A.I.M. "In Depth" Q&A

[OldAIMGuy]

ZIG ZAG ANALYSIS AND AIM

Q.........
How can Zig Zag analysis be used to help set up the proper size Hold Zone for an AIM investment?
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A..............

Don Carlson was kind enough to bring this idea to the AIM forum. http://www.stockcharts.com lets us set up and vary the Zig Zag percentage. First we look at AIM's traditional Hold Zone which is about 30% (Buy SAFE - 10%, Sell SAFE 10%, Buy and Sell Minimums both 5%) We can use that 30% in the longer time frames and see an approximation of the number of AIM "round trips" we might expect over time. When I set up one of those StockCharts.com pictures, here's what I'm using:

Period: Weekly
Style: HLC Bars
Chart Size: Huge
Duration: 3 Years
Price Overlays: Zig Zag (Basic), 35% (to start)
Exponential Moving Average: 26 weeks
Indicator Windows: Williams%R

and this is how it would look on CGNX, for instance:
http://stockcharts.com/def/servlet/SC.web?c=CGNX,uu[h,a]wahlyyay[df][pe35!b26][vc60][iLk14]&pref....
(3 cycles, all correctly on the "right" side of the 26 week M.A.)

At 30%
http://stockcharts.com/def/servlet/SC.web?c=CGNX,uu[h,a]wahlyyay[df][pe30!b26][vc60][iLk14]&pref....
(6 cycles, 3 on the "wrong" side of the M.A.)

At 25%
http://stockcharts.com/def/servlet/SC.web?c=CGNX,uu[h,a]wahlyyay[df][pe25!b26][vc60][iLk14]&pref....
(8 cycles, 3 on the wrong side of the M.A.)

and finally at 20%
http://stockcharts.com/def/servlet/SC.web?c=CGNX,uu[h,a]wahlyyay[df][pe20!b26][vc60][iLk14]&pref....
(15 cycles, 6 on the wrong side of the M.A.)

As you can see, we can develop more trades only by sacrificing the overall return on each "round trip." So, there's going to be a sweet spot somewhere that fits our trading habits and also gives us the best possible return. In E.4 of Mr. L's book he is now asking us to consider roughly a 40% "round trip" (10% SAFE on buys and sells plus 10% minimums on buys and sells for a total of 40%). Here's the same charts with 40% used:
http://stockcharts.com/def/servlet/SC.web?c=CGNX,uu[h,a]wahlyyay[df][pe40!b26][vc60][iLk14]&pref....
(3 cycles, all on the "right" side of the M.A.)

So, if I were going to choose between 35% and 40% I guess I'd choose 40% and not trade very often but make a bundle each time I did. However, a case could be made for Original AIM of 10% SAFE and 5% minimums - 30% overall. We'd be making 30% LIFO six times instead of 40% LIFO just three times. If each of the sells at 30% LIFO was a $1300 trade, then we'd make $300 times 6 or $1800 in realized gains. If we used 40% and had a $1400 trade just three times, we'd make a LIFO of $400 times three or $1200 of realized gains.

For this example, I'd prefer the Original AIM. It generates a 50% improved realized gain.

The point of diminishing returns comes when the number of transactions increases at a slower rate than the drop in LIFO gain per transaction. In the above example we had a 100% gain in the number of transactions along with a 25% drop in LIFO gain. It still netted us more realized gain.

Let's be simplistic here for this series of examples:
40% LIFO X 3 trades ($400 X 3) = $1200 realized gains
30% LIFO X 6 trades ($300 X 6) = $1800 (50% better)
25% LIFO X 8 trades ($250 X 8) = $2000 (11% better)
20% LIFO X 15 trades ($200 X 15) = $3000 (50% better)
15% LIFO X 21 trades ($150 X 21) = $3150 (5% better)
10% LIFO X 30 trades ($100 X 30) = $3000 (5% worse!!!)

Here it would appear that 20% would be the ultimate level without risk of diminishing returns. One also has to understand the consequences of faster cash Burn Rate and other things along with the fact that AIM may sell several times in a row in a rising market which isn't explicitly shown in Zig Zag analysis.

Of course not considered here is the difference between our GROSS and NET gains. Since our "fixed costs" are the same in each trade, we need to understand this. Giving up $15 commission on a $100 cap. gain event is quite different from $15 on a $300 cap. gain! In taxable accounts Uncle Sam always takes his share no matter what, and that's alway just a percent of what's left after commissions.

Robert Gammon had approached this from a different direction in his AIM 2000 presentation showing that a smaller LIFO gain per round trip accelerated his portfolio growth in an IRA when very small commissions are part of the equation.

We've always talked about keeping commissions to something less than 5% of our transaction costs (historically mine have been less than 1%). We've always assumed that AIM's healthy LIFO gains would assure that we made many times what the broker did. This "test" shows that as we reduce the LIFO gain, we also "increase" the percent of gross profit being given to the broker. We started with commissions being about 3.75% of gross profit and ended with it being 15% of gross!

Best regards, Tom