STP Algo Trader - The Method

Welcome to the latest issue of STP Algo Trader "The Method"!

Every Saturday, we will break down each of the inputs that go into our proprietary algorithmic trading system - Signal Trader Pro.

Not only do we want to share the inner workings of our system, but we want to educate you on how to become a better investor. Remember, our ultimate goal is to help you MAKE MONEY!

We are nearing the completion of the initial overview of the system that drives our algorithmic trading system, Signal Trader Pro.

Last week, we shared the final analysis that drives our "15" point-scoring system – the RSI backtest.

Today, we will begin sharing a brief review of each component of our system, along with links to the relevant sections of "The Method" where we previously reviewed them. This issue will focus on the price and liquidity metrics that make up the “6” of our “15” points.

As a reminder, starting next week, we will begin to describe version 2.0 of the system that we are preparing to launch in early July. We have been testing our results and have developed the next evolution of our process.

The new version will feature a new active trading protocol that will help lock in profits and reduce risk. The result is not only to drive our positive hit rate on positions much higher (above 80%) but also to materially reduce drawdowns during periods of market volatility.

We think the new system and the improvements are outstanding. We believe you will agree!

Here are the technical and liquidity contributors to our "15" point system…

Point #1 – Liquidity and Data

Market Capitalization and Coverage Qualification

We begin our process by establishing the universe of stocks that we will analyze, looking for opportunities. We start by examining the companies in the Russell 3000, and then we apply two simple qualifications that are necessary.

First, the company must have a market capitalization of at least $2 billion. Although this doesn't specifically tell us the trading liquidity in the stock, it is a reasonable proxy.

Second, we are seeking at least six Wall Street analysts to cover the stock. This is another proxy for liquidity, as stocks that have at least this number of analysts must have sufficient trading to interest the brokerage houses.

It is also essential for us to have sufficient data to run our metrics accurately. With companies with little or no analyst coverage, we don't have enough data to be able to drive our scoring system.

We discussed these qualifications in this note.

Point #2 – ENTRY SIGNAL

Relative Strength Index Test

The KEY step in our system is having one of our qualified stocks (with a high enough score) trigger the RSI buy signal. This is when the RSI trades below the "30" level and then back above the level.

This indicates that not only was there a significant amount of panic in the selling of the shares but also that sentiment has potentially begun to recover.

The core of our methodology is that high-quality companies (those with a high score) that exhibit this pattern are likely to be good high-probability trading events.

We reviewed this analysis in a recent issue, and you can read that note here.

Points #3 and #4 – Stock Price Uptrend

Relationship of the Moving Averages

Once we know a stock qualifies for our system, we want to start looking for stocks that are in a strong uptrend. Visually, this means a stock that appears to be trending upward and to the right – even if it has experienced a recent pullback.

The mathematical way to identify upward trends is by examining the relationship between the moving averages. We (like most traders) focus on the 50-day, 100-day, and 200-day moving averages.

A simple rule is that a stock where the 50-day and 100-day moving averages are trading above the 200-day moving is in an uptrend.

Look at this chart of a recent successful signal – Broadcom Inc. (AVGO)…

On the chart, you can see where we generated our BUY ENTRY SIGNAL. You can see that even though the stock had sold off dramatically, the 50-day and 100-day moving averages were still nicely above the 200-day moving average.

Even with the damage in the chart, this meant that the longer-term trend was still positive. This is the kind of stock we are looking for as a buy.

We discussed these qualifications in this note.

Point #5 – Stock Price Uptrend

Higher Stock Price Year-over-Year

This is one of our simpler analyses. We are simply looking to see if the stock is trading higher than it was at the same time the previous year.

If the stock is higher than it was a year earlier, then we are confident that it has seen price support during the previous twelve months. This is a good indicator of a positive uptrend.

This qualification was also discussed in the price uptrend note above.

Point #6 – Data Efficacy

RSI Back Test

We mentioned the RSI-driven signal above, but we also look back and see if these signals have worked in the past.

They almost always HAVE worked, but we want additional confirmation from the data.

This involves looking back across the last 25 years (or however much data we have) and seeing if we saw 70% or greater positive outcomes over a 90-day holding period from the ENTRY SIGNAL.

We discussed this test in this recent note.

Next week, we will review the other "9" of our "15" points, which are focused on the operating metrics and momentum of the company.