Zacks Method for Trading: Home Study Course Workbook. Disclaimer. Disclaimer

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2 Zacks Method for Trading: Home Study Course Workbook Disclaimer Disclaimer The performance calculations for the Research Wizard strategies were produced through the backtesting feature of the Research Wizard using the DBCMHIST database and consist of the total return (price changes + dividends) of an equal weighted portfolio. Returns are calculated on a specified periodic basis (most often one or four weeks) and assume no transaction costs. The portfolio is rebalanced at the start of each new period. Returns can be stated as either annualized or compounded. Stock trading/investing involves risk and you can lose some or all of your investment. Hypothetical or backtested results may not always be duplicated in the real world. Backtesting can at times produce an unintended look-ahead bias. Results can also at times be over or understated due to the exclusion of inactive companies. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading, not the least of which is the ability to withstand losses or to adhere to a particular trading strategy in spite of trading losses. These are material points which can also adversely affect actual trading results. The backtested results prepared for these materials were done using the DBCMHIST database and consisted of only active companies. The Research Wizard program has been aligned, to the extent possible, to eliminate look-ahead bias. Zacks however cannot make any guarantees in regard to this or any other possible limitation. For more information on backtesting, please go to: The performance of the Zacks Rank portfolios for annual and year-to-date periods are the linked monthly total returns (price changes + dividends) of equal weighted hypothetical portfolios, consisting of those stocks with the indicated Zacks Rank, assuming monthly rebalancing and zero transaction costs. These are not the returns of actual portfolios. The hypothetical portfolios were created at the beginning of each month from January 1988 forward based on the values of the Zacks Rank available to Zacks' clients before the beginning of each month. The portfolios created monthly from 1988 through September 2006 exclude ADRs and are comprised of stocks that have the indicated Zacks Rank and were covered by at least two analysts at the time of the stocks inclusion in the portfolio. Starting in October 2006 and going forward, the portfolios are comprised of all stocks with the indicated Zacks Rank and do not exclude ADRs, which is more reflective of the list of stocks that customers will find on the Zacks web sites. These performance numbers have been audited from 1995 through 2003 by Virchow, Krause & Company, LLP. The S&P 500 Index ("S&P 500") is a well-known, unmanaged index of the prices of 500 large-company common stocks selected by Standard & Poor's. The S&P 500 includes the reinvestment of all dividends, no transaction costs, and represents the gross returns before management fees. ii 2011 Zacks Investment Research All Rights Reserved.

3 Table of Contents Table of Contents Disclaimer ii Table of Contents iii Symbol Guide iv Lesson 3 (part 1) Creating Screens and Trading Strategies and Backtesting Them for Success Creating Your Own Screens More than Proven, Profitable Strategies The Research Wizard The Importance of Screening and Backtesting Backtesting Step 1: Identify Fundamental Trading Styles Momentum Aggressive Growth Value Growth & Income All Style Style Big Money Price Momentum Screen Aggressive Growth Screen Value Screen Growth & Income Screen All Style Style Growth and Value Ranking Parameters Hot Maps How to Use Hot Maps Changes in the Zacks Rank iii 2011 Zacks Investment Research All Rights Reserved.

4 Symbol Guide Symbol Guide To assist you in the use of this Zacks Method for Trading: Home Study Course Workbook, icons have been used to identify specific areas of interest. They include: Assignment: Identifies areas that require completion before moving on to the next lesson in the workbook. Exercise: Identifies activities or exercises used to review or test your knowledge in the application of the tools or strategies. Key Point: Identifies objects, lessons, main ideas or terms to help you gain expertise while developing strategies for trading. Lesson: Designates practical information helpful in gaining knowledge and understanding of the Zacks Method for Trading in the stock market. : Indicates an area provided in your workbook allowing you to take notes and record additional information from your personal studies. Objectives: Identifies information as well as targeted areas for discussion to be covered during your home study course. Lesson Snapshot: Provides a brief summary or recap of topics or concepts covered in the lesson. Web Address: Indicates a website or web address with supporting information or additional resources to help develop your skills. iv 2011 Zacks Investment Research All Rights Reserved.

5 Lesson Three (part 1) Creating Screens and Trading Strategies and Backtesting Them for Success Objectives The objectives for this lesson include: Creating Your Own Screens The Importance of Screening and Backtesting Step 1: Identify Trading Styles Assignments and Exercises The following assignments will help you in understanding the information in this lesson: Watch the following DVDs: Disc 3: Screening for Stocks and Creating Your Own Trading Strategies Disc 4: Backtesting Your Strategies for Success Plan to devote a minimum of minutes per day to completing the assignments and exercises for each lesson. It is imperative to spend time educating yourself about the market in order to have longterm success and consistency in profitable investing. 1

6 Zacks Method for Trading: Home Study Course Workbook Creating Your Own Screens More than Proven, Profitable Strategies The Zacks Method for Trading and the Research Wizard program are more than just our proven, profitable trading strategies. The Zacks Method for Trading is also about using the right tools. The strategies highlighted in the previous lessons were all made possible by the use of screening and backtesting. And as we mentioned before, the Research Wizard screening and backtesting program is a complete Research Tool. Creating Your Own Screens and Trading Systems with the Research Wizard Zacks Investment Research All Rights Reserved.

7 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success The Research Wizard: Is a screening and stock-picking tool - Create your own screens and trading strategies or pick and choose from the pre-defined screens and strategies that Zacks has already created Allows you to rank your stocks and Industries - See which Sectors and Industries are the best - See which stocks are the best in its Sectors and Industries and in your lists Gives you access to company reports and the ability to customize your own - Access company reports and equity research - Customize your own reports to see the most important data to you - View charts and fundamental overlay studies Helps you manage ticker lists and portfolios Lets you backtest your stock picking ideas and trading strategies - test your screens and trading strategies in all market conditions to see how they work before you trade It comes with: Over 8,600 stocks in its Universe Over 650 different fundamental data items to pick and choose from The ability to create your own customized items - compare one item to another item - combine different items together - compare an item s value to its value from a different time period Over 50 pre-defined screens and proven, profitable trading strategies created by Zacks Access to historical data And more... The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 3

8 Zacks Method for Trading: Home Study Course Workbook The Importance of Screening and Backtesting You may be asking yourself, Why should I use a Stock Screener? The short answer is, Because there are over 10,000 stocks out there and you need a way to find the good ones. The longer answer is: Other than buying the stocks that are talked about on TV or written about in the paper or touted on the Internet (not to mention tips from a friend), how else are you going to find stocks that meet certain fundamental characteristics? Screening Why Should I Use a Stock Screener? Even if you don t use a screener now, most people still do their own screening one way or another. They may hear that a stock has a certain growth rate, or a certain P/E ratio or sales surprise, etc. They then find themselves listening for or reading about or surfing the Internet for stocks that meet this criteria. Why Should I Use a Stock Screener? Zacks Investment Research All Rights Reserved.

9 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success Well, if you want to find stocks that meet certain criteria, you can find them quicker and easier and more accurately with a stock screener. However, just because you narrowed down 10,000 stocks to only a handful, doesn t necessarily mean that you ve picked the best stocks. You may have picked the worst ones. But how will you know? Key Point To find stocks meeting certain criteria, you can find them quickly and easily with a stock screener. Backtesting Once you ve created a screen, you can then backtest it to see how good your screening strategy has performed in the past. In other words, does your screening strategy generally find stocks that go up once they ve been identified or does your screen generally find stocks that go down once they ve been identified? Backtesting The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 5

10 Zacks Method for Trading: Home Study Course Workbook With backtesting, you can see how successful your stock picking strategy has performed in the past, so you ll have a better idea as to what your probability of success will be, now and in the future. Of course, past performance is no guarantee of future results. But if you saw a stock picking strategy that did nothing but lose money, year after year, period after period, stock after stock, over and over again, there s no way you d want to trade that particular strategy or use that screen to pick stocks with. Why? Because it s proven to be a losing strategy. One the other hand, what if you saw a strategy that did great year after year, period after period, over and over again, you d of course want to trade that strategy because it s proven to be a profitable trading strategy. Keep in mind, a screening and backtesting program isn t a box of magic, but it s a great way to see what works and what doesn t before you put your money at risk! How to Screen (Using the Research Wizard) Zacks Investment Research All Rights Reserved.

11 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success Step 1: Identify How to Screen for Fundamental Trading Styles In this lesson, we ll learn about how to identify the kind of trader you are, or the kind of trader you want to become. Then, we ll show you how to build these screens using the Research Wizard to help you find just the right stocks that meet your particular style type. First, ask yourself what kind of an investor you are or want to become. Then, check all that apply: What kind of stocks do you want to be in? High flyers and fast movers Big earnings momentum or aggressive growth Solid companies with dependable growth Mature companies with income producing dividends Deeply discounted or undervalued stocks What kind of characteristics do you want your stocks to have? Low P/E ratios and Price to Sales ratios Great management as reflected by a strong ROE Big earnings growth or earnings surprises Companies with a Zacks Rank of 1 or 2 What do you want your stocks to do for you? Make fast money by getting in and out quickly Find long-term core holdings Stocks that will generate income Medium-term trading strategy to actively pick stocks and grow a portfolio The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 7

12 Zacks Method for Trading: Home Study Course Workbook Fundamental Trading Styles Fundamental Trading Styles Let s look at the four main trading styles. They are: Momentum Aggressive Growth Value Growth & Income Momentum Momentum traders look to take advantage of upward trends (or downward trends) in a stock s price or earnings. They believe that these stocks will continue to head in the same direction because of the momentum that is already behind them Zacks Investment Research All Rights Reserved.

13 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success In fact, there s a lot of evidence to support the idea that stocks making new highs have a tendency of making even higher highs. Aggressive Growth Value Aggressive Growth traders are primarily focused on stocks with aggressive earnings growth or revenue growth (or at least the potential for aggressive growth). You ll often find smaller cap stocks in this category. Value investors and traders favor good stocks at great prices over great stocks at good prices. This does not mean they have to be cheap stocks in price though. The key is the belief that they re undervalued. That they are trading under their true value or potential. And the value investor hopes to get in before the market corrects the price, or in other words, goes higher. Value investors and traders look at valuations such as Price to Book ratios, P/E ratios, etc. Additionally, they often have a longer time horizon because it may take a little longer before the market takes notice of the stock and recognizes its true value. Growth & Income Growth & Income investors and traders are looking for good companies with solid revenue that pay a good dividend. Often these are more mature, large-cap companies that generate solid revenue and then pass it along to shareholders in the form of a dividend. This kind of investor will also have a longer time horizon, especially since they will want to hang onto their stocks long enough to receive the dividends. All-Style Style You can also combine the best of some or all of the trading styles together into one screen. In fact, this is a category that many people fall into. This combination style or all-style style, is a style as well. And we will discuss this more, later on in this lesson. The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 9

14 Zacks Method for Trading: Home Study Course Workbook Key Point No matter what style of trader you are, you ll want to combine the best of any and all trading styles together into one screen. ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Exercise 3.1: Your Trading Style What Kind of a Trader are You? Identify your fundamental trading type based on the previous definitions and exercise. Then, reflect on the holdings currently in your portfolio and determine if your trading style and portfolio are consistent. Record your notes in the space provided. Exercise 3.2: Trading Strategies Momentum Traders Momentum Screen Let s take a closer look at a Momentum screen and how to build one in the Research Wizard. Follow along with the corresponding lesson on your DVDs and then complete the exercises. List some additional items you would use in a momentum style screen Zacks Investment Research All Rights Reserved.

15 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success Big Money Price Momentum Screen The concept of finding the top price performers over one period and then narrowing your search to the top price performers over another period, is a concept that goes into one of our pre-built Momentum strategies called Big Money. (This strategy is included with the program.) In this screening strategy, after the other criteria are laid out, the program looks for the following: Top 20 Price Performers over the last 24 weeks From those 20 stocks, it then finds the Top 10 Price Performers over the last 12 weeks And from those 10, it finally selects the Top 3 Price Performers over the last 4 weeks Big Money Price Momentum Screen The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 11

16 Zacks Method for Trading: Home Study Course Workbook Whether you rebalance this strategy once a week, or every four weeks, this strategy has produced some spectacular returns. However, the Big Money strategy (as well as other momentum strategies especially price momentum strategies) is not without volatility. Often, a momentum strategy picks the high fliers. And sometimes when a high flier turns around, it can be quick. Key Point Just remember, this is part of the identification process. You ll want to identify what kinds of stocks you want to trade and what kind of trader you are or want to become. Momentum ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Zacks Investment Research All Rights Reserved.

17 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success Exercise 3.3: Building the Screen Momentum Traders Refer to the Momentum Screen demo using the Research Wizard. Assignment: Create a momentum screen. ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Aggressive Growth Screen The Aggressive Growth Method put together in the DVD demo has a compounded annual Growth Rate of over 25% a year, and it also comes loaded with the Research Wizard program. Aggressive Growth The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 13

18 Zacks Method for Trading: Home Study Course Workbook Exercise 3.4: Trading Strategies Aggressive Growth Traders Refer to the Aggressive Growth Screen demo using the Research Wizard. Assignment: To create, save and retrieve this screen, follow along with the procedure on your DVDs while duplicating the steps illustrated by the instructor. Complete the procedure before moving on in this workbook. ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Value Screen As a value investor, traders often find themselves looking at different kinds of ratios to get a gauge as to how the market perceives or values those companies. A value investor isn t looking for the biggest growth rates or the biggest EPS surprise, but rather, undervalued companies that are being overlooked by the market. The value investor must have a degree of patience, too. For example, if the company is being overlooked by the market for some reason, it may not change overnight. Therefore, while Momentum traders and Aggressive Growth traders can often be immediately rewarded for finding hot companies, Value traders and investors can take solace in the fact that cheap stocks (low valuation stocks) have historically performed better than growth stocks over time Zacks Investment Research All Rights Reserved.

19 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success Value Ex 3.8 Exercise 3.5: Trading Strategies Value Traders Refer to DVD Disc 3: Screening for Stocks and Creating Your Own Trading Strategies for the Value Screen demo using the Research Wizard. Assignment: To create, save and retrieve this screen, follow along with the procedure on your DVDs while duplicating the steps illustrated by the instructor. Complete the procedure before moving on in this workbook. The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 15

20 Zacks Method for Trading: Home Study Course Workbook Growth & Income Screen A Growth & Income screen allows you to focus on the growth aspects of your stock picks while also concentrating on the income potential many traders are looking for. Growth & Income Exercise 3.6: Trading Strategies Growth & Income Traders Refer to DVD Disc 3: Screening for Stocks and Creating Your Own Trading Strategies for the Growth & Income Screen demo using the Research Wizard. Assignment: To create, save and retrieve this screen, follow along with the procedure on your DVDs while duplicating the steps illustrated by the instructor. Complete the procedure before moving on in this workbook Zacks Investment Research All Rights Reserved.

21 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success All Style Style As you study the various trading styles, don t be concerned about fitting exactly into one style or another. Many traders easily fall into a category, but many others will identify with more than one style, or even identify with components from all styles. Combining the best of different styles can also be a style unto itself. For example, Growth and Value style traders want their companies to have good earnings growth, but they don t want to overpay for their investments. Everybody likes value, but many companies with low valuations are low because they don t have any real growth prospects worth consideration. On the other hand, looking for companies with strong earnings and low valuations can give you the best of two different styles all rolled up in one. For example, you can look at companies that have both strong growth and great valuations. There are a lot of companies that fit these criteria and in the Research Wizard we have a strategy that does just that. It s a screen called aptly enough, Growth and Value. Growth and Value The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 17

22 Zacks Method for Trading: Home Study Course Workbook Growth and Value In this screen we are looking for stocks that have growth rates greater than 80% of the stocks in the Universe while simultaneously having P/E ratios lower than 80% of the companies in the Universe. The screen breaks down the Universe into uniform groups of Then, it screens for the companies that are better than 80% of all the other groups. Let s take a look at the parameters that go into this screen. Exercise 3.7: Trading Strategies Growth and Value Traders Follow along with the procedure on the DVD presentation. Refer to the parameters listed below. Then, duplicate the steps illustrated by the instructor. Record your notes in the space provided. Growth and Value Zacks Investment Research All Rights Reserved.

23 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success Ranking Parameters For the Growth Rate between 1-99, the higher numbers were assigned to the stocks with the better Growth Rates For the P/E Ratio between 1-99, the higher numbers were assigned to the stocks with the lower (i.e., better) P/E Ratios. Let s look at the following examples: Rush Enterprises has a growth rate greater than 83% percent of all the other companies while also having a P/E ratio lower than 95% of all the other companies. Southern Peru Copper has a growth rate greater than 96% percent of all the other companies and a P/E Ratio lower than 90% of all the other companies. Rush Enterprises The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 19

24 Zacks Method for Trading: Home Study Course Workbook Southern Peru Copper The Ranking Methodology The Ranking Methodology we were using is called a Uniform Rank. Other Ranking methods in the program include Histogram Ranking and Ordinal Ranking. But one of the best and easiest to use Ranking Methods in the Research Wizard is the color-coded Hot Maps feature. ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Zacks Investment Research All Rights Reserved.

25 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success Hot Maps After you run a screen or report, you can access the hot maps by going to graphics on your menu bar. Menu Bar > Graphics Graphics > Hot Maps The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 21

26 Zacks Method for Trading: Home Study Course Workbook Hot Maps Data The Hot Maps allow you to graphically view the attractiveness of the companies within your screen, report or ticker list based on the items within your report. You can rank your stocks on a singular item or on multiple items in your report. Each item is ranked based on their numerical values. The individual scores are then combined into a composite rank. (The composite rank for the company is the equally weighted average of the individual rank for each item.) The stocks are then color coded using varying shades of green for most attractive and varying shades of red for least attractive. A neutral score is represented by white. If there is no data for a company (i.e., N/A), it will be colored gray. Using a composite indicator is a technique used by professional investors to rank stocks based on more than one factor to determine the most attractive stocks Zacks Investment Research All Rights Reserved.

27 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success How to Use Hot Maps After you ve identified your stocks, select the key ratios that you want to rank your stocks with (such as: Earnings Estimate Revisions, EPS Growth, P/E ratios and etc.) and add them to your report. The Hot Maps ranks your stocks based on the items in your report. If you only want to rank your stocks based on one factor or item, then only have that one item in your report. If you want to rank your stocks on multiple items, then be sure to add those to your report. Hot Maps enables you to rank your stocks using multiple items simultaneously. If you re running a screen, the screened items are automatically added to your report. If you do not want to rank your stocks on some or all of the items used in your screen, then delete them from your report and add only those items you want to your report. Then only your key ratios will be ranked. The composite rank created by the Hot Maps equal weights each of the key ratios. If you want to place more weight on one ratio, simply include that ratio twice in your report. It will then be used twice (twice the weighting) in the creating of the composite rank. Key Point The Hot Maps can be run only after displaying the results of a screen, ticker list or report. The Hot Maps can be organized by: Zacks Sector Zacks M (Medium) Industry Zacks X (Expanded) Industry Zacks Sector then by M Industry Zacks Sector then by X Industry If you do not want to have your report organized, select None. Key Point The Hot Maps feature lets you rank your stocks on a singular item or on multiple items in your report. The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 23

28 Zacks Method for Trading: Home Study Course Workbook Ranking Stocks using Hot Maps Exercise 3.8: The Hot Maps Function Assignment: To retrieve the Hot Maps function in the Research Wizard, follow along with the procedure on your DVDs while duplicating the steps illustrated by your instructor. Complete the procedure before moving on in this workbook. Changes in the Zacks Rank Let s look at another powerful way to screen for stocks. This powerful screen looks for changes in the Zacks Rank. We can do this from the Calculation Expression feature or from the main page of the program Zacks Investment Research All Rights Reserved.

29 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success Exercise 3.9: Trading Strategies Changes in the Zacks Rank Refer to DVD Disc 3: Screening for Stocks and Creating Your Own Trading Strategies for the Changes in the Zacks Rank demo using the Research Wizard. Assignment: To run this screen, follow the procedure on your DVDs while duplicating the steps illustrated by the instructor. Complete the procedure before moving on in this workbook. ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 25

30 Lesson Three Creating Screens and Trading Strategies and Backtesting Them for Success The return numbers presented assume no transaction costs. Details of how Zacks calculates performance for the Zacks Rank Portfolios and the backtested strategies can be found on page ii and at 26