TradeSmith’s Newest Low-Risk, High Reward Idea

December 4, 2024

TradeSmith's Newest Low-Risk, High Reward Idea

BY Keith Kaplan
CEO, TradeSmith

In the last few months, I’ve been laser-focused on product development with our research team.

My top priority was to build out a robust idea testing process. We needed to be able to test new trading and investing ideas at a super quick pace – and be able to throw a lot of different things at this process without it breaking.

That work is done.

Now, the only thing separating us from a new potential breakthrough are a few variables and a testbed of stocks or ETFs.

It’s good ol’ fashioned science: hypothesis, test, conclusion. Except now we can draw those conclusions in a matter of minutes and change our hypothesis in seconds.

Often, I’ve found, we’re pleasantly surprised by those conclusions. Especially because this process allows us to refine so quickly and easily.

This week, I’d like to share one of those pleasant surprises with you…

The Low-Risk, High-Reward Trade Idea

They say you should never try to catch a falling knife. That’s certainly true if you’re doing it without a plan.

But trading stocks in steep downtrends and banking on a reversal can be quite lucrative if you go about it right.

We wanted to see if we could devise a system that was like catching a falling knife with Kevlar gloves on… where the risk/reward ratio was highly in your favor.

We tested lots of variables and we found one combination that produces a rare but quite reliable trading signal:

When a stock’s eight-day simple moving average (SMA) trades below its 13-day SMA by 5% or more, and the stock is at a three-month low, that’s the signal to buy.

If you know charts and moving averages, you can probably already tell this is a very extreme slide in an already bad downtrend. A perfect falling knife.

This kind of setup doesn’t happen often, and it rarely happens in stocks with a low Volatility Quotient.

But when it does happen, it’s really interesting what happens next.

We tested this simple signal on S&P 500 stocks for the past 10 years. Of the 342 cases we found, roughly a third of which were during the initial panic selloff of March 2020, 80% saw positive returns 21 trading days later. And the average return, counting wins and losses, was 15.86%.

Those are strong returns. And the short-term nature of this system makes for a great swing-trading strategy.

Let me show you a couple examples. Here’s one from the pandemic panic crash, in Humana (HUM).

In our backtest of this strategy, we spotted a trade on HUM during the pandemic crash. Its eight-day SMA was more than 5% below its 13-day SMA, and the stock was at a three-month low.

The signal triggered on HUM on March 23, 2020. Buying it at $206.99 and holding for the next 21 trading days probably sounded like a horrible idea at the time. But just one month later, you would’ve walked away with a 71.6% return as the stock recovered to $355.18:

This was the pandemic, though. A lot of stocks pulled moves like this.

Let’s look at a more isolated incident involving insurance company Globe Life (GL) from earlier this year.

GL was the target of a short report which accused insurance fraud. The stock dropped more than 50% in a single session, and the spread between the two moving averages widened to -7.4%. That was enough to trigger the buy signal on April 15 at a price of $55.52.

Twenty-one trading days later, the stock recovered to $88.10. returning 58.7%, as you see in the chart below:

Then there’s one of the cleanest examples I’ve found – a case from 2022, in Caesar Entertainment (CZR).

CZR was at a three-month low, and the spread between those two SMAs grew to 8.19%. Buying the stock at $32.36 on Sept. 30 would’ve left to a 35.5% gain if you’d sold it 21 trading days later (on Oct. 31) for $43.73:

These are all some of the best-performers the system found over the last 10 years. To be clear, there were losers, too. But in our study, only one-fifth of the signals lost money.

So, I’m guessing you want to try it out?

Good news: there’s a live signal right now.

A Tradable Signal on MPWR

Check out this chart of electronics company Monolithic Power (MPWR):

On Nov. 20, this system flashed a new trade on MPWR. The eight-day and 13-day simple moving averages are about 8% apart, and the stock is at a three-month low.

The rules are the system were to have bought on Nov. 20 and hold through Dec. 20 (21 trading days). We’re a bit late to this trade, but it is currently the most recent signal in our system.

Luckily, the price hasn’t moved much. In fact, it looks like it’s trying to bottom out.

You could buy the stock of MPWR here and look to sell it as it reaches the average gain the system achieved in our backtest – about 16%. That’d be a very respectable return for 21 trading days.

If you did that, you’d be looking at a gain of about $90 per share. That’s not bad. And MPWR also happens to be close to its Red Zone, so you could use that as a very aggressive stop, if you wanted to.

But that doesn’t seem like the best risk/reward setup to me. You’re risking almost $600 to make $90.

So instead, a call option might be a better choice. A call option at the $670 strike expiring on Dec. 20 is trading for $2.65 per contract at writing. So instead of almost paying $600 to control one share of MPWR, you can pay $265 to control the price action of 100 shares.

If MPWR does recover by 15.86% (the average gain of this strategy) to reach $682 per share by the day before expiration, Dec. 19, that option will be worth about $14.87 per contract or a gain of $1,222… a 461% return.

That, to me, is a better risk/reward setup.

If MPWR continues its downtrend from here, traders can cut their losses early and with far less upfront cost.

And if it starts to rise, they stand to make much more on the option than they ever would on the stock… with a gain that more than triples their money assuming the average stock return this strategy provides.

We’ll be rolling this strategy out to our Ideas by TradeSmith and TradeSmith Platinum subscribers very soon. When we integrate it into our software platform TradeSmith Finance, they’ll be able to see new entry signals on this strategy and follow along if they wish.

In the meantime, let us know what you think of it by writing feedback@TradeSmithDaily.com. We’re working on other new strategies as well, some of which will be AI powered – so let us know what tests you’d like to see based on what you like to invest in. We’d love to hear your ideas.

All the best,