- Only long signals are taken
- Stocks can be highly correlated
- Low-priced stocks can be just as volatile as higher-priced stocks
- Individual stocks may have price shocks that cause large price changes
- The portfolios must be filled as much as possible; otherwise, the available funds are idle and returns will be lower
- There is no leverage
Importance of Maximizing Returns
A portfolio of 10 stocks, each trading $5000, results in an investment of $50,000. If our expected return for each stock is 15% per year, then a full portfolio would return 15%. However, if we can only find trading signals to fill 75% of the portfolio on an average day, then the returns drop to 11.25% per year.
With fewer markets active in the portfolio we can also expect more risk, so the information ratio (reward/risk) will also drop. How do we keep the portfolio filled given the restrictions?
Choose stocks that have a positive return ratio over a period of, for example, 6 months to 2 years.
- Choose stocks that are more volatile than the average stock. More volatility often leads to higher returns.
- Choose stocks that have a minimum volatility. Even “more” volatile may not be enough.
- Choose stocks that have a current position. It won’t matter if it shows a profit or loss since its entry into this position. It is difficult to predict whether the rest of the trade will be profitable, but expectations favor profits over losses.
- Do not choose stocks that have recent large jumps in price, whether up or down. Some stocks, such as Apple (AAPL) and American Airlines (AAMRQ) have had jumps in excess of 20%. That will be interpreted as opportunity for a mean-reverting program but is excessive risk in a trend program. We find that a history of price shocks is a warning to avoid trend trading in that market until it calms down.
- Don’t choose stocks that are below a price threshold. Low prices mean larger positions which presents “event risk.”
Changing Stocks in a Portfolio
Adding and removing stocks from a portfolio based on a short-term trading strategy is straightforward. You wait until the trade is over, then fill that slot with the stock seen as the next best opportunity.
For a trend system it is more difficult. Trades are held for a long time and only exit when the trend changes direction. However, among those stocks trending up, some are better than others. We believe that those stocks that are strong will lead the market and continue to outperform –until they stop! If a high-performing stock drops out of the top zone we replace it with another stock that has moved into that zone.
The top zone is ranked by a combination of long and short-term performance criteria. None of this guarantees that a stock chosen for the portfolio will not have a drop of 20% or even 40% on a single day.
When American Airlines was recently told by the Justice Department that they would not permit the merger (takeover) by US Airways, the stock dropped about 30% in one day. We can try to avoid those stocks that are risky, but there are no assurances. The markets always surprise. Trading more stocks is a way to decrease the impact that these surprises have on the portfolio.
A Note On ETF Portfolios
For sector ETFs, only the long trades are tracked; however, for Country ETFs, and for many other markets both long and short trades are tracked, although only long positions are taken.