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Risk Management, Trader education

How Some Signal Providers And Stock Market Newsletters Overstate Performance

In most cases it is not fraud but a result of incompetence. However, it is a fact that some signal providers and stock market newsletters overstate performance due to unrealistic calculations and lack of risk and money management application.

There are many services and newsletters that provide signals to traders and investors in different timeframes. Although there are some competent people that have the knowledge and experience for doing this properly, there are also some clueless individuals that are unqualified for the task.

One problem with some of these services, including those that involve technical and/or fundamental analysis, is that they offer no performance reports, or when they do, the performance may be way overstated. This is not intentional fraud in most cases but the performance is overstated due to an improper calculation of returns.

The wrong performance figures are caused by the combined effect of a large number of trading signals and lack of risk management. The signal provider keeps on issuing signals to buy various names, in the case of the stock market for example, without properly accounting for capitalization constraints and risk. The first sign of trouble is the constant generation of a large number of signals. The second and even more serious sign is the calculation of returns by considering unlimited margin and full investment of trading capital each time a signal is issued. Due of the lack of proper allocation and risk management, returns are overstated when in fact can be even negative, depending on which signals a user of the service considered. Let us look at an example for illustration purposes only:

–  The signal service provider issues 5 buy signals for 5 different stocks on day one that end up with a loss of 1% each after 10 days. On day two he issues another signal that results in a 10% gain after 9 days. Then, the signal provider claims a return of 5%. 

– The signal service user allocates 20% of capital to each stock on day one. On day two there are no funds left for trading another signal. The net loss is 1% as compared to a 5% gain reported by the signal provider.

The problems with miscalculation of returns  can get more complicated. Below is what I wrote in the past in one of the signal services I offered (closed to new registrations now) that illustrates how I deal with these issues:

A total of 79 signals were generated since inception, or about 12 signals per month. Maximum allocation is 0.4% of capital per signal and a maximum of five signals are allowed (2% max risk). This is the proper way of accounting for performance while controlling risk. Many, if not the majority, of newsletters that publish signals often overstate performance because they do not account for maximum “portfolio heat”, capital requirements and drawdown but consider all signals. The actual performance of some of those newsletters can vary from negative to positive depending on which trades one decides to execute and how much money is allocated to each of them. This naive way of doing things is a clear indication that the authors of such newsletters do not have actual trading experience… 

Below is a brief description of the method I use to control risk and calculate position size:

A maximum of 5 positions are held open at any time, sized using a 0.4% fixed risk based on the available equity. Thus, the maximum “portfolio heat” is always no more than 2%. The stop-loss amount (entry price – stop-loss price) is required for properly sizing positions using the following formula:

Number of shares = (0.4 × available equity)/stop-loss in points

The final position size result is the minimum of:

min{Number of shares, available equity × 0.4/entry price}

In the case that: risk percent = 100 ×  (stop-loss in points)/entry price, then the allocated capital is fully utilized. Also note that the number of shares to maintain a constant percent risk per trade does not directly depend on the target but only of the stop. However, the target may depend on the stop. More details can be found in this article.

Signal services do offer value and there are many competent and knowledgeable providers around. Before subscribing to a service it may be a good idea to consider asking the following questions:

(1) How is performance calculated? If no measure of performance is offered, even a simple one that counts how many times the signal provider was correct, this may imply that it is avoided.

(2) How is position size calculated? If there is no clear indication of how this is done, you are probably dealing with a clueless individual who has little connection to actual trading. Usually, any ability to analyze the market is related to actual trading experience, preferably acquired while working for some company, bank, fund, trading house, etc.

(3) Are well-defined exit levels offered? If only entry levels are provided but no well-defined exit levels, then you may be dealing with a clueless individual because a trade involves an entry and an exit. In many cases exits are more difficult to establish than entries.

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