Our long-term fundamental analysis allows us to divide our stock coverage list into two broad categories. Stocks of companies with improving fundamentals are likely to outperform the market average, and stocks of companies with deteriorating fundamentals are likely to under-perform. This allows us to forecast the longer term trend direction of the share price relative to the market. Any trend direction in the share price will have a range of volatility around it. Some stocks are more volatile than others. A significant share price change for one stock may be well within the standard volatility range of another.

 Once we have established the likely trend direction of the share price (based on the trend of fundamentals of the company,) we measure the standard volatility range of the share price. The period over which the range is calculated is based on the location of the last change in the trend direction of fundamentals. When a company’s fundamentals change direction, whether for the better or the worse, the shares will become more volatile. When the direction of fundamentals is stable, the volatility range of the shares will tend to narrow. If we measure a volatility range through a period of changing fundamental trend, the volatility range that we calculate will be exaggerated and unreliable. By anchoring the volatility range calculation at the point when the company’s fundamentals last changed direction, we can produce a more reliable range calculation. That means that the time horizon for the calculation of the share price volatility range will be different for each stock.

We are interested in buying improving companies when the shares are near the bottom of their standard volatility range. Since our goal is to extract trading returns from unusually depressed shares, we sell the position as soon as the stock is no longer depressed¾ even if the long-term investment conclusion is still buy. In practical terms, the buy decision is made when the shares trade below a one standard error volatility range. The long position is sold when the shares move higher than 95% of the bottom of the volatility range. We will also be forced to sell a trading long position if the company’s fundamentals deteriorate badly enough to produce a long-term investment sell decision. Each day the share price changes, the location of the volatility range of the stock changes, and the fundamentals might change. It is possible to be forced to sell a long position at a loss, if the volatility range moves down relative to the price, or if fundamentals deteriorate.

We are interested in selling short the shares of companies with deteriorating fundamentals when the shares are trading near the top of their standard volatility range. In practical terms, shares are sold short when the price moves about the one standard error volatility range. The short position is covered when the shares drop below 95% of the top of the volatility range. Most short positions are still ranked "sell" from an investment standpoint when the short position is reversed. Our goal with this strategy is to sell short only extended share price stocks, and cover the position when the stock is no longer extended. We may be forced to reverse a short position, at a loss, if the range moves up relative to the share price, or if the fundamentals of the company improve to a sufficient degree to reverse our long-term Sell recommendation to a Buy.

Our strategy forces several disciplines on the investor. First, we are only buying evidently improving companies. Although any improving fundamental trends can deteriorate, we can lower the risk of a bad buy decision by focusing on improving companies. We are further disciplined to buy only stocks that we can measure as significantly depressed relative to their standard volatility range. By buying only depressed stocks, we lower the potential cost of an error. By focusing on improving company fundamentals we lower the probability of an error.

Similarly on the short side, our discipline means we only short companies who’s fundamentals are deteriorating. Also, by only shorting stocks that are significantly extended relative to their volatility range, we reduce the potential cost of an error.

Each day we calculate the location of each share price relative to its standard volatility range. If a stock falls below the standard range, and the fundamentals of the company are improving, the stock is a new trading buy. If the shares fall further below the standard range than they were the day before and the positive fundamental trends are intact, the shares are a better trading buy. Both "new buy" and "better buy" positions can be added-to at yesterday’s closing price. Do not pay more than the closing price. If the shares move above 95% of the lower end of the volatility range, the trading position is sold. Note that if the trend of the fundamentals is still positive, a trading long position might be sold when the long-term investment opinion is still Buy.

If the shares move above their standard volatility range, and the fundamentals of the company are deteriorating, the stocks is a "new" trading short. If the shares advance further above the standard range than they were the day before, the shares are a "better" trading short. Both "new short" and "better short" positions can be added-to at yesterday’s closing price. Do not short at prices lower than yesterdays close.

Each day we publish the top 100 long and short positions as of the previous day’s close. The list is ranked from the most to the least depressed for longs, and from the most to the least extended for shorts. Transact at least 25 stocks from each category and be careful to keep the value of each fund the same. If you have an equal dollar amount invested in each fund, and an equal number of stocks each with an equal weight, your investment returns should be close to those that we simulate each week. In a market when share prices are generally down, the short fund should be up more than the long fund is down¾ generating a profit. In a market when share prices are up, the long fund should be up more than the short fund is down¾ again generating a profit.

Register now with GEARS and select the free long/short email. Each day we will deliver an email describing yesterday’s market activity and listing any new long or short ideas that emerged. We’ll also list any existing positions, either long or short, that should be covered at yesterday’s closing price.