The Trailing Stop

Are You a Successful Trader?

In some respects, every person who trades is successful. This is because everyone gets something from trading. For most, however that something is not profit!  Some of us need something to be angry over - as a root for a dramatic episode, perhaps as a diversion from something greater. Some need to feel right.

Are you making profits? If not, then what are you making?

If this line of thought intrigues you, I suggest you set aside a few hours and visit Ed Seykota's Trading Tribe website.  Some of you may recognize Ed as one of the original Turtles, or from Market Wizards.  Ed is about to come out with a book detailing his Trading Tribe Process, but some time on the site will get you a head start, as will joining your local tribe.

Happy Trading!

Do You Know What You Did?

Since most of us can remember, we can recall the tradition of coaches going over game films. They go over their own after a game to see exactly who did what and how they can repeat successes and prevent the same mistakes from happening again.  They also review films of the competition, and of teams doing well so that they can learn how to prepare better.

Doing the same with your trades can provide invaluable insight. Raise your right hand and repeat after me: "I will review every trade I make after I have closed it out."  When reviewing the trade, ask yourself why you bought, why you sold, and what you were thinking and feeling. Keeping a journal will make this process even more insightful.

Happy Trading!

Anatomy of a Buy

The single most important thing you can do when buying a stock is manage the risk to your portfolio. Today I will walk you through the process of how, once I have identified a stock to purchase, to size that purchase and manage the risk.

For our example I will use yesterday's pick,  LNET - Lodgenet Entertainment.  I will need to know a few things before I start calculating the purchase specifics.  Grab a stickie and note the following:

• The anticipated purchase price of the stock (17.90)
• the current ATR of the stock. (I use a 14 day - you should use whatever fits your trading time frame) (For LNET today this is .311)
• Your current total account balance ($100,000)

The idea  with this process is that I want to size my purchase based upon the amount of risk in the trade.  With this process, the dollar amount of my trades will vary widely, but the amount of risk in the trade will be approximately the same.

ATR, or Average True Range, helps us to measure the volatility of a stock over a given time range, in this case, the last 14 trading days. With a ATR(14) of .311, you could reasonably expect LNET to move .31 in any given day. Since we don't want to be stopped out of our trade my normal movement, we'll plan to put a stop in below our purchase price (for long trades).  Putting that stop at 2 x ATR allows us room for movement, but protects us in the event of an unusually adverse move. If we were stopped out, we would lose 2 ATR, or 62 cents. This is the amount we are putting at risk in this trade. (I like to use stockcharts.com to get ATR)

I typically risk 1% of my portfolio on any given trade.  This amount fluctuate based on the performance of my portfolio, but never exceeds 2%. At a current risk level of 1%, this means that I am willing to risk $1000 of a $100,000 account. (I always was a math stud.)

With $1000 to risk, and now knowing that we will risk .62 for every share that we trade, we can arrive at the # of share we want to buy by dividing:

$1000 / .62 = 1612.9032 shares

I find that I get cleaner execution in round lots, so I would round this down to 1600 shares. I would place the buy order for 1600 shares  along with the accompanying stop order to sell at 17.28 .

Each of the trades is an equal "unit" of risk.  This method allows you to balance risk across every trade, and further allows to me manage exposure to a given sector. I try to limit exposure to any one sector by balancing the # of units across sectors, and even trying to find inversely correlated sectors to trade when I am heavy in a sector.

Standardizing risk-per-trade lends itself  to system development and measurement, and enables money management to be added to back-testing programs, providing more accurate outcomes for each tested scenario.

Same Candidates - Different Day.

Lats Wednesday morning I mentioned a new scan that I had been trying out. On whole, not a bad group:

 
Now of course I also called out Skechers (SKX) as a dog.  Just goes to show - buy based on your system, and let your money management take care of the rest.

Now one that appears a bit lackluster on the table above is LNET. LodgeNet, however, seems to be a little pressure cooker waiting for something to happen.  I really like the nice W formation, and the consolidation over the past four weeks has been accompanied by a a net influx of cash and increasing institutional interest.

What's up? Nothing obvious in the news or anywhere else, but I smell some excitement brewing. In at 18, and a 2ATR stop comes in at 17.36.

Happy Trading!

How do I get out?

For the majority of individuals involved in the markets, there is a never ending search for the perfect stock.  In today's world of constant technological assault on the senses, even our stream of consciousness has become a recognized for of communication. (Instant Messaging) So is it any wonder that we are always looking for the hot new stock?

What if the hot new stock is the same stock as the one from yesterday, last week, and the month (or even year) before? How do you know if a hot tip that comes along is any better than what you already have? I suspect this same quandary in a personal context  is responsible for most of the failed relationships that have become common.  The January 2001  American Psychological Association  journal  published the results of a study on happiness (here) that found that freedom of choice is a significant contributor to lack of happiness.  In your portfolio, it can also be a significant contributor to a lack of returns.  As you look longingly at a hot new tip that crosses you desk - whether from your brother-in-law or from this morning's WSJ, take heart in the fact that picking the right stock has very little to do with making money in the market.

Far more important than how or what stock you choose is the when and why. The market is ultimately a  measure of human emotion.  This understanding serves as the elixir to soothe you when a perfectly good company's stock continues to go down.  We are talking about perception here - not reality.  At least until the quote comes across the ticker - then the perception becomes reality.

If you've been reading for any time at all, you have likely gathered that I am a technician. And while I am a true believer in the ability of a chart to communicate the emotion and opinions of a mass of people, I also believe that  Graham & Dodd had something as well. More information always helps, so if you have the time I encourage you to dig into the fundamentals.  Given the amount of information available (and not),  it is hard to imagine that I would have access to all of  it as a lowly individual investor.

My time is very valuable, and I am not interested in spending a significant amount of it to compile all of the information relevant to a given stock. Instead, I rely on others to tell me what I want to know - by looking at what they have done with their money.  If enough of them follow a given course of action, they even have the power to overwhelm the fundamentals of a company - making "cheap" stocks go down and "expensive" stocks  go higher.

Today a particularly smart friend of mine made the observation that in illiquid markets, you make money when you buy.  Much of the system development advice that you will read will tell you that in the (very liquid) markets you make money when you sell. It would seem to follow that in real estate, then, you would want to concentrate a great deal of your research on information gathering about the appropriate entry point, while the converse would be true in the much more liquid commercial markets.

I have taken much too long to arrive at my point: Don't worry too much about picking the right stock. Worry more about what you will do after you buy it. Where will you set your stop? When will you add to your position if you are right? And most importantly: When and how will you get out?

Happy Trading!

Prison - Was it Good?

The market still can't decide what it wants to do.  We're looking at some NASDAQ bellwethers having some real trouble. CSCO, JNPR, SBUX, AMZN all getting killed. If the other market's turn similarly foul we will end our brief rally and head into a downturn for the mid-term and it will be time to start taking a look at the longer term averages - to see if they are next.

A friend emailed to ask about a recent buy of his, and it looks quite nice. He bought the Buffet way - he understands the product, sees the market forces at work, a hot market, and OBTW - say that Mark Burnett had visited the ex-CEO in prison. Hmmm. So he bought.

He bought at 22, but I still think it looks quite nice:

MSO has just sailed through all visible resistance and has surpassed it's IPO all time high. It's Market (Media) and sub-market (Publishing - Periodicals) are both headed up as well. Martha is into uncharted territory here, so keep your stops tight. Then fix yourself some curry-butter popcorn with organic sea salt, pull out that hand blown glass lamp that you've turned into a serving bowl, and get ready for the show.

Follow Through

Yesterday I commented that we really needed another solid day of advance before we could feel like we were headed up. We got that day overall but some quarters were not along for the ride. I remain unconvinced, and continue to look for a consolidation in the overall market. That being said, this could have been a disastrous week, with the Iraq elections, a Fed Meeting, and the State of the Union - instead we get tentative positive movement. I think we'll see more of the same today.

Our picks from yesterday did well, with 4 advances, 3 declines, and one sitting tight. The one with no movement was PTA, one of my purchases. Alas, I did not review the average daily volume on PTA, which is something I usually evaluate. Here was have less than 200,000 shares traded daily - something that would have made me take a pass had a noticed it before.

Good trading!

A Handful of Good Candidates

I ran across these this morning. Could be a fluke, but I think I found a great new scan. If it bears out over the next week or so, I'll share it with you. Here's  what I found: PDCO, GIS, PHS, SKX, VTRU, LNET,  PTA, and JAH. This is the entire output of the scan, so I think there is some less exciting stuff here - Sketchers is a good example, but taken as a whole, a pretty strong group.

Of particular interest is Penn Treaty:

Most of the other issues in this list are in solid trends, or have just broken out in the last few months. PTA seems to be about to start a new uptrend. If it does (and other indicators look awfully good), then it will be a breakout move. There is a bit of resistance at 2.55ish, but I think it should move past that with good momentum. Definitely one to put on the watch list. I'll be putting in a buy this morning, with a stop at 2ATR, or .14 below my entry, which also happens to be just below that nice W formation.

Another consistent player in a firmly established trend, but with a recent momentum surge, is Jarden:

Yesterday's blip may make you a little nervous, but I think it will prove to be an anomaly. Money has been flowing into this stock consistently since '02, but the pace of inflows has picked up as of late.

The last chart I'll show you today is General Mills:

Now I have done some business (or tried to) with General Mills, and have to say they didn't impress me all that much as an organization. (Note the thinly disguised sour grapes.) But I guess you can't argue with every kid on earth eating Count Chocula for breakfast.

There is generally held belief among traders that a new breakout will generally be equal in size to it's preceding base. The breakout will be as tall as the breakout was long. I always wondered how to set up my chart to get this measurement, but regardless of how you do it, GIS has some legs to it. Also going on my buy list this morning. I'm looking for run to at least 56, but there may be a rest along the way.

A Great Day! (or Not?)

Those of you excited about yesterday's performance may not want to read on, as I hate to burst what is probably a perfectly justifiable bubble.

Today seemed to be an across the board good day, with the gainers vs losers at 710 to 240. This is generally a very strong indicator. My trepidation lies with the fact that yesterday's number was 801 to 169.  I would have felt better if our Iraq election enthusiasm had continued with vigor rather then beginning to taper. Two data points do not make a trend, so today we'll add a third, but with the Fed expected to raise rates a quarter-point again,  don't expect to much jubilance. All bets are off if they go more or less than a quarter point, of course.

The System Personality Test

In the the last post we discussed the various elements that comprise a trading system. When combined, these various elements  produce a system that bears a unique signature, or personality. In order to discover whether you and this system will get along, you'll need to know more about it. Today we'll discuss some of the key questions to ask of your new found system so that you can begin to divine the likelihood of a successful future together.

One of the fundamental determinants of this personality is the  expectancy of the system.  Expectancy tells you how much you might expect to make per dollar risked. This is calculated across a large number of trades, and can be calculated as follows:

Expectancy = (CW * AW) - (CL * AL)

where CL is your chance of a winning trade and CL is your chance of losing on a trade. AW is your average gain on a win, and AL is your average loss on a losing trade. Those of you that are mathematicians can transform the equation, further, but this form serves the illustration nicely. If this type of thing gets you going, the I would recommend reading up on game theory, probability, and expectancy, as a solid foundation will only help to better understand system design and behavior. You can start with a few favorites here and here. (Courtesy of bjmath.com)

Next of the list of personality traits is reliability, or the chance that you will make money on a given trade. This is a figure easily produced by any of hundreds of back-testing applications.

Here's a crazy thought: You can lose 80% or more of the time and still make money! In order for this to be true, then you must keep your losses small and your wins big. Again, most back-testing applications can tell you average winner vs. average loser. This will help you to know the  relative size of winners vs. losers.

What is your model for determining trade size? This is key, as many systems break down when they don't have access to large amounts of leverage, or to an unlimited source of funds.

How much do you have to trade? It's amazing to watch the difference in system performance based upon different account sizes. Think of this as "room to breathe".  It is also key in overcoming transaction costs, including commission and slippage, which leads us to:

Transaction costs, or the amount it costs you to make a trade. I am a fan of BrownCo since they only charge $5 each way.  Slippage should be considered as well, and you will often pay higher commissions for split-second fills. You'll need to determine whether your system is dependent on good fills.  Some of the more advanced back-testing software can allow for slippage testing in a random fashion, but it would be best to avoid systems where you are cutting the margin of error this close.

Last, but not least is how often you will get the opportunity to trade, or frequency. I have a killer system on the shelf that gives an average of 30 signals a day. Since I trade end-of-day, this kind of system is not the best.  A system that only generates 2 trades a year may not allow you enough chance to make money (or make money back in the event that the last two didn't go your way.) It's up to you to find a system that will generate the right amount of trades to fit your style.

You should determine the above seven variables for every system you plan to trade.  The testing required to determine these numbers will ensure that you have a good feel for your ability to trade (read: to stick to) the system in question.