The stock market is a collection of individual human beings, and human beings are fallible. With almost every stock trade, one person is right and another is wrong. While the averages do in fact represent the net effect, or “collective wisdom” of market participants’ judgments about the future, history shows time and again that millions of people can be as wrong as one, and the stock market is no exception. The nature of the market simply allows participants to adjust and correct their errors rapidly. Any method of analysis that claims the markets are infallible is flawed at its roots.
The theory of “efficient markets” is a case in point. The main premise is that with the advent of computers, information is disseminated so fast and efficiently that it is impossible to “beat the market.” This is nothing more than an extrapolation into absurdity of Dow Theory’s tenet that “the averages discount everything.” It is also ridiculous. The idea that everyone receives all significant information simultaneously is absurd because everyone doesn’t agree on what is “significant.” Even if everyone did receive exactly the same information simultaneously, they would respond to it according to their own particular circumstances and preferences. If everyone knew exactly the same things and responded the same way, then there would be no market! You must always remember that markets exist to facilitate exchange, and exchange is the result of differences in value preferences and differences in judgments.
Friday, October 30, 2009
Tuesday, October 27, 2009
A Business Philosophy for Consistent Success
Translated into more businesslike terms, I base my business philosophy on three principles, listed here in order of importance: preservation of capital, consistent profitability, and the pursuit of superior returns.
These principals are basic in the sense that they underlie and guide all of my market decisions. Each principle carries a different weight in my speculative strategy, and they evolve from one to the other. That is preservation of capital leads to consistent profits, which makes pursuit of superior returns possible.
These principals are basic in the sense that they underlie and guide all of my market decisions. Each principle carries a different weight in my speculative strategy, and they evolve from one to the other. That is preservation of capital leads to consistent profits, which makes pursuit of superior returns possible.
Monday, October 26, 2009
Becoming an Expert at Just One Market Behavior
Because there is so much information and because so much of that information is conflicting, the beginning trader will need specifically to limit his awareness of the market information to which he allows himself to be exposed. More is not better; it just creates confusion and overload that will ultimately lead to losses.
You need to start as small as possible and then gradually allow yourself to grow into greater and greater amounts of market information. What you want to do is become an expert at just one particular type of behavior pattern that repeats itself with some degree of frequency. To become an expert, choose one simple trading system that identifies a pattern, preferably one that is mechanical, instead of mathematical, so that you will be working with a visual representation of market behavior. Your objective is to understand completely every aspect of the system — all the relationships between the components — and its potential to produce profitable trades. In the meantime, it is important to avoid another possibilities and information.
Out of all the combinations of behavior possible, you are going to limit your focus of attention to just one combination. Consequently, you will be letting all the other opportunities go by. Starting small and gradually working into other combinations is a real exercise in discipline that has a couple of important psychological benefits. First, you will be building a base of confidence as you learn that you can, in fact, accurately assess what will most likely happen next. It is much easier to gain this confidence if you don’t overwhelm yourself with the market’s seemingly infinite possibilities. Second, by passing up other opportunities that you are not an expert at yet, you will be releasing yourself from any compelling desire to trade. Any compelling behavior is usually the result of some fear. That fear, in turn, will cause you to behave in many inappropriate ways.
If the idea of letting go of opportunities that don’t fit into your framework is troubling to you, then ask yourself, what is the rush? If you are confident in your ability to transform yourself into a successful trader, what difference could it make that you let go of some opportunities now for educational purposes? Once you learn to become the trader you want to be, you can then give yourself as much money as you desire. However, to get to that point, your objective should be to plan your development in such a way that you do the least amount of damage to yourself, both financially and psychologically. Then after you have developed the appropriate skills, taking money out of the markets can be as easy as almost everyone believes it is before he started trading.
You need to start as small as possible and then gradually allow yourself to grow into greater and greater amounts of market information. What you want to do is become an expert at just one particular type of behavior pattern that repeats itself with some degree of frequency. To become an expert, choose one simple trading system that identifies a pattern, preferably one that is mechanical, instead of mathematical, so that you will be working with a visual representation of market behavior. Your objective is to understand completely every aspect of the system — all the relationships between the components — and its potential to produce profitable trades. In the meantime, it is important to avoid another possibilities and information.
Out of all the combinations of behavior possible, you are going to limit your focus of attention to just one combination. Consequently, you will be letting all the other opportunities go by. Starting small and gradually working into other combinations is a real exercise in discipline that has a couple of important psychological benefits. First, you will be building a base of confidence as you learn that you can, in fact, accurately assess what will most likely happen next. It is much easier to gain this confidence if you don’t overwhelm yourself with the market’s seemingly infinite possibilities. Second, by passing up other opportunities that you are not an expert at yet, you will be releasing yourself from any compelling desire to trade. Any compelling behavior is usually the result of some fear. That fear, in turn, will cause you to behave in many inappropriate ways.
If the idea of letting go of opportunities that don’t fit into your framework is troubling to you, then ask yourself, what is the rush? If you are confident in your ability to transform yourself into a successful trader, what difference could it make that you let go of some opportunities now for educational purposes? Once you learn to become the trader you want to be, you can then give yourself as much money as you desire. However, to get to that point, your objective should be to plan your development in such a way that you do the least amount of damage to yourself, both financially and psychologically. Then after you have developed the appropriate skills, taking money out of the markets can be as easy as almost everyone believes it is before he started trading.
Friday, October 23, 2009
Attribution and Bias Among Traders
Much of how we process the world consists of attributions: qualities that we attribute to ourselves and explanations that we attribute to events. As human beings, we are driven to make sense of our world, and attributions are an important element of that sense-making.
One of the most basic attributions traders make is to their gains or losses. Are profits and drawdowns attributable to the self; the result of positive or negative actions that we take? Alternatively, do we attribute gains and losses to outside forces or to sheer chance? How we attribute the outcomes of our trading performances will necessarily play a large role in what we do about those performances. If, for instance, we tend to attribute gains to the self, but losses to bad luck, we might stick with faulty trade ideas, exacerbating initial losses.
Traders with a self-serving bias tend to give themselves too much credit when trades go their way and rationalize situations that lose money. As a result, they are likely to become overconfident after a string of winning trades, raise their trading size/frequency, and place themselves at risk.
Reason dictates that there is a difference between a good trade (one placed with an edge in one's favor) and a winning trade (one that makes money), just as there is a difference between a bad trade (one that lacks an objective, positive set of expectations) and a trade that loses money. Sheer chance alone can create situations in which good trades lose money and bad ones happen to get lucky. The self-serving trader who overemphasizes the role of chance in losses creates a situation in which learning from experience becomes impossible.
But there is another kind of trader - one with an overinclusive attributional style - that tends to own losses and gains with equal fervor. By minimizing the role of chance, the trader attributes all outcomes to the self, feeling good when the profits are rolling in and becoming discouraged during (inevitable) periods of drawdown. This is the "illusion of control" documented in the research of a London Business School research team, who found that traders who thought they could predict markets shown to them (which were actually random price series) performed worse than less confident traders. The result is that you can reliably track traders' moods by their P/L statements.
Traders tend to blame their losses on such factors as "loss of discipline" and "overtrading" when, in fact, these are frequently the results of attributional biases. The majority of traders spend more time trying to understand market movements than trying to understand their own thinking about markets. An interesting line of research finds that individuals who experience increased emotion tend to shift their attributional styles, reducing their tendency to own negative outcomes. Successful traders not only need to be able to think about markets, but also think about their thinking. Awareness of a tendency toward bias can be a powerful antidote to biased decision-making.
One of the most basic attributions traders make is to their gains or losses. Are profits and drawdowns attributable to the self; the result of positive or negative actions that we take? Alternatively, do we attribute gains and losses to outside forces or to sheer chance? How we attribute the outcomes of our trading performances will necessarily play a large role in what we do about those performances. If, for instance, we tend to attribute gains to the self, but losses to bad luck, we might stick with faulty trade ideas, exacerbating initial losses.
Traders with a self-serving bias tend to give themselves too much credit when trades go their way and rationalize situations that lose money. As a result, they are likely to become overconfident after a string of winning trades, raise their trading size/frequency, and place themselves at risk.
Reason dictates that there is a difference between a good trade (one placed with an edge in one's favor) and a winning trade (one that makes money), just as there is a difference between a bad trade (one that lacks an objective, positive set of expectations) and a trade that loses money. Sheer chance alone can create situations in which good trades lose money and bad ones happen to get lucky. The self-serving trader who overemphasizes the role of chance in losses creates a situation in which learning from experience becomes impossible.
But there is another kind of trader - one with an overinclusive attributional style - that tends to own losses and gains with equal fervor. By minimizing the role of chance, the trader attributes all outcomes to the self, feeling good when the profits are rolling in and becoming discouraged during (inevitable) periods of drawdown. This is the "illusion of control" documented in the research of a London Business School research team, who found that traders who thought they could predict markets shown to them (which were actually random price series) performed worse than less confident traders. The result is that you can reliably track traders' moods by their P/L statements.
Traders tend to blame their losses on such factors as "loss of discipline" and "overtrading" when, in fact, these are frequently the results of attributional biases. The majority of traders spend more time trying to understand market movements than trying to understand their own thinking about markets. An interesting line of research finds that individuals who experience increased emotion tend to shift their attributional styles, reducing their tendency to own negative outcomes. Successful traders not only need to be able to think about markets, but also think about their thinking. Awareness of a tendency toward bias can be a powerful antidote to biased decision-making.
Take the Loss When You Are Wrong
When you know you are wrong, close your position! Don’t rationalize, hope, pray, or anything else, just get out. Don’t change your position, hedge it, or anything else; just take the loss and get out!
Tuesday, October 20, 2009
Dealing With Losses
Predefine what a loss is in every potential trade. By “predefine,” I mean determine what the market has to look like or do, to tell you that the trade no longer represents an opportunity, at least not an opportunity in the time frame in which you trade.
Be willing to change your definitions of what it means to lose. Losses do not diminish you as a person. The sooner you believe it, the easier it will be to identify and execute a losing trade. By making the execution of a losing trade an automatic function of your trading strategy, you make yourself psychologically available to take advantage of the next opportunity, even if that opportunity is in the same direction of the losing trade you just got out of.
Execute your losing trades immediately upon perception that they exist. When losses are predefined and executed without hesitation, there is nothing to consider, weigh, or judge and consequently nothing to tempt yourself with. There will be no threat of allowing yourself the possibility of ultimate disaster. If you find yourself considering, weighing, or judging, then you are either not predefining what a loss is or you are not executing them immediately upon perception, in which case, if you don’t and it turns out to be profitable, you are reinforcing an inappropriate behavior that will inevitably lead to disaster. Or if you don’t and the loss worsens, you will create a negative cycle of pain, that once started will be difficult to stop.
Be willing to change your definitions of what it means to lose. Losses do not diminish you as a person. The sooner you believe it, the easier it will be to identify and execute a losing trade. By making the execution of a losing trade an automatic function of your trading strategy, you make yourself psychologically available to take advantage of the next opportunity, even if that opportunity is in the same direction of the losing trade you just got out of.
Execute your losing trades immediately upon perception that they exist. When losses are predefined and executed without hesitation, there is nothing to consider, weigh, or judge and consequently nothing to tempt yourself with. There will be no threat of allowing yourself the possibility of ultimate disaster. If you find yourself considering, weighing, or judging, then you are either not predefining what a loss is or you are not executing them immediately upon perception, in which case, if you don’t and it turns out to be profitable, you are reinforcing an inappropriate behavior that will inevitably lead to disaster. Or if you don’t and the loss worsens, you will create a negative cycle of pain, that once started will be difficult to stop.
Don't Offer Market Advice to Your Friends
Don’t do your friends a favor by offering them unsolicited advice on any market position. It’s one thing to manage someone’s money, even a friend’s, on a professional basis; if you lose, it’s just part of the professional agreement. It’s another thing to offer market advice when you think you’re doing people a favor — you usually hurt them more than you help them.
Friday, October 9, 2009
Capitulation on the Upside
A capitulation on the upside is a capitulation of the shorts. Otherwise known as a capitulation top, it happens when those who have been shorting a stock are being squeezed by the advancing price of the stock caused by frenzied buying and extreme optimism to levels that are no longer sustainable. The shorts are losing money as the price moves up, pushed up by buyers who have to own the stock and are willing to pay up for it and the fact that there may not be enough sellers around. Fearful of an ever-increasing price, the sellers become so frightened that the elevation in prices will never cease that they panic and experience enormous pressure to cover their positions and buy back the stock. With a shortage of stock, the price goes even higher, reaching what is known as blow-off top where the price goes way beyond expectations until the buyers become sellers of the stock.
Often capitulation is started by the short sellers panicking to cover. In effect, they take the rally higher. Once they cover their positions and run the stock price up farther, they run out of gas. Then another short seller comes in.
The onset of capitulation is marked by a blow-off. Blow-offs are price action moves of stocks where they explode or dramatically move upward to levels beyond what might be expected. Essentially blow-offs mark inflection points driven by changes in fundamentals. The trader who can remain cool, calm, and collected and follow the price action without picking up the panic of the crowd can take advantage of these situations to short a stock before the blow-off and then prepare to buy the stock back after panic selling forces everything down.
Often capitulation is started by the short sellers panicking to cover. In effect, they take the rally higher. Once they cover their positions and run the stock price up farther, they run out of gas. Then another short seller comes in.
The onset of capitulation is marked by a blow-off. Blow-offs are price action moves of stocks where they explode or dramatically move upward to levels beyond what might be expected. Essentially blow-offs mark inflection points driven by changes in fundamentals. The trader who can remain cool, calm, and collected and follow the price action without picking up the panic of the crowd can take advantage of these situations to short a stock before the blow-off and then prepare to buy the stock back after panic selling forces everything down.
Missed Opportunities
Except for the inability to accept a loss, there isn’t anything that has the potential to cause more psychological damage than a belief in missed opportunities. Missed opportunities are trades that would have always turned out perfectly because they only occurred in our minds, where we can make anything be as we want it to be. Of course, we would have responded exactly as the conditions warranted without flaw. The problem is we didn’t do it, and the resulting sense of loss we feel is difficult to reconcile. Therefore, these missed opportunity trades have the potential to cause more anxiety and stress than the trades we actually do take that turn out to be losers.
Nothing’s worse than missing a “perfect” opportunity. However, if you could have, you would have; it’s that simple. The sooner you accept this, the sooner you will be able to take advantage of these missed opportunities instead of beating yourself up over them. Besides there really isn’t anything to miss because the markets are in perpetual motion and will continue to be until everyone agrees on value. As long as the price keeps changing, there will always be another opportunity.
Nothing’s worse than missing a “perfect” opportunity. However, if you could have, you would have; it’s that simple. The sooner you accept this, the sooner you will be able to take advantage of these missed opportunities instead of beating yourself up over them. Besides there really isn’t anything to miss because the markets are in perpetual motion and will continue to be until everyone agrees on value. As long as the price keeps changing, there will always be another opportunity.
Cut Your Losses Short
When you make a trading decision, you should feel absolutely confident that you are right, but you must also recognize that the market can prove you wrong. In other words, you are absolutely right until you are proven wrong. Consequently, you have to trade by rules and principles that take precedence over your feelings or wishes. Whenever you buy or sell any market, you have to ask yourself, “At what point will the market prove that I’m wrong?” Once you establish that point, nothing should stop you from closing out when the market hits it. This is the basis for the rule: cut your losses short. Violating this rule is the single biggest reason that people lose large sums of money in the financial markets. It is a curiosity of human nature that no matter how many books talk about this, saying the same thing in different ways, people still keep making the same mistake.
Thursday, October 8, 2009
You Can’t Control the Markets
Keep in mind that you can’t physically control what the markets do; you can only learn to control your perception of the markets to share the highest degree of reality (the least amount of distortion) with everyone else who is participating or has the potential to participate.
The more sophisticated you become as a trader, the more you will realize that trading is completely mental. It isn’t you against the markets, it’s just you. All the other traders participating to make the market provide you with an opportunity to make money from their divergent beliefs about the future. If people didn’t disagree about the future value of any particular commodity or stock, then there would be nothing to compel them to either bid a price higher or offer it lower, and the opportunity to profit from these changes would cease to exist. So the markets just offer the individual trader opportunity. They don’t choose the data on which you focus your attention, and they certainly don’t interpret the data you perceive. Nor are the markets responsible for what you can’t perceive because of the distinctions you haven’t learned to make yet. They also don’t choose when you put on a trade, how long you stay in, when you get out, or how many contracts you buy or sell.
The more sophisticated you become as a trader, the more you will realize that trading is completely mental. It isn’t you against the markets, it’s just you. All the other traders participating to make the market provide you with an opportunity to make money from their divergent beliefs about the future. If people didn’t disagree about the future value of any particular commodity or stock, then there would be nothing to compel them to either bid a price higher or offer it lower, and the opportunity to profit from these changes would cease to exist. So the markets just offer the individual trader opportunity. They don’t choose the data on which you focus your attention, and they certainly don’t interpret the data you perceive. Nor are the markets responsible for what you can’t perceive because of the distinctions you haven’t learned to make yet. They also don’t choose when you put on a trade, how long you stay in, when you get out, or how many contracts you buy or sell.
Traders, Speculators, and Investors
There are three price trends that are simultaneously active in any market: the short-term trend. Which lasts from days to weeks; the intermediate-term trend. Which lasts from weeks to months; and the long-term trend, which lasts from months to years. Within each market there are three basic types of participant: traders, speculators, and investors.
Traders focus their activity on the intraday and-or short-term trend. They buy and sell stocks, bonds, commodities or whatever within a time frame varying from minutes to weeks. Speculators focus on the intermediate trend, taking market positions and holding them for a period lasting from weeks to months. Investors, dealing mainly in the long term trend, hold their positions from months to years.
Traders focus their activity on the intraday and-or short-term trend. They buy and sell stocks, bonds, commodities or whatever within a time frame varying from minutes to weeks. Speculators focus on the intermediate trend, taking market positions and holding them for a period lasting from weeks to months. Investors, dealing mainly in the long term trend, hold their positions from months to years.
From Gambler to Banker
“When as a young and unknown man I started to be successful I was referred to as a gambler. My operations increased in scope and volume. Then I was known as a speculator. The sphere of my activities continued to expand and presently I was known as a banker. Actually I had been doing the same thing all the time.”
Sir Ernest Cassell, the private banker to King Edward VI
Sir Ernest Cassell, the private banker to King Edward VI
Wednesday, October 7, 2009
Capitulation on the Upside
A capitulation on the upside is a capitulation of the shorts. Otherwise known as a capitulation top, it happens when those who have been shorting a stock are being squeezed by the advancing price of the stock caused by frenzied buying and extreme optimism to levels that are no longer sustainable. The shorts are losing money as the price moves up, pushed up by buyers who have to own the stock and are willing to pay up for it and the fact that there may not be enough sellers around. Fearful of an ever-increasing price, the sellers become so frightened that the elevation in prices will never cease that they panic and experience enormous pressure to cover their positions and buy back the stock. With a shortage of stock, the price goes even higher, reaching what is known as blow-off top where the price goes way beyond expectations until the buyers become sellers of the stock.
Often capitulation is started by the short sellers panicking to cover. In effect, they take the rally higher. Once they cover their positions and run the stock price up farther, they run out of gas. Then another short seller comes in.
The onset of capitulation is marked by a blow-off. Blow-offs are price action moves of stocks where they explode or dramatically move upward to levels beyond what might be expected. Essentially blow-offs mark inflection points driven by changes in fundamentals. The trader who can remain cool, calm, and collected and follow the price action without picking up the panic of the crowd can take advantage of these situations to short a stock before the blow-off and then prepare to buy the stock back after panic selling forces everything down.
Often capitulation is started by the short sellers panicking to cover. In effect, they take the rally higher. Once they cover their positions and run the stock price up farther, they run out of gas. Then another short seller comes in.
The onset of capitulation is marked by a blow-off. Blow-offs are price action moves of stocks where they explode or dramatically move upward to levels beyond what might be expected. Essentially blow-offs mark inflection points driven by changes in fundamentals. The trader who can remain cool, calm, and collected and follow the price action without picking up the panic of the crowd can take advantage of these situations to short a stock before the blow-off and then prepare to buy the stock back after panic selling forces everything down.
High — Retrace — Rally to a Lower High
No matter how simple a trade this is, it has very sound psychological reasons for working. In this example, the market made new highs and sold off. The sell-off could be the result of new sellers coming into the market in force, or old buyers selling to take their profits, or a combination of both. Prices will continue to drop until enough traders believe the price is cheap and are willing to take the initiative and bid the price back up. As the price approaches the last previous high, buyers will begin to anticipate whether or not prices can penetrate, and sellers will be looking for another top.
In either case expectations by both will be raised. If some buyers are willing to bid the price past the previous highs to some significant level, it will make believers out of others who were on the sidelines. If they do come in, it will add to the momentum.
Some old sellers will admit to being wrong and will have to buy to get out of their trades, thus adding to the upward momentum.
However, what if the market approaches the highs the second time, and sellers come back into the market again with enough force to keep the price from exceeding or equaling the previous high? Buyers will start to become disappointed. Where will they really be disappointed? — if enough buyers don’t come into the market to support the price at the previous low. If prices penetrate that low, watch for buyers to bail out en masse. For them to get out of their position, who is going to buy it from them? If everybody is trying to sell and no one is available to buy, what are prices going to do? Fall like a rock.
The reason why a bull market is ready to turn into a bear market when the general public gets involved is because the general public has the least tolerance for risk and consequently needs the most reassurance and confirmation that what they are doing is a sure thing. As a result, they will be the last to be convinced that the rising market represents an opportunity. If a bull market has lasted for any length of time, the general public will feel compelled to jump on the bandwagon so to speak, because of their perception that everyone else is doing it and making money. They will pick up on any reason that sounds the most rational to justify their participation, when in reality, they will know very little about what they are doing, but since everyone else is doing it, how can they go wrong.
A continuing bull market requires the continual infusion of new traders who are willing to pay higher and higher prices. The longer a bull market lasts, the greater the number of people who are already participating as buyers, leaving fewer and fewer traders who haven’t already bought and fewer and fewer traders who are willing to bid the price up. These older buyers obviously want to see the market keep on going up, but they also don’t want to get caught holding the bag, if the market stops going up. As their profits accumulate from the higher prices, they start to get nervous about taking their profits.
By the time the general public starts buying en masse, the professional traders knows the end is near. How does the professional know this? Because the professional knows that there is a practical limit to the number of people who will participate to bid the price up. There will come a point where everyone who is likely to be a buyer will have already bought, quite literally leaving no one else to buy. The professional trader would like the market to continue to go up indefinitely just like all the other buyers. However, he also understands the impracticality of that happening, so he starts taking his profits while there are still some buyers available to sell to. When the last buyer has bought, the market has no place to go but down.
The public gets stuck because they weren’t willing to take the risk when there was still potential for the market to move. For the market to sustain itself, it needs to attract more and more people. As big as this country is or the world for that matter, there are only so many people who will buy. Eventually the supply of buyers runs out, and when it does the market falls like a rock.
The professionals have been selling out their positions before this happens, but once the supply of buyers runs out, the professionals start to compete among one another for the available supply of buyers which is dwindling fast, so they offer lower and lower prices to attract someone into the market so they can get out. At some point, instead of the lower prices being attractive to people, it panics them. The public didn’t anticipate losing. Their expectations are very high with very little toleration for disappointment. The only reason they got in was because it was a sure thing. When the public starts to sell, it starts a stampede.
Again, people will ascribe their actions to some rational reason because nobody wants to be thought of as irrational and panic-stricken. The real reason why people panicked and the prices fell is simply because prices didn’t keep on going up.
In either case expectations by both will be raised. If some buyers are willing to bid the price past the previous highs to some significant level, it will make believers out of others who were on the sidelines. If they do come in, it will add to the momentum.
Some old sellers will admit to being wrong and will have to buy to get out of their trades, thus adding to the upward momentum.
However, what if the market approaches the highs the second time, and sellers come back into the market again with enough force to keep the price from exceeding or equaling the previous high? Buyers will start to become disappointed. Where will they really be disappointed? — if enough buyers don’t come into the market to support the price at the previous low. If prices penetrate that low, watch for buyers to bail out en masse. For them to get out of their position, who is going to buy it from them? If everybody is trying to sell and no one is available to buy, what are prices going to do? Fall like a rock.
The reason why a bull market is ready to turn into a bear market when the general public gets involved is because the general public has the least tolerance for risk and consequently needs the most reassurance and confirmation that what they are doing is a sure thing. As a result, they will be the last to be convinced that the rising market represents an opportunity. If a bull market has lasted for any length of time, the general public will feel compelled to jump on the bandwagon so to speak, because of their perception that everyone else is doing it and making money. They will pick up on any reason that sounds the most rational to justify their participation, when in reality, they will know very little about what they are doing, but since everyone else is doing it, how can they go wrong.
A continuing bull market requires the continual infusion of new traders who are willing to pay higher and higher prices. The longer a bull market lasts, the greater the number of people who are already participating as buyers, leaving fewer and fewer traders who haven’t already bought and fewer and fewer traders who are willing to bid the price up. These older buyers obviously want to see the market keep on going up, but they also don’t want to get caught holding the bag, if the market stops going up. As their profits accumulate from the higher prices, they start to get nervous about taking their profits.
By the time the general public starts buying en masse, the professional traders knows the end is near. How does the professional know this? Because the professional knows that there is a practical limit to the number of people who will participate to bid the price up. There will come a point where everyone who is likely to be a buyer will have already bought, quite literally leaving no one else to buy. The professional trader would like the market to continue to go up indefinitely just like all the other buyers. However, he also understands the impracticality of that happening, so he starts taking his profits while there are still some buyers available to sell to. When the last buyer has bought, the market has no place to go but down.
The public gets stuck because they weren’t willing to take the risk when there was still potential for the market to move. For the market to sustain itself, it needs to attract more and more people. As big as this country is or the world for that matter, there are only so many people who will buy. Eventually the supply of buyers runs out, and when it does the market falls like a rock.
The professionals have been selling out their positions before this happens, but once the supply of buyers runs out, the professionals start to compete among one another for the available supply of buyers which is dwindling fast, so they offer lower and lower prices to attract someone into the market so they can get out. At some point, instead of the lower prices being attractive to people, it panics them. The public didn’t anticipate losing. Their expectations are very high with very little toleration for disappointment. The only reason they got in was because it was a sure thing. When the public starts to sell, it starts a stampede.
Again, people will ascribe their actions to some rational reason because nobody wants to be thought of as irrational and panic-stricken. The real reason why people panicked and the prices fell is simply because prices didn’t keep on going up.
The Most Challenging of Human Endeavors
Trading the financial markets is among the most challenging of human endeavors. At its best, trading is a celebration of the human mind's capacity to master complexity. Rarely does any single activity so reward individual initiative and the exercise of the reasoning mind. And yet, financial rewards are only part of the allure of trading. In mastering the markets, we are called upon to exercise extraordinary self-mastery. Like any noble undertaking, such as art, science, or athletics, trading is a means of self-development, fostering the ability to act intentionally, in the service of one's training and ideals.
Tuesday, October 6, 2009
Handle the Losses
Losses are natural and are supposed to look a certain way. Anxiety builds with each new day of losses. Therefore, it helps to know the duration of a drawdown. By knowing a little of what to expect, you can ride it out a little easier.
Day one through four, most traders can deal with it. Days five through eight, they start projecting their current situation into the future ad infinitum. Days nine and ten they are numb. By days eleven and twelve the cycle is over.
Day one through four, most traders can deal with it. Days five through eight, they start projecting their current situation into the future ad infinitum. Days nine and ten they are numb. By days eleven and twelve the cycle is over.
Trends and Trendlines
Trends, a series of higher highs and higher lows, or lower highs and lower lows over a period of time, work because there aren’t enough sellers to absorb the number of buyers competing with each other to get into the market during that period of time. Adding to this buying force will be old sellers at lower levels who finally lose faith and bail out of their positions. They will do this in significant numbers when the prices penetrate what they believe to be significant reference points.
Keep in mind that trends are a function of time. The next tick up could be defined as a one-tick trend. How long will the imbalance between buyers and sellers last?
In an upward-trending market, prices will retrace because buyers are taking profits. This will create some counteracting pressure, but if he trend continues after a normal retracement, it just tells you there still aren’t enough sellers around to absorb all the buyers, with enough left over to create downward momentum. You will know when that has happened when the trending market breaks its normal ebb and flow pattern. That is why markets that break trendlines have a tendency to keep on going in the direction of the break, because it signals a significant shift in the balance of forces.
After a certain period of time, you can notice how trending markets will develop a certain rhythm and flow, making the price movement look very symmetrical on a bar chart. You really don’t have to know why this is so, you just have to notice that it exists. When this flow is broken (the market trading above or below a significant trend line), it is a good indication the balance of the market forces has shifted. Then ask yourself, what is the likelihood the shift will gain hold and continue trending in the direction of the break?
You don’t even have to know the answer to that question. Put in an order at a spot that would confirm the highest probability of a change in the balance. Then wait for the market to define itself. If your order is filled, put a stop where the market shouldn’t be to confirm that your trade is still valid. “What is a valid trade?” you ask. One where the highest probabilities for price movement are in the direction of the prevailing force.
Keep in mind that trends are a function of time. The next tick up could be defined as a one-tick trend. How long will the imbalance between buyers and sellers last?
In an upward-trending market, prices will retrace because buyers are taking profits. This will create some counteracting pressure, but if he trend continues after a normal retracement, it just tells you there still aren’t enough sellers around to absorb all the buyers, with enough left over to create downward momentum. You will know when that has happened when the trending market breaks its normal ebb and flow pattern. That is why markets that break trendlines have a tendency to keep on going in the direction of the break, because it signals a significant shift in the balance of forces.
After a certain period of time, you can notice how trending markets will develop a certain rhythm and flow, making the price movement look very symmetrical on a bar chart. You really don’t have to know why this is so, you just have to notice that it exists. When this flow is broken (the market trading above or below a significant trend line), it is a good indication the balance of the market forces has shifted. Then ask yourself, what is the likelihood the shift will gain hold and continue trending in the direction of the break?
You don’t even have to know the answer to that question. Put in an order at a spot that would confirm the highest probability of a change in the balance. Then wait for the market to define itself. If your order is filled, put a stop where the market shouldn’t be to confirm that your trade is still valid. “What is a valid trade?” you ask. One where the highest probabilities for price movement are in the direction of the prevailing force.
How History Tells Us to Invest
The best all-purpose value measure is price-to-sales.
Dividend yield is a great value measure against large companies.
The best growth measure is relative strength. Buying stocks that did well last year is a component of every winning strategy. Last year’s biggest losers are the worst stocks you can own.
Even growth strategies need to include some measure of value, such as price-to-sales, to avoid paying too much for a company.
The simplest and one of the best value strategies is to buy large, market-leading companies with high dividend yields.
The simplest and one of the best growth strategies is to buy small, young companies that have posted earnings gains for the past five consecutive years, have price-to-sales ratios below 1.5, and display the best one-year price performance.
Combining a value and a growth strategy is an excellent way to boost your returns while keeping risk tolerable.
Dividend yield is a great value measure against large companies.
The best growth measure is relative strength. Buying stocks that did well last year is a component of every winning strategy. Last year’s biggest losers are the worst stocks you can own.
Even growth strategies need to include some measure of value, such as price-to-sales, to avoid paying too much for a company.
The simplest and one of the best value strategies is to buy large, market-leading companies with high dividend yields.
The simplest and one of the best growth strategies is to buy small, young companies that have posted earnings gains for the past five consecutive years, have price-to-sales ratios below 1.5, and display the best one-year price performance.
Combining a value and a growth strategy is an excellent way to boost your returns while keeping risk tolerable.
Monday, October 5, 2009
Fear
The uncertain and chaotic nature of the markets helps to foster anxiety, uncertainty, and fear. Trading in the realm of uncertainty typically triggers insecurity because you don’t know which way things are going to go. This reaction is normal, but insecurity triggers anxiety, which in turn can lead to panic, paralysis, overreaction, and a variety of emotionally crippling states of mind. These states of mind can produce major trading mistakes such as not getting big enough in winning positions, covering short positions too soon, failing to move into more opportunistic trades, or failing to allow yourself to ride out such events as a short squeeze.
Fear throws you off your game. You can’t concentrate on assessing reality when you are in that kind of a reactive state. When you become aware of how you are reacting and how you are trading on the basis of your reaction, you can correct for it and see reality a little bit more clearly.
Fear throws you off your game. You can’t concentrate on assessing reality when you are in that kind of a reactive state. When you become aware of how you are reacting and how you are trading on the basis of your reaction, you can correct for it and see reality a little bit more clearly.
Support Becomes Resistance and Resistance Becomes Support
Many traders have read or heard that old support becomes resistance and old resistance becomes support. This bit of market insight is valid for some very sound psychological reasons.
If resistance has been established at 95.25, it is because there were enough traders who sold at that price to make it resistance. In fact, It would probably be the same group of traders who sold at 95.25 each time the market approached that price. So, every time the market rallied up to 95.25 and sold off, it made winners out of all those traders who chose to sell at or near that price. As a result, 95.25 will take on a great deal of significance in the minds of the traders who were successful. Each subsequent time they are successful will only strengthen their belief and faith in that price level.
Now, the prices rally up to 95.25 again, maybe for the fourth or fifth time, and like the last time, you will have a group of traders who believe in that resistance level and will sell against it. Only this time the buyers are very strong on the way up and continue to buy right on through the resistance level.
All the traders who choose to sell at 95.25 are now faced with having to deal with a losing trade. Some will get out with a small loss, others will hang on hoping the market will come back. In any case, the market invalidated their beliefs about the future, and they are suffering considerably. They had faith in 95.25, and in their minds the market betrayed them.
If the market happens to come back to 95.25 after rallying for several days, how do you think the group of traders who sold at 95.25 the last time — the ones who believe they were betrayed — are going to behave? First, the traders who were hanging on in hopes of the market coming back will bail out as soon as they are close to being made whole. They are so grateful for getting their money back, there is no way they will stay in that trade regardless of what the possibilities are for additional profits. They will have to be buyers to liquidate their shorts and will be all too happy to end their suffering.
The traders who originally cut their losses when the market blew through 95.25 won’t consider selling at that price again because of the emotional pain of being wrong the last time they sold at that price. I am not saying they will in turn be buyers at that level, but they are very likely not to sell. The overall effect this will have on the balance of the market is to take away from the existing pool of available sellers at 95.25 (old resistance), thereby causing the balance to be tipped in favor of the buyers. Hence, old resistance becomes support, and old support becomes resistance for the same reasons.
If resistance has been established at 95.25, it is because there were enough traders who sold at that price to make it resistance. In fact, It would probably be the same group of traders who sold at 95.25 each time the market approached that price. So, every time the market rallied up to 95.25 and sold off, it made winners out of all those traders who chose to sell at or near that price. As a result, 95.25 will take on a great deal of significance in the minds of the traders who were successful. Each subsequent time they are successful will only strengthen their belief and faith in that price level.
Now, the prices rally up to 95.25 again, maybe for the fourth or fifth time, and like the last time, you will have a group of traders who believe in that resistance level and will sell against it. Only this time the buyers are very strong on the way up and continue to buy right on through the resistance level.
All the traders who choose to sell at 95.25 are now faced with having to deal with a losing trade. Some will get out with a small loss, others will hang on hoping the market will come back. In any case, the market invalidated their beliefs about the future, and they are suffering considerably. They had faith in 95.25, and in their minds the market betrayed them.
If the market happens to come back to 95.25 after rallying for several days, how do you think the group of traders who sold at 95.25 the last time — the ones who believe they were betrayed — are going to behave? First, the traders who were hanging on in hopes of the market coming back will bail out as soon as they are close to being made whole. They are so grateful for getting their money back, there is no way they will stay in that trade regardless of what the possibilities are for additional profits. They will have to be buyers to liquidate their shorts and will be all too happy to end their suffering.
The traders who originally cut their losses when the market blew through 95.25 won’t consider selling at that price again because of the emotional pain of being wrong the last time they sold at that price. I am not saying they will in turn be buyers at that level, but they are very likely not to sell. The overall effect this will have on the balance of the market is to take away from the existing pool of available sellers at 95.25 (old resistance), thereby causing the balance to be tipped in favor of the buyers. Hence, old resistance becomes support, and old support becomes resistance for the same reasons.
How the Masters Tell Us to Invest
Your investment strategy should be clearly defined and measurable. This way, you avoid the common emotional traps of greed and fear. Rely on a set of specific criteria to find superior companies.
Look for strong income statements and balance sheets. Every company is helped by high profit margins, lots of cash, and little or no debt.
Look for insider stock ownership and company buybacks. Peter Lynch writes, “There’s only one reason that insiders buy: they think the stock price is undervalued and will eventually go up.”
Conduct thorough research. Warren Buffett says to exercise the same scrutiny when buying shares in a company as you’d exercise when buying the company itself. Never act on tips. Always know what you’re buying and precisely the reasons why.
Buy at a price below the company’s potential. If it’s an expensive growth stock, it had better be growing quickly enough to justify the high price. If it’s a depressed value stock, it had better have some good plans for recovery and be executing them well.
Buy more of what’s working. If you identified a good company and its stock is rising, consider buying more if the company’s strengths have improved as the price rose.
Take advantage of price dips. If you own a quality company and its stock drops, verify that it remains a quality company. If it’s just as strong as when you first invested, consider buying more at the discount price.
Look for strong income statements and balance sheets. Every company is helped by high profit margins, lots of cash, and little or no debt.
Look for insider stock ownership and company buybacks. Peter Lynch writes, “There’s only one reason that insiders buy: they think the stock price is undervalued and will eventually go up.”
Conduct thorough research. Warren Buffett says to exercise the same scrutiny when buying shares in a company as you’d exercise when buying the company itself. Never act on tips. Always know what you’re buying and precisely the reasons why.
Buy at a price below the company’s potential. If it’s an expensive growth stock, it had better be growing quickly enough to justify the high price. If it’s a depressed value stock, it had better have some good plans for recovery and be executing them well.
Buy more of what’s working. If you identified a good company and its stock is rising, consider buying more if the company’s strengths have improved as the price rose.
Take advantage of price dips. If you own a quality company and its stock drops, verify that it remains a quality company. If it’s just as strong as when you first invested, consider buying more at the discount price.
Friday, October 2, 2009
Support and Resistance
In a falling market, support is a price level where buyers entered the market or old sellers liquidated their shorts with enough force to keep prices from going any lower. In a rising market, resistance is a price level where sellers entered the market or old buyers liquidated their longs with enough force to keep prices from going any higher.
Support and resistance levels are significant reference points because many traders recognize support and resistance on charts and believe in their significance. That statement may seem redundant to some people, but it really illustrates a very important point about the nature of the markets (traders acting on their belief in future value). All beliefs eventually become self-fulfilling prophecies. If enough traders believe in the significance of support and resistance, and demonstrate their belief by making trades at those levels, they are in effect fulfilling their own beliefs about the future.
Now it really doesn’t matter why the balance of forces shifted from buyers to sellers. Everybody will have his own reasons for what caused prices to reverse. All of them will usually be way beyond the simplest and most obvious reason — that enough traders were displaying a strong enough conviction in their belief in future value to stop the upward price momentum and create downward price momentum.
What is really important about this, however, is that many traders will remember the market reversed at that price level. As a result, that price will then have a degree of significance in the minds of those traders who experienced the reversal.
Support and resistance levels are significant reference points because many traders recognize support and resistance on charts and believe in their significance. That statement may seem redundant to some people, but it really illustrates a very important point about the nature of the markets (traders acting on their belief in future value). All beliefs eventually become self-fulfilling prophecies. If enough traders believe in the significance of support and resistance, and demonstrate their belief by making trades at those levels, they are in effect fulfilling their own beliefs about the future.
Now it really doesn’t matter why the balance of forces shifted from buyers to sellers. Everybody will have his own reasons for what caused prices to reverse. All of them will usually be way beyond the simplest and most obvious reason — that enough traders were displaying a strong enough conviction in their belief in future value to stop the upward price momentum and create downward price momentum.
What is really important about this, however, is that many traders will remember the market reversed at that price level. As a result, that price will then have a degree of significance in the minds of those traders who experienced the reversal.
Make Gradual Sells
As with buying stock, I prefer to make gradual sells. The market is just as unpredictable when it comes to choosing the right time to sell as it is when choosing the right time to buy. If you move everything out because you’re afraid of losing it all, how will you feel if the stock recovers to your buy price and then pushes beyond? If the stock doubles after you buy it and you sell everything, how will you feel when it becomes one of the legendary tenbaggers? In both cases, you’ll feel terrible. Gradual moves into and out of positions take some of the pressure off because everything doesn’t need to happen just right for you to make money. Things can be a little fuzzy on the buy and sell. As long as you’re making gradual moves, you’ll be fine.
Key Reasons People Miss Buying Big Winning Stocks
- Disbelief, fear, and lack of knowledge. Most big winners are newer companies (IPOs in the last seven or eight years). Everyone knows Sears and General Motors, but most people are simply unaware or unfamiliar with the hundreds of new names coming into the market every year. The new America names are the growth engine of America, creating innovative new products and services plus most of the new technology.
- P/E bias. Contrary to conventional wisdom, the best stocks rarely sell at low P/Es. Just like the best ballplayers make the highest salaries, the better companies sell at better (higher) P/Es. Using P/Es as a selection criteria will prevent you from buying many of the best stocks.
- Not understanding that the real leaders start their big moves by selling near or at new price highs, not near new lows or off a good amount from their highs. Investors like to buy stocks that look cheap because the stocks are lower than they were at few months ago, so they buy stocks on the way down. They think they are getting bargains. They should be buying stocks on the way up, just making new price highs as they are breaking out of a base or price consolidation area.
- Selling too soon, either because they get shaken out or they are too quick to take a profit, and psychologically having a hard time buying back the stock. They also sell too late, letting a small loss turn into a devastating one by not cutting all their losses at 8%.
Thursday, October 1, 2009
Important Guidelines to Remember
- Don’t buy cheap stocks. Buy Nasdaq stocks mainly selling between $15 and $300 a share and NYSE stocks from $20 to $300 a share. Avoid the junk pile.
- Buy growth stocks that show each of the last three years’ annual earnigs per share up at least 25% and the next year’s consensus earnings estimate up 25% or more. Most growth stocks should also have annual cash flow of 20% or more above EPS.
- Make sure the last two or three quarters’ earnings per share are up a huge amount. Look for a minimum of 25% to 30%. In bull markets, look for EPS up 40% to 500%. (The higher, the better.)
- See that each of the last three quarters’ sales are accelerating in their percentage increases or the last quarter’s sales are up at least 25%.
- Buy stocks with a return on equity of 17% or more. The best companies will show a return on equity of 25% to 50%.
- Make sure the recent quarterly after-tax profit margins are improving and near the stock’s peak after-tax margins.
- Don’t buy a stock because of its dividend or P/E ratio. Buy it because it’s the number one company in its particular field in terms of earnings and sales growth, ROE, profit margins, and product superiority.
- Any size capitalization will do, but the majority of your stocks should trade an average daily volume of several hundred thousand shares or more.
- Learn to read charts and recognize proper bases and exact buy points. Use daily and weekly charts to materially improve your stock selection and timing. Buy stocks as they initially break out of sound and proper bases with volume for the day 50% or more above normal trading volume.
- Carefully average up, not down, and cut every single loss when it is 7% or 8% below your purchase price with absolutely no exceptions.
- Write out your sell rules that show when you will sell and nail down a profit in your stock.
- Make sure your stock has at least one or two better-performing mutual funds who have bought it in the last reporting period. You want your stocks to have increasing institutional sponsorship over the last several quarters.
- The company should have an excellent new product or service that is selling well. It should also have a big market for its product and the opportunity for repeat sales.
- Don’t mess around with options, stocks trading in foreign markets, bonds, preferred stocks, or commodities. It doesn’t pay to be a “Jack of all trades” or to over diversify or over-asset allocate. Either avoid options outright or restrict them to 5% or 10% of your portfolio.
- The stock should have ownership by top management.
- Forget your pride and ego; the market doesn’t know or care what YOU think. No matter how smart you think you are, the market is always smarter. A high IQ and a master’s degree are not guarantees of market success. Your ego could cost you a lot of money. Don’t argue with the market, and never try to prove you’re right and the market is wrong.
- Watch for companies that have recently announced they are buying back 5% to 10% or more of their common stock Find out if there is new management in the company and where it came from.
- Don’t try to buy a stock at the bottom or on the way down in price, and don’t average down. (If you buy at $40, don’t buy more if it goes down to $35 or S30.)
Patience
Trading requires patience and responsibility to your strategy. You have to police yourself. The important thing is not to undermine your confidence. When things aren’t going well, it is important not to abandon what has worked or to try radically new things. A better solution is to stick to your strategy and to review what you need to do to get back in line with it. You need to fine tune, to eliminate misguided efforts, and remain focused and calm.
Previous Highs and Lows
Probably the most prominent of significant reference points are previous highs and lows. If prices are moving steadily higher, buyers will begin to anticipate whether or not prices can penetrate the last high, and sellers will be looking for another top.
In the mind of the seller, that last top, or other tops in the distant past, was a place where the market met enough resistance to stop the rally. In other words, enough traders thought the price was expensive the last time it was there, and they will begin to anticipate whether the same will happen again.
Both buyers and sellers will have raised expectations about the likelihood of the market doing one of two possible things — making new highs or failing to make new highs. As the market approaches this high, if some of them are willing to bid the price past it to some significant level, it could make believers out of other traders who were on the sidelines. If these new traders come into the market as buyers, it will add to the upward momentum, possibly causing old sellers to bailout of their positions. This will also add to the upward momentum of price movement.
In the mind of the seller, that last top, or other tops in the distant past, was a place where the market met enough resistance to stop the rally. In other words, enough traders thought the price was expensive the last time it was there, and they will begin to anticipate whether the same will happen again.
Both buyers and sellers will have raised expectations about the likelihood of the market doing one of two possible things — making new highs or failing to make new highs. As the market approaches this high, if some of them are willing to bid the price past it to some significant level, it could make believers out of other traders who were on the sidelines. If these new traders come into the market as buyers, it will add to the upward momentum, possibly causing old sellers to bailout of their positions. This will also add to the upward momentum of price movement.
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