Trend Sigma – Stock Trading System

Financial markets are basically a zero-sum game. Everybody tries to win, but the cake is not infinitely big and the market adapts ghostly to the group of winners that has become too large, leveling their advantage down.

Yet, for a small minority there is a way to consistently escape the crunching mechanisms of the markets. In order to get an impression of what that could be, let’s have a look at a chart of one of the recent stars of the stock market:

During its steep ascent the price of Hansen Natural’s stock got multiplied by a factor of about 100 in a matter of only 3 years. This is of course hindsight and I presented on purpose an impressive example, but the chart demonstrates something.

It shows directly that you could have made hundredfold back of what you invested. Stocks often have large moves, much bigger than the ones of commodities or currencies. But at risk would have been only the investment itself. This asymmetry clearly favors stocks over all other financial instruments. Their leverage is no compensation for the asymmetric price behavior the stock investor enjoys. Trading on margin with Forex or futures can let the account go below zero, which is simply a linear and not a logarithmic growth behavior. Options have a premium that decreases over time, which destroys the advantage their non-linear pricing pretends to offer at a first glance.

But there is something else. The multiplying happened with a trend that went straight up and was almost always at its current high. In such a situation the market forces that are playing against the small trader are diminished….

Most traders, and investors even more, are not aware that a price at the high is a different situation than a price elsewhere. Generally, it is a signal for more of the same to come and not for a retreat, as it may look to so many. It is an exceptional situation, indicating that there is a force hindering the price to swing back, which it normally would do.

Still, trading is what it used to be, a statistical game. There are situations near the high where the odds are skewed to your favor, but you must be able to identify them and to behave methodically. In other words, to exploit this exception, a trading system is necessary.

It is a trading system for the stock market that is trying to take advantage of longer-term moves of stocks. That does not mean that only long-time investments are put on. Chances for swing trades are also more likely found and successfully executed within a longer lasting upwards move or a relative price strength in a bear market.

At its best a stock gets held for many month, but only few trades will make it that long and so typical holding periods are starting from one day, commonly lasting a few days up to a few weeks. Trades are not conducted to be swing trades or longer investments, instead a position is held as long as it makes sense – the market decides, according to the rules of this system, of course.

Often trades can be executed automatically with a suitable limit or stop order. Depending on the situation this may hold true for entry and exit orders.

This system can be applied also to ETFs and more generally to everything that is traded on stock exchanges.

Possibly interested in this system could be trend followers and swing traders, but also investors who want to pursue a more active approach in the market. It may be also valuable for day traders, even if they are not willing to use the longer-term components of the system. But who knows, perhaps one or the other of them will finally find out where the real money is.

The whole stock universe is screened by selection criteria for companies with the right product coupled with long-term price strength of their stocks. The fundamental growth situation of a company that is caused by its special product is something which likely has an ongoing momentum. Together with a confirming price strength this is the best possible indicator for an enduring trend. Consequently this process will find the gems that have the greatest future potential.

There is a set of simple rules accompanied by three groups of buy setups and another set of sell signals. This rigid structure enables a daily bar oriented trading style. There are situations where intraday charts may be used, but the emphasis lies on trading the daily bar chart and you can ignore completely any information with a shorter-term horizon. This rule-based trend trading system tries to achieve efficiency with simplicity.

Both points above suggest that this is the modern version of Nicolas Darvas’ famous "techno-fundamental" trading system. However, its entry system is much more elaborated to be better adapted to modern market behavior. The selection of trading candidates is also more sophisticated. Darvas entered a stock only at its absolute high, something that proves to be a real constraint. If, for instance, the whole market is weak, this method allows to trade on relative strength alone far from the actual high. There are other differences like money management. Darvas essentially had none, as he grossly over-traded back then. But luck was with him, as he started directly at the beginning of a bull market. This trading system could be viewed as the successor of the Darvas method. Major parts of it, like the entry rules, got replaced completely and all in all it is much more refined as a system.

A necessary part of any trading system is sound money management. This system maximizes the long-term performance and keeps the principal risks in check. Simply diversifying into many stocks is not the answer, because that would dilute not only the single failure but also the single gain away. Instead, using the right borderlines, knowing what you can do and…