STP Algo Trader - The Method

Here at STP Algo Trader, we have a weekly series called “The Method.”

This series of essays describes the inner workings and drivers behind our proprietary algorithmic trading system – Signal Trader Pro.

In the last couple of issues, we have published special issues where we describe how we adjust our algorithm when we move from a BULL market phase to a NON-BULL phase in the stock market. The changes we make are called the “BULL SWITCH.”

The difference between these two phases is the degree of volatility (and downside), which leads us to change the "settings" on our screening system.

In the first note we published, we discussed the differences between these two phases. We also discussed the specific changes we were making for new ENTRY SIGNALS.

You can read that note here.

In the second note, we discussed other changes we were making to the system, including how we exit older signals and manage risk differently in the new environment.

You can read that note here.

In this final note, we will discuss some last changes to our EXIT SIGNALS along with how the system will perform in this phase of the market. We also will discuss when we will change back to the BULL market “settings” of the system.

1) Exit Signal Methodology

We have two types of EXIT SIGNALS. They are either profit-taking or stop-loss signals.

Our stop-loss signals are calculated using an alpha-based model. This means we are looking at the absolute loss on a position and the loss relative to the overall market.

We want to ensure we don't get "shaken out" of a position by market volatility.

The benefit of this strategy during a BULL market phase is that it keeps you invested despite any corrections. In a BULL market phase, this is an extremely profitable strategy.

When the market environment changes from BULL to NON-BULL, there is a period when this goes from being profitable to being painful.

The good news is that this change only happens once every couple of years. The other good news is that we have a well-defined process to exit the positions while maximizing return.

We have doing that process these last few weeks.

Now that we are in the NON-BULL phase, our stop-loss EXIT SIGNAL methodology will not change. The transition period is painful, but the alpha-based methodology also works well in NON-BULL markets.

What will change (and be reset) are our EXIT SIGNALS around profit-taking.

Usually, our profit-taking signals are based on a two-third retracement to the 52-week high.

This makes sense in a BULL market phase, as most stocks are trending higher. This means that this level will often be triggered if not exceeded.

When we transition from a BULL to a NON-BULL phase, though, the reality is that we may not reach that level for months or even years.

This means we could make excellent returns in a position but not have the appropriate profit-taking signal.

As a result, we reset the profit-taking signal to exit at two-thirds of the 90-day trailing high in the stock.

This allows us to make a lot of money from the heightened volatility and maintain an appropriate exit discipline.

2) Performance During Non-Bull Phases

Our system's resulting portfolio of signals will have far fewer names and only be of the highest quality. Not only are they the highest quality companies, but they are also oversold.

We might not even see a half dozen of these signals in a full year of a BULL market. In a NON-BULL phase, though, we might see dozens in just a few months.

The “velocity” of the portfolio will also increase with heightened volatility. “Velocity” refers to the speed at which we enter and exit positions.

In a BULL market, the market seldom moves more than +/-1% and rarely moves more than +/-3%.

During a NON-BULL phase – especially if it evolves into a BEAR market – these big moves become the norm.

This means we will see the kind of moves we would normally see happen in months in just a few days.

We've adjusted the "settings" on the system to take advantage of this volatility.

In fact, the more volatility – the better. We WANT the market to go up and down as much as possible in short waves.

We can trade the highest quality companies in a disciplined fashion and, in essence, "harvest" this volatility.

3) Bull Phase Return

When do we return to the BULL market phase settings of the system?

We want to see the 50-day and 100-day moving averages on the S&P 500 trading above a rising 200-day moving average.

These are the same group of signals that we are looking for in individual stocks.

In this case, we will want to see it in the overall market to believe that we have moved back to a lower volatility phase that would allow us to go back.

The stock market may have rallied significantly by this time, but that doesn't matter to us. Even in our NON-BULL phase setting, we can take advantage of a rally and volatility.

When do we think this is likely to happen?

We don't know, but it is unlikely to happen mathematically in the next months.

History has shown us that it typically takes a minimum of four months and sometimes can take several years.

Again, though, we are indifferent as we can make just as much money (or money) in the most violent NON-BULL phases.

One last note – unlike the change from the BULL to the NON-BULL phase, which is tricky for our strategy, the inverse movement is nicely profitable for the strategy.

Selfishly, we hope that volatility persists and allows our system to truly differentiate itself.

As we said in the last few issues of "The Method"…

The algorithmic trading system that drives Signal Trader Pro is something we have developed over our three-decade career in the markets.

The most important part of being a successful trader is not making money in BULL markets but learning how to SURVIVE when not in a BULL market.

We have implemented systems and practices to react to a change in the overall environment properly. These are in place to optimize our returns over a market cycle.

We now are engaging that BULL SWITCH and look forward to taking advantage of this period of heightened volatility.

Click here for more information and to sign up for the market’s best algorithmic trading platform, Signal Trader Pro.