Go Off the Beaten Path

 | Aug 27, 2013 | 2:00 PM EDT  | Comments
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Stock quotes in this article:

sfy

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key

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dks

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pnra

After yesterday's column on insider cluster selling, I spent some time last night considering one of my favorite subjects. When I talk to retail traders, they always seem to be trading the same names. Apple (AAPL), Netflix (NFLX) and other "hot" stocks of the day seem to make up the inventory of the average trader I speak with these days.

I find this very puzzling, as this removes many of the advantages of being an individual trader. You are going head to head with the high-frequency and physics folks, and it would seem that you at a disadvantage against a supercomputer programmed by a math genius.

When I ask traders about this, the answer I usually get is they need the liquidity. This may be true if you are a frantic day-trader, but very few people who have careers, families and other time commitments are day-traders. Most are swing traders who are trying to capture those intermediate-term moves that last several days to several months. To continually butt heads with every other trader in the world as well as their computers strikes me as foolish behavior. Furthermore, the liquidity argument is ridiculous.

Last night, I made some calls to some traders of my acquaintance. We talked about risk management and how much to risk on each trade. I asked them for their win rates and average profit-and-loss statistics and gathered these data to compile an average. Keep in mind that these traders have been around forever and have traded the pits in markets such as stocks, grains, bonds and options. All of them have moved off the trading floor, but they have been trading a long, long time with a great deal of success.

I plugged their numbers into the Kelly Formula to determine optimum bet size. According to the formula for optimum gain, the average bet should be about 28% of their bankroll to make as much money as possible. When I reported back to them, they all informed me that while this formula might maximize profit, it also maximized the chance of gambler's ruin. The most aggressive of them would risk about 5% on any individual trade. The average figure was around 2% of the trading account balance on any one trade.

Let's apply those numbers to retail stock traders. Let's say that you have a $250,000 trading account. According to my trading friends, the amount per trade should be between $5,000 and $12,500 per trade. You don't need the stocks to have 10,000 shares bid or offered to get your trades done. You do not need to be trading the same stuff as everyone else. Although I am loath to bring John Templeton into a discussion on trading, his maxim about it being hard to outperform doing the same things as the crowd would seem to apply here.

If I were a stock trader looking to capture profits over a few weeks to a few months, my entire universe would the insider buying and selling lists. Stocks that have heavy insider activity tend to move in the direction of the activity. Stocks that have heavy insider selling tend to go down and outperform the market on the downside. Stocks that have insider buying tend to go up and outperform on the upside. My own work shows that stocks that have buying by the CEO and CFO have about a 75% probability of going higher.

Looking at the list of stocks with top executive buying right now, I see stocks such as KeyCorp (KEY), Dick's Sporting Goods (DKS), Panera Bread (PNRA) and one of my favorites, Swift Energy (SFY), It would be easy to get of a trade of $5,000, $12,500 or even $70,000 worth of stock if you decide to use the Kelly Formula and swing for the fences. If you have system or approach that gives you an edge against the market, then adding stocks that already have a tendency to move in a certain direction should multiply your advantage.

You do not need to be trading the same big names as everyone else in order to trade intermediate-term moves. The majority of the stocks on the insider activity list can be shorted, often with an easier borrow than the hot stocks, and they can also be traded with options.

It just doesn't make sense to me to go head to head every day with the folks who do need the liquidity to trade millions of dollars' worth of stock at a time. They can move quicker than you, and they have more information than you do. The odds favor them picking your pocket on a regular basis. Put the odds in your favor by switching to stocks that already have a tendency to move in a certain direction, and put your trading tools to work in those names.

At some point you have to ask yourself if the purpose of your trading is to make money or just be able to talk about trading the same stocks as everyone else.

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