The Rubber Band Theory

Rubber band Theory - stairway of phiLast month, I downloaded an application Stock Trainer for free from the Google Play Store, using it to attempt to turn a profit day trading using virtual money (so nothing real).  Throughout the month, I had great results - at one point having gained over a 33% return, ending the month with just over an 18% return.  Though on such a short term (and no 3 day wait period after 'sells'), I can't claim that this strategy will always work.  However, after having such good results, I determined it was time to take the play gloves off and try it again - this time with real cash!

Earlier this week, I registered with Robinhood - a fairly new, completely free, real-time stock trader.  (By completely free, I mean no service charge and NO user commission charges which is great!)

Having such a long wait period in between sells (unlike Stock Trainer, which allowed you to make a new buy instantly), I'm sure the way I handle the day trading will change in ways that I cannot currently anticipate.  However, I'm planning on going into it, implementing the strategy that did me so well last month - something I call The Rubber Band Theory.

 

The Rubber Band Theory

The Rubber Band Theory is based on the premise that the stock market, in the short term, is seemingly random and is made of many dips and peaks.  This, coupled with the idea that, on average, the stock market is growing implies that, in a volatile environment, if something is going down, it is likely to go back up.

Now, obviously, the longer we wait, the longer the chance a company (that doesn't go out of business) will grow to a state where the stock price is higher than when purchased, making the deal profitable.  However, the goal isn't to wait for years to complete a transaction (at least not here - that should be done in a less-experimental, long term account) - the point is to buy and sell on a short time frame, trying to maximize the effectiveness of those dips and peaks by buying close to the bottom of the dip and selling near the tip of the peak.  By doing this, the desired wins can accumulate, earning immediate interest on the previous winnings!

This is easier said than done.

While numerous studies have shown that buying a stock and just sitting on it for your entire holding period is likely to make you a greater profit, my curiosity (like many of you, I'm sure) still needs to be satisfied!  So regardless of the odds being against me, I'm still going for it.  After all, what's the worst that can happen?  I lose a little bit of non-essential money, hopefully learn something, and satisfy my curiosity.  I can live with that risk.

By targeting highly volatile (high beta) stocks, viewing their past progress on a short timeline (ex: 5 days, 1 month), we can see a rough mid-point.  This is where our imaginary "rubber band" is attached to, the other end of the rubber band being attached to the current price of the stock.  The further the rubber band is pulled, the more tension it stores and the further it will stretch when released.  I want to embrace that release. 

Now, I just stated that stocks are seemingly random and that, by all professional advice, you should not try to predict them, as no one can predict the future.  Therefore, a stock's price should randomly go "up" or "down", bearing no resemblance to a rubber band.  But by narrowing down conditions in which I "buy", the idea is that I can buy stocks that will go up in the short term, cash out, then move to something else depressed which has potential to "bounce".

 

Rubberband Theory 1 - Stairway of Phi

 

This is an example of the "rubber band' being stretched over a midpoint and responding as anticipated.

The Rules:

  1. Only attempt to buy the undervalued stock of "good" companies whose value appears to be increasing.  Following Benjamin Graham's belief that we should buy stocks when their price is less than their inherent value, I will try to buy after a bought of bad news or a sudden drop.
  2. Only purchase stocks with a beta value of greater than 2.  Remember, I want volatility to "bounce" around.
  3. In the event of a big gain which makes the stock overvalued, sell the stock.  The idea is to win then move on, hopefully accumulating more wins than losses to beat the market.  If a stock is overvalued, Graham's idea mentioned in rule #1 will strike again, bringing the stock price down.  By not trying to milk a stock for all it's worth after being happy with it's progress, I won't miss out on other potential stock "jumps".
  4. No shorting.  Actually, I don't think you can short on Robinhood.  However, even if I could, I wouldn't.  There is limited upside in shorting and unlimited downside, whereas the reverse is true with just plain-old buying!  (In a similar vein, I won't be investing anything I can't afford to lose.)
  5. In the event of catastrophe, cut my losses.  Again, my goal here is to bob and weave, not stake a tent.  If I've failed, I've failed.  And that's okay.  But staying around longer in the hopes that something positive will happen will only shut out other opportunities and leave me even more so at the mercy of the market.

 

The Real Problem:

  1. While last month, I was able to achieve good results, those were also nearly meaningless.  Since there was no money attached to them, there was no real emotion associated either (other than the curiosity factor).  This month, I'll be trying to live by my rules to eliminate that emotion, making decisions that I believe will sway the 'randomness' of the market to my favor.
  2. When stocks fall in price, it doesn't mean they're bad stocks.  By jumping around so much, I could miss out on the opportunity of growth which could be found in a longer-term portfolio.

 

Well, there's only one way to see if the theory works (or if it's even worth it) so I'm jumping in!  I'll update at the end of the month with my progress!

 

-Phi

 

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