June 5th, 2007

Life Cycle Investing vs. Rule-based Trading

Although the focus of this series of posts is Life Cycle Investing, I think it worthwhile to take a side-trip and explore current trends in online trading and stock analysis software. I don’t profess to be an expert in the field but I’ll venture some observations based on my experience.

“It used to be day-trading but today we see trading platforms.” That’s that answer someone recently gave on CNBC in answer to a question as to whether individual traders coming back to the market as “traders” or as “investor”. First, it was the creation of online trading, then the proliferation of Windows-based stock charting software, the growth of ETF’s and options and, now, the addition of data presentation on back-testing software.

Tradestation (a publicly traded company) was probably the first to offer a platform that made available to the individual investor, seamlessly on their PC, the three elements needed by active traders. According to their literature, Tradestation offers:

  • Scanning, ranking and filtering stocks based on both technical indicators and/or fundamental data enabling users to create custom scans based on over 400 financial statistics (such as 17 years of EPS data) and 500 snapshots and ratios (such as Insider Trading)
  • Back-test of strategies (user defined buy and sell rules) against 20 years of historical price data
  • Interfaced and automated trading based on the back-tested rules, contingent orders and manually-entered orders

Many are now emulating that model. For example, Fidelity introduced Wealth Builder Pro, their back-testing system to integrate with ActiveTrader Pro, their platform for active traders. And, now, Worder Bros. is rolling out Blocks, a robust and relatively easy to use data (i.e., charting) presentation and an strategy testing software package.

I recently attended a demonstration where the system was put through its paces. It seemed easy enough. The system had more than enough technical indicator (from the mundane like moving averages to the obscure like detrended oscillator …. no I don’t know what that is!) and an almost unlimited number of back-testing strategies could be performed on individual stocks, a watchlist or all currently listed stocks for up to 25 years worth of daily data. The back-testing rules could be based on technical indicators for the stock, a watchlist, an industry group, and a market (e.g., NASDAQ). The rules could also be a against a host of company-specific financial data from 20 years of financials to the number of analysts covering the stock and the amount of insider trading. Trades could then automatically be sent to TD Ameritrade, a partner.

In demonstration, various rules strategies produced profits of up to 25-50% per year but entailed hundreds or thousands of trades. However, the strategies needed to be strenuously followed since they often entailed significant drawdowns before losses were recouped and gains recovered.

The whole things sounds as simple as the commercial for Channeling Stocks, buy when stocks hit the bottom of a range and sell when it moves to the top range, over and over again.

I guess I’m in the camp of making money the old fashion way, by earning it through hard work. And if you’re a stock chartist that means scrolling through hundreds, if not thousands, of charts, discerning pivot points, drawing and redrawing trendlines and, when you are able to get in on the ground floor of a winner, holding on to it through its life cycle.

(More on that next time around)

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