Friday, March 21, 2008

O'Neil's Exception to the 20% Profit Target, Part 1

In his book, How to Make Money in Stocks, William O’Neil advocates the use of a 20% profit target with one caveat.

“If a stock was so powerful that it vaulted 20% in less than eight weeks, the stock had to be held at least eight weeks.” Third edition, page 103.
He goes on suggest that after eight-weeks, we analyze the stock for a longer term gain but offers very few specifics on how this is to be done. More on this in the future.

If we think about this for a second, it means that the 20% profit target only becomes active after eight weeks (40 trading days) because if it reaches the price target before that, we do not exit until our time threshold has expired. The benefit this stop has is that if the stock’s movement is particularly strong, we allow our winner to run beyond the 20% target. As the previous couple of studies have illustrated, this is a critically important concept. The eight week period smells a little arbitrary but we will accept it for now and implement this concept in the following way:

If BarsSinceEntry >= 40 Then Exit with Limit Order at EntryPrice * 1.2

As in the previous tests, we will use the Stockbee IBD200 breakout entry on our 300 stock IBD basket and then use the Nasdaq and S&P components to confirm our results. All tests will also implement an 8% protective stop in addition to the profit-taking stop being tested.

8% protective + 20% Profit Target Only
These are the results from the earlier set of tests I am repeating here for ease of comparison.

IBD Basket
AverageTrade(win and loss)/ AverageLosingTrade = Expectancy per dollar risked
24.21 / 82.52 = 29.3 cents per dollar risked.

Nasdaq Basket
AverageTrade(win and loss)/ AverageLosingTrade = Expectancy per dollar risked
12.53 / 82.43 = 15.2 cents per dollar risked.


S&P500 Basket
AverageTrade(win and loss)/ AverageLosingTrade = Expectancy per dollar risked
13.63 / 81.50 = 16.7 cents per dollar risked.


8% protective + 20% Profit Target w/ 40-day time threshold
Now we will test the addition of Mr. O’Neil’s time threshold:
If BarsSinceEntry >= 40 Then Exit with Limit Order at EntryPrice * 1.2

IBD Basket
AverageTrade(win and loss) / AverageLosingTrade = Expectancy per dollar risked
35.83 / 82.45 = 43.5 cents per dollar risked.

Nasdaq Basket
AverageTrade(win and loss) / AverageLosingTrade = Expectancy per dollar risked
25.23 / 82.55 = 30.6 cents per dollar risked.

S&P500 Basket
AverageTrade(win and loss) / AverageLosingTrade = Expectancy per dollar risked
19.21 / 81.60 = 23.5 cents per dollar risked.

Conclusions

So we can see that this implementation of Mr. O’Neil’s exception to the 20% profit target is an effective strategy to let our winners run. The simple addition of this time threshold has elevated our expectancy per dollar risked by 48% in our IBD basket, 101% in our Nasdaq basket, and 41% in our S&P500 basket. Part 2 will extend this study through a different interpretation of Mr. O’Neil’s suggestion, as a Rate of Change (ROC) stop.

4 comments:

Damian said...

Great blog - just added to my reader. Two questions for you:

1. Is the 8% protective stop a trailing stop, or is it fixed from the entry?

2. I looked through the posts for a listing of the entry methodology (from Stockbee) and did not see it - what is the entry criteria?

Thanks!

bhh said...

The 8% protective stop is fixed. The "case for multiple entries, part1" used an 8% trailing in one of the tests and you can read about that there. I don't want to take the liberty of sharing the details of the Stockbee entries here but it is basically a percentage breakout with volume and recent weakness criteria.

cam said...

Is there any way you could show how many days these trades lasted on average?

It would seem that a system that averaged a 10% gain per trade over 20 days would be better than one that averaged a 20% gain per trade over 200 days.

bhh said...

Yes, i will start listing average number of days for winning and losing trades.