Fresh out of high school and you think the whole world belongs to you. You…
I started trading in 1984 and like many novice traders I lost a few thousand dollars. But in 1985 I started to get the hang of it and I managed to make a few HUNDRED dollars. And by 1986 my bottom line was close to 6 figures. I really never looked back after that. I have traded accounts of about $3,000 and I have traded accounts in excess of $6,000,000. And I have traded them all about the same way.
Curiously I found my success a little perplexing. I used a simple break out system that got me in one day and out the next. I did not day trade. There are many published variations of this simple system and it clearly was not rocket science. This trading style did not seem too risky and yet, for me, it was yielding annualized gains approaching 100% year after year. This kind of performance flew in the face of conventional thinking regarding performance and risk.
I gradually began to develop theories regarding market behavior and money management that might help explain why this simple approach to trading did so well.
I am going to discuss in this article one of the most critical of those theories, my theory of margin efficiency.
To explain my theory of margin efficiency I am going to discuss a simple study I did using only one market over a 34 day period of time. In and of itself this study proves nothing and it is used here only to illustrate my theory of margin efficiency.
I tested two systems I shall call simply LONG TERM BREAK OUT SYSTEM and SHORT TERM BREAK OUT SYSTEM. The single NASDAQ market I used was SEED, Origin Agritech Limited. I tested the systems over a 34 trading day period, 11/24/09 to 01/12/10. Using my money management strategy both systems bought and sold 80 shares for all trades. This number of shares is calculated to limit the cash margin requirement to approximately $1,000 per trade. During this time period SEED put in a range of about $6 to $14.50 per share. I consider this to be a very volatile market and hence a very good market for my trading strategies.
These are some of the numbers coming out of this study:
-Long Term break out system
-Short Term break out system
Test from 11/24/09 to 1/12/10 (34 trading or “Study” days)
LONG TERM SYSTEM made one trade lasting 34 days.
It bought 80 shares of SEED on 11/24/09 at 11.74 (cash margin requirement $939)
It sold 80 shares on 1/12/10 at 14.14
Net Profit $192 – $10 transaction costs = ACTUAL NET PROFIT = $182
SHORT TERM SYSTEM Made 6 trades buying and selling 80 shares each time.
The 6 trades lasted two days each buying at an average price of 12.00 (average cash margin requirement $960)
3 win totaling $451
3 losers totaling $259
Net Profit = $192 -$60 transaction costs = ACTUAL NET PROFIT = $132
Now this is my formula for calculating margin efficiency:
Margin efficiency (ME) = ((Study Days / Days in Market) * (Actual Net Profit/ cash margin)) * 100
That should read number of Study Days DIVIDED BY days the trade is in the market TIMES Actual Net Profit DIVIDED BY the required cash margin (price times number of shares) TIMES 100.
Now let’s plug in the numbers for each system:
LONG TERM SYSTEM:
ME = ((34/34) * ($182/$939)) * 100 = 19.38
SHORT TERM SYSTEM:
ME = ((34/12) * ($132/$960)) * 100 = 38.91
The ME for the SHORT TERM SYSTEM is twice what the ME is for the LONG TERM SYSTEM. What does that mean? IN THEORY it means that a portfolio of ME 39s should make twice as much money as a portfolio of ME 19s.
In order to understand this better let us return to our study. The LONG TERM SYSTEM makes $182 in 34 days but there are no unused days. During those 34 days a trader can only trade ONE market using the allocated cash margin requirement.
The SHORT TERM SYSTEM, on the other hand, makes less, $132, but it is only in the market for 12 days. That means that during the 34 study days there are 24 unused days and that means that other markets can use those blank days without increasing the margin requirement.
Now if we fill up those blank days with short term trades from other markets that means we can make a lot more money in the same amount of time with the SHORT TERM SYSTEM than we can with the LONG TERM SYSTEM without increasing our margin requirement. How much more can we make?
If the LONG TERM SYSTEM makes $182 in 34 days it is making $5.36 per day. If the SHORT TERM SYSTEM makes $132 in 12 days it is making $11.00 per day.
If we fill in the 22 blank days with markets that also make $11 per day we can add $242 (22 * 11) to our net profits of $132 to get total net profits for the SHORT TERM SYSTEM equal to $374. Now we are comparing $374 in profits for the SHORT TERM SYSTEM against $182 for the LONG TERM SYSTEM. This is of course a theoretical value because markets never fill in those blanks perfectly.
Another way to arrive at a theoretical value is to use the ME numbers we have already calculated. If we divide the SHORT TERM SYSTEM ME of 38.91 by the LONG TERM SYSTEM ME of 19. 38 we get 2.01. Now if we multiply our original SHORT TERM SYSTEM profits of $132 by 2.01 we get $265.
Now we have two theoretical numbers $265 and $374 for projected profits for the SHORT TERM SYSTEM over period of 34 days. Reality probably falls somewhere in between because the reality is that the blanks will not be filled by markets as volatile and trading as well as SEED.
But regardless of volatility and performance how do we fill in the blank days with other market trades? This starts to get into money management theory that is a little too long and complicated to cover in this one article. However the simple answer is that I trade a lot of markets, currently 96, to assure that all the blanks are filled. And you now should understand of course that with a SHORT TERM SYSTEM I can trade many more markets with the same amount of money than I can with the LONG TERM SYSTEM and that by trading more markets I can reduce risk through market diversification.
This then in the most simple of terms explains my theory of margin efficiency, how it applies to stock market portfolio construction, and explains in part why these simple short term break out trading systems can produce such high yields with limited risk.
When deciding a strategy for trading the stock market you should carefully consider margin efficiency when selecting a time frame (long term vs. short term) for your trading strategies.
Robert Buran, StockBrain2010 on Twitter, is the author of “How I Quit My Job and Turned $6,000 Into a Half Million Trading