This Common Bias Could Cost You Dearly

Humans are visual creatures.

Our ability to learn through sight is second to none.

It doesn’t matter what age you are. Sight is how most of us make sense of the world. If we can see how something is put together, chances are we’ll understand how it works.

Quant trading involves lots of code, data, and statistics. But it’s what I see when I study the charts that matters most. This is how I truly get to understand what’s going on.

You’re going to see a lot of charts this week. This is my favourite way of explaining a strategy.

Visuals can have a faster and stronger reaction than words alone. They help you engage with the topic, and this can really boost your understanding.

Yes, average returns and strike rates have their place. But nothing beats examples. This lets you see what’s happening behind the numbers.

The classic ‘buy low’ stock

You may remember an email from three week’s ago. It was from a member who was skeptical about Quant Trader’s entry points. She thought many of the buy signals were too late.

Here’s an extract:

The readings say that Quant Trader doesn’t pick bottoms or tops but aims to jump on and ride mid-trend. But I am seeing quite a lot of signals that indicate to me the mid trend has being missed; and the signals are kicking in where things look a bit extreme. I am also leery of the signals that get triggered by a sudden price gap.

Apologies if I have the wrong end of the stick on all this. Perhaps I am looking at these charts with “non Quant” eyeballs. Mostly what I am seeing with my eyeballs is trends already done and trade signals that don’t make too much sense.

Member, Christine

I can understand Christine’s point of view. Some of Quant Trader’s buy signals come after a sizable advance. Many people would assume the bulk of the move is over.

You’ll be familiar with the phrase ‘buy low, sell high’. Yes, this sounds obvious. Of course you want to buy at a lower price than you sell. That’s maths 101.

But there’s a trick to this. How do you define buying low?

Now, this is an important concept. I want you to consider what buying low actually means. Take a moment to think. Getting this right could make a big difference to how you trade.

OK, have a look at this chart…

Source: BigCharts
[Click to enlarge]

Is this the sort of situation that comes to mind?

This is a classic ‘buy low, sell high’ scenario. You buy near a major low, and then sell close to the top. Many people believe this is what successful trading is all about.

The stock in this example is asset manager Pacific Current Group [ASX:PAC]. This is a trade from Quant Trader’s back-testing. The system gets practically the entire uptrend.

But this isn’t the only way to buy low. Making money doesn’t hinge on getting in early.

Christine did an analysis of 17 recent Quant Trader signals. You saw one of these earlier this month. It was for Sigma Pharmaceuticals [ASX:SIP]. You can read more about this here.

Let me show you another. This is what Christine says:

Pinnacle Investment Management [ASX:PNI]: QT’s buy signal is at what looks like a toppy high point after a steep uptrend and some gapping since early this year. I wouldn’t usually look at a chart like this and think it was a screaming buy to catch a nice mid-term trend on the make.

Here’s what the chart looks like…

Source: BigCharts
[Click to enlarge]

PNI isn’t down-and-out like Pacific Current. The shares have been performing well for most of the year. This isn’t the ‘buy low’ situation that I think most people imagine.

Christine says she wouldn’t usually consider this type of stock. And I’m sure she’s not unique. Many traders have a natural bias against buying stocks near their highs.

But, as I told you last week, strength is not a sign of looming weakness. While PNI could peak tomorrow, the odds favour the trend continuing.

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High flyers that soar

I have three stocks I want you to see. These are from Quant Trader’s back-testing. I’m using back-testing because it has a longer history than live signals.

Here’s the first one…

Source: BigCharts
[Click to enlarge]

This is a price chart for Ainsworth Game Technology [ASX:AGI]. You’ll notice it’s broadly similar to the previous chart for PNI — both stocks are well off their lows, and in strong uptrends.

Christine’s comments for PNI could easily apply to this stock. Many people would say AGI is at a toppy high point after a steep uptrend and some gapping since early this year.

I doubt many traders would call AGI a screaming buy. But there would probably be many people saying they’d missed it…and a bunch more rushing in to take profits.

Here’s what happened next…

Source: BigCharts
[Click to enlarge]

Yes, this is the same stock you just saw. Few people would expect such a big move. But that’s the nature of trends — they can extend much further than you think is possible.

Quant Trader’s signal 3 was at $0.80 on 14 February 2012. The eventual exit was just over two years later, at $3.82. That’s a gain of 377%.

I’ve got another example. The company’s name is G8 Education [ASX:GEM].

Source: BigCharts
[Click to enlarge]

Again, this stock had not been languishing. It was up almost 204% in the previous 11 months. Many traders would avoid this situation. They’d say it was too late to consider buying.

Quant Trader’s entry was at an all-time high of $1.25. The date was 12 September 2012.

Here’s how it was looking two years later…

Source: BigCharts
[Click to enlarge]

The trend had a lot further to run. Quant Trader’s exit was at $4.57 on 19 November 2014. That’s a 265% gain from September 2012’s record high.

I have one more stock to show you — Ramsay Health Care [ASX:RHC].

Source: BigCharts
[Click to enlarge]

Now, just think. Would you want to buy this stock? The shares were up 180% over the past four years. I’m betting most people would think it was far too late to get in.

But it wasn’t…

Source: BigCharts
[Click to enlarge]

RHC went on to double again. The end result was a gain of 143%.

You may be wondering why Quant Trader didn’t get in sooner. It’s all to do with the portfolio’s 100-company cap. There simply wasn’t room to accept an earlier signal.

Quant Trader doesn’t predict a stock’s top or bottom. Instead, it identifies momentum. The aim is to catch the big, middle part of the trend.

Christine makes a good observation. She says ‘…I am seeing quite a lot of signals that indicate to me the mid trend has being missed…

I think many people looking at the first chart of RHC would agree.

But here’s the thing: You can only see the middle of the trend in hindsight. As it turns out, Quant Trader did get a big, middle section of this trend.

Many trades won’t be this successful. Some promising trends will reverse immediately and lead to a loss. Others will only post modest gains. And that’s OK. It’s all part of the strategy.

The important thing is that you spread your risk widely. This increases the odds that you get several trades like the ones above. These can make a big difference to your overall results.

I have one graph to finish with. It compares two versions of Quant Trader. The first is the regular service. The other one only signals a stock if it’s within 40% of a major low.

Have a look at this…

Source: BigCharts
[Click to enlarge]

This shows the hypothetical performance of the two strategies. The back-test runs from January 2010 to October 2016. It doesn’t take account of cost or dividends.

The blue line is the regular Quant Trader strategy. This is the simulation that produces the examples you saw earlier. The orange line is the result of only buying stocks like Pacific Current at the start of an upward trend.

Both strategies perform well. But Quant Trader’s regular strategy does best. This is because it doesn’t just aim for down-and-out stocks; it identifies trades at many places within the trend.

So don’t be afraid to buy a stock because it’s doing well. There’s every chance it will continue moving in the same direction. That’s what trend-following is all about.

Until next week,

Jason McIntosh,
Editor, Quant Trader

Publisher’s Note: Do you struggle to buy a stock after it has run? Don’t worry if you do, you’re not alone. But consider this: Some of the biggest gains come from stocks that are already on the move.

Here’s something I suggest you do — check out Jason McIntosh’s Quant Trader advisory service. It’s a fully algorithmic trading system for ASX stocks. Quant Trader can help give you the confidence to buy into trends that you might otherwise miss — trends that could see your portfolio soar.

Give it a go. Quant Trader could change the way you trade forever.

PS: Quant Trader sources all images unless otherwise stated.

Jason McIntosh

Jason McIntosh

Jason is a professional quantitative analyst. Before he graduated in 1991 he joined Bankers Trust — a Wall Street investment bank — to be a trader. After Bankers Trust was taken over in 1999, Jason, already financially independent, co-founded a stock market advisory and funds management business called Fat Prophets. At 37 he sold his part of that business and retired. These days, he’s a private trader and system developer. In 2014 he launched the wildly successful trading service: Quant Trader.

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