Artificial intelligence seems to be taking over the world. While its application to self driving cars and trucks are new, artificial intelligence has been employed by hedge funds and other large investors for some time.
Many of these investors are using technology to find and execute trades. For example, funds may subscribe to a service like Dow Jones Newswire. With natural language programming, they set up computers to read headlines and articles.
Computer algorithms determine whether the article is bullish or bearish and then creates a trading strategy. Trades can then be automatically implemented by algorithms without any human intervention. This can be profitable, but it is expensive.
In order to execute trades like this, firms need expensive data and powerful computers. The recipe for these profits is widely known on Wall Street which means there is an expensive battle for the fastest and most powerful data connections, algorithms and processing power.
We don’t know the exact costs of the battle but we do know that the costs are rising. According to market researchers with the Tabb Group, US market makers reported $1.1 billion in revenue in 2016, compared with $7.2 billion in 2009.
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This trend appears to be continuing. Virtu Financial, Inc. (Nasdaq: VIRT) is a large publicly traded high frequency trading firm. The trend in their profits is clearly lower in the chart below.
Source: Quartz Media
Can Individuals Compete in This Space?
Given the fact that there is still a significant amount of money available to these firms, more than $1 billion at the end of last year, major Wall Street firms will continue to battle for the fastest and most profitable trading systems.
That means it is expensive to be a high frequency trader and individuals should avoid this style of trading. The truth is that individuals will not usually have the capability to compete with wall Street firms in any space. Large firms have more capital and dedicated personnel than individual traders.
But, individuals can develop their own systems that use free resources and offer the ability to succeed in short term trading. It will not be possible to win consistently with intraday trading, but short term trading can work.
By short term trading, we mean trades that will be open for less than a week. This is a system that requires data to implement and data can be expensive. We worked to find a low cost, but powerful, online trading system.
A Simple, Low Cost and Powerful Online Trading System
We found a strategy that delivered wins on 80% of its trades. The complete rules are simple. You buy whenever a stock becomes oversold and sell when the trade shows a profit or after holding for one week. The results are shown below.
This is a screen shot from the trading software we used. You won’t need software as we explain below. Before explaining the results, here are the rules:
- Buy when RSI falls below 20. Use a market order to buy on the open the next day.
- Sell at the open when the position shows a gain. This can be done with a limit order opened the evening after the trade is opened.
- If the position is open after one week, close the trade. Use a market order to sell on the open the next day.
That’s it. This system was designed to require less than ten minutes a day to follow.
Those are all of the rules we used, and anyone can follow them, as we will show.
We tested this system on a list of liquid stocks over the past ten years. The list includes all of the stocks in the S&P 100 and Nasdaq 100 indexes that have options available. There are 180 stocks in the list as of now. We assumed a $10,000 investment in each stock. Any size could be used here, even $10 per trade.
Our test period covered about ten years, beginning on November 1, 2007 and running through the close on November 10, 2017. Results include a deduction of $5 per trade for commissions and trading costs.
There were 418 trades and 80.1% of them were winners. This is a large number of trades and shows a statistically significant sample size.
Because there are so many trades, the system is likely to deliver this type of performance in the future. This is especially true because the rules are so simple.
We are buying oversold stocks. We selected RSI as the indicator to use because its popular and available for free. This is the Relative Strength Index and we used the 14-day default calculation, again because it is available for free. There are better indicators and parameters, but they are not available for free.
The idea of buying when a stock is oversold is designed to catch a quick rebound. We often see a stock rally after a selloff as bargain hunters rush in. This system benefits from that rally. It is short term with an average holding period of about 3 days. There are an average of 41.7 trades a year, almost one a week.
The sell rules are intended to minimize the holding period. We are selling when a profit is available because the buy rule is looking for stocks likely to rally quickly. We are not using a fundamental screen so these are not trades that should be held for the long term without additional research.
Our second sell rule is a time stop. We are stopping the trade if it doesn’t work quickly. This avoids holding on to losses too long. It allows traders to rapidly turn over their money and maximize gains. And this strategy produced significant gains.
Over the past ten years, the system delivered an average annual gain of 16.4%.
Implementing Your Online Trading System
The first thing you will need to trade this system is a source of data. We developed this trading system to be implemented with little effort and with no costs other than commissions. You will simply need a list of stocks that are trading with an RSI below 20.
This information is available at the free screening site, FinViz.com. Our screen is shown below.
There are only two criteria selected. We limited the list to stocks in the S&P 500 so that the trades can be executed at low cost with market orders. This strategy should not be used with illiquid stocks because the market orders would result in poor execution prices and lower profits.
We then set the RSI(14) filter to oversold (20) in order to find stocks to buy. The list is shown in the next figure. On this day, there were just two stocks.
Now, all you need is an online broker to complete the implementation of your online trading system. There are many available, but we recommend using the one with the lowest costs. Paying less in commissions to execute orders is the most effective way to increase your trading profits.
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