“Magnificent promises are always to be suspected.” – Theodore Parker
Dr. Steve Sjuggerud, ETR’s resident stock expert (and as conservative an investor as you can find), recently detailed a 6-step method on how to determine whether a trading system might be worth your time and money.
1. The first step, Steve says, is to measure the risk involved in a market investment against the potential reward. A good ratio is one to three. That is, if you’re willing to lose all your money (100%) in an option trade, you must expect a gain of at least 300%.
2. Next, you should establish a maximum acceptable loss. This means that if you’re willing to accept a loss of 20%, you’d need only a 60% gain to keep your 3-to-1 risk-reward ratio intact. If you’re willing to risk 50% of your capital, you’d need a potential reward of 150% before you’d invest.
3. Most of the stock market systems being sold today won’t hold up to these first two criteria. But for those that do, Steve has additional hurdles for them to clear.
A worthy trading system will not phony up its record by using what he calls the “high-probability winner” claim. (“Eight out of 10 recommendations went up” or “Since inception, we’ve been right 86% of the time.”
Such claims can be misleading because they don’t take into account actual profits. It may be true, for example, that eight out of 10 stock picks went up — but if each went up only 2% and the two that went down dropped 90%, you have a very dismal situation. According to Steve, when it comes to track record, the only thing that matters is the net profits at the end of the trading period. To determine this, you need to check out the system’s entire track record. (You can often use the Internet to verify this kind of information.)
4. In looking at a system’s track record, take into account just how much of the percentage gain at the end of a trading period is the result of one huge winner. If that’s the case, be aware that a winning deal like that might never be duplicated.
5. Make sure the track record is long enough to be useful. Just about anybody can point to a three-month or six-month period when they made money. Several years of good profits is a stronger indicator that a trading system works.
6. Finally, make sure you understand and factor in the real cost of the trading service, including fees and any commissions. Base your risk-reward numbers on the real cost, not the theoretical cost.
Getting information about track records and fees might require some digging on your part. For example, I just received an e-mail promotion from an options-trading service that claimed fantastic results. By going to the Internet and doing a quick search using the trading-service name, I found its home page. There, I learned that the service was claiming a phenomenal annualized success rate over the last several years — but little else. I did, however, find a contact telephone number. If I were seriously thinking about subscribing to this service (and I’m not), I would call that number and ask for specifics of every trade entered into and closed over at least the last three years. If that information were not made available, I would not put my money at risk. It’s that simple.
Like MMF, I don’t plan to increase my market exposure anytime soon. Perhaps you don’t either. But if you do, or if you’re thinking about using some advisory service that promises the moon, I suggest you do some diligent research either online or on the telephone to get the information you need — and then use Steve Sjuggerud’s 6-point checklist before you make a decision.
(Editorial Note: Dr. Steve Sjuggerud is the editor of the True Wealth investment-advisory service and of “Investment U.”)