Beginning traders should always use stops. Experienced traders who trade large positions may choose not to use stops, because they do not wish to become the target of other traders gunning for stopped shares. Instead, these traders employ mental stops by setting a time-price perimeter and watching their positions closely.
Stops should not be used routinely to exit positions, but should be placed in order to safeguard against the unexpected. Stops are a form of accident insurance. We all have insurance, but all of us hope never to benefit from it. The alert trader will cut back or eliminate endangered positions before stops are reached.
Stops should be placed outside the price limits you have set for your trade. You should use your own judgement to reduce or exit a position within the perimeter you have set. Your stop should be triggered only in the unlikely event that your perimeter is breached before you are able to act. If you expect to be away from the market for any significant period, use stops.
If you are trading online, you may experience a communications failure at any time. In the event of a sudden sharp move in the market, your broker may be swamped and unavailable either by phone or online. To protect yourself against these possibilities, use stops.
Most traders set stops at whole numbers. If, for example, there is near-term support for a stock at 55, then one might expect a cluster of sell stops at 54, and again at 53, and so on. Traders gun for these stops in order to scoop up cheap shares. If support is broken, then one might expect the stock to trade down to an even number before support is asserted. For this reason, it makes sense to set your own stop beyond whole-numbered prices. Instead of 54 on a sell-stop, set your stop at 53 7/8 or 53 3/4.
After whole numbers, these fractions attract the most stops, in descending order: halves, quarters, eights. In most cases, it's a good idea to set your stop at some multiple of eights beyond the nearest whole number.
Most beginning traders make the mistake of increasing their position when a trade has moved against them. Their logic is this: averaging in lower cost shares with higher cost shares lowers overall cost per share. As a matter of pure arithmetic, that is correct. As a matter of practice, it is lethal.
If there is one mistake that will sooner or later destroy a trader, it is averaging down. NEVER, EVER, AVERAGE DOWN. The first article of successful trading is this: reduce losing positions and add to winning positions. Averaging down runs directly counter to this imperative. By extension, the inverse is true of short positions: never average up a losing short position.
Keep a daily log of account equity. What is most important to the trader is the trend of profits, not the trend of prices. Add to trading capital when you are winning, cut back when you are falling behind.
Even experienced traders sometimes make the mistake of increasing the size or frequency of trading in an attempt to make up for losing trades. This is the gambler's trap. Addicted gamblers hope to get even by digging their way out of a hole. If this becomes your pattern of response to losses, stop trading (and get help).
A quite different, but equally destructive response to a series of losses, is to stop trading out of fear. Even more serious than loss of capital is loss of nerve. Trading is the business of the trader. If the trader cannot trade, he is out of business. After a string of loses, continue to trade, but trade small until your equity begins to rise again. As your trading results improve, increase trading size slowly until you are back on a winning track.
If you are committed to becoming a consistently successful trader, then every loss is a lesson. A loss is not a loss if you have learned something important.
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When I first started speculating in organized markets, I quickly ran a $40,000 initial stake into $22 million. My technique was simple: I bought gold at $290. Each time it went up $10, I pyramided and added to my holdings with my profits. Victor Niederhoffer The Education of a Speculator |
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It takes courage to be a pig. Stanley Drukenmiller Managing Director, Quantum Fund |
When I was a beginning trader, I met another trader who had run a few thousand dollars into one-half million dollars. He had managed this phenomenal feat by pyamiding a bull move in airline stocks. When I asked him how he did it, he replied, "Each day when I came into the office, I checked my buying power. If I had any, I bought more bonds."
I was at once amazed and alarmed. What a risky way to trade! He put all of his eggs in one basket, and then continued to buy more at higher and higher prices. This man had clearly done everything wrong! He owned only one issue, so he had none of the benefits of diversification. And chasing after the stock as it rose struck me as extremely imprudent, since the average cost of his position continued to rise as well. That made him increasingly vulnerable, since even a modest correction to a point below his average cost would have wiped him out.
And yet, the proof was in the pudding. He had made a lot of money from a little--either through dumb luck, or crazed bullishness, or some craftiness beyond my ken. It took me years to figure out which it was.
My friend had kept all of his old charts, and he showed me hand-drawn, multi-year charts for every listed airline stock, as well as for many other leading issues. Each confirmed the other; at the time he began his operations, sizeable bases had formed in many stocks, each capable of supporting a large bull move. He became convinced that the broad market was set up for a substantial run.
Over the years, he came to realize that successful traders took losses on many, if not most, of their trades and made their fortunes on relatively few. He was looking for a big move. Small trades were of no interest to him. The standards he set for trade selection were extremely high. He was not willing to risk his capital on a trade which did not hold out the promise of a return many times his risk.
Out of his possible choices, he zeroed in on the airlines because of their huge potential. From the airline group, he chose to focus initially on relatively few issues.
Wasn't this imprudent? What about diversification?
What happens when the painter mixes all the colors of his pallet together? Brown, or gray, or some dull, nameless color results. In the same way, over-diversification draws the trader toward the average; the more positions carried in a portfolio, the more likely that portfolio will produce average results. Above-average results require focus, not diversification.
Traders who seek a diversified portfolio often settle for multiple positions with only modest indications, as if many weak threads will together form a strong rope. Such trades seldom pan out. The best candidates stand out as exceptional from the beginning. Focus on those few opportunities which offer the best chance for profit.
Because he was using leverage, he created new buying power only when his positions advanced; no new buying power was created when they declined. Even if he had wanted to, he could not have averaged down. Instead, he was forced to average up if he wished to increase his share position.
The tactic of adding to winning positions just inverts the recommended tactic of cutting back on losing positions. This trader refined that tactic further by cutting back on laggard, albeit profitable, positions in favor of the position which performed best. Over time, his share position in the best performer grew, while his share commitment to laggard positions declined. His approach was to seed, then weed, his positions until only the best remained.
Research your trading candidates thoroughly, then take positions in a few of the best. Seed each candidate with initial capital. Then gradually weed out those candidates which under-perform, and reallocate capital to strongly performing positions.
Most traders cannot stand to hold a profitable position. The temptation to nail down profits becomes overwhelming for those who have little confidence either in the trade or in themselves.
Confidence in the trade is the single most important element to winning big. To possess enough confidence to trade from strength you must:
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Have confidence in your analysis. Know what technical elements you need to see in a trade, then find opportunities which match your requirements. Know your threshold of acceptable risk, and do not cross it. One trader has said that he always cuts back his positions until he is able to sleep well. If you find that a trade is on your mind even when you are away from the market, cut back on your position until you no longer worry over it. Most traders develop an area of special competence. Some prefer the long side, while others are more adept, and therefore more comfortable, on the short side. Some prefer volatile stocks, while for others, highly active stocks introduce too much short-term risk. Some prefer to position for the longer-term, while others trade intermediate swings or day-trade. Once you identify your area of special competence, you will have much less difficulty staying with winning positions. |
My friend won big, not because of luck, but because hard work had uncovered a well-researched, sizeable market opportunity, and because he had acquired the self-confidence and savvy to play out a winning hand.
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The trend is your friend Market Saying (I'm sure you have heard it ;) |
The trend is an expression of probabilities. The most closely followed trend is the trend of prices. But, as we shall see, the trend of the Spread has an important bearing on trading success.
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First, a few simple definitions: Rising Market: A period during which both relative-strength leaders and RS laggards are rising. Specifically, the average RS leader and the average RS laggard are above their respective 30-day moving averages.Rising Market: A period during which both relative-strength leaders and RS laggards are rising. Specifically, the average RS leader and the average RS laggard are above their respective 30-day moving averages. Falling Market: A period during which both RS leaders and RS laggards are falling. Specifically, the average RS leader and the average RS laggard are below their respective 30-day moving averages. Mixed Market: A period during which RS leaders and RS laggards are moving in different directions. Specifically, the average of either RS leaders or laggards is above its 30-day moving average, while the other is below its 30-day moving average. Rising Spread: The Spread is above its 30-day moving average. Falling Spread: The Spread is below its 30-day moving average. |
In the matrix below, the combined effect of market trend and the trend of the Spread are shown in detail.
Percentages under "Leaders" and "Laggards" compare the Average Daily Change (ADC) in each category with the maximum ADC registered by any category. The maximum Average Daily Change was experienced by RS leaders when the market and the Spread both rose; the ADC in that case equals 100%. All other ADCs are given as a percent of that maximum.
A negative ADC is indicated by a minus sign. For example, when the market and the Spread both fell, RS leaders experienced an ADC nearly as large as the maximum (92% of maximum) but in the opposite direction, indicated by a minus sign.
The percent of total time spent in each category is shown under "Time". Our study of eighty industrial groups from 1986 to 1999, a generally bullish period, shows that the market rose 56% of the time, fell 25%, and was mixed 19% of the time.
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By comparing entries in this matrix, we get a sense of the odds of success for long and short bets under different market conditions. As you can see, some bets are better than others. Mixed markets produce relatively meager ADCs. Trending (rising and falling) markets offer the highest ADCs and, hence, the best trading opportunities. Exceptional combinations have been highlighted in the matrix above.
The most bullish market periods--when odds of success on the long side are greatest--feature a rising market and a rising Spread. During these periods a strength-following strategy emphasizing RS leaders works best (review: The Nature of Strength-Following Markets). RS laggards perform relatively poorly during these periods, with an historic ADC of only 61%, against and ADC of 100% for RS leaders.
A falling Spread tends to dampen the overall profitability of a rising market. Nevertheless, a falling Spread during a rising market produces a relatively high ADC for laggard issues. During these periods a contrarian strategy emphasizing laggards is best (review: The Nature of Contrarian Markets). RS laggards did 50% better than RS leaders (80% ADC for laggards versus 54% ADC for RS leaders).
When the market is falling, a rising Spread favors shorting laggards.
The most bearish configuration--when the odds of success on the short side are best--is the combination of a falling market and a falling Spread, the inverse of the most bullish configuration (see Rising Market, Rising Spread).
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Eighty percent of your trouble comes from twenty percent of your problems Pareto's Rule |
On the principal that capital should follow opportunity, recent history is a useful guide. Out of the twelve possible combinations shown above, only four show themselves worthy of a substantial commitment of capital. Indeed, had one elected to commit capital only during those periods highlighted above, one might have sat the market out 20% of the time, selecting the choicest opportunities while avoiding risk during periods which offered only modest odds of success.