How A Veteran Look For Ideas #2

The second instalment of The Veteran's series on idea generation.

Part one can be found here...

One of the most important tools that a trader can equip themselves with is a method through which they can screen the markets.

After all, there are thousands of financial instruments that we can trade, and if we include derivatives of those instruments then that number probably rises by a factor of 10.

Being able to screen and filter the universe of potential trading opportunities means that a trader can drill-down and focus on what he or she sees as the most compelling opportunities (or at least the ones that speak loudly).

I like to try and do this in two ways; Firstly by screening for trading signals, and secondly by filtering for outliers.

For the purposes of this article, I will be discussing how I do this for equities and equity-related instruments.

Although the process may need tweaking for other assets classes, the basic principles are broadly consistent across the market.

Over the last 20 years, I have been increasingly interested in using models and systems to help me take a systematic approach to idea generation.

These models have evolved as market conditions change and access to information ebbs and a flows.

For example, I can still remember when we had a consolidated ticker for UK equities which listed all trades that were conducted on the LSE as they happened or were trade reported.

Sadly that functionality no longer exists so I‘ve had to adapt, move on and focus on the information that is available to me.

In recent years markets have been driven by momentum - what I mean here is the propensity of a move in a particular direction, within the price of an instrument, to create further moves in the same direction.

Sometimes that momentum is a measure of broad-based investor sentiment and on other occasions, it can be a more granular reflection of the price action in a particular stock or stocks.

I like to view momentum as the trigger that brings a trade idea into play rather than the source of the idea.

Taking that a stage further I believe that technicals highlight a trade set up or idea, but that there is usually a fundamental catalyst that brings that setup or idea into focus.

Though it’s also true to say that we may not always know what that is and perhaps more controversially, that not knowing doesn't actually matter...

In trading what’s important is that something does or doesn't happen - the factors behind it are secondary, at least on a per-trade basis.

People often think that a system that generates or highlights trade opportunities must be complex and highly technical but I try to shy away from that where I can and keep it simple.

To illustrate this point let's look at a chart of Harley Davidson (ticker HOG).

A simple line chart (and to be precise a 10-day chart on an hourly time scale).

The price line is in black and there are three other indicators on the plot;

• A 5-period simple moving average in green

• A 20-period simple moving average drawn in brown

• And the VWAP or the volume-weighted average price line drawn in purple.

I have highlighted an area of interest on the chart in a red ellipse. Within that ellipse, we see the price line cross down through VWAP and then cross the  5-period MA line.

Shortly after that, the price and VWAP lines break below the 20-period MA line. And finally, the 5-period line crosses below the 20-period line.

That last event was the trigger to a trade idea because it showed that that short term momentum in the price of HOG was heading lower.

This model relies on a simple mathematical premise which is that a 5-period moving average is updated or refreshed 4 times quickly as the 20-period version and that the interplay between these lines shows us what’s happening to price momentum over those timeframes.

When the faster moving 5-period line crosses the slower moving 20 -period line something is up.

In this instance, the signal highlighted a near 10% downside move in the price of HOG that was relatively independent of wider market moves.

We can therefore see in the following chart (HOG vs the S&P 500) that the move could be considered as demonstrating alpha.

This system is easy to set up on most charting platforms and a quick scan through the charts of a 20 or 30 stock universe should throw up ideas on a reasonably regular basis.

In the next of this short series of articles, we will look at how I screen for outliers using a model.