Stock Trading Strategies

Stock Trading Strategies

The Trader’s U E-Letter: Issue # 172

Wednesday, January 25, 2006

Stock Trading Strategies: It’s No Myth - Round Numbers DO Matter… And Can Give You An Edge

By D.R. Barton, Jr., Chairman, Trader’s U We’ve done our share of myth busting here at Trader’s U. We’ve busted myths about short selling, buy-and-hold investing, and the January Effect.

And just yesterday, I got into a discussion about the “myth of round numbers” with a new friend and trader from Indiana who you’ll hear more about in the future.

Round numbers are, in general, numbers that end in zero. And there are many variations on what different traders and investors classify as round numbers.

The myth is this: “Prices gravitate toward or have special respect for round numbers.”

Today, I’m proud to report that this is no myth! Numbers do actually move toward and/or respect round numbers.

And while that information may be useful at your next cocktail party, let’s find out how you apply this knowledge to your stock trading strategies and put some extra money in your investment portfolio.

Cross-Eyed For the Sake of Knowledge

How can we know if prices tend to move toward or stop at “round numbers”?

First, we need a definition of “round numbers.” There are a number of ways to look at these. My earlier definition of “anything that ends in zero” is a good starting point. (We’ll concentrate on stock prices here, but I have seen data that show similar effects for futures and currencies.)

I landed at this question: “How often do prices stop and reverse at a 10-cent or dollar increment versus what we could reasonably expect statistically?” I had the idea to use weekly data - the high price and the low price for a given stock each week. If the high and the low prices hit exactly on dime or dollar increments more than an average amount, then this “round number” myth could be real.

And then I threw myself physically at the problem. Pouring over literally thousands of data points, I sacrificed my eyesight just for the sake of you, the loyal readers of Trader’s U! But enough about my selfless acts. Let’s get to the research…

Compelling Evidence That Round Numbers Matter in Your Stock Trading Strategies

So here’s the hypothesis: If a weekly high or low fell on a dime increment more than 10% of the time (if prices are purely random, then the highs and lows should fall on 10-cent increments 10% of the time), then we have a good chance that traders favor round numbers. Likewise, if weekly highs or lows fall on dollar increments more than 1% of the time (random prices should land on whole dollars only 1% of the time), then prices really do favor round numbers.

To do the trading research, I looked at 250 weeks’ worth of data for each stock. Decimalization - the pricing of stocks in one-cent increments - became a regulatory requirement almost exactly 250 weeks ago. So we have 250 weeks of good data where prices were quoted in terms of pennies, not in eighths or sixteenths. Since I looked at the high and the low for each week, that gave me 500 data points per stock, which should make a statistically significant sample.

I choose two heavily traded NYSE stocks and two heavily traded Nasdaq stocks so that pricing could not be influenced by light trading volumes. The results:

Stock

% of Highs or Lows that “Stopped On A Dime”

% of Highs or Lows that Stopped On the Dollar

Int’l Business Machines (NYSE: IBM)

30.3%

5.4%

General Motors (NYSE: GM)

25.0%

3.4%

Microsoft (Nasdaq: MSFT)

21.2%

4.2%

Qualcomm (Nasdaq: QCOM)

18.4%

4.2%

That’s pretty compelling evidence! With four randomly picked stocks, weekly highs or lows stopped exactly at 10-cent increments two to three times more frequently than random. And the weekly highs and lows stopped exactly on a dollar price three to five more times more often than could be randomly expected.There is no doubt that prices stop on round numbers.

How to Use Round Numbers to Gain a Stock Trading Competitive Edge

The “round number” research is good fodder to kick around the water cooler, but how can we use it to add some dollars to our trading and investing equity? Take a look at the following strategies:

1. Placing stop loss orders where they are less likely to get hit.

There is no doubt that round numbers are turning points because of human psychology. To buy or sell a stock, most people give orders to buy it at $65 or sell it if it hits $60. Since most peoples’ strategies are to place their orders at round numbers, you can gain an edge by placing your orders above or below round numbers.

For example, let’s say you take a position and your stop loss calculation says to exit the position if the price hits $24. You know from today’s research that the price is more likely to reverse on $24 than other numbers. So instead of putting your stop at $24, put it at $23.97. Once or twice a year, you’ll get a pleasant surprise to see that a stock in your portfolio traded right down to $24 (or some other round number) and reversed and you were still in the position because your stop was a few ticks below the round number.

2. Get better entry confirmation.

With some trading and investment strategies, you enter when a price event is triggered. A system may have you buy when a fast moving average crosses a slow one or when a trend line or other resistance level is broken. You can use the “round number” tendency approach to help with these entries.

Note that if you get an entry signal to buy at $54.96, you will usually be better served to wait until the price breaks through $55 by a few cents. This won’t make a difference on every trade, but a few times a year, it will keep you out of a trade that hits a round number and reverses.

In a similar way, if your entry signal says to buy when the price breaks $55.04, you can feel pretty comfortable buying two or three cents early because the price will have already cleared the round number hurdle.

Conclusions:

Round numbers DO matter. They are not impenetrable, but they do represent price areas where resting orders are more likely to be found and where price action is more likely to provide support or resistance. Use these well-known areas to gain an edge for your investing and stock trading strategies, and you should get a nice surprise a couple of times per year when they really help you out.

Today’s Trader’s U Tips & Tricks

  • Another “round number” to watch in your trading: 50-cent or half-dollar increments. Prices were almost as likely to stop on the half dollar as they were on the whole dollar increments. So $XX.50 represents another important round number price point that you can use as an edge for your trading and investing.
  • Making research like today’s work is what separates the great traders from the average ones in their investment plans of attack. Because we’re on the subject of improving our portfolio’s results, I highly recommend you take a look back at some of our previous discussions - Trader’s U #166, The Curse of the Low-Quality Trade, and #167. And #168: Stock Trading in 2006: How to Make the New Year Your Best Yet explains that making a habit of one particular technique can make 2006 a great trading year for you.

The Chart of the Week

Trader's U Chart of the Week

Intel Corp. (Nasdaq: INTC) released a very negatively received quarterly earnings and outlook last week. In our Trader’s U #171, we talked about price shocks like this one and how to handle them. INTC showed that this may be a fundamental issue with the stock when it sliced through the first important support level. The stock should hold above $19.65. If it doesn’t, it could be in danger of testing the 2002 lows.

Great trading,

D.R.

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