Let’s face it. We are enamored with the idea of buying things that have fallen in price and buying at a discount. It’s the Siren’s song of catching an investment at the perfect bottom and then watching it take right back off to the upside.
It’s a fantasy … and I’m finally throwing in the towel on this insidious idea.
There are few things that academics, value investors and technical analysts agree on. Momentum is one of them … maybe even the only one. Even the famous academics Fama and French have written about momentum in the stock market.
The simple idea behind momentum is that investments that are increasing in price are more likely to continue increasing in price … and investments that are decreasing in price are more likely to continue decreasing in price.
I recently came across some additional compelling evidence in support of this thesis as part of my own research. I’ll share it with you now.
As you hopefully know by now, my SSI indicator is a three state system – Green, Red and Yellow. Very briefly …
- Green is the strongest state. The investment has risen nicely off of a major bottom. It is trending positive and is only experiencing mild corrections.
- Yellow means that the investment has fallen in price significantly but it’s still within the boundaries of its expected volatility. It’s getting close to being in the Red Zone but hasn’t gotten there yet.
- Red means that the investment has corrected more than it should have corrected based on its expected volatility. In our SSI system, the stock is “stopped out.”
In addition to paying attention to which of the three states an investment is currently in, we pay close attention when an investment changes from one state to another state.
I recently asked my research staff to study which SSI state changes presented the best buying opportunities. We looked at three different state changes:
- Red to Green – The investment was stopped out per the SSI and just triggered a new SSI Entry signal by rising substantially off of a bottom and establishing a brand new uptrend.
- Green to Yellow – The investment was in the Green Zone but has corrected more than halfway towards the Red Zone. It’s getting close to being stopped out but hasn’t been stopped out yet.
- Yellow to Green – The investment corrected into the Yellow Zone and has just risen back out of the Yellow Zone and back into the Green Zone. It has reasserted its upward momentum.
Using our database of several hundred securities with data back to 2000, we looked at which changes of state triggered the best buy signals. Here’s what we found.
There were 7,469 trades generated from the historical data. 52.7% of these trades resulted in a positive return. The average gain of all these trades was 36.6%. The average gain of the winning trades was 84.3%. The average loss of the losing trades was 16.4%. The ratio of the average gain of the winners vs. the average loss of the losers was 5.1. Winners were 5.1 times more profitable on average than losers.
OK … I know that’s a lot of data but I want to be sure that you understand the numbers. Now let’s talk about some of the results.
Clearly buying on the change from Red to Green leads to the biggest winning percent … by a substantial amount. Buying on Red to Green also has the biggest average gain at 36.6% and the biggest average winner at 84.3%.
The only category in which Buy on Red to Green doesn’t win is Average Loser. The average loss of a trade that was triggered on a change from Red to Green was 16.4%. The other two strategies had smaller average losses.
The smallest average loss was for the Buy on Green to Yellow strategy. That makes sense because the stocks are already getting close to the top of the Red Zone … where they will get stopped out if they close in the Red Zone.
Having that tighter stop loss point, however, meant more losers overall than winners and a smaller average gain.
Pretty interesting, isn’t it?
I’ll be writing more about this in the weeks to come. For now, I’d say that the evidence is pretty clear that it’s time to go Green,
Richard M. Smith, PhD
CEO & Founder, TradeStops