Trading Systems Series

10 Trading Systems Series 10 TIMES YOUR MONEY IN 30 TRADES THE 4% SWING SYSTEM 30 4% This report will outline a simple 5 min a week strategy that has beat the market for over 40 years. What you are about to learn is not my trading system, I did not come up with it, I wish I had! A little background before I tell you what it is and how it works. It was originally developed by Ned Davis, but it was first published in 1986 in a best-selling book called Wining on Wall Street by Martin Zweig. Martin was a Billionaire Hedge Fund Manager, he tested this strategy from 1962 to 1986, when he published it in his book. Years later, it was again tested by Nelson Freeburg, a trading systems designer and Founder of Formula Research, a well respected periodical that has the ears of many famous Wall Street Traders. Nelson tested this strategy from 1982 to 1998. And finally a Fund Manager, Michael Collins published his results on this strategy testing it from 2001 to 2009. So as you can see it has been tested by a variety of people from different backgrounds, myself included, and through various time periods. Here is how it works: The 4% Indicator Often, the simpler the indicator, the easier the model is to execute. Well this doesn t get much simpler! As Zweig shows in his book, the 4% indicator uses a little known index called the Value Line Composite Index (shown below) to generate the buy and sell signals. The Value Line Geometric Index averages the returns on a daily basis of 1700 stocks that are traded in the markets. This index is special because it is made up of mainly mid-sized companies or mid-caps, so it gives a good reflection of what the overall trend of the market is and it s what is called a non-weighted index. What that means is that it is a true average of all the stocks in the index. The DOW and S&P are weighted averages, the DOW by price and the S&P by size or market capitalization, in political terms it would be proportional representation. Now you can t buy an index directly, but this system uses the Value Line Geometric Index to gauge when to buy and sell another Mutual fund or Index fund you can purchase, known as ETF s. The ETF that makes the most sense is the one that Michael Collins had the best results with, the i-shares Russell 2000 (IWM). The reason the IWM gives better results, as 1

opposed to using the Dow Jones industrial average or the Standard & Poor 500 Index is simple. The Russell 2000 represents most of the smaller companies or small caps in the market. And if you think about it, the growth for a billion dollar company tends to be smaller year on year than a company that is significantly smaller but is expanding rapidly. For example for McDonalds to grow by 8% a year is a huge ask, and very impressive growth but for a relatively new company growing by 20% or more is not as much of a stretch. So bottom line, the IWM trends better and goes up for longer when the market is bullish and go down faster when the market is bearish. Bigger swings mean more money from the system. You only need to look at the Value Line index once a week and perform the necessary calculation to determine if any action needs to be taken. For example, assume the weekly close of the index is 316.69. 4% of 316.69 is 12.67. To initiate a trade, the index must close 4% higher or lower the following week. It will have to have gone up or down by 12.67 points. If this does not happen, you do nothing. In this case, let s assume the Value Line closes the following week at 330. Since 330 is 4% higher than the prior week s close of 316.69, you will initiate a buy. You would hold this position until the index closes 4% or lower than the previous week. Continuing with the example, assume the market rallies and four weeks later the index is now at 355. The next week, the index closes at 337. Since 337 is 4% less than the previous week s close of 355, you exit your position. The result is a gain of approximately 6%. Now let s develop the model. Value Line Geometric Index: The Trading Model This long/short model is mechanical in nature. Going long just means to buy the underlying security (e.g. stock), Going short means that you place an order hoping that the underlying security will go down, so you make money only when it goes down. If at this point you are confused by shorting, don t worry, it is just as easy as buying a stock and will be explained with the help of whatever online broker you use. Buy/sell decisions are clearly defined and based on price using the 4% indicator. The model uses the Value Line Index to generate the buy and sell signals. The exchange traded fund (ETF) used for trading purposes, as 2

mentioned, will be the Russell 2000 I-Share (IWM). IWM is extremely liquid, trading more than 60 million shares a daily. Extremely liquid just means that it has lots of shares changing hands everyday, so you can get in and out fairly quickly no matter the amount you are trading. In at Nutshell: The basic premise is to buy the Russell 2000 ETF (IWM) when the weekly closing points total for the Value Line Index goes up 4% versus the previous week and hold the position until a sell signal occurs. The sell signal will be the opposite,you sell when the Value Line Index points total closes 4% below last weeks closing number. At which point you close the long position and initiate a new short position at the opening of the next trading day. Again, the position is held until the next buy signal, simple right? As an investor you are either long or short the IWM all the time. Remember, the buy/sell decisions are made using the Value Line Index and the trades are executed using IWM. The model results in this summary have been back tested from 2001; that is the first full year that i Shares traded on the Russell 2000. The i-shares i Russell 2000 (IWM): 3 Performance Summary As Figure 1 illustrates, utilizing the model produced amazing results. What Michael found was that $1 million grew to more than $5 million in approximately nine years, producing a total return of more than 400%. In the table I have added the same returns ratio to $10,000 and $100,000. The results equate to an approximate 20% compounded annual rate of return and compares favourably to the returns that Zweig produced in his study more than 20 years ago.

Figure1: Would you agree that the above results are a pretty good Return on your investment? When I first saw Michael s results my eyes bulged out of my head, what he found is that starting with $1,000,000 in 2001, in just over 8 years he had over $5,000,000, AMAZING...but can we make it even better? How to get even better returns: From my own personal findings, when I first discovered this system, I tried to improve it by adding some sort of filter, but as hard as I tried to overlay something to get better buy and short signals, nothing worked as well as the original system. I analysed this system for weeks, finally concluding that its original form is the best way to trade it. So the only way to get better returns is to use margin. Margin allows you to borrow against the cash you have in your trading account so that you can double (US) or triple (Canada Only) your trading funds at a ridiculously low annual interest rate. You can find out more about margin and how it works from your broker. 4

So take that same $1m, use margin, and start trading with approximately $2.25m, by the end of 2009 using the same system you d have taken $1m and turned it into $10m. So you can start with $10,000 and imagine it being $100,000 by the end of this trading period. The starting number doesn t matter, it is the compounding percentage return that is so impressive here. Have you ever bought a piece of real estate and sold it for 10 times its value less than 10 years later? Me neither Conclusion: Is the 4% Indicator still relevant 20 years later? The model seems to hold winners and cut losses quickly, one of the keys to trading success. On average, a losing trade was held only 31 days, while winning trades were held more than four times longer (159 days) Michael s Summary: The model produced 29 trading signals over the past eight plus years. The model produced positive returns in every year but 1 (2007). The system underperformed the S&P in just 2 of the last nine years. In all three scenarios, the model performance results significantly exceed the buy and hold ETF index returns. The win/loss ratio is consistent across all scenarios, but the winning trades are almost three times as large as the losing trades. Interestingly, Zweig produced similar results using this indicator more than 20 years ago and Nelson Freeburg had similar results from 1982 to 1998. The worst year for the model was 2007. Investors experienced a -2.24% return. The timing model significantly outperformed in flat to down (bear) markets. This was especially true in 2001, 2002 and 2008. The system signals are mechanical and based on price. The strategy is clearly designed to keep you, the investor in tune with the price trend of the market. All entry and exit signals are executed according to the 4% model indicator, without regard to personal biases or emotions. The results show that the model has been very successful. Given the results, the simple 4% indicator has stood the test of time, exhibiting a superior 40 year track record. Of course, past performance is not a guarantee of future results, but after 40 years of consistent results, you have to think it would continue to be successful... Link to the Value Line Index: http://finance.yahoo.com/q?s=%5evlic&ql=0 Link to the i-shares Russell 2000: http://finance.yahoo.com/q?s=iwm&ql=0 May today be a profitable day...for all of us. 5