More on Random Stock Entries

Last week I wrote about how it was not necessarily WHAT you buy that is the most important variable in stock trading, but WHEN you sell that is key. To further illustrate this concept, I have thought of the following hypothetical scenario:

Imagine that you trade with a broker that does not allow you to initiate any new positions. With this broker, you are unable to buy or short into any new positions; instead your broker randomly buys and shorts stocks on your behalf. Some of the positions added will be short, others long. Any stock/ETF that trades on an exchange is fair game.

With this broker, the only thing you have control over is when to liquidate positions. For simplicity, say you decide to liquidate whenever a stock crosses its 50dma. Therefore, longs are stopped out when they fall below their 50dma, and shorts are stopped out when they cross above their 50dma. Assume further that when a stock is liquidated, a new (randomly selected) stock is added to replace it.

Imagine you open an account with this broker, and the broker randomly "chooses" 5 long and 5 short positions. Assume that at this time, a strong bull market is underway. One by one the shorts are stopped out as the general market rises. Some of these shorts are replaced by more shorts, which are in turn stopped out again, while other shorts are replaced randomly by longs, which rise with the general market.

Eventually, your portfolio of 5 shorts and 5 longs stocks would evolve into a portfolio of 10 longs, as the shorts die off and are replaced by longs, which are rising along with the market. This portfolio would likely remain intact for as long as the bull market raged on.

Eventually, the bull market would become exhausted, and the trend would change. This could happen in a matter of weeks or years; there is no way of knowing. But when it does happen, a few longs will likely breach their 50dma, and become stopped out. Once a stock is stopped out, it is randomly replaced by another position, either long or short. If it is another long position, it may very well get stopped out again if the bear market continues. If the randomly selected stock is a short position, it will likely thrive as the general market is falling.

As the bear market continued, long positions, one by one, will be stopped out and replaced eventually by shorts. It is also worth noting that the weakest longs would be the first to go, while the more resilient longs would be held the longest.

The net effect of this process is that this portfolio would be mostly long during bull markets, and mostly short during bear markets. In bull markets, it will have a tendency to "select" the strongest stocks in the strongest sectors, and in bear markets it will have a tendency to select the weakest stocks in the weakest sectors.

Sadly, very few bloggers focus on when to sell, instead focusing soley on what to buy. However, one blogger that understands this concept is Olivier Tischendorf. Here is a quote taken from a recent blog entry:

Your job as a trader is easy. Once you’ve identified what kind of stocks you have push your winners. Kill your losers. No hard feelings.

To summarize, I would like to repeat this sage quote from William Eckhardt:

It seems to be part of human nature to focus on the most hopeful point of the trading cycle. Our research indicated that liquidations are vastly more important than initiations. If you initiate purely randomly, you do surprising well with a good liquidation criterion.