HUGE INSIGHTS: The Big Picture - Issue #4
HUGE INSIGHTS is our big picture investment newsletter designed to help traders and individual investors capitalize on thematic market opportunities that we uncover in our research. Our methodology considers the underlying fundamentals first, but also utilizes technical analysis, and employs systematic trend following techniques. Our goal is to educate our readers while helping them to generate consistent trading profits and manage risk.
A REVIEW OF OUR TRADING STRATEGY
The main purpose of this note is to shed some additional light on our trading and hedging strategy for all of our readers, but especially our newer subscribers. As all will know, each week we publish a list of at least 10 fresh new actionable trade ideas. These ideas are based upon several screens and tiers of analysis. If a stock or ETF meets all of our criteria, then it makes the list. We then rank the list qualitatively and choose what we deem to be the best risk/return opportunities.
About 70% of the time the list is comprised solely of bullish trade set-ups. About 25% of the time it is split between bullish and bearish trade set-ups. And about 5% of the time it's comprised solely of bearish trade set-ups. This makes sense because on average, the market closes up about 70% of the trading days in any given year. If and how you chose to trade these ideas is your business. Of the many professional investors that we've worked with over our 30+ year career, we can think of no two that have the identical approach to trading stocks or managing risk.
For us, it's all about following our trading rules to the letter -- without exception. If you don't have a specific set of trading rules, then we suggest that you make a point of writing down your trading process and organizing it into a check list. If you don't have a trading process, then your success or failure is probably a combination of factors that is some part investment acumen and some part luck -- good or bad. In our opinion, the luck part is closely hinged to your emotions. If you're an emotional trader who has high convictions about your security selection choices, and the associated narratives that surround them, then your results are more apt to be affected by the luck part. If you're a disciplined systematic trader, then you have removed luck from the equation. Your success or failure depends upon whether or not your system works. By 'works" we mean, has "positive expectancy."
Positive expectancy is that statistical relationship between wins and losses that results in a net profit. It can be quantified using a metric commonly referred to by traders as the "profit factor." The profit factor is simply the ratio of total gains to total losses (in positive dollar terms). It can be estimated using a sample size of around 100 trades, but to get to a true measure of your profit factor, one must use a sample of at least 1,000 live trades. This live-test exercise seeks to validate a trading system's actual efficacy. A profit factor that is greater than 1.0 proves that the system has positive expectancy. The greater the profit factor, the more profitable the system. A profit factor of 2.0 is considered to be very good. A profit factor of 3.0 is excellent. Renaissance Technologies is purported to have developed a system that produced a profit factor of 12.7. This result is obviously off-the-charts in terms of any objective scale.
Another metric that systematic traders commonly reference is a systems "win rate." The win rate is simply the ratio of profitable trades to total trades expressed as a percentage. In our opinion, this metric is far less important than the profit factor. To quote the estimable George Soros, "It's not how often you are right or wrong that matters. It's how much you make when you're right, and how much you lose when you're wrong." It was reported in Greg Zuckerman's, The Man Who Solved The Market, that Renaissance Technologies' lifetime win rate was just under 51%, yet their gross CAGR over 30 years exceeded 66%! Our point is that a high win rate is not necessary to generate above average returns, but we do think that a win rate of at least 20% is probably necessary in order to avoid the risk of ruin in the event of a prolonged cold streak.
The ALPHA INSIGHTS trading system was launched on August 1, 2018. Since then, we've published 1,720 actionable trade ideas, both long and short. Based upon strict adherence to the trading rules outlined below, the system has generated a profit factor of 2.7 and a win rate of 40% since inception. From September 2020 through September 2021, we posted 72 select long-only actionable trade ideas to the Trade Exchange platform. The verified 1-year results are presented here.
OUR TOP 10 TRADING RULES
Only buy market leadership: Stocks that are leading the market and leading their sector or industry peer group on the relative strength spectrum.
Only buy strong momentum: Stocks that are posting new all-time highs or new 52-week highs.
Only buy stocks that are trading above their intermediate-term trend as defined by the 50-day SMA.
Only buy stocks that are confirmed to be emerging from an identifiable range or base consolidation.
Only buy stocks that have a positive risk skew of 3:1 or greater.
Proper position sizing is the first line of defense. Manage position size according to a stock's volatility, defined by its average true range, and your maximum adverse excursion.
Calculate your maximum adverse excursion (MAR) for each position and then set an initial stop-loss at the level at which the MAR requires you to sell.
Once the 10-week EMA overtakes your entry point, then the 10-week EMA becomes your trailing stop-loss level (basis weekly close).
If the slope of a stock's uptrend begins to steepen aggressively, tighten your trailing stop-loss to the 20-day EMA (basis daily close).
Once a stock doubles in price, sell half the position without exception. Repeat until you're down to your last share (former investors in WCOM, ENE, and LEH will understand why).
PORTFOLIO HEDGING
Occasionally, when we believe that our work gives us an edge on a high probability directional market move, we will recommend a portfolio hedge. Historically, we have published tactical hedging advice using VIX proxies and put options. Today, we think that there is a unique set of circumstances that surrounds the ARK Innovation ETF (ARKK). As all will know, we published a bearish trade set-up featuring ARKK in our last Weekly Playbook. ARKK posted a 152% total return for 2020. As such, it garnered significant media attention and investor interest, resulting in an enormous increase in AUM at the firm level, ultimately exceeding $50B at its peak this year. Cathie Wood, the firm's founder, was immediately catapulted to celebrity status. We respect Cathie, both personally and professionally, and we wish her the utmost success.
That being said, ARKK is down some 35% from its mid-February high, and the vast majority of the volume in ARKK occurred above the last trade. Given that we are in the season of tax-loss selling, it should not surprise anyone that this ETF and many of its largest holdings are in near-liquidation mode. We think the selling will continue into year-end. As such, we think that short exposure to the fund could potentially represents a unique opportunity as a portfolio hedge. Since ARKK is hard to borrow, making it too expensive to sell short directly, we suggest investigating the recently launched Tuttle Capital Short Innovation ETF (SARK), which seeks to replicate the inverse of the daily return of the ARK Innovation ETF (ARKK). Please do your own homework on this before taking any action. You can access a prospectus and other relevant documents pertaining to the fund via the link: https://sarketf.com/. The chart above illustrates the potential downside risk.
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DISCLAIMER
All information and data contained on this site and in reports, analytics, etc. produced by Jeffrey W. Huge (the “author”) is for informational purposes only. The author makes no representations as to accuracy, completeness, suitability, or validity, of any information. The author will not be liable for any errors, omissions, or any losses, injuries, or damages arising from its display or use. All information is provided AS IS with no warranties, and confers no rights.
External links are often provided within the author’s newsletter for the convenience of the reader. The author will not be responsible for any material that is found at the end of these external links.
The author is NOT registered as a securities broker dealer or investment adviser with either the U.S. Securities and Exchange Commission or with any state securities regulatory authority.
The content of the author’s newsletter should not be considered professional financial investment advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. The author may hold positions or other interests in securities mentioned, including positions inconsistent with the views expressed.
The user bears complete responsibility for their own investment research and should seek the advice of a qualified investment professional before making any investment decisions.
Past performance is no guarantee of future results.