The Natural Selection System
There are three critical elements to the natural selection investing system. The first is being able to identify a trend and trade it using appropriate buy and sell signals. The second is being able to effectively manage risk, which means not giving up gains or enduring losses in a bear market or market crash. The third element is being able to manage a portfolio of trending stocks in perpetuity, which means having a ready watch-list of new candidates to replace the failing trends with new trends (survival of the fittest!). Natural Selection investing (and indeed any investing) cannot be successful without accomplishing all three of these objectives. Let’s take a quick look at how these objectives are achieved.
Trend Identification and Buy and Sell Signals
Referring to the chart below, we can see that the Natural Selection System seeks to identify stocks and ETFs that are in transition from down-trend to up-trend, which is reflected by the flattening of the 50-period moving average (pma) and transition to a positive slope (note the bowl shape of the 50 pma). The 50 pma functions as our primary trend indicator, while the short-term price action (as reflected by the candlesticks) provides us with entry and exit signals around the trend. The transition process from down-trend to up-trend is a process that I refer to as base-building. The base is a zone of flattish price action and is characterized by a security no longer making lower lows and eventually starting to make higher highs. Recognizing this process is important but the real key here is knowing when to buy. The four primary buy signals are indicated on the chart.
Buy Signals - My system does not buy a security unless the 50 pma is almost flat and moving strongly towards a positive slope. This is because without the slope changing in our favour, we have a very high risk of entering a trend that may never materialize. Each successive buy signal provides greater confirmation that a trend is underway. In the case of Buy 1, we can see the price moves upwards across the 50 pma and makes a higher high at the same time. In this case, it is an early buy signal because we do not yet have clear evidence of an emerging trend and there is still a high probability of initial trend failure. The correct use of stop-losses (as discussed in the Risk Management section) is important to avoid being unnecessarily stopped out of a potentially successful trade and also to minimize our losses in the event that the trend fails. Buy 2 occurs on a completed test of the 50 pma, which means the price has corrected down to the moving average and has then reversed upwards again. The moving average is now positively sloped and is acting as price support. Buy 3 occurs at the point that a higher high is made following the successful test. At this point, the stock is clearly an emerging trend and investors should now own this company unless they have chosen to opt for Buy 4, which occurs on a pull-back and reversal upwards within its established up-trend. In reality, if the trend is lasting, there will be several opportunities to buy on pull-backs.
Sell Signals - Although buying is important, many amateur investors spend the majority of their time looking for buy signals and give little consideration to selling, which is actually far more critical to achieving investment success. It is critical because it serves the purpose of maximizing gains on positive trends but also minimizing losses on trends that never materialize (via the initial stop-loss). Not having a plan for selling is extremely common and will yield results similar to buy and hold, or worse, will result in the investor selling at the very bottom of a correction. With that in mind, let’s take a closer look at the Natural Selection sell signals.
In addition to the initial stop-loss, the Natural Selection system utilizes four profit-taking sell signals. Sell 1 provides the investor with the option of selling into extreme strength. This signal is primarily useful if a longer-term trend has become stretched above its moving average(s) to the point that a sizeable correction is likely. The objective is to maximize the large profits that have already been earned. Sell 2 occurs when a security moves down across its 20 pma. Again, this is done with the intention of not giving back earlier gains but it also may be appropriate if the 20 pma has previously acted as support, as is the case in the chart above. Sell 3 is perhaps the strongest signal because lower lows are often followed by lower highs (and vise-versa), which indicates that the trend has ended or is about to end. This is the signal that I rely on most often in my portfolios. Sell 4 is the final stop for the Natural Selection system because a movement down across a flattening 50 pma indicates that the positive trend has ended and that a down trend is likely. Although it would be convenient to have a single buy and sell signal as part of a fully automated system, the reality is that every chart pattern looks a little different, and no single buy or sell signal is appropriate in all cases. It is the flexibility of this system that allows these portfolios to be successful.
I have provided the primary buy and sell signals here but the investment system can be refined by using other valuable indicators to help us decide which buy signal to use and when to rotate out of our ageing trends. These decisions should consider historical price behaviour, areas of support, volume, stochastic oscillators, and potentially others. For subscribers, I provide rationale for my buys and sells in the Live Blog section but I encourage readers to click on the links provided here to gain additional understanding.
If you are new to investing, some of this may sound complicated but in reality, it is really not all that difficult. Most long-term investors will be investing on the slow moving weekly time-frame, so the buying and selling of securities is rather infrequent and investors have plenty of time to assess and respond to changing conditions in a measured and unemotional way. Let's move on discuss how we manage risk. NEXT
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