I am very excited to join TradingMarkets as Senior Editor.Â I have long been a fan of the work of Larry Connors, founder and CEO of TradingMarkets, whose trading set-ups and market analysis I first encountered years ago through his books, Investment Secrets of a Hedge Fund Manager, Street Smarts and How Markets Really Work.Â To find myself a part of this organization, after many years with my nose figuratively pressed against the windowpane, is truly an honor, and I look forward to helping TradingMarkets subscribers and clients become the best traders and investors they can be.
During my seven years with Technical Analysis of Stocks & Commodities magazine, I read and analyzed a tremendous number of different approaches to trading — from the most discretionary of swing trading to the strict discipline of long-term, system trend trading — and pretty much everything in between.
This experience has convinced me of two things.Â First, there are plenty of worthwhile, valuable strategies that, serious retail traders can use to make money in the markets.Â Second, many of these same worthwhile and valuable strategies will prove not so worthwhile and not so valuable if traders do not understand the fundamental keys behind all trading — technical or fundamental, discretionary or system-based.
Becoming a Better Trader
Teaching these fundamental keys to successful trading is what TradingMarkets is all about.Â We will soon be unveiling a new course specifically designed to ensure that all those who are interested in either learning how to trade for the first time or in improving their current trading performance are operating from a solid foundation.
This foundation, to put it bluntly, is based on what works.Â It is the product of both decades of experience trading the financial markets, as well as a powerful database of rigorous, quantified and on-going research into finding markets that will outperform and how to minimize the risks involved in trading them.
I am convinced that those who come to embrace this foundation will become better traders.Â Not only will those who learn and master these fundamental keys find themselves looking at the financial markets differently from the way they may have before, but also they will see their behavior as traders and the performance of their trading portfolios improve significantly.
What Does Market Neutral Trading Mean?
Letâ€™s begin with the concept of market neutral trading.
There are two factors that are of utmost importance when speculating in financial markets: taking good positions and protecting those positions against the inherent risks in the broader market.
No one paying attention to the markets these days needs to be reminded of the risks in the stock market.Â Late in 2007, both October and November saw markets get hammered repeatedly, falling hundreds of points in a single session and taking stock portfolios down with them.Â Dramatic sell-offs — with markets in free fall and stocks gapping down, breaking down and crashing down — are unruly and unpredictable.Â Not only do they take traders and investors completely by surprise, but also these sell-offs can be indiscriminate in the damage they inflict, battering the best stocks as well as the worst.
The good news is that traders do not have to be preoccupied with these sorts of uncertainties.Â By protecting their positions using market neutral strategies, traders can stick with the sound positions they have made, while letting any market weakness run its course.Â With the best market neutral strategies, traders can even profit from their protection during adverse market conditions.Â This â€œprotection systemâ€ is what market neutral trading is all about.
Building a Market Neutral Stock Portfolio
The simplest approach to building a market neutral stock portfolio uses what is called a â€œ1 to 1 hedge.â€Â A â€œ1 to 1 hedgeâ€ simply means that for every dollar invested in stocks, the trader shorts an equal dollar amount of a major market index such as the Russell 2000, the S&P 500 or the NASDAQ 100.
For just one example, a trader can take long positions in high PowerRatings stocks — â€œ9â€™sâ€ and â€œ10â€™sâ€ — and then short an equal dollar amount of the IWM, the exchange-traded tracking stock for the Russell 2000. To learn more about PowerRatings stocks and how to use them in your trading, click here.Â Traders can even build specialized portfolios, for example, of tech stocks with high PowerRatings, and instead of protecting that position with the Russell 2000 iShares
PowerRating), hedge the portfolio by shorting an equal dollar amount of the Nasdaq 100 tracking stock
The goal of a market neutral stock portfolio using PowerRatings is simple.Â By using PowerRatings, and staying â€œin the greenâ€ by picking only high PowerRatings stocks, traders can be assured that the stocks they own and trade have historically outperformed both the market and their peers.Â Our research, going back to 1995, shows that high PowerRatings stocks — the â€œ9â€™sâ€ and the â€œ10â€™sâ€ — have gained an average of more than 18% and 20%, respectively, one year later.Â Compare this to the average stock, which has gained approximately 12% over the same period.
By hedging those high PowerRatings stocks by shorting an equal dollar amount of the IWM or the QQQQ or the SPY, traders protect themselves against the kind of market volatility that has seen the Dow Industrials drop more than 300 points in a single session — as it has at least five times so far in 2007, and twice in the month of October alone.
Performance and Protection: The 5x5x5
Many market participants fear that the cost of any protection for a portfolio comes right out of any profits the investment or trade may realize.Â However, our research suggests that when the right stocks and strategies are used to take positions, not only does the protection part of the market neutral trading strategy minimize losses, but also it does so without significantly reducing the overall profitability of the portfolio.
Letâ€™s take a look at one of our more successful, momentum-based trading strategies: the 5x5x5. To learn more about the 5x5x5 trading system, click here.Â Our research, analyzing this system through thousands of simulated trades between 1995 and 2007, revealed only a modest difference between the compound annual growth rates (CAGR) of the unhedged and hedged versions of the same strategy, with the unprotected portfolio returning 270% and the protected portfolio returning 259%.
At the same time, the protected portfolio experienced lower drawdowns across the board compared to the unprotected portfolio: lower maximum drawdowns, lower average drawdowns, as well as shorter drawdown durations.
Selection and Protection: The Right Stocks at the Right Time
The key to a successful market neutral strategy lies first in picking the right stocks to be protected.Â All the protection in the world will be of limited value if the stocks to be traded are not the right stocks picked at the right time.Â TradingMarkets provides a variety of strategies ranging from the simple to the complex that traders can use to determine what stocks should be traded and when.Â For more information on trading strategies available through TradingMarkets, click here for a free trial.
In order to maximize your performance as a trader and investor, a solid foundation must be laid first.Â This foundation is the TradingMarkets Trading Course, which will educate traders in three key areas that all traders must know and master in order to be successful.
- Finding the powerful â€œedgesâ€ that separate robust trading strategies from mediocre and losing ones.
- Developing the appropriate â€œprotection systemâ€ for your carefully selected trading positions.
- Creating the proper mindset necessary to withstand the psychological â€œtraumaâ€ of trading and investing in todayâ€™s markets.
No one knows what the markets will look like over the next few years.Â Whether the kind of volatility traders experienced in 2007 will follow us into 2008 and beyond is utterly unknowable.Â It is, however, something that serious traders can and should prepare themselves for.Â And there is no better preparation than the TradingMarkets Trading Course.
Take the first step in the process of becoming the confident, profitable, and successful trader and investor you have always dreamed of being.Â Click here now to register for the kind of in-depth education and training that only the TradingMarkets Trading Course can provide.
David Penn is Senior Editor of TradingMarkets.com.