How to Choose a Stock Trading System

Stock traders look for winning systems

Stock traders look for winning systems

Stock trading systems abound, but only three of them are widely recognized in the investment community: algorithmic trading, value trading and momentum trading. Other systems, many of them based on the Fibonacci Series, such as Eliot Wave Theory, have their proponents, but research indicates their predictive results are no better than chance.

Algorithmic Trading

The algorithmic trading model consists of a collection of super-computers manned by a large staff of people with Ph.D's in physics and mathematics. These experts use quantitative analysis to identify such things as price anomalies between different trading markets and platforms that may last for only a short period of time, and they use this information to buy or sell very large quantities of equities. The trades in and back out again may take only a few milliseconds. A 2009 "New York Times" article on the subject noted that more than two-thirds of the trading volume in major U.S. exchanges were algorithmic trades. Only users with substantial capital can undertake algorithmic trading.

Value Investing

The value investor seeks to buy stocks that appear to be undervalued when subjected to a fundamental analysis of the company’s worth. A stock would be attractive, for example, if it traded at less than its net asset value -- the value of all the company's physical components, such as buildings, equipment, inventory and other property. The value investor also looks for companies whose regularly declared dividends form a higher percentage of the stock price than other similar stocks, such as a transportation stock that regularly declared a 5 percent dividend while other transportation stocks declared a dividend of 2 percent to 3 percent. The classic book on value investing is Benjamin Graham's "The Intelligent Investor," first published in 1934, and revised in 2006 with material added by Warren Buffet.

Momentum Trading

Momentum trading takes almost the opposite approach. While the value investor seeks to determine the intrinsic value of a stock, the momentum trader buys stock on the basis of its recent price performance without consideration of its fundamental value. Although there are many momentum trading variants, the basic idea is that a stock that has recently increased significantly in value and has outperformed its sector of the market generally will tend to continue to do so until some significant external event changes investor perception. "The Investor's Business Daily," a daily newspaper, gives daily updates of the price momentum patterns of most stocks in all major markets and is a good place to go to begin learning about the strategy.

Other Trading Systems

Many mathematically derived stock trading systems have a purported relation to the Fibonacci Series. Proponents assert that the series (1,1, 2, 3, 5, 8 ... ), where the next number is determined by adding together the two most recent numbers, is found widely in nature and can be used to predict such things as reversion points at which a stock's rising or falling price will reverse. The widely followed Eliot Wave Theory is an elaborated exposition of the system. "Magic Numbers in the Dow," an extensive analysis of various Fibonacci based stock trading strategies by two London economists, concludes that sometimes Fibonacci analyses do match real-world results, but “no more than would be expected by chance.”

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  • The Three Secrets to Momentum Trading Indicators; David Penn

About the Author

Patrick Gleeson received a doctorate in 18th century English literature at the University of Washington. He served as a professor of English at the University of Victoria and was head of freshman English at San Francisco State University. Gleeson is the director of technical publications for McClarie Group and manages an investment fund. He is a Registered Investment Advisor.

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