I want to welcome you to my blog. This is where I hope to share trading research and strategies with you. I also look forward to your thoughts as I'll incorporate them into future posts.

I've been trading the markets for nearly three decades. Actually I've been in the markets now nearly 40 years...for my 8 year old birthday my grandfather gave me stock in Exxon and Laclede Gas. At 7 years old it was baseball -- a glove and a bat for my birthday. At 8 years old it was stocks.

And ever since that time, both still compete for my attention every day.

I've also been seriously researching the markets for the past two decades. I've been lucky enough to have gotten to know and become friends with some great traders. And I'm also fortunate to have a team of market researchers who are a heck of a lot smarter than I am.

I've written a handful of books over the years. “Street Smarts” is probably the one I'm best known for. But "How Markets Really Work" is the one I'm proudest of because it's the statistical source from which all our trading has evolved. My philosophy of the markets has not changed much over the years...it's made up of only three simple pieces. They are...

1. Markets tend to revert to their mean on a short-term basis. Once you figure that out...the game gets a bit easier.
   
2. Markets are efficient long-term. There is little statistical evidence to prove otherwise. But markets can be very inefficient short-term. There's ample statistical evidence to prove this. And that's where the best opportunities are today.
   
3. Risk control is underestimated, under-utilized, emotionally driven, and is likely the least understood aspect of professional trading and the market place. Get this part down, and you'll likely have a very long and prosperous career over the years to come.

I'll add one more piece to this list, especially for those of you who like to watch a certain TV station and read well known newspapers every day..."Opinions are fine. Statistics are better."

How I Trade

The main theme behind my research and our trading is "reversion to the mean". To us this is the holy grail of trading. This is not only our opinion; it's backed statistically with literally thousands of tests we've run over the years.

Let me qualify this a bit. Reversion to the mean can be interpreted many different ways and on its most literal level, it carries little weight when one takes the belief that every stock reverts to its mean in every time frame. There's nothing further from the truth.

But, in specific, recurring situations, reversion to the mean is the key to identifying market behavior. And we as traders only care about one thing-short-term market behavior. Longer-term predictions are tougher, and at least on the surface appears to be a game that few can beat. For every Warren Buffett in the world, there are (and have been) literally thousands of very smart Ivy League MBA's, CFA's, market analysts, etc, whose long-term performance has only been within a few points of the market averages. One would think that the entire exercise these people go through would be considered meaningless. But the fundamental analysis industry is much too big and established, and there's no chance that this game will come to an end in our lifetime. I'm fairly certain that if each of the 9 year olds on the baseball team I coach bought 100 shares of the SPY today... they'd outperform 50% (or more) of the money managers in this country over the next five years. Not only am I fairly certain of this... I'd guarantee it (and I'm not in the habit of guaranteeing many things).

The edges lie elsewhere, and based upon what the statistics show over and over again, it's in a reversion to the mean in short-term stock prices.

What is reversion to the mean? It's simply the concept that prices move back to levels they previously were trading at. Again though, there's not a great deal of evidence that it exists in longer-term pricing of securities. But shorter term-at least looking back more than a decade-it certainly has existed.

As I mentioned earlier, we can literally show you thousands of tests to prove this point. But to keep things simple, here's one simple example.

• A stock is above its 200-day moving average. Today it trades at its lowest price in ten days. If markets are efficient, the future price of these securities should be random. There should be about a 50-50 chance of them rising or falling in the near term. But, in reality that has not been the truth.

Let’s look at the results from 1/1/95 to 6/30/06 of buying a stock that made a 10-day high (above its 200-day moving average) and exiting when it closes below its 5-day moving average; versus buying a stock that made a 10-day low (also above its 200-day moving average) and exiting when it closes above its 5-day moving average.

Here are the results:

Two things stand out. First, the average returns for the stocks that made 10-day lows is nearly double that of stocks that made 10-day highs (see chart 1). Even more eye opening is the percentage of winning trades. Buying 10-day lows was correct nearly 65% of the time, while buying 10-day highs was correct only 38% of the time (see chart 2). And these numbers are not based upon a few hand-picked trades; they are based upon hundreds of thousands of trades.

Chart 1

Chart 2

Is this by chance? Not likely, especially when you're looking at hundreds of thousand of trades over decades worth of time.

These statistics start to tell a story. And it's a story that the long-term fundamental people, who have been doing this much longer, and with far more resources than us traders have had, can never tell, at least statistically. Prices on a short-term basis are predictable at certain identifiable times. Looking at 10-day highs and lows is just one very, very, simple example. Over time in this blog, I'll go into this much deeper with you with both research and strategies. But for today, it's a good place for us to start.

If you'd like to see more research (and statistically backed indicators from our research), you can find it on the TradingMarkets website.

Larry