Some trading ads you see on the Internet may tout their trading strategies. They might make a pitch like the following:

Use My Proven trading strategy that wins on 95% of its trades.

It sounds too good to be true, and that’s because it likely is too good to be true. No trading strategy should have a 95% success rate.

I don’t want to know where “Money-Making Investment Ideas” is going to to take me.

A 95% trading success rate, especially over a short time period, may imply that the trading strategy is skewed towards small winners, with rare big losers.

Examples of 95% “Success” Rate Trading Strategies

Selling out-of-the-money “naked” options

This is potentially the most dangerous version of a trading strategy with a 95% “win” rate, because of its use of leverage. The idea would be to sell an out-of-the-money option without having a position in the underlying stock.

For example, you might sell a put, which means that someone is paying you money for the option to sell the stock at a certain price by a certain date. For example, you might sell a put to sell Apple shares at $160 in the next month for $2 a share. You collect the $2 a share, and when Apple doesn’t crash, you keep the money. You repeat this month after month, collecting small wins.

Most of the time you’ll make money, but if Apple were to fall, you’d get crushed, with unlimited downside risk.

However, when Apple does crash, you are left holding the bag. Let’s say that Apple has a bad earnings report and falls to $140 a share. The holder of the put option that you sold will execute the option and sell Apple shares for $160, and you will have to buy Apple shares at $160, even though it is currently trading at $140. You are already losing $20/share. You were collecting $2 a share “dividends” but then lost $20 when the stock crashes.

Buying a stock, and then placing a limit order a few pennies above your buy price

Another flawed trading strategy would be a day-trading strategy to try to take advantage of the daily swings of the stock market. For example, you might buy Apple shares for $170, and then immediately put a limit order to sell the shares for $170.25. Since the daily range for Apple stock can be a dollar or more per share, your limit order is often executed within a day or two, and you make $0.25/share. Repeat this enough times, and you make good money.


The problem is when Apple goes immediately down after you buy the stock. Then you’re stuck in a losing trade. The stock may not come back to your buying price for weeks or longer. Eventually, you have to decide whether to take a loss, or hold out to “break even.” This trading strategy, without a clearly defined plan, is a recipe for underperformance.

Holding losers too long and waiting to break even

There can be an obsession with having winning trades. It’s hard to admit you made a mistake and accept a losing trade. This can cause you to hold your losers longer than you should.

You could artificially increase your trading win rate by holding on to your losers, waiting for the stock to come back so that you can break even or eke out a small profit. This increases your win rate, but does not actually improve your returns. Eventually, there will be a trade where the stock has fallen so much that it will seem hopeless that the stock will ever return back to your buying price.

Remember that only you, not the market, cares where you bought a stock.

Don’t pick up pennies in front of a steamroller

There’s a common trading adage: don’t pick up pennies in front of a steamroller. But this is precisely what you’re doing with some of these 95% win rate trading strategies.

Most of the time you’re able to grab the penny before getting hit. But every once in a while, you get crushed.

Stay far away from the steamroller.

Backtested Strategies are Prone to Artificially High Win Rates

I’ve compared backtested trading strategies to retrospective research in medicine. Bactesting is where you use past stock market prices to test how a trading strategy might perform. It is easy to, consciously or unconsciously, “overfit” the data and create a trading strategy that would have performed well on past stock market prices, but would have poor performance on future stock market prices.

Here’s One Trade with a 95% Success Rate

There is one “trading” strategy that has a greater than 95% success rate — buy and hold. The stock market generally trends up, and according to Crestmont Research, the stock market has gone up over a 10 year period 96% of the time. The only exceptions were in the 1930s and the 2000s, when you had an annualized negative return of less than 2%. On average, the stock market has had a 10% annualized return. The best trading strategy is not to trade.

Conclusion

Avoid trading strategies that claim to have very high success or “win” rates. They may not capture the downside risk and may put you at risk for big losses. Alternatively, these strategies may be backtested trading strategies that won’t necessarily perform well in live trading conditions. The only consistently winning “trading strategy” for regular investors is a buy and hold strategy.

What do you think? Have you ever seen ads or sales pitches for trading strategies with really high win rates? Have you ever tried to sell “naked” options? Comment below!

6 COMMENTS

  1. If you collect $2 95% of the time and pay out $20 in 5% of the cases then you made a nice profit. Besides, for at-the-money options on a volatile stock like Apple, you’ll likely get much, much more than $2. I’ve been running a strategy like this with S&P500 futures options since 2011 and it’s quite profitable. Higher returns, lower volatility than stocks. Also, if you average over many random variables with extreme negative skewness (i.e. naked put selling) the long-term returns become Normal again, thanks to the Central Limit Theorem:
    https://earlyretirementnow.com/2017/07/12/we-are-so-skewed/

    But I don’t try to talk others into doing this. More profits for me! 🙂

    • The central limit theorem takes a 95% win rate strategy and turns it into a 50% win rate strategy over time (assuming zero expected return). As you know, the central assumption of your put-writing strategy is that it has a positive expectation, and that the buyers of the put are willing to take negative returns to buy the lottery ticket (or protect their long equity investments). I tend to disagree with that, although given the implied volatility skew (smile) that has been present since at least the 1987 stock market crash, you are picking the more expensive options to sell.

      I will appeal to the efficient market hypothesis defense here. There’s a lot of quantitative hedge fund money out there that should be taking advantage of these mispricings, if they exist. In fact, the most famous quantitative hedge fund of them all, run by one of the inventors of the Black-Scholes model itself (Myron Scholes), Long-Term Capital Management, blew up in 1998, requiring a bailout.

      Finally, I will use the Warren Buffett argument. Warren Buffett has called derivatives (of which stock options are the most basic) “weapons of mass destruction.” Let the professional traders handle the derivatives, although admittedly even they have blown themselves (and others) up through mishandling of derivatives (LTCM, financial crisis, etc.).

      • No. Expected returns are not zero. The CLT takes the skewed return distribution and turns it into one that has 50% chance of beating the mean and the mean is >0. The vol/skew premium has been pretty extensively documented in the literature. The efficient market hypothesis is the reason why this works. You are getting a risk premium, i.e., being compensated for the downside risk. Nobody is ever getting compensated for upside risk. Otherwise, lotteries would be very profitable.

        Also: LTCM didn’t blow up from put selling. We both know that.

        Warren Buffett: If he understood not just accounting but also finance he’d probably be more amenable to this strategy.

        But I suspect we can’t litigate this in the comments section. But check out some of the things I have written on the topic:
        https://earlyretirementnow.com/category/derivatives/

  2. Even if this did work then there are the taxes to be paid. The few times over the years that I’ve been even remotely tempted I remind myself that even Warren Buffett can’t time the market.

    • Excellent point. These trading strategies are short-term, and if done in a taxable account, require the hurdle of beating the difference in tax rates between short and long-term capital gains when comparing it with a buy and hold strategy.

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