The Fallacy of Backtesting and Adapting to Current Market Conditions

I recently engaged in an interesting chat with a novice trader this weekend. It got me thinking about the fallacy of backtesting and why I don't rely on past statistics. 

You heard me correctly. My take on backtesting is controversial and puts me in the minority. Some have called me an idiot for this view and I don't mind at all. The majority is often wrong, and I've made a career out of going against the grain. 

Here's the conversation that illustrates my point.

Paul, how are you doing trading breakout-pullbacks?

I haven't traded any this year.

Why not? A few years ago you made a killing off that setup.

That was a few years ago.

Yeah, but I backtested the past 10 years and they have a 58 percent win rate and average gain over 7 percent on winners.

Nice stats but they don't apply to this market.

Stats don't lie Paul.

Have you made any money this year trading breakout-pullbacks?

No.

The take away from this chat is that you need to understand the current market you are trading. Backtesting can give you a general idea of how reliable a setup is, but there is much more to trading a setup. 

You can not test for every variable and different market reacts differently to specific setups. A successful swing trader must understand the current market and adapt accordingly.

Forget about backtesting, understand the current market conditions, and trade right setup for the right market.

Subscribe to The Market Speculator by Email and never miss a post!

Watch me on YouTube 

If you would like to learn more about how I trade, receive my nightly focus list with market analysis, setups and trade alerts, sign up at BullsonWallStreet.com.

21 profitable stock trading setups and the optimal conditions to trade them

Most full-time traders have a basket of "goto" setups that they trade repeatedly. Some do so mindlessly, irrespective of market conditions. You can make money this way, but you will not become wealthy.

The best traders optimize their trading by deploying the right setup for the right market. For instance, a "trading range" setup is highly profitable in choppy, rangebound markets. Just don't expect it to make you money in a parabolic momentum market.
Please retweet if you like this article Tweet
Here are some of my favorite setups and the best conditions to trade that setup:

1. Trend pullback: trending markets that successfully tag key moving average support
2. Bottoming formation: downtrending markets forming a base
3. Rubber band short: parabolic markets nearing resistance showing signs of weakening
4. Rubber band bounce: parabolic downtrending markets near major support levels
5. RSI divergence shorts: market near highs but showing weakening overall breadth
6. RSI divergence longs: markets near lows but showing strengthening overall breadth
7. Breakouts: earnings season in an up trending market
8. Breakout pullbacks: trending and rangebound markets, avoid downtrending markets
9. Breakdown shorts: downtrending, rangebound and stalling trending markets
10. Trading range bounce: rangebound and trending markets
11. Trading range short: rangebound and downtrending markets.
12. Breakout failure: Downtrending markets that are bouncing, or stalling at highs.
13. Breakdown failure: momentum markets
14. Remounts: any market
15. Earnings Breakouts: Any market
16. Head and shoulders short: Extending markets showing negative volume patterns
17. Double Top short: Extended markets showing negative volume patterns
18. Earnings Breakdowns: Downtrending markets
19. Moving average bounce: any market for small bounces, trending markets for sustained bounces
20. Pre (anticipatory) breakouts: Trending markets
21. Dead cat bounce: down trending markets, rangebound markets

All of these setups will allow you to keep up with or slightly "beat the market". However, if you want to make serious money in the trading game you must deploy these setups under optimal market conditions.

If you would like to learn more about how I trade, receive my nightly focus list with market analysis,setups and trade alerts, sign up for a 14 day free trial at BullsonWallStreet.com.  

If you like this article, follow me on twitter

Subscribe to The Market Speculator by Email

P.S. If you like this article, share it, comment on it or let me know.
Image courtesy of scottchan at FreeDigitalPhotos.net

Trading "Leak": Impatience and the GS Trade

One of my mantras is to "set it and forget it" after making a trade. Once a trade is made, I set my stop and target, then forget about the trade until one of the price objectives is hit. At least I usually do . . .

My recent GS trade is a good example of a trading "leak" that many traders have, the error of impatience. GS was not a losing trade, but I could have done better. I originally entered at the bottom of the current trading range as an "oversold" setup as the stock neared support and was oversold. My initial target was hit, I took a partial profit, then moved my stop up just under the current support range. If I had stuck to it, the second half of my trade would see a profit right now.

Instead, I got tired of waiting for something to happen and exited on Friday before my stop was hit. Thus, I missed out on today's 2 percent gain.

We all must remember that we set out stops and targets for a reason, and little good comes from "micro-managing" trades.

STEC Short Entry: Time to Take Profits?

Is it time to take profits in the STEC short? Entry was made back on September 24th at $30.75., so we are looking at a 15-20 percent gain.

My general approach to exits is to set a target based on support/resistance levels and take a partial profit at that level. As you can see from the chart, a consolidation zone is in the $22-25 range. Thus, I took profits yesterday around $26.

After taking profits, I move my stop to entry to "lock in" the initial profit. This allows me to stick with the trade if it continues to drop, without worrying about giving back too much. If price reaches the 200 day moving average, I'll take full profits.

Monday Game Plan and Free Trade Report

To see the report with charts, click here

August 24, 2009

Market Notes:

In the law there is a term called "de novo", which means to consider a matter anew. It's commonly used when an appeals court reviews a lower court decision. The appeals court can review the case with a fresh pair of eyes.

I like to think of my weekend review of the markets as a "de novo" review. I throw out my previous analysis and biases, and start from scratch. Let's do that with the market.

On the short term chart, SPY has broke out over recent highs on decent volume. This looks to be a good breakout-pullback setup. While I entered on breakout Friday, I'd like to add more on a dip.

My previous bearish take has been invalidated, as the dip turned out to be a pullback rather than start of a deeper pullback. This is surprising, as last Monday and Tuesday were very bearish moves on strong volume. If we were stubborn here, we'd hold onto the past and say to ourselves, "the market has to go down". We cant play that game.

However, note that if the recent highs are pierced to the down side (especially on a close), that would invalidate the breakout and the "failed breakout" setup would emerge.




Now let's look at the longer term 1 year chart. We see a really nice looking bottom pattern that's take a year to form. We are now near a major resistance level, the gap down zone in the $105-110 range. This will be a good area to take some short positions.




Game Plan:

Buy the dips. Look to get short on a rally into the $105-110 zone.

Trade Tracker:

I entered SPY on the breakout. As I noted on Thursday, we were in a trading range and a break in either direction would clue is in on how to position ourselves. A good strategy when waiting for a level to break is to place a buy entry at that level. I had buy entires placed at the bottom of the range for a short trade and the top of the range for a long trade.

I entered 500 shares of SSO at $31.80 , and 200 shares of SPY at $102.

I was stopped out of my SDS position. I am still short LMT, AMZN, POT and VPRT. Note that while SPY is breaking out to recent highs, my short positions are not. They still could get taken up with the market, but this does tell me that these were good short positions.

Focus List:

The easy trade right now is to just focus on the indexes. You can gain volatility by trading the leveraged ETFs.

SSO, DDM

The only non-index trade I am looking to make tomorrow is LUV. It looks like it may be done pulling back after a strong uptrend. The moving averages are about to cross and the trade is easy to manage with a stop placed at the pivot low.




Shorts: Focus list stocks BCSI, AAP and SNDA

Disclaimer: All information and opinions expressed in this report are to be used for entertainment purposes only. The author of this report is not an investment adviser and does not give buy, sell or hold recommendations. Trading stocks is a risky undertaking, and due diligence is required before making a trade. Consult an investment professional before making a trade. The information in this report is not verified and may be incorrect. The author of this report may or may not hold a position in stocks mentioned in this report.

Apple is a Tough Read

If it were any other stock, I'd take a stab at shorting AAPL right here, right now. Technically, it shows signs of losing steam and is a good "pioneer short trade."

We see negative divergences in both RSI and Stochastics. Price is making new highs while the two indicators are not. On top of that, volume has been declining as price floats up to new highs, rather than decisively showing strong price breakouts and accumulation.

I love this setup. Not only does it offer a good edge, it also offers a good reward to risk ratio. You can set a stop just above the highs and place a target at support.

So why am I hesitant? One, the market has been resiliant and bucking many technical signals. Also, AAPL has been doing the same.

I'll probably spend the rest of the day thinking long and hard about shoring AAPL. I'll update you if I pull the trigger.

Part-time Trader Series (tip 2): Have a Plan

This is the second in a series of tips for the part-time trader who trades around a full-time job.

As a part-time trader, time management is as vital to success as picking stocks or managing my portfolio. Over the years I have developed tricks to streamline what used to take me up to 4 hours a night, down to about 45 minutes.

How many hours have you wasted agonizing over a trade you have just made? You place a trade, get back to work, look up at your monitor and watch every tick the stock makes. You try to get back to work, but you can't get the trade out of your mind. You don't know what to do. Should I sell now the stock has ticked up for a small profit? Should I exit now that it's gone the other direction?

The easiest way to combat this problem is to have a plan before entering every trade. In tip 1, we developing a weekly focus list which you fine tune on a daily basis. Every night you should review your focus list and mark each stock with an entry level, stop and target. Accompanied by these numbers should be comments on the setup and risk analysis.

By doing this, you make post-trade decision making a snap. The plan is there so you have no need to sweat as the trade develops. This type of preparation will not only make trading easier, you'll get more work done at your day job!

Tip 1

Pair Trade: RIMM and AMZN

On Friday I went short AMZN and long RIMM. This is a "pair trade" trade using the folling strategy:

1- enter one stock long and one stock short from similar fields.

2- the short stock should exhibit a very bearish pattern, while the long stock a very bullish pattern.

The idea behind this trade is that if the market goes up or down significantly, it will likely take both stocks and you break even or have a slight gain or loss. However, if there is not a major market move, the stocks will move according to their patterns. This could give back significant profits in two trades that end up working out.


RIMM is consolidating post breakout of 50 day moving average. AMZN is a "failed breakout" setup.

On Time Frames and Over-Trading

Since joining Twitter, I've had a number of conversations with Trade Report members who also use twitter. I've found a common mistake between twitter users, and that is over-trading and not understanding time frames.

Yesterday, a member told me he had entered one of my focus list stocks. I asked him why, since it was not near the entry point that I had suggested. He said somebody that he follows on twitter has suggested that same stock and had taken a position.

The stock is down over $1.50 today and is now near entry level. Meanwhile, the trader report member who entered is down 5 percent on the trade and needs to exit before support levels, or the loss could get too big for his account.

I did a little research on the "tweets" that suggested the stock, and it turns out that the person who suggested the trade is a daytrader. He would have been stopped out of the trade long ago for a minimal loss, and was looking at support levels mean for a daytrader, not swing trader.

The loss the guy on twitter took was perfectly acceptable, but only on his own time frame and trading style. However, the Trade Report member, who traded it as a swing trade, made a major blunder. He traded the stock without a plan and under the wrong time frame.

This is a common mistake amongst traders. Make sure when you follow a recommendation on twitter or anywhere else, that you know the trading style of the person recommending a stock. Then do your *own* analysis and see if the trade fits your trading style, risk and trade management principles.

Another common mistake that is prevalent with twitter users is becoming trigger happy after reading about what other traders are doing. There are a lot of great tools out there (when used properly), but one must stay disciplined and stick to their own, effective trading style.

Strategy Session: Using Distribution Patterns to Predict Trends and Trend Failure

The second most important aspect of my trading strategy (behind support and resistance) is using volume to classify stocks that are under accumulation and distribution.

Distribution is under way when, over a period of time, stocks show higher volume on down days and lower volume on up days. In a bullish trend, this predicts the trend will pullback or fail. In a bearish trend, expect the trend to continue until the distribution pattern is reversed.

Take a look at GME. This stock shows classic distribution. During the recent uptrend, positive volume was putrid. Trend failure was easily predicted. Currently, the distribution pattern is continuing. This suggests a retest of recent lows.

I will likely short this stock soon.

One That Got Away: IBN

A useful tool for improving trading is to analyze trades that you did not take. IBN has been on my radar for since the April breakout. I did not trade it because the volume pattern was not to my liking.

However, the risk ratios have been good through out that time period. Price has been near support and provided classic entries, the latest being the recent consolidation pre-breakout. Lately I've been lossening my volume requirements when I get favorable risk ratios (usually above 3:1). Obviously IBN would have been an ideal candidate for my new stategy.

Poker, Trading and Making Adjustments

In my Thursday report to members, I talk about the current market, making adjustments and poker:

Before we begin, let me compare what's going on now to poker. In Texas Hold'em, the best hand pre-flop is pocket Aces. Most players try to get as much money into the pot as they can when they are dealt this hand. While this is a great hand before the flop (the three community cards that are dealt to everybody), a flop that leaves open the possibility for a flush, straight or trips (hands that beat pocket aces) can spell disaster. Great players can lay down pocket aces or control the betting in order to limit risk. Amatuers can't adjust and end up losing their bankroll. The ability to adjust the game plan as more information presents itself is what seperates the men from the boys.

With the poker analogy in mind, let's analyze what's going on with the market. Originally I planned to start shorting as low as $87.50. At his level I expected stochastics to reach 90, which would give an extremely overbought reading. However, we've had enough consolidation to drop stochastics enough that the $87 price level will probably only give us a mild overbought reading. Thus, it's time to adjust.

I am raising my short entry level to $89-91. If stochastics are still not near 90, I'll raise the price entry to $93-95. These price level correspond with the resistance lines on the chart below.

I am not looking to enter at these levels. Basically, we are at a level that is too overbought to enter, yet not overbought enough to enter short.

On Probability, Trading and Current Market

What do I mean by high probability?  In trading, I define a high probability setup as one that gives me a significant edge over an average trade.  For instance, in my back tests, when stochastics hit 90 (extremely overbought) in a bear market, coupled with a few specific trading setups, the success rate of shorting is above 75 percent.  This is a very high probability setup.  Obviously, it doesn't occur often.  When it does, I usually get very aggressive with the trade.  

Adding volume and paying attention to accumulation and distribution patterns can add or subtract to the probability of a pattern setup.  For instance, in the bottoming price pattern, strong accumulation (positive volume pattern) underlying the price pattern increases the probability that the trade will be a winner.

Currently their are no high probability setups.  However, if the market pulls back to support, or ramps higher toward resistance levels and become extremely overbought, well see high probability setups emerge.

A Crappy Picture That Clarifies the Ideal Volume Pattern

This picture I created ain't pretty, but it does a good job of showing the type of volume pattern I look for during bottom formations:

Trades: VLO, USO and STLD

Here is the intra-day trade alert I sent to my subcribers (this is not a regular feature of the Trade Report, but I do send trade alerts from time to time):

The gap down this morning blew past the entry and stop points I had set for SSO and QLD. Also, most of the stocks listed in the report last night also gapped below entries and stops. Obviously I made no entries in these setups.

Two stocks holding up above support are VLO and STLD. They did gap down, which is a violation of my "orderly pullback" rule. However, they still provide low risk so I decided to enter with small positions.

200 shares VLO @22.94. Stop 21.90. Target 24.90. Risk: 2:1

200 shares STLD @11.56. Stop 10.90. Target 13.90. Risk: 4:1

Due to the nature of the market and the gap downs, these are *not* high probability trades. Those that are looking for wins and can't take losses should not make these trades. Since there is a possibility of multiple are gains, I am willing to take these trades, with the expectation of loss.

I also made a *speculative* energy trade. USO is extremely oversold (stochastics at 11).

200 shares USO @ 23.88. Stop at $22.90. Unsure of target.

The idea behind these trades is they will only give me small losses and have the possibility (not probability) of multiple R gains.

Again, do not piggyback these trades unless you have done your own analysis and realize that they are not high probability trades.

Friday Game Plan

I'd like to pick up a few long positions in anticipation of an inauguration rally. The fact that we are very oversold increases the chances of a rally. I will still use tight stops with the strategy of taking a small loss with the possibility of a big gain.

10 Market Thoughts to Start the New Year

1. Be patient with trades and setups. Do not chase trades. Let them come to you. If you miss a trade, that's okay.

2. The best setups in this market focus on extremes. Buy extreme weakness and sell extreme strength.

3. Watch for accumulation patterns that form as prices base near lows. This will get you in on "bottom" trades early.

4. Ignore the market forecasters and pundits.

5. It's all about the charts. Price, volume, support, resistance, overbought and oversold indicators are all you need to make money.

6. Manage risk vigilantly.

7. Define your stop-loss and target before entering a trade, and stick to it!

8. Keep an eye on breakouts and watch for sectors that are well represented in breakout scans. These sectors will lead the next rally.

9. Do not watch CNBC.

10. Write down a few important resolutions, post them on a big board in your office, look at them every day, *act* on them everyday and stick to them. I will post mine soon.

Buying and Sellng Extremes: The SKF Trade

My strategy over the past few months has been to be patient and wait for extreme conditions to surface before making both long and short entries. A good example of this type of trade is the SKF position I entered yesterday (detailed in the trade report).

Here are my entry notes with chart:

I took one "low risk speculative" trade today, shorting financials via SKF. The inverse ETF has dipped down to a strong area of support, making it a low risk entry. I bought 100 shares at $103 and have a mental stop under support at $97-98. I will likely take partial profits if it bounces to $110, and then again at $120.

If the market continues to rally, I'll lose a minimal amount. However, if it pulls back, this could be a very profitable trade. For those looking to take this trade, I probably would not enter above $103-104. As price moves higher, risk increases.



I took partial profits today at $111 and moved my stop up to entry level, effectively locking in today's profit. My final target is $120.

SSO Provides Low Risk Entry

While the "edge" or probability for the trade may be 50 percent or less (accumulation pattern is not what it was a week ago), SSO does provide a low risk entry point that can be easily managed with a stop under the recent lows.

I am willing to take low risk setups even if the probability for success is not what I like, especially when the reward is big. For example, if I entered with 500 shares, the most I would lose is $1000. My potential gain is $7000-10000 if the intial target is hit.

I could lose on this type of trade 6 times in a row and still make money if I hit on the 7th try. Thus, I'd only neeed to be right about 15 percent of the time to make it in the green.

The RSI Effect

As long as the lows hold, the bottoming thesis is in effect. I have focused on more short term 3-6 month charts lately, but here is a two year chart showing the power of the oversold RSI, even in a longer term down trending "topping" market.