Certainty Criteria Method

What would you do if you could see the future? I am asking an honest question. I really liked Back To The Future Part 2 because the story line brought out the most obvious benefit to seeing the future; winning with 100% certainty. In the story, they used sports betting. It could have easily been just as useful to buy stocks. I think sports betting was much easier to understand for an audience and more fun to chase the Sports Almanac around from scene to scene but still, the premise was the same; see the future and become unreasonably wealthy.

Stock market traders (“traders”) live for it. Trading inherently is prognosticating. Investing can be wishful for future returns to be part of a diversified portfolio (sounds like a textbook definition). But trading is taking “bets” that the stock market will sufficiently satisfy their desired position (usually up but not uncommon for them to want it to go down). They are thinking something will happen (for purposes of this writing, bullish sentiment will be used from here forward). We want the stock to go UP. Traders are predicting the future. To capitalize on this prediction, they are willing to take a position (which is to actually perform the action to buy the stock). They put their money on the table. Position is on.

What kind of traders are they? Swing, day, momentum? It doesn’t matter. They all come up with their “magic 8 ball” of ways they think the market will do what they need it to. They listen to pundits, watch Jim Cramer’s Mad Money, watch CNBC with Bobby “the brain”, read the Wall Street Journal online, listen at country clubs, throw darts, hire monkeys with typewriters. They all have their methods and, sometimes, they do really well and sometimes they don’t.

This is one of those methods.

Chapter 1 – The Cardinal Rules

To read the remainder of this writing, you must believe and hold true a few things. I have studied myself and my losses (and gains) and watched and listened to many traders and individuals on how they predict the future.

These are the basic thoughts of how this method works. These thoughts are really rules. It is best to not break them. If you do, you simply are not following this method for that duration of trade or position.

  1. Discipline is the #1 most important rule. If you don’t follow discipline, your outcome will not be based on this method. I have reviewed years of my trades. I found every loss was based around my carelessness or emotions and not being disciplined to wait for the position to present itself. I thought I knew what was going to happen without using my own method and I was always WRONG.
  2. This is a method that can be a supplemental method to something else you already are doing. Why not? What’s wrong with MORE information? Can you make decisions directly off of this method without any further information gathering, yes, but know and think that it can be used as a supplement as well.
  3. There is no 100% certainty. We aren’t promised tomorrow. We can’t see the future. While we think we know what will happen, we don’t.
  4. Black Swan events will happen along with the “X” factor – the Federal Government. They like to mess with interest rates which mess with the markets.
  5. There are only a few days a year to take a position.
  6. Make a market in 5-7 stocks only, watch 15-20.
  7. There is a difference between investing and trading, make sure you know the differences.
  8. Stocks move on interest rates and earnings. The rest of the time, they are traded.
  9. Treat this method as a business.

Chapter 2. The Origins

Trading is not investing and it is not gambling either. At the worst definition, it is speculation. It is to take a position with the hopes of gain but the possibility of loss.

Most of the time with trading, you don’t lose all of your money in one position. With casino gambling or online betting, each individual position, albeit very small from $.25 cents in a pull of the slot machine, $5 bet on one hand of Black Jack or a spin of the roulette wheel, or $50 on the New Orleans Saints over the Falcons, are fully vested, 100% win or lose. There is no chance you could get back $46 of the football bet if things aren’t working out. The way they compensate is by giving odds (chance of winning MORE money than you bet or altering the point spread to favor one team or another) but at the end of the day, gambling involves gaining or losing ALL of the money in the position at one instance. The stock market does not have this hurdle. This is not to say you can’t buy a stock and lose all of your money but there is a very good chance you will have many opportunities to get out at a small loss or breakeven. I realize there are extremely rare cases where a stock is halted for a certain amount of time or de-listed but these are very rare cases and are really not material. We are going assume the capital markets are efficient and will maintain proper working order with the outlier stocks not part of our selection criteria. After all, if we are making a market in 5-7 stocks, the other 5,000+ really don’t matter.The level of certainty method comes from the basic premise that while you can’t see the future, what if you could still have some reasonable level of certainty that a stock would go up. What if you were 95% sure? Or what about 85%? Or 87%? How much money would you put on stock, in a trading fashion, if you were between 80 and 90% sure it would go up tomorrow or was on a trend for the next few trading sessions? Or even the same day!

This is the basis. It is to increase the level of certainty. The reason we want to increase it is because the more certain we are, the more shares we will buy. This is the ultimate goal; higher the certainty, higher the number of shares purchased OR time to look to write a put. This is why this is a great supplement OR a great way to select stocks for an initial position. Start with this method then take the issues and continue whatever other research you want to use (crystal ball, Jim Cramer, ask your best friend who knows a guy). The origins are from many backgrounds. When I was out of college, the casinos showed up on the riverfront in my hometown. They were new and got lots of attention and local people’s money. One of my friends started playing black jack and he won around $5,000 over a few weeks. I was ready to learn. That was a lot of money. It turned out he studied a method called “Winning At Today’s Black Jack”. He showed it to me and my takeaway was you will lose some hands and win some hands so bet accordingly. I don’t remember the entire method nor would I divulge their recipe (if you want to find it, I’m sure it exists somewhere). The piece I liked was the honesty about losing. You will lose. BUT when you do, lose a little. You will win. AND when you do, place big bets and win big! Their method helped you figure all of this out as you had to place your bet BEFORE you won or lost.

As I said, the takeaway was to have little bets on when you lose and big bets on when you win. When adding this to the criteria method, the more certain you are that you have a winner, add more shares (another difference to the “one bet” world of gambling; stocks allow additional and removal of shares). This piece laid out the large scale positions.

The next was all the finance classes in college. Dr. Sale’s Finance 301 class on investing. He really laid out some fantastic investment advice through teaching but, as a college student, you have no money so you don’t really get to use any of the advice till much later in life.There was a study done that he told us about. They concluded, by 1990’s (when I was in college long before the internet and real-time quotes were on your Apple watch) that there was only a few times a year you needed to buy stock. This meant there was really only a few times a year that the stocks presented themselves in a position that buying was not aimless dollar cost averaging.He also told us that the markets move on interest rates and earnings. I still believe this today. It doesn’t matter how meta or cloud something is. At the end of the day, the markets (not just individual stocks) but the macro moves of the markets (sentiment) fluctuate by interest rates and earnings. Why would someone with $200,000,000 buy any stock? Why take the risk? The more money you have, the less risk you NEED to take to agree with the basic philosophy that the stock market is for wealth preservation. Higher interest rates present different vehicles to use for investments without the risk of the stock market which lends itself to a more attractive place to put your wealth and still get a decent return.

When I was in my 20’s I went out to San Francisco to spend some time on the floor of the Pacific Exchange. My father knew someone who left but was going back to visit some people so I went out there and met him. I went on the floor and listened and gathered information about trading stock options. The software they had was not found anywhere. Today, it’s everywhere. Their methods were precise and they used them to hedge. The take away was they only made a market in 5-7 issues at one time. Too many trades at one time and you would forget your limits of why you were in the position. As well, the floor was flooded with trades. They were mostly looking for a “tiny” or a 1/16th of a point. The next lesson was to get anything that goes up. An 1/8, ¼, ½, a full point, 2 points. If you are up; you are out. Take what the market gives you and get on to the next trade. The good traders didn’t chase stocks. Don’t chase the next best stock.

I continued my journey and started seeing the differences between investing and trading. I wish I had seen it sooner or I would not have sold ISRG in 1998. Some stocks you invest in and some you trade. It is determined by the entirety of all your holdings and investment plan.

Next came the Turtles. The Turtles was a really cool story. I recommend you find it and read about it. I came across it when I was studying futures trading. At its core, it is about trend trading. There is an old adage, “the trend is your friend”. I found a .pdf file of the original turtles method and read it. It was very fun and technical. My takeaway is all about finding trends and looking for certain pieces, the one I focus on is daily higher lows. A higher low is after the trading day is over, there is a high, low and close. On day 2, the next trading session, the low should be higher than the previous day’s low. I don’t really care about how high it went during the session (that’s a different method). So if a stock has a low of $25.25 on day 1, the next day the low was $25.87 and the next day the low as $26.01, this is a trend of higher lows.The next methods came from researching technical analysis. I came across J. Welles Wilder’s Relative Strength Index – RSI Wilders using a 25 day period. This all came from the same research in New Concepts in Technical Trading systems. I did not read the entire book but took the pieces about the RSI and collectively added them into the system.

I modified the RSI Wilders to a 60 overbought and 40 oversold from the traditional 70 / 30. This came from research during the review of a bull market trend change in RSI indicators. I have always used it.The next criteria came from researching the timing of markets in the Stock Market almanac. There was a method of buying and selling stocks that led to an adage “sell in May and go away”. This was cute and clever and they did an analysis on it. As it turned out it was pretty close and had some interesting returns. I wasn’t really interested in this adage but rather the research was the interesting part; the discovery they made. They said that if you followed the MACD (Moving average convergence divergence) of the same time period of “sell in May” it put you in a little earlier and took you out a little later and the returns were astronomically different. This is a really interesting method of following changes in directions. There is a slow and a fast average, their difference apart or when they cross helps see when momentum of an issue’s price. It is pretty generic but along with the other pieces, it helps. It’s a typical indicator that is used in this method. No changes are needed to it.

Moving averages, along with MACD, are typical technical analysis pieces and should be used. The adage about the moving averages were “buy the day after a stock closes above its 50 day moving average and sell the day it crosses beneath it”. I have never done this. I’ve watched it for many years but not really tried it. It doesn’t seem to be a great method by itself. It whips around too much. It would put you in and out of stocks too many times per year. With all that said, I still use it but not for these reasons. I use it to watch for the trend of the 200 day moving average mainly and when it crosses with the 50 day moving average. There are lots of books about these 2 averages specifically. If you would like more knowledge of them, you can find all you want. For these purposes, I use the 50 day and 200 day exponential moving averages.