Forward Testing the Oversold Buy Signal. A Nice 30%+ Gain On Our First Trade!

A while back we back-tested the Chaikin Oversold Buy Signal on optionable, liquid stocks with tight bid-ask spreads.  The results yielded an impressive 70% win rate, with approximately the same 5% gain on winners as the 5% lost on losers.   The Oversold Buy Signal is the shortest term of the Chaikin Signals, and it comes the closest to replicating swing trading. Here's a refresher on the rules for our forward test: 

Conditions that MUST be in place prior to taking an Oversold Buy trade: 

• Price must be above the long-term Chaikin Trend (orange)
• Money Flow must be green
• Relative Strength must be positive (above .50)
• Power Gauge must be at least bullish, if not very bullish
• Industry Group must be strong
• Price must be oversold.
• We prefer bullish market conditions, but have some discretion initiating bullish trades in a down market, provided the sector and industry group are counter trend bullish performers. 

Entry

• Entry is the day after an Oversold buy signal.  Chaikin is an End-of-Day system, See the user's manual for what must happen for a signal to fire. 
• We choose an  IN the money (.70 delta) call strike with approximately 6 - 9 months before expiration.  We do this to minimize the impact of  time decay and to approximate movement in the price of the option to correspondent with movement in the price of the stock. It's not perfect
• We set no stop loss.  In fact, we choose options because single stocks are volatile and, even with a high win rate, we don't want to suffer portfolio drawdown that comes with single stock trading risk.  We position size based on MAX loss, which for us is .5% of the total portfolio value on any one trade.  Even with 20 losers in a row (unlikely) our drawdown  would only be 10%.  We can recover from that.  Over the long haul, we expect 7 in 10 trades to be winners. 

Management and Exits

• Management.  If the security makes an extreme move to the upside in the first week of the trade, we'd consider rolling down in the same expiration month if the delta increased to .86 or greater.   This is simply a way of reducing risk while staying in the trade. If you are but an option beginner, you can bypass this step. 
• Beginner Rule (or if you don't have the bandwidth to manage your trades daily), set a stop if the option price reaches 150% of your cost basis. 
• EXIT after 30 calendar days, or on the Monday or Tuesday trading day if the 30 day exit point falls on the (holiday weekend)
• EXIT if price touches the upper volatility band. 

Case Study:

We exited our  first forward test trade as a winner today. 

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On June 15th, we bought the  October 21 call strikes on Applied Materials ($AMAT) for $3.40.  This was the strike closest to the .70 delta at the time we took the trade.  Today, we exited because the price touched the outer volatility band and sold  for $4.60, a 35%+ gain!

We have several trades that are approaching the 30 day mark (and their upper volatility band).  We'll keep you up to date on how we fare with the rest. 

NOTE:  We bought the AMAT option the week prior to the Brexit decision.  As you see from the chart above, the drawdown was signficant.  That's why we really believe in using options for speculative short term bets.  The most we could lose is $340 per contract no matter how low the market crashed.  I'm not sure I would have had the stomach for staying in this trade if I had paid up to hold a hundred shares of AMT stock.