TRADING STOCKS BY THE NUMBERS FINANCIAL ENGINEERING FOR PROFIT Grant Henning PhD Copyright © 2015 Grant Henning PhD All rights reserved. ISBN: 1517283264 ISBN 13: 9781517283261 Library of Congress Control Number: 2015915039 CreateSpace Independent Publishing Platform North Charleston, South Carolina DEDICATION This work is dedicated first to the memory of my parents who, though not having a college education themselves, taught me to persevere in study to solve life’s problems. It is also dedicated to my dear wife, Ruth, who has been with me through most of this exciting journey of life as an example of resourcefulness, hospitality, perseverance, and courage. It is also dedicated to my two children and seven grandchildren—especially my son, Jeffrey, who is the best trader I know and who has been my constant sounding board.
Finally, it is dedicated to Professor Charles Cao, Chairman of the Finance Department at Smeal College of Business, the Pennsylvania State University, for his friendship and encouragement and his exemplary teaching and research. TABLE OF CONTENTS Preface Introduction A Background Rationale for the Use of Mathematical Models in Stock Trading Chapter 1 Defining a Portfolio Database Summary: PART ONE TECHNICALS Chapter 2 Percentage Lag (Proximity to New Highs) Evaluation and Summary: Chapter 3 Momentum Summary: Chapter 4 Price-Action Ranking Summary: Chapter 5 Regression Residuals Summary: Chapter 6 The Relative Strength Index (RSI) and The Cumulative Technical Ranking Index (CTR) Summary of Part One PART TWO FUNDAMENTALS Chapter 7 Choosing Fundamental Indices Price-to-Sales Ratio (PSR) Earnings per Share (EPS) Five-Year Annual Sales Growth (5YSG) Return on Assets (ROA) Profit Margin (PM) Combining Ranks Summary PART THREE COMPOSITE RANKINGS OF STOCKS Chapter 8 Global Aggregate Ranks Deriving a Global Total Ranking Index The Technical-Fundamental Discrepancy Index Aggregation for Decision Making Deriving a Universal Index Summary: PART FOUR TRADING STRATEGIES Chapter 9 Implementing Momentum Trading Strategies 1. The Percentage Lag Strategy 2. The One-Month Momentum Strategy 3.
The Cumulative Momentum Strategy 4. The Multiple Ratio Momentum Strategy 5. The Patterned Price Movement Strategy Summary: Chapter 10 Implementing Performance Trading Strategies 1. The One-Month Gain Strategy 2.
The Universal Index Strategy 3. The Global Total Performance Strategy 4. The Comprehensive Performance Strategy 5. The Future Trend Strategy Strategies Compared Summary: PART FIVE MARKET TIMING AND LEVERAGING Chapter 11 Timing Indicators Macro Timing Indicators PE Averages and RSI Averages VIX Trends and Put/Call Ratios Micro Timing Indicators 1.
The Relative Strength Index (RSI) Trend Line 2. The Volume Indicator Histogram 3. The Moving Average Convergence/Divergence (MACD) Histogram and Moving Average Crossovers 4. The ADX Trend Lines Timing Indicators Compared Summary: Chapter 12 Leverage Risk Using Margin Leveraged Bull and Bear Funds Options Summary Chapter 13 Afterthoughts and Wrapping Up Housekeeping Issues 1.
What should be done about missing data? 2. How often should data be updated? 3. What may be the most suitable criteria for adding and deleting stocks from the database? 4. How dependable are internet data sources? Recent Insights Interval Gains Ranking New Prediction Variables Research Needed Perspective Index A List of Tables Index B List of Figures Index C Recommended Websites Index D Recommended Readings PREFACE T his is intended as a sequel to my earlier book published in 2010 by Wiley & Sons under the title The Value and Momentum Trader: Dynamic Stock Selection Models to Beat the Market.
That book captured my continuing philosophy of and approach to trading and was accompanied by an Excel DVD with an actual preliminary spreadsheet that allowed any trader to input data from current stocks of interest and obtain a mathematical ranking of stocks at any given time to aid decisions of buying and selling. The book was reasonably well received in worldwide distribution and is still available online or possibly also at your local library. This present work is not designed to replace that book, but only to complement it by adding additional new information. Therefore, the reader is encouraged to begin with that work to obtain necessary basic information that will not be revisited here.
The essential vocabulary and syntax of trading will not be defined or explained in this book, but the assumption is made that the reader is already informed about necessary terminology and practice—what I there termed the vocabulary and syntax of trading. In the previous book an extensive introductory bibliography was presented so that the novice could quickly gather auxiliary information to grasp the fundamental features of trading. Unlike that prior publication, the present book is not accompanied by any preprogrammed Excel DVD, so there is an assumption here that the reader will already have obtained or gained access to such software in order to implement mathematical trading systems. What is unique in this book is a systematic presentation of lessons learned in the intervening years since publication of the earlier book.
Like the previous book, this one is offered as a guide to appropriate trading strategies. This one is also a work in progress in the sense that every trading system benefits from continual refinement. In recent years I have found important new information that serves to enhance trading success. This new information is potentially so useful that I have felt compelled to share it in this way.
To the extent that the present book is successful, it will be a source of empowerment for many readers. However, I have made a conscious effort here to complement power with parsimony. In my own research my spreadsheets have grown to over a hundred columns with scores of variables producing reams of data for analysis and comparison. Here I have made every attempt to reduce the scope of the work to a minimum number of the most productive concepts.
My hope is that the reader will embellish the work with additional channels of investigation that will be personally relevant, just as I too fully expect to find additional useful information in years to come. Given my age and stage, however, it is likely that this will be my last book on trading. Because of my growing interest in history and religion, it is probable that any of my future writing efforts will be focused in those areas. I am making this present work public because I do not want the years of effort represented here to be lost to those few serious persons who will want to take advantage of these findings.
One other comment is necessary here at the beginning of this work. Trading is an honorable occupation. It provides bread to the eater. If done properly, it should not be considered to be gambling any more than a farmer should be considered to be gambling when he plants his crops.
Moreover, trading must not be considered anti-religious behavior. It is a longstanding fallacy to equate business success with crass materialism and selfish greed. In fact, for persons like me who are serious followers of Jesus Christ, trading provides an opportunity to fulfill the Lord’s directive, “Actively trade until I come,” (Luke 19:13, original Greek). Furthermore, a belief in creative design adds impetus to trading because it reinforces the view that natural phenomena such as market trends follow predictable patterns and are governed by rules just like other physical and behavioral phenomena in the cosmos.
Religious faith is compatible with a view that market behavior constitutes a category of phenomena that is every bit as predictable as the weather. Nor should trading activity be viewed as an alternative to work—indeed, it may involve more intensive labor than you are accustomed to—but it is a means of harnessing the beneficial elements of modern capitalism that have thanklessly contributed so much to our high standard of living. Capitalism as a system is not without its challenges, but it is clearly better than any alternatives that have presented themselves so far. However, the potential benefits of free-market capitalism have been greatly impeded in today’s world.
Remember that just as there is a profound difference between capitalism and socialism, so also there is a great chasm between capitalism and crony capitalism. Just as democracy is associated with the right to vote for the leadership we desire and thereby ensure personal liberty, so capitalism is associated with the right to own shares of publicly traded companies and thereby increase wealth. I believe that, to the extent that we have the privilege to exercise these rights, we also have the responsibility to do so. At this time of serious problems in the international economy, including uncontrolled government spending with its concomitant red ink and rising private sector unemployment, I wish to offer encouraging information about a viable method of financial subsistence.
My target audience includes recent university graduates who find themselves saddled with debt and unable to gain suitable employment, as well as retirees whose incomes are inadequate, and various members of a displaced work force who resent living on government subsidies. I hope also to demonstrate here that one does not need huge capital resources to benefit financially from market participation. Of course there are financial hazards in equities trading that dictate that every trader must be circumspect. Few persons come away from the marketplace unscathed, and many of those who do are often unscathed because they are trading with other people’s money (OPM).
However, the old adage, “Nothing ventured, nothing gained,” is just as appropriate today as it has been in earlier times. The very presence of apparent hazards often serves as a portent of undiscovered rewards. The complex gyrations and awesome rewards entailed in equities trading also present an enormous challenge to any enquiring mind with an inclination to problem solving. This is a ferocious chess game with huge benefits for the winners.
Even so eminent a scholar and thinker as Albert Einstein is reported to have said that if he had it to do over again, he would become a stock operator instead of a physicist. As it happens, some of the world’s keenest minds have already concentrated on the study of the intricacies of financial markets. If you are seeking a challenge, you have come to the right place. What you will read in the coming chapters constitutes this author’s own best effort to meet that challenge.
INTRODUCTION A BACKGROUND RATIONALE FOR THE USE OF MATHEMATICAL MODELS IN STOCK TRADING W atching stock market fluctuations, the casual observer may conclude that the stock market is like a gigantic pot of alphabet soup boiling over a hot fire. Stocks, as their share prices increase, rise to the top for a few days or weeks, only to cool and sink back down into the pot. In their constant churning, the majority of stocks never even reach the top of the pot. Many observers of this boiling chaos have given up all hope of finding a reliable pattern of stock performance.
They have been told that market activity is a “random walk” and near-term market participation is at best a risky gamble. Nobel laureate economists have demonstrated to the satisfaction of many in the academic community that the market is “efficient.” This is interpreted to mean that any legal informational advantage to guide traders about price movement has already been priced into the market. In other words, non-zero risk-adjusted returns (RARs)—otherwise known as “anomalies” that represent profitable disequilibria in the market—rarely if ever exist. Of course, not everyone agrees with this dictum.
The joke has been told about a university finance professor of the strong efficient market school who was walking along the street one day with one of his graduate students. Together they spied a ten dollar bill lying on the sidewalk. When the student reached down to pick it up, the professor admonished him, “Don’t bother. If it were a real ten dollar bill, someone would have picked it up by now.” So it is that advocates of the strong version of the efficient market hypothesis miss a lot of good opportunities.
In the face of such chaos and confusion, it seems that serious market participants are of two main types.