Victory to the Bulls

Mar 21, 2007: 10:19 PM CST

How did everyone enjoy today’s market action? I am noticing a shockingly similar pattern to trading days where Federal Reserve policy is announced: There is sharp contraction in volatility and immediately following the action, there are usually three sudden pulses (bursts) of trending price movement.

Such days are indeed for the bold and daring, but stops can be maintained very close to the entry and price targets (rewards) – if you are willing to hold through up to three impulses – are astronomical compared to the risk you take. I must admit that I didn’t hold through the full duration of the rapid move following the announcement but I’m not kicking myself either.

I noticed the Advance/Decline line tilting decidedly positive going into noon while the market stayed relatively flat. This was an internal hint that the market bias was biased to the upside, but entering before Fed Decisions is dangerous. Today was one of those “grit your teeth and hope you’re right” days if you chose to play.

With all the fun of the day’s action behind us, today leaves the major indices above critical resistance levels and the entire technical picture is brighter where dark clouds once loomed mightily over the horizon (in the form of converging declining moving averages). We are in a new technical picture and now odds could be favoring a potential upside bias now. This is especially true on the weekly charts.

From a “Swing” perspective only, price on the daily chart made a lower low, lower high, found support at the lower low, and then rallied to take out the recent swing high. This sets up a good picture bullishly.

On the daily charts, we found support above the rising 50 period moving average and made a higher swing low. This also is good for the bullish camp.

What looked horrible last week is now looking brighter for the market.

A major negative, however, is that this quick rally occurred on lower relative volume that the most recent (shock) decline. We’ll need to see if the moving averages can hold as potential support before sounding the “all clear” and jumping back aggressively into long positions.  If the market fails below them, then all bullish bets are off the table.

One other cautionary note: Those who own stock who refused to sell during the shock decline in early March may see a second chance to unload their position (some for breakeven now) and might sell into this recent rally. We would need to clear those pockets of supply here before going markedly higher.

I hope you enjoyed the ride down and then back up!

Addendum:

As per Vega’s comment, I wanted to post the Fibonacci grid of the most recent market move and, Vega is right – it is important to temper the bullishness with the following chart which shows that the DIA hit (to the penny) the 68.2% retracement and could indeed head lower based on this fact. What looks exciting this morning could actually be the top of a simple retracement. Do keep an eye on this if you are overly bullish on this most recent move.

Always consider both sides of the equasion before trading!

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Stop Losses – Two Recent Perspectives

Mar 21, 2007: 8:49 AM CST

I wanted to highlight two recent posts concerning whether or not to use stops, and what exactly is their purpose.

From Move the Markets, Prospectus discusses “What Is a Stop Loss For Anyway?” The premise is that many investors make an error by placing a stop at the point where “the market will prove your opinion wrong” and waiting for that spot to be triggered before exiting the position. A quote:

“It wasn’t the stop that proved me wrong, it was the price action immediately after my entry that clearly said that my position was wrong.”

He then describes proper usages of stops as “damage protection” or maximum loss per trade, with implications on position sizing.

He comments on how you must use stops, yet if the trade you enter does not work in your favor immediately (meaning the trade must prove itself right), then you should exit before the market declines to hit your stop. By doing this, you keep your losses very low and don’t wait for the market to drift down to your stop and cause you a larger loss – losses can be limited by exiting before your stop is hit if price does not perform in your direction immediately.

Read the article and check out the comment section on the site. A few of the comments from the other side include:

“I don’t think people should look for any excuse to exit a trade, just because the price is below their long entry. After all, they hopefully picked a stop that would be below the leeway they are willing to give the stock within their setup.” -Richard

“I’ve realized that I was moving my stop way too soon. Sure, there were trades where I’d save 0.5R or maybe a little more by doing it, but I missed out on over 10R worth of profit by moving my stop too soon.” -Dave

A second recent article from Trade 4 Cash blog entitled “Stop Losses, Should You Use Them?” took the opposing view, and questioned whether you should use stop-losses at all! The author tested various stop-loss methods and posted the results, which were quite shocking, but logical.

A quote from the site:

“There are disadvantages of using stop-loss orders, however. Many times a stop-loss order will force the trader to sell a stock during a normal correction, especially if the stop price is set to close to the original purchase price. A stock needs room to move during the course of a day/week/month, and stop orders that are set too tight will result in several premature sells, negatively affecting overall performance.”

In summarizing the results:

“The question of whether or not to use stop-loss orders is one to be answered by each individual trader.” Some systems benefit (statistically) from stops while others do not – it depends on the trader and the system.

In general, stop-loss orders will

1. Reduce the success percentage (% correct)
2. Increase the turnover rate (increasing commissions)
3. Decrease the average drawdown per trade”

These are serious topics and so many perspectives on this issue. I have heard that “Trading is a game of who can take the most heat,” which means that those that succeed in the long run are those who can take on the pressures of a position going agaisnt them (withing selling immediately) while others capitulate.

In my experience, I have entered or seen clear buy signals, taken them (or observed them), placed my stops “properly” (below a key techincal area “beyond noise”), seen my “proper” stop be taken out and I move on, only to look back and the trade violently moved in the proper direction after the “stops were taken out.” This has happened far too many times to be coincidence, and I will be addressing this further.

I do want to encourage readers to think about stop loss placement and usage, and not just go by “textbook explanations” – your goal is either to place your stop beyond where everyone else is placing it, or (aggressively) try to enter like a professional at points where stops appear to be taken out, just before the expected rally.

It ultimately depends on your system and your risk preference, and the only way to learn is to gather your own data and analyze various stop-loss methods. Question conventional wisdom and see what works for you.

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Overcoming Mental Accounting Errors

Mar 19, 2007: 9:57 PM CST

Once you understand how mental accounting errors can hurt trading results, it is helpful to identify patterns in your own thinking and trading which can be challenged with personal strategies.

While a blog entry cannot attempt to identify and correct these errors, I can challenge you to identify your own thoughts and seek out further resources to help you if you feel you fall victim often to mental accounting errors.

It is much easier to overcome the accounting error which is derived from windfall profits. Simply equate ‘free’ money with earned money and treat it like you would any other trading capital, rather than using it as an excuse to take that risky trade you have been eyeing. Be thankful for the profit, but consider pulling some out to treat yourself, rather than putting it back to work in a speculative play.

Most traders trade with scared money (money they cannot lose), and so that is the approach upon which I will focus.

First, ask yourself how you feel about money. Ask yourself what money means to you. Common responses include “power” “security” “authority” “happiness” “things/toys” etc. Now interchange terms: “When you are losing money, you are losing … power, security, happiness…”

Losing money you can’t afford to lose usually results in one of three behaviors:

  1. You are too scared to enter any further trades, and keep your money in cash
  2. You enter a trade, but cut it early when you have a very small profit and store the rest in cash
  3. You endure a small loss and hold on while the small loss becomes a big loss when you finally sell

As you see, mental accounting helps us understand why retail investors are much less likely to “let winners run and cut losers short.” It’s because they can’t afford to lose money and the perils of loss.

How should you view your trading dollars? When you first start as a trader, it might be best to view your account not as money, but as something entirely different, like poker chips or “play money” or whatever works best for you to detach the mental link between your trading capital and the efforts required to achieve that capital. Do you think casinos would be as profitable if we used real dollars to make bets? They manipulate the psychology behind this concept.

You need to focus on the process and structure of trading and following rules, rather than the emotions of having money on the line.

Sometimes, it is best to view that money as “spent money” on education. It has been said many times “only trade with money you can afford to lose” and so why not “mentally account” for the fact that it is already gone? Any time you take a loss, it doesn’t matter because you’ve already “mentally” lost the money. Any profits will just be wonderful and will beat expectations (profit, of course, is your goal – do not ‘expect’ to lose when trading).

Business owners turn money into products and inventory, and it would be rather foolish to imagine them thinking like some traders do. “Ohh, I can’t buy this or that product because no one will buy it and I might lose money.” Picture yourself like a business owner – your capital becomes products (shares of a company) that you hold for a bit (but without spoilage or warehouse/stocking fees) that you will in turn sell to others who want what you bought earlier (hopefully at a higher price than you paid). Deeply envision this so that you de-link the association between money in trading.

Money becomes a vehicle to make more money in the market. Be glad that, as a trader, you do not have expenses such as advertising, stocking, inventory, rent (for a business), etc. Of course, your losses can be “mentally accounted” for as normal operating expenses, to further the analogy, which puts you back on par with the business owner example.

  • Find a way to disassociate your trading account with your money in the bank account.
  • Find a strategy that is personalized that works for you.

Your goal in trading is to establish a tested strategy, employ proper money and risk management, and follow a code of behavior/action (discipline) that is personalized for you and tested by you. Decisions regarding when to enter, how long to assume risk, and when to exit must be made by your system – not by emotions or mental accounting errors.

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March 19 New Momentum High – Markets (5-min)

Mar 19, 2007: 10:19 AM CST

I wanted to post a lunchtime chart of the QQQQ’s which had the best 5-minute New Momentum High and “two trade” Impulse Buy set-up I’ve been describing. The DIA and SPY had almost identical impulse buy setups. Remember, after a new momentum high, wait for a pullback (ideally to a key moving average) and play for the target just beyond the most recent swing high. Usually there are three pushes up, but the highest probability comes only for playing the first two upswings following the new momentum high.

Remember that these trades are good for “scalps” only, but the pattern can be applied when observed on any timeframe. Don’t get greedy and “overstay your welcome”. Play for the highest probability target and move on. Beware the natural momentum divergence (decreasing momentum on each upswing) that accompanies this pattern. Consolidation (or possible retracement) is more likely than further upside potential (in this chart).

Your stops are placed at least 10 cents from entry.

Charts courtesy TradeStation. 5 minute charts – QQQQ.

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Mental Accounting Errors set up Failure

Mar 18, 2007: 5:42 PM CST

Quick: What if I gave you $1,000 to invest however you wanted right now? It’s your money now – free. Would you put it on a speculative option play and try to double it within a week?

Now, ask yourself, would you be likely to make the same speculative decision if forced to use your own money to make a trade? Probably not. The answers to these questions help illustrate the main point of “Mental Accounting.”

Strictly speaking, we value earned money (especially if we had to work hard for it) more carefully than free money or ‘windfall’ profits. As such, we are more likely to take chances and speculate with free money, and we are more likely to preserve earned money. This, of course, makes intuitive sense but how does this affect your decisions in the market and how does it set you up for possible failure?

When you get a windfall profit you did not anticipate from a trade, you are elated and think you are a pro and want to put that money right back to work to make even more profits. It doesn’t take long before violating your money and risk management rules lead to that windfall profit dissapating like the dust in the wind.

On the flipside, when you only have a small amount of money to invest (especially if you worked hard at a job you didn’t enjoy), you are much more likely to guard that money with your life. This means (in the trading world) that you are more likely to wait for confirmation before entering, which not only may lead to missed profits, but missed opportunities. It only takes a few losses when trading with “scared money” for you to develop a heightened sense of fear before trading away your hard-earned dollars.

Going further, if you carefully research a company and charts before putting on a trade (with scared money), you enter when you are totally certain of reward and profit, yet the price goes against you. What do you do? You are losing money now, and it’s money you really can’t afford to lose. My guess is that you hold on to the position, knowing (hoping) that the price will reverse and you will still make a profit. However, the stock goes further against you. Do you sell?

Probably not. Now you hope to exit for break-even and at least get your hard-earned money back. Finally, you can’t take the pain of loss any longer and you sell. It doesn’t matter what the stock does next – you violated your discipline to cut losers short because you couldn’t afford to have a loss.

Valuing money differently leads to overtrading and excessive risk on one hand, and undertrading and holding on to losers too long on the other hand.

If you are interested in the academics behind Mental Accounting, a great resource is at www.behaviouralfinance.net

Next, I will discuss how to view money in the market and steps to reduce mental accounting errors.

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