Saturday, December 20, 2008

Start from the Beginning

Over the past several months the markets have shown extraordinary volatility and we have been witnessing a serious bear market. During that time I have spoken to many traders and investors who have accumulated large losses. More recently, quite a few have said that they have just sold their positions for significant losses. I am regularly asked whether I think we have hit the bottom.

Each of those facts, the accumulation of large losses, the closing of positions after a big drop, and the quest for opinions of whether a bottom has been reached signal underscore some problems common to many unsuccessful traders. Accumulating large losses is generally evidence of a buy and hold philosophy and fails to honor the concept of cutting losses. Instead, it illustrates an all too common issue of letting losses run. As many regular readers know, I have long advocated an exit strategy be in place before a position is entered. It can be a variety of things, but it needs to be there or the large losses will inevitably accumulate.

Selling positions only after losses have become too painful rather than as a consequence of a pre-determined exit strategy is another characteristic of a high number of retail investors. Many traders lose and, sadly, but interestingly it is because they tend to buy near the tops and sell near the bottoms. The fact that so many of the folks to whom I have spoken are now liquidating positions may, indeed, be a signal that we are nearing a bottom. We are getting to the point where there are fewer and fewer sellers left.

Of course, neither I nor anyone else can say whether we have a final bottom or not and I personally believe it is a futile exercise to try to predict that or almost anything else. A big sell-off on high volume is often a tip that we may be seeing a bottom, but like anything else in the markets, it does not tell us with certainty. While we may predict that an index or a sector or a stock is going to move in a certain direction, we must always keep in mind that doesn't necessarily make it so. We must understand and accept that our prediction may be wrong and ready to pull the plug as soon as the error is demonstrated.

I titled this article "Start from the Beginning" and, for me, the beginning of a directional play is the determination of what the market is currently doing. In general, roughly 80% of the stocks in an index are moving in the direction of the market (otherwise, the market probably would not be moving in that direction). Why play against that direction? Would we rather choose something that has an 80% chance of success or only a 20% chance of success. If we see there is a downtrend, it just makes sense to make bearish plays or stand aside. If the market is trending up, the reverse is true. In general, we make profits when we can enter and follow a trend so why not do just that as we start from the beginning?

Merry Christmas to those who celebrate Christmas and to those who don't may whatever your holiday is be filled with joy for you and your family.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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To comment on Bill's article click on the "comments" link below.


Dario said...

Hi Bill:

Such as always, lucid and sensible words.

I want to associate myself with a few quotes that allow us to reflect on the topic.

"Do not ever accept as true a thing if it is not so clear for you. Avoid the rush." (Rene Descartes)

"There is only one side of the market and is not the bull side or the bearish side, is the correct side." (Jesse Lauriston Livermore)

"After practicing psychiatry for many years, I have concluded that most of the failures in life are due to self-sabotage." (Dr. Alexander Elder)

"If you can not take a small loss. Sooner or later will face the mother of all losses." (Ed Seykota)

"The hope is indeed the worst of evils, because it prolongs the torture of men." (Friedrich Wilhelm Nietzsche)

And finally, I want to comment on the analogy of the frog and hot water. If you put a frog in hot water, this will jump out of the pot because the high temperature. On the other hand, if you put a frog in cold water and then put the pot to heat, the frog die when the water boils, because they are not able to detect small gradual changes in temperature ... to think with regard to tolerate our little lost.

By the time "Money Machine" will be in the stores? I look forward.



Donato said...

The year (2008) opened with me being from the fundamental background and the buy and hold strategy.

The year will close with me being a trader who fully grasp's the concept that the only "safe" position is a closed position.

You are correct Bill. Ironically, the exit strategy for an equity is probably the least thought of element for the bulk of the population.

Anonymous said...

Dear Bill,
I like your style. No hype, no gripe - just plain common sense.
This market has given us so many signals in the past year that only a blind man could not see them.
I began pulling out in August, 2007. At that time I put 90% of my cash into CDs and began to use only the interest to buy stock. Of course, I lost a large percentage of that, but it only represented 5% of my net worth. Meanwhile, the interest from the CDs more than covered the loses. I am now slightly ahead in my over-all net worth.
Will I jump back in now? Nope, because I expect a further drop to continue until at least for another year.

Anonymous said...

Hi Bill and a Merry Christmas to you. I just want to say that, as a stock trader, I read your weekly blurbs religiously and find them extremely helpful. I hope you continue with your instructive thoughts and I hope in the future you try to ignore your detractors--they are just static to me. By the way, I have been trading currencies in the last few months and found that applying your advice to that market has worked wonders, especially the part of cutting your losses at a pre-decided point and letting your profits run. Do you think applying your advice to currency trading is precarious? Thanks again for all your efforts on behalf of your "students" out here. John Watson, Laurel, MD

Anonymous said...

I am one of the small guys hurt by what has happenedand. I am waiting for conversation that focusas on what is being done to keep it from hapening again. It is my understanding certin banks as a group raised the margin rates over night from 15% to 35% and forced market devaluation sell-off by way of margin calls. At least let us know whitch banks are involved.

Bill Kraft, said...

Thank you for some wonderful quotes, Dario.
Bill Kraft

Bill Kraft, said...

Thanks for writing Donato and I hope the transition wasn't too painful.
Bill Kraft

Bill Kraft, said...

Thanks for writing Marty and congratulations on your move. The only thing I have to add is I don't know whether or not there will be another leg down, all we can do is see what the market is telling us and play the right side of the chart with an exit strategy in place.
Bill Kraft

Bill Kraft, said...

Hi John and thanks for writing. I think the application of solid trading strategies applies to all markets, not just stock and options. I try to apply the principles to futures and to currencies as well. Money management, risk awareness (and control) and exit strategies seem to be valuable no matter what the market. Merry Christmas to you, as well.
Bill Kraft

Bill Kraft, said...

Anonymous, there are many culprits out there. Primary among them, I think, is a lot of greed and attempts at instant gratification coming from a lot of directions. I am sorry I can't answer your question because I don't know whether or not the premise is accurate and I don't know which, if any, banks may have been involved. It isn't just the small guys who have been hurt; it is a whole lot of folks, big and small, all around the world.
Bill Kraft

Michael said...

Hi Bill, I have recently subscribed and have witnessed a few successful trades since I joined but I am concerned that I see a few large losses you are holding with your system. This could tie up a lot of money for some traders. Is an exit strategy still in place on these stocks?

Secondly, you mention making directional plays but I did not see any short plays in your list of previous trades. Is the trend trader service you offer better for that?

Thank you and Happy Holidays. I look forward to your reply.


Bill Kraft, said...

Hi Michael. I'm not sure what service you subscribe to. I edit only Trend Trader, Option Trader, and $10 Trader. Of those services I edit, Option Trader is the most likely to make bearish plays. Trend Trader has bought some short and ultrashort ETFs over the year but since it is generally considered a buy stock service, I have been mostly in cash in that one for most of the run down in the markets. I am unable to comment on the other services since I have no involvement with them whatsoever.
Bill Kraft

Anonymous said...

Hi Bill,

Keep up the good work in '09. Merry Christmas to you!
Earl McHugh

Bill Kraft, said...

Thanks, Earl and a Merry Christmas to you, too!
Bill Kraft

Alexander said...

Your advice seems to pertain to day traders, looking to follow trends for the short term. I was curious to your thoughts on value investing in this market? By using a margin of safety would it be worth it to sustain these losses, due to high volitility, if you think the intrinsic value of a stock is much higher?

Bill Kraft, said...

Hi Alexander. No, my thoughts definitely do not pertain just to day traders, or, for that matter, swing traders only. I simply believe everyone should have an exit plan. I think it is unwise, for example, to hold something like QQQQ from a top of over 107 as it fell into the 20's over a two year period. During that fall, there were many times where an investor may have thought it was a good time to enter because he may have thought there was greater intrinsic value. Undoubtedly, for example, investors thought there was higher intrinsic value when they bought at 107 or they wouldn't have bought. I very much like the concept of value investing if it is employed in conjunction with the understanding that the value is what the market is willing to pay and if the investor "uses a margin of safety" as you suggest. That margin of safety means to me that the investor recognizes he could be wrong and when the stock price demonstrates the error he should exit. Most inexperienced investors hold on and seemingly forget that even if they exit there is nothing to prevent a re-entry if the price turns back up.
Bill Kraft

Anonymous said...

You are so right to have an exit strategy. Why do so many of us get stupid and not follow the rules that we have set up for ourselves. We would all be much more successful if we had more discipline.
I like using the stop loss, but when I have outstanding options it becomes more difficult to buy back the option and then sell the stock before disaster strikes.

Michael said...

Thanks for your reply Bill. I am on a trial subscription to the Success Trading Group to see if it is suitable for me.


Bill Kraft, said...

Thank you for writing, Anonymous. It sounds like you may be trading covered calls when you write that " becomes more difficult to buy back the option and then sell the stock before disaster strikes". It is important in my view to remember that writing covered calls is essentially a bullish to neutral strategy. When the stock drops through the exit, it is time to sell it. Most traders then must buy to close the calls otherwise it would be a naked call position. In most cases, there is a loss on the stock (cutting the loss) and at least many times a gain on the call that does not equal the loss on the stock.
Bill Kraft