System P

About nine years ago, a friend of mine needed help in setting up a hedge fund firm. Over lunch, I outlined how to set it up and how to operate it. He was grateful for my saving him time. At the time, he was teaching a course in trading via a series of live seminars. After lunch, I asked whether I could attend his seminars. He said "sure." I called it "System P."

Some subscribers recall how I considered using the strategy at the time with the current service. As it turned out, I discovered the system had certain similarities to System R, and I decided to shelve it.

Recently, I received an invite from my friend to attend a coaching webinar involving the system. This piqued my curiosity, and I have been studying the system again.

My friend had me sign an NDA as he does everyone at the time they attend his seminars. Therefore, I cannot discuss the system in detail beyond what is discussed here, but I wanted to provide an overview of it, as I believe some of its setups will appear on the Focus List before long.

In most cases, System P seeks to enter a stock transitioning from a down trend to an up trend or vice versa. It is neither breakout, pullback, nor reversal. It is what I would call a "momentum strategy." It relies on several indicators, each measuring a different facet of momentum. Each can stand on its own as a stand-alone system. Having them confirm a setup is like a panel of experts coming to the same conclusion. More opinions are better than one.

An entry is signaled when a majority of the indicators line up. The more, the better. The indicators are not the type that one sees very often, if at all, in one's journey through trading. This does not necessarily make the system better, but I mention it nonetheless.

If a long entry is signaled, either stock or a call option is purchased. Most people who trade the system use it with options. For options, a monthly contract two expirations out is chosen. E.g. if today is May 8, the June contract would be chosen. Once the May contract expires, the July contract is used. An option two strikes in the money is used, though I do not believe this is material to the system's profitability. I realize some players love their out-of-the-money options.

As a rough estimate, a move in a stock will tend to produce a 10x move in an option. E.g. if a stock goes from 40 to 44, the option can be roughly estimated to have a 100% gain. This 10x relationship is something I have observed, but is just a rule-of-thumb, and should not be relied on for anything other than a rough estimate.

Exits. While there is nothing wrong with playing an option out for a 100% gain, and this should be encouraged when the opportunity presents itself, the players that do best with this system target consistent 2%-5% gains. This may not sound glamorous, but 20%-50% on an option in a few days sheds new light.

Actually, a 1%-1.5% gain on the underlying equates to a roughly 10%-15% gain on the options. Some great stock traders target 10%-15% gains and then exit and look for the next opportunity. Consistency is key with this system.

The use of targets is encouraged when exiting a winner. These include: 1) key moving averages like 20 ema, 50 ma, and 200 ma, 2) natural areas of support and resistance, and 3) lower and upper Bollinger bands.

One of the exits calls for exiting a trade when one point is gained. Another uses the opposite Bollinger Band as an exit level. The break of a very short moving average can also be used among other exits we have discussed in the past.

Positions will be held for 3-5 days or less in most cases, though each trader will find what he is most comfortable with. Opening gaps are treated as a trader would treat a breakout gap. In other words, the trade-through and back-door entries we have discussed with pullback trading do not apply. Stops can be placed the other side of the signal bar or a straight % below entry or any one of a number of methods.

If a position does nothing for two days, it should be exited.