Some signal providers and stock market newsletters overstate performance due to unrealistic calculations and a lack of risk and money management application.
Some services and newsletters provide signals to traders and investors in different timeframes. Although competent people have the knowledge and experience to do this properly, some clueless individuals 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 is usually overstated. This may not be intentional fraud in many cases but 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 a 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 to 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 the signal provider issues another signal that results in a 10% gain after 9 days. Then, they claim 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 the miscalculation of returns can get more complicated. Below is a brief description of the method I used in the past 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}
Note that 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 on the stop. However, the target may depend on the stop. More details can be found in this article.
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 or even fraud. 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.
