The 30-Minute Stock Trader

by Laurens Bensdorp

  Fundamental traders guess the future. These traders analyze earnings reports and other company numbers, and predict where the price will go based on their analysis. They have a conceptual idea of where the market will go, and then they make predictions. For example, they might say, “The economy is slowing down, so stock prices will probably go down.”

  Basically, it’s the Warren Buffett model of investing. That sounds great, except that it’s highly skill based. Buffett is the master in picking the right stocks, and few people are able to learn that skill. They think they can, but when they actually try to pick stocks, they fail. The common anecdote goes like this: If the average investor compared his results to a monkey choosing ten different stocks, the monkey would do better on average.

  Picking random stocks beats the average investors’ skill, because picking stocks is incredibly difficult, random, and counterintuitive. Using Buffett’s strategy to pick stocks would be like using LeBron James’s strategy to play basketball. Sure, slam dunking every play sounds like a nice strategy in theory, but if the average guy tried it, he would fall on his face. You need Buffett’s otherworldly skill, decades of experience, and hours of daily hard work if you want to attempt his strategy.

  It’s also difficult for fundamental traders to create strict rules for when to buy and sell, because their discipline is so instinctive and skill based. Quantifying their exact decisions for when to buy and sell is therefore mostly impossible. They make a trade because they expect a certain outcome—that a company is going to do well. But what if they’re wrong? Even the best traders will be wrong frequently. They don’t have an exit strategy, because they’re simply making a bet that a company will do well, and when it doesn’t, they still expect things to turn around eventually.

  Additionally, fundamental traders don’t tend to have a strategy for when there is a big downturn. Whenever market sentiment is down, their accounts are down, too. They attempt to spread risk by investing in different companies and sectors; however, their complete exposure is long. Therefore, even though they are “diversified,” their assets are correlated; they go up and down together. When the entire market sentiment is negative, all sectors go down. Diversification sounds nice in theory, but if all of your exposure is long, you will go down with the market.

  When you most need protection, sector diversification won’t help you. In bad times, your “diversified” stocks go down together, and you suffer.

  By that, I mean this: Investors think that a diversified portfolio will protect them from catastrophe. That’s not true, because diversification only applies to sectors, not market types. When there is a bad bear market and the markets are down, all sectors go down. All sectors are correlated in bear markets. Diversification works somewhat in bull markets—some sectors will do better than others—but when market sentiment is down, diversification is useless. Your entire portfolio will go down. I call this concept “Lockstep”. It’s when emotional responses create the mood in the market that everything is now going the other way and correlations are either 1.00 (perfectly correlated with zero diversification) or -1.00 (perfectly inversely correlated which means that you can’t make any profits)

  That’s what happened in 2008. It didn’t matter how you had diversified your portfolio—all of your “diversified” stocks went down together, and you suffered.

  Once in a while, fundamental traders will be right, and it will pay outsized dividends. Often, they’ll be painfully wrong, like with gold, as I’ll explain in a moment. Over the past seven years or so, writers have been saying the US economy is in bad shape. The government is trillions of dollars in debt, and so on, which is true. It is in incredibly bad shape. However, that doesn’t tell you exactly what will happen to stock prices in the coming year, because the emotions of traders are what control stock prices. You can’t predict exactly when the inevitable downturn will occur, nor its magnitude. It could happen in a day, a month, a year, or a decade, and it could be of any size.

  In 2011, gold was at $1,900, and I have never seen more newsletters start to say, “The world’s going to end; the financial system is going to collapse; you must buy gold!” They reasoned that “gold always holds its value and maintains its purchasing power,” “we might even go back to gold standards,” and so on, and “then the price of gold will explode!”

  Conceptually, there is truth in this analysis. The people who said it are not stupid. Yet from 2011 to 2015, gold dropped from $1,900 to $1,050, almost 50 percent! While the fundamental analysis made conceptual sense, and implied that gold would rise dramatically, the price action told you something different. Price action is all that matters.

  The standard, fundamental analysis (touted by many newsletters and media) would have lost you almost 50 percent on the big recommendation of gold, but a simple, long-term trend-following model would have told you otherwise. That model simply closes the position whenever it’s below the two-hundred-day simple-moving average, so you would have gotten out around $1,600.

  As usual, the white noise of newsletters and media was wrong, and a simple, technical exit based on price action would have saved you from disaster.

  If I were trading a long-term, trend-following strategy, I would have definitely been in a long position on gold at $1,900, like the fundamental traders. However, technical analysis gives you clear rules on an exit plan. That’s the key. You can be in a position that will eventually go bust, but you’ll get out before it goes bust, because you’re prepared.

  There will be a moment where the computer measures the trend and tells you, “In this situation, historically, prices start to go down.” It will tell you: “Based on past statistical evidence, this price is broken. Let’s get out of here and eliminate our position on gold.” Your balance would be saved.

  Under a trend-following approach, you stay until the trend flips. Your technical strategy makes you far better off, because it understands that you must never be overconfident in your analysis, because all that matters is what prices the market displays. Fundamental traders, however, don’t have that safeguard against overconfidence.

  It wouldn’t have mattered which specific trend-following approach you used. Any approach would have saved you from catastrophe, forcing you to exit as soon as the trend was measured over. All that matters is that you measure price action, and base your buying and selling decisions on that. That’s the key.

  Simple-moving averages (SMA), as I’ll show in part 4, are a tenet in the philosophy of trend following. It’s simple. When the computer tells you, based on SMA, that a trend is over, you exit. (See Ch. 4 for an example with Enron.)

  You can analyze the fundamentals all you want, but the stock market is controlled by market sentiment. If the market doesn’t agree with your analysis, you’ll lose, even if your analysis was logically sound. That’s why I focus solely on price action. It’s the best measure of market sentiment that exists.

  Another example of fundamental traders failing was in early 2009, with the S&P 500. We had just experienced the large bear market in 2008, and in March 2009, that bear market hit its low. From then on, the S&P 500 went up in price. In mid-2009, my trend-following strategies recognized buying signals, based on that price action. However, fundamental traders were still in a negative headspace, thinking, The economy does not look good, therefore I’m not optimistic. But if they had simply followed price action, the charts would have shown them that sometime in the summer or fall of 2009, they could’ve again entered positions. From then on, the S&P more than doubled in value.

  Fundamental traders cried about the massive national debt and other issues, yet the S&P tripled in value from its low in 2009. If you had completely ignored the fundamentals and all of the market’s issues, and simply followed price action, you would have done incredibly well.

  Technical analysis analyzes the past. Technical analysis completely ignores fundamentals, and looks at price action instead. My strategies analyze the historical price movements of the market, in order to f
ind statistical edges. There are patterns that will repeat themselves in the long run, and if you trade according to these patterns, consistently, you will have an edge and beat the market. You don’t predict the markets, like typical advisors do. That’s nearly impossible; the market is too unpredictable. You simply react to the movements of the markets, once they happen. The key difference is that your strategy, based on past statistics, can accurately describe the market sentiment in numerical form and tell you what that sentiment means for future price action. You wait for the market to tell you something, and then you react based on your proven strategy.

  Basically, the strategy quantifies how people are feeling about the market, based on price action. But it does this all with long-term, statistical significance—any pattern that hasn’t been proven over a large sample size (which is quite common) is ignored. All recommendations are a combination of sound logic programmed into the strategy, plus statistical analysis.

  My approach works, because we use statistical evidence based on real past historical price action data. Using price action data allows you to react according to the market. You may own a company’s stock that looks good fundamentally, but if market sentiment isn’t good, the price will go down.

  You could have owned the greatest company in the world in 2008, with healthy earnings ratios and the like, but market sentiment would have killed you. All stocks went down, on average, 50 percent. Your fundamental analysis could have been perfect, but you would have lost half of your value because your exits weren’t based on price action. That’s the danger of working with fee-based advisors.

  If you don’t look at price action for a stock, you have no idea where the price is going. That’s why I advise all of my clients to build their strategies based on price action. For the past fifteen years, I’ve trained myself to ignore fundamentals, while all of the “experts” who want your money do the opposite.

  My approach is a quantified, technical approach. It is simply creating a proven strategy, and then following that strategy. Once you have this strategy (and I will teach you proven ones), you do not need to have any skill. You follow the strategy. Fundamental trading can work if you have tremendous skill, but most people, myself included, do not have this skill. Unless you’re Warren Buffett, fundamental trading is incredibly risky, and not particularly smart.

  In the end, the computer program uses a strategy with a scientifically proven edge and predefined entry and exit rules that are based on historical performance. The rules tell you exactly what to do: when to buy, sell, and sit still. All you have to do is follow its instructions, like in the earlier example about gold.

  Your computer is following a strategy of proven rules based on how investments have behaved in the past, and it knows when to cut losses short. It eliminates the risk of ruin inherent in fundamental traders’ recommendations, which put too much stock in risky, unscientific predictions. Technical trading is the complete opposite of guesswork. It is quantified technical analysis of past price data. It only looks at price action, because that is the most accurate measure of market sentiment, which is the best predictor of stock prices. Everything is back tested, so every rule in the computer has a proven scientific edge over the benchmarks that wealth managers hope and pray to beat with their crystal balls.

  My strategies use historical price action data, but there is a huge variety in each strategy type. A classic one is trend following. We cover many styles, but this is the easiest and simplest to start with. The data identifies stocks that are trending up. When they’re trending up, you have the belief that when you enter that trade and buy, you will ride that trend until it’s over. The data tells you when to stop, and at that moment, you cut your losses short. You get out of the trade, because the price action is telling you that the company’s sentiment is not good anymore, regardless of its actual quality.

  It’s no longer the misleading news messages that tell you if a company is good or bad. The price tells you. If the price goes up, it’s a good company. If the price goes down, it’s a bad company. You’ll get out, because otherwise, you’d lose money.

  Still, there is no better option than using past data. Would you rather look into a crystal ball, or use beliefs based on the statistical proof that would have made money in the past? As long as you test your trading hypotheses and beliefs and prove them to be true and based on sound market concepts, you should make money over the long run.

  Most importantly, using an automated strategy takes the emotion out of what can be an emotional business.

  A quantified strategy means you defer to your computer. Every day, it tells you what to buy and sell. The computer’s recommendations are rooted in your beliefs, because they are programmed into the computer. You’re simply outsourcing the number crunching, and you get clear directions on exactly what to do. Your decisions are not based on predictive hunches—where you think the market is going. They’re based on proven strategies, reactions to what the market tells you about current conditions.

  Emotions are the number-one reason people fail in the stock market, but in my strategies, emotions play zero impact on your decision making. It’s impossible for a human to behave like a rational computer on a day-to-day basis—but it’s pretty darn easy for a computer to behave like a computer.

  The key, though, is using multiple strategies in concert with each other. You can’t focus only on trend following, for example. My trading plan works because it uses a suite of noncorrelated strategies—all traded simultaneously—so money can be made in every type of market. Mean reversion is the opposite of trend following, and yet it works great when the two are combined. That’s because when one strategy is struggling, the other strategy makes up for it. I’ll explain this in depth in part 4, when you learn how to set up your own strategy.

  The idea is this: You trade different strategies, with different purposes, at the same time. There are three basic directional states a market can be in: bull market, bear market, and sideways market. We can further define based on volatility, but for this example we’ll stick with direction. When you have a long-only strategy, like fundamental traders, you’ll do well in bull markets, but you won’t make money in sideways markets (the markets aren’t moving). You’ll also lose money in bear markets, like in 2008 when the S&P 500 dropped 56 percent and the NASDAQ dropped 74 percent. The bad times will wipe out all of the good times.

  Perfect execution of a suite of noncorrelated strategies would look as follows. We start with a strategy that makes money when the market goes up: long-term trend following. That strategy will thrive only when we are invested in long positions. When the trends start to bend, those positions will be stopped out until we’re going flat. Another type of strategy that works well in bull markets is a mean-reversion long strategy.

  But the market will go down at some point, and your long positions will lose. That’s why you’ll be trading a short-selling strategy at the same time—to prepare for bear markets. It’s a hedge strategy, ensuring that you’ll make money when the market turns and goes down. Of course, you need to make sure you’re not giving too much back with this hedge strategy, because it will lose money when the market is going up. But that’s all covered in my strategies, as I’ll explain.

  It’s an insurance premium, basically. You need to pay it to make sure that when the market goes down, you’re covered. In a good year, when the market is going up, your long strategies will make great money, and your short-selling strategy will lose a little bit. But if another 2008-like situation happens, or even to a smaller degree like early this year (2016), your insurance will pay off and you’ll end the year positive. At the same time, fundamental traders will be losing big.

  In the previous graph, we can clearly see a few things. At the end of 2007, the Weekly Rotation strategy (grey line) started to lose money, dropping about 25 percent. However, at the same time, our short-selling strategy (black line) made up for that with large profits.

  In mid-2009, the situation reversed. The
markets entered an uptrend, meaning the Weekly Rotation strategy (grey line) kicked in, and we started to execute a lot of long-term trades, making great money. The short-selling strategy (black line) lost a tiny bit. Overall profits were large.

  That covers bear and bull markets, but there are also sideways markets, in which trend-following strategies don’t generally work. However, we don’t suspend those strategies. We are always trading every strategy simultaneously, because we want to be prepared for all unexpected market types. Therefore, we need strategies that work in sideways markets. Those are mean reversion strategies.

  Mean reversion strategies are virtually the opposite of trend-following strategies. They buy the fear and sell the greed. If a stock is oversold, that means there has been a lot of panic regarding that stock. According to a mean-reversion strategy, that moment of panic is the perfect moment to buy that stock, because there is a statistically larger than random likelihood it will revert back to its mean price once the panic has subsided. Once the price returns to its mean, you exit the stock again. The strategy works in reverse, too. When there is a lot of greed in the market and stocks are overbought (there are too many bulls in the market), that’s a good moment to sell greed. The reason is that there’s a statistically larger chance than random that the market will react to the downsides.

  You’re buying the fear, because it has gotten so extreme that it has become a low-risk idea to invest, even though prices are going down. More than likely, things will turn around. This is based on a large sample of statistics. Sample size is key. If it were based on, say, thirty trades, the statistical likelihood of your hypothesis being true would be tiny. But when it’s based on scientific proof from three thousand trades, your likelihood is high, and in the long run, you’ll win.