
returns
Probability of returns <
1.4% 1.8% 1.3%
-20%
Probability of returns >
3.8% 6.3% 9.1%
+20%
Probability of returns <
4.0% 4.5% 3.9%
-10%
Probability of returns >
15.2% 21.0% 28.4%
+10%
Portfolio Growth
17400% 5500% 590%
Jan 96- Jul 99

You can see how large the average return was for the Low Risk Strategies. The risk to return ratios are also much
better for these strategies. But the number of trades for these strategies were much smaller than for the first one.
For example, trading opportunities open approximately once every two weeks for the Trading Strategy-2. In
conclusion: portfolio growth for the Low Risk Trading Strategies is less than for the Basic Trading Strategy. This is
the payment for smaller risk.

Our statistical analysis presented on the main page

has been performed for the Low Risk Strategy-1, i.e.
for 5% level. The Figure shows histograms of quarterly
for Low Risk Strategy and for NASDAQ-100 and Dow
Jones. Brokerage commissions and bid-ask spread
was supposed to be equal 5%. The period from
January 1996 to September 2002 has been
considered.

Combined Trading Strategy

Short Description
This strategy is a combination of the Basic and Sell-Short Trading Strategies. One can spend 50% of the trading
capital to trade stocks using Basics Strategy and 50% to trade stocks using Sell-Short Trading Strategy.

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 Basic Strategy

Sell-Short Strategy

More details

The Combined Strategy has lower risk and better risk/return ratio than other strategies. However, one
needs a larger trading capital to minimize the influence of the brokerage commissions.

It worth mentioning that 50/50 capital division may be not optimal for some markets. For the bear market, for
example, it is better to use larger portion of the capital to sell short. In our history files we consider only 50/50
case.

The Figure shows quarterly returns of the Combined Strategy and quarterly returns of the Dow Jones Industrial
Average and the NASDAQ-100 index. The period from January 1996 to September 2002 has been considered.

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Trading Strategy for Busy People (BPTS)
Short description
Every day we supply a list of two stocks. This day we call the day of Busy People Trading Strategy Analysis (Day
of BPTS Analysis). On the next trading day before market opening we place the LIMIT - DAY orders to buy these
stocks. The LIMIT prices are equal to 95% of previous closing prices of the corresponding stocks.

If the stock prices touch the LIMIT levels then the stocks will be bought. We hold these stocks for two days and
sell them on the market opening of the third day.

Buy using LIMIT Sell on the market

Day of BPTS Analysis Hold Hold
orders opening

The trading capital should be divided into three parts and we use these parts to buy stocks every day.

The basic ideas of the Busy People Trading Strategy

Like our other trading strategies this strategy is based on the computer stock selection. Trader's emotions play no
role in this selection. This approach allows us to play against the crowd.

This is a short-term stock trading strategy. Our time frame is three to four days. Our strategy is not a daytrading
technique which needs a large capital to make money from 1/8 - 1/4 stock price moves.

We do not need to watch stock prices during the trading day. The orders to sell or to buy can be placed before
market opening. This is why we call this strategy the Busy People Trading Strategy.

General
The strategy is based on a statistical analysis of the US stock market. We have found a method of stock selection
which allows us to find the stocks with the highest growth potential. These stocks are presented in our daily list of
potentially bullish stocks. This list is published on our website every day before the US market opening. We have
found that buying two stocks with maximum price drops (in %) during the next trading day and selling them in two
days on the market opening is a very profitable strategy. We call this method the Basic Trading Strategy.

However, this method is not good for people who cannot place BUY orders at 4 p.m. (market closing). Many of
us are too busy be watching the market at this time. Some companies even use firewalls to limit the internet
access for their employees during working hours.

The Busy People Trading Strategy (BPTS) allows us to overcome these difficulties. What is the difference
between the BPTS and the Basic Trading Strategy?

Basic Trading Strategy Busy People Trading Strategy

The probability of finding stocks to buy is close to The probability of buying stocks can be much less
100% than 100% and depends on the LIMIT price.

We can also divide the trading capital into three

We can divide the trading capital into three parts
parts and use every part to buy two stocks.
and every part of the capital should be used to buy
However, because of the stocks are held there is a
two stocks.
small probability of a money deficit (*).

These probabilities depend on the LIMIT price. All

Probability of larger than 10% returns per trade =
probabilities for BPTS are better than probabilities
15%. Probability of smaller than -10% returns per
for the Basic Trading Strategy if we consider
trade = 4%
transaction costs.

Historical quarterly return = 43% Historical quarterly return = 18%.

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 We need to watch the market at 4:00 p.m. We can place all orders before market opening.

(*) About the possible money deficit. Suppose we are lucky and our Limits are touched every day. So, we buy
two stocks on days #2, #3 and #4. Before market opening on day #5 we need to place two LIMIT orders to buy
two other stocks and two MARKET orders to sell stocks which were bought on day #2. The BUY orders will not be
accepted because we have already spent all our money. We should sell stocks first and then place the BUY LIMIT
orders. This means we have to wait till the market opening and place BUY LIMIT orders after selling the two
stocks which were bought on day #2. However, the probability of these events is very low.

Statistics for the Busy People Trading Strategy

Here we present some statistical data for the Busy People Trading Strategy for 1996 - 1999 period. We have
assumed that the transaction costs (brokerage commissions and bid-ask spreads) are equal to 0.75%.

Why is the expected quarterly return of the Busy People Trading Strategy is less than the expected quarterly
return of the Basic Trading Strategy. The answer is simple: the quarterly number of trades for BPTS is less.

The next plot shows the number of trades per quarter (in %) relative to all possible trades. If we choose the LIMIT
price to be 95% of the closing stock price the number of trades for the BPTS is only 25%. So, on average we can
buy only one stock per two days.

The next plot shows the growth of the virtual trading portfolio during 1996 - 1999 for the BPTS depending on the
LIMIT price. Twelve times growth in 3.5 years is not bad, but using the Basic Trading Strategy gives an even more
exciting result.

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The next plot shows the dependence of the probabilities of the large stock price changes per trade on the LIMIT
prices. If the LIMIT = 95% then the probability of the price change > 10% is equal to 18% and the probability of
price change < -10% is equal to 7%. This is better than the results using the Basic Trading Strategy if we take
into account transaction costs.

The next plot shows returns per trades (transaction costs have been taken into account) and the risk to return
ratios as functions of the LIMIT prices. For LIMIT = 95% and less, the risk to return ratio is very low and stable.
The quarterly return has its maximum in the range 95 - 98%. So, the optimal value of the LIMIT = 95% of stock
closing price.

The next plot shows the probabilities of positive returns per trade for various Limits. The transaction costs =
0.75% have been taken into account. If LIMIT = 95% the probability of positive return = 64%. So, we should
accept that in 1/3 of trades we will lose money.

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5. Example of a BPTS daily file

Such files are published on our website every day. They look like:

Selected stocks for the Busy People Trading Strategy

Date of BPTS Analysis (YYMMDD): 020821

TICKER CLOSING PRICE 95% LIMIT

RGC 16.25 15.4375
ASH 29.7 28.215

The full list of sorted stocks (price changes in % during the last day are shown)
RGC 0.3
ASH 0.47
COL 1.79
AZN 3.4
XJT 4.9
UTSI 11.36

At the end of the file you can see the whole list of stocks with %% change during the trading day. All changes
were positive and in this case one should select two stocks with minimal %% price change: RGC and ASH as it is
shown in the table.

On the next trading day (8/22/02) we should place LIMIT DAY orders to buy RGC and ASH. The limit prices are
equal:

RGC LIMIT = 15.4

ASH LIMIT = 28.2

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