Busting Two Myths About Options: It Pays to Lose, and Simple Works
I’m going to tell you something you don’t want to hear but you need to hear it.
One of the keys to successful trading is being comfortable losing. That’s difficult for many aspiring traders to accept.
For some reason, traders think they need to have high win rates. That’s not true. But rather than prove it theoretically, let’s use a real example.
First, we need a trading strategy. The rules I’ll use are below:
- Trade ETFs using 5-minute charts.
- Buy when the 2-period relative strength (RSI) falls below 10.
- Sell 1 hour after the buy signal.
That’s the entire strategy.
(A quick note: RSI is usually calculated with 14 periods but you won’t make money doing that. Instead, change the calculation from 14 periods to 2. You can do that on any popular charting website including StockCharts.com or TradingView.com.)
I used ETFs because they have less risk than individual stocks. Managing risk is important but that will be the subject of another article.
The strategy trades 5-minute charts because I know many of you want to understand day trading. This is a strategy you could apply at any time since it’s simple and doesn’t require specialized software. Even Yahoo! Finance allows you to look at charts like this.
RSI, the relative strength index, is a popular indicator. Most traders use the default settings. For RSI, that’s a setting of 14 bars or “periods” in the formula. The indicator always has a value between 0 and 100. Low readings are often followed by higher prices.
The problem with using 14 bars in the calculation is that high readings of RSI are also often followed by higher prices. In other words, the indicator doesn’t work as expected.
If you actually want to make money with RSI, use 2 periods in the formula. When the value of the 2-period RSI falls below 10 there has been a steep selloff. For a day trader, that’s a buy signal.
Many day traders fail because they don’t have a well-defined sell signal. In this strategy, I am using one of the simplest sell signals possible. Wait one hour after you buy and then sell. This allows you to watch for additional buy signals.
That sell rule also prevents you from allowing emotions to dictate when you sell. Whether prices rise or fall, wait for 60 minutes after you buy and then sell.
This strategy is easy to test. On a diversified group of ETFs, 53% of trades were winners in the past year.
To some, that sounds no better than the flip of a coin. To me, that win rate seems a little high.
These rules made money in 10 of the past 12 months, an average of $15,000 a month on a $100,000 account.
That’s definitely not bad. But the strategy could be improved. It can make more money by taking more risk. Holding positions for two hours increases the average monthly gain to $19,000. But it only made money in 9 of the last 12 months. Other risk measures increased as well.
This example blows up two of the biggest myths associated with trading.
Many traders believe simple strategies can’t work. That’s obviously not true since this strategy uses one indicator and doesn’t even try to fine-tune the exits.
Many traders believe high win rates are necessary. This strategy makes money while relying on a probability about equal to the number of times heads will come up when you flip a coin.
Now, there are much better systems than this one. There are also better ways to trade this strategy. Options can lower risks and increase gains, especially since short-term options can be used.
And there are better indicators. RSI is one of the most popular but least effective indicators available. Less popular indicators tend to be more profitable.
But this is a good starting point if you want to be a day trader.
To see a better example of why simple strategies can work best, check out One Trade.
Michael Carr, CMT, CFTe
Editor, One Trade