Evaluating the trade

My background is in engineering, so I like to take an analytical approach to investing. First I setup a set of criteria, then once something meets those criteria, I evaluate and create my prediction, then I develop a trade to capitalize on that prediction.  I then evaluate the trade around the prediction and create scenarios and create a plan on how to adapt to those scenarios.

To develop my criteria I need some rule or guideline to base it off.  Previously I discussed the RSI and how a quote by  John Maynard Keynes “The market can stay irrational longer than you can stay solvent.” shows that the RSI and a stock price can stay high and even go higher more then would seem possible and cause your account significant pain.  I have 2 ways that I try to mitigate this fact and make use of the RSI.

First is to find a stock or index that is mean reverting.  Stocks can act far more “irrationally” then index’s tend to do because index’s are a collection of stocks and their irrational tendencies can balance each other out. So I start my search there, then I will do what is called back testing. I will setup a script that will buy the index when the RSI is oversold, below 30 or 20, and then sell the index when it is above 70 or 80.  I then review the profit or loss of this back test to see if the index is mean reverting. I have found that the S&P 500 is very mean reverting on the short term.

The second thing I do is an attempt to counter act the Irrational patterns even more.  There is another quote that I don’t know who coined it, “don’t fight the tape,”  this basically says that when a market is trending one way to not bet against it. So what I do is I combine this with the RSI. I look at the 200 day moving average, if it is pointing up then the market is trending up. When the market is trending up I am more confident to step in and buy when the RSI shows over sold.

So now I have 3 components that make up the criteria. First, is it mean reverting (small list of indexes), Second is it trending up (200 Day moving up), Third is the RSI over sold (RSI < 30). When all of these criteria are met then I am going to look into entering a bullish trade.  I have back tested that with very positive results and I trade this in my account.  I have back tested this through the crash of 2008 and it that yields good returns and was kept out of the bear market.

 

Bob Bullock

Contributing Writer