"Everybody gets what they want out of the market"

The quote is spoken by the great Ed Seykota, a system trader whom many trend traders glorify. He is quite a character, a true intellectual. He dabbles into creating his own inventions, loves to banter about Bernoulli's principle and is one of the greatest traders of our time. His public approach to trading stresses personal growth and being psychologically sound, as evidenced from his website: www.seykota.com/tribe Many claim he is too vague whenever he makes a public appearance, offering none of his opinions on the markets. But the consistent point he is trying to make is that it doesn't matter what he, a great experienced trader with an incredible track record (60% annual return from 1990-2000) or anyone else thinks, it is what the market gives you. "Traders who predict the future dwell upon a nonexistent place." That quote is in essence, why he has no opinions on the market, for he is no fortune teller, just a trend follower.

"Everybody gets what they want out of the market." Let that thought marinate in your conscience for a minute before you read on what I believe his famous quote means.

Let me paint a picture. You have Person A, someone who watches Jim Cramer everyday, who reads the Wall Street Journal and the Financial Times, who is clearly very enthusiastic about the market. But, he has little experience in the market and feels that the professional looking and sounding people on CNBC know the markets better than him and he will follow Cramer's stock picks. Then you have Person B, someone who also reads the financial prints, but makes use of his business bachelors degree and studies the earnings reports of all the companies in the sectors he is interested in investing in. He makes his own trading decisions based on his fundamentals, value-investing approach. Finally you have Person C, someone who believes in following technical clues in the markets. He bases his trading on sound risk-reward scenarios and is constantly scanning for opportunities in the markets.

Let me say right off the bat that Person A is bound to fail. Besides the fact that he is not willing to do his own homework on his own trading, his trades are at the mercy of those on TV. If Cramer tells you to buy today, you are at his mercy of when you can sell. Another factor to keep in mind is that the vast majority of retail investors in the market lose money. It has just been that way ever since the beginning. Why would you want to lump yourself in a batch of people who are bound to lose money statistically? The people who are prowling for your money don't care that you are incredibly enthusiastic about the markets; that factor alone will get you nowhere. I've mentioned before that there are no right ways to play the market but there are wrong ways. This is one of the many wrong ways. He gets what he wants out of the market.

Person B does his own homework and believes in value-investing. He/she takes his investing seriously and makes sure that the companies he invests in are high quality companies with strong cash flows and high growth prospects. He has invested in the likes of AAPL, IBM, etc. A very high percentage of his trades have made him money. However, there are still certain trades that have not shown him profitability yet, namely former leaders such as QCOM, CSCO. In late 2008, he was discipline in his system and kept buying as the market came off. Hopefully, he avoided the likes of Bear Stearns and Lehman. He made a nice return in 2009 to offset some of the unrealized losses in 2008. The concept of value-investing has no timing mechanism because when financial markets turn bear, the stocks keep looking cheaper and cheaper. While institutions are dumping their stock, the strategy require you to be buying from them. This always lends itself to a position of weakness. Also, value-investing prohibits person B to invest in stocks with incredibly high P/E, PEG, or whatever value parameter he uses. This is an important consequence, because these "expensive" stocks are invariably the ones with parabolic moves that can make a trader's year. Just recently, the energy bubble in 2008 made several smaller-cap natural gas/oil stocks soar to nearly double their price and some big cap names to returns of 25% or more. Examples include CHK, HK, APC, COP, etc. More than likely, while person B might catch investments that may double his position value, he will also invariably be buying strong growth prospect companies that have become out of favor of the institutions. Examples of such companies are the aforementioned CSCO, QCOM and currently: RIMM, FSLR.

By in large, I am not against fundamental investing, I just don't believe in it. There are many examples of successful investors to prove me wrong and they certainly are of the smarter breed. Do keep in mind though that there are a countless number of those who have failed, mostly with a whimper, which we will never hear of their stories, and some with a bang, which will be highlighted in financial articles. But you better be one of the smartest kids on the block. And the successful ones have incredible insight into each sector, with either an in-house research staff or thousands of dollars to spend on outside research. This is a full-time job and more. Will you be willing to do this work to make your money? Otherwise, the market will tell you how much your half-baked ideas are worth.

Person C is of the technical kind, the one that follows trends. I've made it clear enough about my biases, but I want to quickly go over why I feel this is a strategy that works over the long-run. Before I list the merits of technical trading, there are millions of trading systems off of technicals, and person C will have to find one concoction of parameters and patterns he feels comfortable with to trade.
#1. The cardinal rule for technical trading is risk-reward. Inherently, great trading systems are risk measuring systems that predetermine the downside but leave the upside open.
#2. No asset class is too expensive or too cheap to be entered into. The whole universe of equities, futures, commodities and bonds are possible candidates.
#3. The markets are moved by institutions with billions of dollars at their disposal. Eventually, trends will be established and followers of this system are on the same side as these market behemoths.
#4. Trend followers are not the smartest people in the class. But, they are smart enough to follow the smartest person.
#5. After establishing a system, there is a set of parameters used for each trade. Thus, the strategy is replicable and consistent.

There are no holy grails however. There are downfalls to this family of thought and it usually boils down to person C's own faults.
#1. Personal issues and emotions can get in the way of discretionary technical trading. If Seykota will devote his public image to this point, it's probably important.
#2. Market do not always trend. Trend-followers' worst nightmares involve markets that dilly-dally around ranges. It is up to the trader's own discretion to prevent more drawdowns (losses) based on his own set of rules.
#3. The learning period to concoct a technical strategy that works requires serious dedication and years to perfect. Many are not willing to do the work and thus, become one of the 90+% that fail to become traders.
#4. The number of losses versus winners are usually skewed towards the losses in trend trading. That's why it's important to let winners ride to make up for the small, but numerous amount of losses.

Technical trading is not just a mish-mash of arbitrary downtrend and uptrend lines, it's hard work that requires a strong understanding of the basics of the market and time and capital to perfect. Unfortunately, it is not a stable job, where you know you will get a paycheck every 2 weeks. In this job, there will be many times in which your boss will take money from you. That thought alone scares away many people. But if you choose to become a trader and have set out to prepare yourself for potentially months and a few years of non-profitability, then you already have conquered the most difficult of all the hurdles: yourself. Then I am sure your true passion and interest in the markets will lead you to find that researching past leadership asset classes isn't hard work, it's entertaining.

Feel free to post comments, I will respond and appreciate every one. Also, if you would like me to discuss a certain topic in my next post, post it in the comment section as well. Until then, never leave home without a stop-loss.

Stash away the news, buy the dips

Take a look at Yahoo Finance's news section for today. In the morning, the jobs number can only be summed up in one word: disappointing. Job losses in the economy. The market did look dreary, reacting with a downmove all the way to yesterday's lows in the premarket for the Nasdaq futures.

And then the market rallied up to new yearly highs. Now take a look at their explanation: Take report in stride?. Suddenly there was a pleasant surprise in the numbers. Keep in mind that this "surprise" is the same number in the morning that showed that the US economy has lost 85,000 jobs in December. Once again, reporters who know very little about the market try to fit the news to market action. This is a great example of how market psychology rules price. The market psychology now is to buy whenever there is a favorable buying opportunity, such as today.

Buying "dips", which is trader lingo for buying stock when it quickly falls in price, has been the very profitable in these past few months, as you can see from the chart to the left. Starting from November, you could have realistically bought the market 4 times on dips and if you correctly set your stops and let your position ride, you would be in an incredible position of strength now. What is most important to remember when buying dips is that you must only do so when the market is in an uptrend, and you must use a stop just in case the dip you bought into happens to be a change in trend. And even though this strategy has worked for the past couple of months, it would not surprise me if it fails to work the next time it happens. But until it fails, I will be buying the dips as well.

On a side note, the inverse correlation between the market upmove and the dollar's downmove had been well documented by many of the media outlets. Just recently in the past few days though, it looks as if the market and the dollar have both been moving in the same direction. This could be a sign of a the end of this correlation. I have provided a link that maps both the market and the dollar: Market vs Dollar.

Feel free to post comments, I will respond and appreciate every one.  Also, if you would like me to discuss a certain topic in my next post, post it in the comment section as well. Until then, never leave home without a stop-loss.

What are financial markets?

What are the markets? Are financial markets a bunch of stock tickers, varied commodities and a multitude of currencies? Are they really the products they represent? Is GLD really gold?

All of the above questions were things I never thought about before I became seriously interested in the markets. I did view the stock market as stock tickers with ever-changing prices. And I did think that these prices reflected the value of the company it represented, since in financial theory, all markets are efficient and traded by rational participants. These assumptions had to be true, since many of the financial markets are traded by the brightest people with the latest and greatest technology. Who am I to question those who are smarter and more experienced than I am?

In the beginning, my approach to trading was haphazard and I my results showed. I made all the rookie mistakes and quickly began to question whether I could continue. It was at my lowest point in my first year that I decided I needed to change my approach to trading. I started to view the markets in a different lens, from the eyes of great trend-followers through the books I've read, and began to understand what a "market" really was.

Market prices for any tradeable security is not the actual value of the company, rather, it is the sentiment that the participants hold of the company discounted for the future. The best example of this is an earnings report. For those who have followed the markets, you've seen many instances where the earnings report for a company either beats or misses estimates and the stock reacted in the opposite manner of what you expected. And why would the company's stock price do the opposite of what they have reported? Because the sentiment of the major players in the company's equity holdings changed, regardless of what the reasons were. As traders, it is not our job to pinpoint what piece of information changed the complexion of the stock, it is our job to react to changes in the prices and act according to our system.

A great example of this was DNDN (Dendreon, a pharma company with a promising prostate cancer drug) on September 14th, when the price of the stock shot up close to 15% from 24 to 27.50s and people were clamoring for the reason for such a move. The company repeatedly said there wasn't any news or findings on their pipeline drug. There HAS to be news when a stock makes such a move, doesn't it? The point is, pricing creates news and sentiment creates prices. Yahoo Finance will find "reasons" for a move because people want to hear and believe in fundamental changes. I just chuckle when they pinpoint a market rise due to some number and the next day, they attribute a market fall due to another number.

Another great example of sentiment in play involved the same company on April 28th. It had an important presentation on their lupus drug during the after-market hours and people involved in the stock were waiting for any leakage in information. In an otherwise quiet time in the market at 2pm, I saw the stock plummet from 25 to 7.50 in mere minutes. The actual change in prices on my screen was awe-inspiring. Apparently there were some negative rumors on the drug and equity holders panicked out of their holdings. The stock was halted and the Nasdaq exchange began to investigate the issue. It turned out that these rumors were false and the stock opened up higher than the previous day's price. However, if they were true, what would have been the fate of those who bought and held onto their positions? And if the markets are made up of rational players, how would you explain such a violent downmove under this assumption? Remember the words of John Maynard Keynes, "The markets can remain irrational longer than you can remain solvent."

Another aspect of the market that needs to be understood is that once information on a company is public, the price of the company has already reflected such information. For example, Warren Buffet bought out the remaining shares of Burlington Railroad (BNI) for 100 per share in November 3rd. On market open, the price of BNI already reflected such a change, opening up at 97.85. Reasons for the difference in price reflects the probability that the deal goes through, since the announcing of the deal is not the closing of the deal (a good example is Harman Kardon, symbol HAR, look at year 2007 when KKR proposed and eventually backed out of a 120 buyout deal). Regardless, the meat of the move from the 70s to the high 90s was immediately reflected the day of the announcement. There are people who know more than you earlier and faster than you ever will.

I will end with explaining why I call participating in the market, the "game." In this psychological game, a game where you are pitted against an untold number of participants clawing at your money, there are rules set forth that many have tried to break but none have succeeded.  A few of the most important ones are as follows, in no particular order:

• No one entity can stop the eventual price of a company, no matter how much capital and respect they command, a great example being Long Term Capital Management's downfall. 
• Discipline is key to surviving your inevitable losses and reaping great rewards.
• Fundamentals, in the very long run, do affect the pricing of companies. Look at Enron, Lehman Brothers, Worldcom, etc. What will you do in between this period of time?
• Risk management is the single most important factor you must understand, practice and respect in this game.
• No one ever knows what the market will do in the future
  
• There are no holy grails in this game. 
• There is no one right way to trade the market but there are wrong ways.

Feel free to post comments, I will respond and appreciate every one (reminiscences from experienced traders very welcome as well).  Also, if you would like me to discuss a certain topic in my next post, post it in the comment section as well. Until then, never leave home without a stop-loss.