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The internet is full of advertisements on trading systems that are 80%, 90% and even close to 100% accuracy. These accuracy numbers surely attract allot of novice traders and many end up buying these systems only to find out that they had lived up to their expectations. Why is that? was there something wrong with the systems? The answer is yes and no.
Before I clarify the above situation, I'll have to explain to you some details that the novice trader don't pay attention to, details that will turn a "winning trading system" into a losing one. You have to pay attention to what I am going to explain and try absorb the information.
Lets assume that we are going to test a trading system based on a chart setup that we suspect is going to be profitable but don't know yet how profitable it is going to be. So decide to backtest it. Backtesting means that we are going to look for this specific setup or chart pattern ,if you will, through a long period of time over the past. So, one occurence by one, we are going to see if the chart pattern has resulted in a profit or loss and record that on a peice of paper. The more occurences we will have recorded on our paper, the more accurate and realistic the results would be. In genereal, 100 occurences or data samples is suffecient to us and give a good degree of confidence.
To make things more clear, assume that our chart setp is composed of two candlesticks, one bearish and opens at the top of the candle and closes at the bottom. The other candle is a bullish with an open at the bottom of the candle and a close at the top of the candle. Like the ones shown in the following figure.
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This is the pattern. Our system says that once these two candles show up, we want to buy 2 cents above the high of the bullish candle and will sell 25 cents above that level. For example, if the high of the current bullish candle was $1.25, then we would buy at $1.27 and sell 25 cents above that at $1.52.
Lets assume that we recorded 100 patterns and 90% of these patterns hit the target and 10% were losers. Can we say that our system is 90% accurate? yes we can. Can we say that it is profitable. No we can't.
There is one important peice of information that is very essential to any trading system success. it is the spread between the bid and the ask.
As traders, we are only able to buy at the Ask price and sell at the Bid price. The Ask price is set by traders or money makers who already own shares in a stock and they want to sell for traders who are interested. Therefore, they will offer to sell shares at a certain price. The lowest price offered among these traders is shown in the first pisition and given the priority to be sold. The Bid price on the other hand is the price set by traders who don't own the stock but are willing to buy it. However, they don't want to buy it at the Ask, they want to buy it at a lower price. The price shown in the first position here is the highest price these traders want to buy at. If you find this complicated, don't worry, you don't have to be concerned since all you need to know is the Ask and the Bid prices which are already displayed for you. In addition, once you start trading using level II screens, you would understand it very well. The point to remember is that the Ask price is most of the time (99% or more) bigger than the Bid price. which means that if you baught shares in a stock and immediately turned around and sold these shares, you are already at a loss. This loss is equal to the difference between the bid and the ask (the spread) times the number of shares you have baught plus commissions.
The spread in penny stocks is usually high and in some low volume penny stocks is extremely high which means that if you baught a stock, the stock has to move tremendously to the upside for you to make a profit. In our example above, we said that our entry was 2 cents above the high of the bullish candle. Assume that the spread in that specific penny stock was 20 cents. sSo if the price reached $1.27, do you think that you will be able to buy at $1.27. The answer is yes if the ask price was at $1.27. However, where the bid price would be at then, remember, the bid price is where you will be able to sell your shares if you decided to, it would be 20 cents less which means it is going to be at $1.07. This means that you are sitting at a loss of 20 cents already. If the price of the stock reached $1.52 as in the above example, this would mean that the ask price is at $1.52 and the bid price would be at $1.32. Remember, your objective was to sell 25 cents above the entry price which means that the bid price has to be 25 cents more than the entry price which means that the bid price should be at $1.52. If the bid price reached the $1.52 price, it would mean that the ask price would be at $1.72. This was not the case since our price reached ask price of $1.52. This means that this trade is a loss as far as the two candles are concerned.
As you can see, if the spread was not taken into consideration, this sample data would show a profit. If you analyse the remaining 99 data samples the same way, you might end up with 20% or less trading system. a system that will cause you losses in real life trading and profits on paper.
There are other factors that will affect the accuracy of a trading system such as commissions and risk/reward ratios which I might talk about in the future. However, the spread factor is the major one when trading penny stocks.
