Overview:
In a nutshell, this trading system involves buying a certain dollar amount of an exchange traded fund(ETF). Let’s use $2000 as an example. Then if your equity goes down about 10% or about $200, then you would buy more shares to get your equity back to your original starting amount. On the other hand, if your original equity goes up 10% or about $200, you would sell enough shares to get you back to your original starting amount.
For example, let’s say you like an ETF called XXX(fictional). You notice that XXX is currently $10.00/share. Let’s say you want your equity for each ETF bought to be $2000. To get the amount of stock to purchase, just take $2000 and divide it by $10/share. You get 200 shares. So you start with 200 shares of XXX and have $2000 invested.
Now suppose your XXX equity goes down about 10% or about $200. You now have 200 shares of XXX worth only $1800. To get the new price/share, just take $1800 and divide by 200 shares to get $9.00/share. Do you see that the price/share has gone down $1.00? You have lost $200(200 shares x $1.00/share).
You are now at a new buy point. You want to buy another $200.00 worth of XXX at the new lower share price of $9.00/share. Assuming you get in at this price, you will buy another $200.00/$9.00 per share or about 22 more shares. So you started with 200 XXX shares and you now have 222 XXX shares. Notice your new equity is close to your original $2000.
Conversely, if your equity in XXX goes up $200, you have now reached a sell point. You need to sell $200 worth of XXX to get back down to your original equity. The new share price would be $2200/200 shares or $11.00/share. So you need to sell $200/$11 per share or about 18 shares. The total dollar amount realized is 18 shares x $11.00/share or $198.00.
The whole idea is to buy more shares at an agreed upon equity loss and sell some shares at an agreed upon equity gain. I usually use +-$200. You can use any amount that suits your trading style.
Notice that you are always buying more shares when the price is lower and taking money off the table when the stock price is higher.
My Trading System In Detail:
1. I use only exchange traded funds(ETF’s). ETF’s have the best qualities of both mutual funds and individual stocks. An ETF can contain hundreds of stocks, just like a mutual fund. Trading ETF’s is far less volatile than trading an individual stock. You simply can’t trade a mutual fund like a stock. ETF’s are funds, but they trade just like an individual stock.
2. As I am building my portfolio, I look for ETF’s that meet these criteria:
* Low total expense ratio
* Low annual holdings turnover, or at least less than the industry category average
*Category: Is it value oriented, growth oriented or a blend?
*Asset Size: Is it considered a large cap, medium cap or small cap?
*Type: Is it a specialized fund, such as natural resources?
*Decent dividend yield
*How long has the fund been in existence? Does it have a good track record?
*Good Morningstar ratings
*How has the fund performed in the last two weeks?
*What are the risks?
*Active versus passive management
3. Let’s take each of the above criteria in turn:
Expense ratio: Ideally, this should be no more than 0.40%. I always look for the lowest possible expense ratios. Vanguard has some of the lowest rates in the industry. Most of my current ETF holdings have expense ratios of about 0.20%. You can’t get much lower than this.
Annual turnover: If you see a very high percent annual turnover, especially when it is more than the industry average, you should be wary. Why has this happened? Did the fund lose a lot of money in the last year? Why did the fund managers trade this much? Find out before you invest!
Type and category of ETF: You want as diverse a portfolio as possible using this system. For example, you don’t want all large growth funds. I pick different specialty ETF’s, like REIT’s or commodities. I’d strongly recommend that you include in your portfolio a good mix of ETF’s that represent all asset classes and all equity cap sizes.
It’s a nice bonus if the ETF you are considering offers a decent quarterly or even monthly dividend, say 2% or so. This isn’t absolutely necessary, but any extra money is welcome.
I hesitate to buy into ETF’s that have not been around for at least three years. After three years or more, you can discern a track record. Note carefully how many times top management has changed. For example, if you are considering an ETF that has changed management teams three times in three years, you should consider this a very bad sign. Find another fund.
Do yourself a favor and get a Morningstar subscription. It is well worth a few hundred dollars a year. Morningstar will give you analyst research, their star rating(* is poor, ***** is excellent), suitability analysis, fair value estimates(so you know if a fund is undervalued, at a fair price, or overvalued), and a projected expected return for the year. Morningstar will also show you the top holdings, top sectors, and asset allocations for each ETF fund. Most importantly, it will give you a risk rating(low, average, or high) versus a return rating(low, average, or high) compared to other ETF’s in the same industry. Ideally, you want a low risk rating and a high return rating. These ETF funds do exist!
Let’s talk about beta ratings. This is a number that tells you how volatile the fund is compared to other funds in the same industry. Look for a beta of about 1.40. If beta is 1.00, the ETF hardly moves at all(municipal bond funds are a good example). A beta of say 1.80 or higher starts getting into risky territory. You are trying to find a happy medium. You want your fund to be volatile enough so that you will make good money in a reasonable time period.
Look for passively managed funds. These funds are usually based upon some industry index. Management simply oversees the fund, but tries hard not to make too many changes in the fund portfolio. Vanguard has a lot of these types of ETF’s. Passively managed funds are more stable and usually have a fairly consistent track record. You will also notice a lower percentage of asset turnover compared to other ETF’s in the same industry.
4. I allocate $3000/month to my portfolio. You can allocate more or less, depending on your financial situation. I use the above criteria to find another ETF to invest in. I put $2000 into a new ETF and $1000 into a cash reserve fund. This cash reserve is actually a municipal bond fund ETF that hardly moves at all. It gives me a decent dividend of about 2.5% per month, which beats leaving it in your account as cash and getting perhaps 0.35% per month from your broker.
5. If I must buy new shares of any ETF, I take it straight from my municipal bond cash reserve. If I need to sell some shares, I put the realized cash into the broker’s cash account until it reaches about $1000. Then I buy more shares of the municipal bond ETF so I can earn a much better dividend. I wait until I have $1000 to minimize commission charges.
By the way, make sure your cash reserve fund is an ETF and not a mutual fund. Mutual funds can be very inflexible with lots of rules. Use an ETF instead, which trades just like stocks. Also, find a fund that barely moves and has a decent dividend. A municipal bond fund is your best choice.
Also, your cash reserve is just that: a reserve. You will use it to buy new shares of an existing ETF if needed. Do not use your cash reserve to buy a new fund. Instead, buy new funds with your monthly allocation.
6. Once you have a well-diversified ETF portfolio, you can take your first look at how much profit you have made with each fund. I am just to this point now after five months of investing.
Take a look at the top three percent returns. If you see that just one fund is far ahead of all the others, then you make your next monthly investment in just that fund. If two funds have similar percentage profits, then divide your monthly allocation in half and invest in the two top returning ETF’s. If three or more of your funds have performed well, you can try to find another fund or simply don’t invest money that month. Remember, you want to keep your commissions as low as possible.
7. If you invest monthly like I do, you will take three to six months to get a truly diversified ETF portfolio. It all depends on your total investment equity at the beginning. My starting equity was about $30,000.
Once you are diversified, you need to take a look at the laggards. My rule of thumb is that if an ETF fund has not returned at least 2%/month(or 6% for three months), I will sell all shares at market and buy a new fund. Then each month thereafter, I will compare the percent return for the current month with the percent return from last month. If I don’t see at least a 2% monthly rise in a particular ETF, I will consider selling all shares and finding another fund.
8. Continue this monthly cycle of chopping out laggards, investing more in your best performers, and finding new ETF’s to add to your portfolio. This cycle can continue for as long as you wish to trade this system.
Conclusions:
This truly is a no-lose trading system. Done properly, you will realize nice gains every month. You are always buying more shares at a lower price and selling shares at a higher price.
By the way, I use close prices only and usually only look at my portfolio after the market closes. Then if I need to put in a buy or sell order, I can do so at that time. I’ve always used market orders and have never had any problem.
Also, find a broker with very low commissions. I use OptionsHouse, which charges just $2.95 per stock or ETF transaction. That’s rock bottom. You don’t want high commission rates to eat into your profits.
If you are looking to make a living just by trading this system, you will need at least $250,000 in capital. I only have about $45,000 now and at my $3000/month rate of investing, it will take me about another five and a half years to get to $250,000.
I consider a living as an average profit of about $4000/month. With $250,000 total equity, making about $4000/month profit means about a 1.6% monthly return, which is realistic and attainable.
Trading any system is not worth doing if you are undercapitalized or impatient. You should have at least $10,000 to start with. Then you contribute so much per month. The amount you invest monthly is up to you. You will not get rich quick using this system. It assumes you have a very long term trading horizon.
Again, I only trade ETF’s because the volatility is much lower. Do not try this system with mutual funds. Mutual funds trade just once per day and are not meant to be traded frequently. If you don’t mind higher risk, you can try gathering a diversified portfolio of individual equities instead. I don’t do this because I value capital preservation just as much as profits. I take low to medium risks.
I have never tried this system with stock options. If you truly understand how stock options work and enjoy options trading, then you can try trading stock options using this system. As for me, no matter how much I’ve studied stock options, I don’t truly understand how they work. I have to feel in total control of my destiny, so I stick with ETF’s.
Be patient. Be patient. Be patient. Things won’t happen overnight. This is a slow, safe way to get nice investment returns. If you start with say $10,000 and invest perhaps $3000 each month, you would probably be able to make a good living in about seven years. I would consider this method only if you intend to trade for the very long term.
If you need daily action, this is not the trading system for you. I’ve noticed that buy/sell points seem to come in bunches and at irregular times. Trading this way is not exciting or “sexy”. If you need that, you can try day trading or options trading. Just remember, the more you trade, the more risk you bring upon yourself.
So is this trading system for you? Ask yourself some questions. For example, do you have another life besides trading? Do you have a family and other outside activities? Assuming you are just starting out, do you have another means of income that will tide you over until you can make a living trading this system? Perhaps your spouse or significant other works and supports your dream. Having family support really helps. Or maybe you have a large savings account that will last for five years or more without you having to work for other people. Here’s the most important question: are you willing to be patient and take small amounts of money off the table when the market offers it to you? Are you into trading for the long haul?