Drawdowns

The act of losing money, especially losing more than you expect or intended to, is really an emotion that cannot be described and must be experienced by the person him/herself. I've seen people react very differently: vocal anger, physical outbursts and sometimes just a state of shock. For a trader, losing money is planned and should be expected. But what hurts the trader's state of calm and ego is when he loses more than expected on trades that are absolutely poor with regards to risk-reward. I went through such an episode yesterday.

For those who have been following, you know that I am concentrating on the short side of the market. But, the market has already come off 10% and by in large, the action in the market this week has been rally attempts on Monday and Thursday. As a trend follower, this is exactly the type of market action I am looking to short into, especially weak volume rallies, such as Thursday's, has highlighted by the chart. So if this is the type of market I am expecting, the next question should be why did I lose money and lots of it?

 

To be brutally honest, I did not listen to my own teachings of preparing and planning trades. I broke my own rules. I saw the market attempting to rally on weak volume and got giddy, looking for stocks at good prices. And without any confirmation with regards to chart patterns, resistance or any other technical tools I know work, I began to blindly short what became one of the strongest stocks in the market that day (CLF, which was on my weak watchlist stocks). Trader lingo for shorting at perceived "good prices" without any confirmation of any sorts is called picking the top (or bottom, if I was buying into a down market). I became an egomaniac with my view of the market and disregarded my system, my bread and butter. I was acting as if I was an institutional player with millions of shares to short, who most of the time, are forced to do what I was doing in order to get all the shares they want. But I am just a minuscule fish in the sea, with no buying power to affect any stock. What was I thinking? 

Anytime you are wrong, the market will make sure you get smacked in the face. This time, I was smacked hard, deservedly so, and without any mercy. As the stock kept rising, I kept covering and shorting more. After a big fat check from the market, I realized in the insanity I was going through and covered my entire position (using full leverage, adding insult to injury) at a price way out of the money. As I was replaying the scenario in my head, I had thoughts of anger, disappointment and ultimately sat in a state of shock, which might be worse than letting out the frustration through vocalization or physical exertion. I felt like a drunk mess in Vegas, saddled with an exorbitant bill I did not want to pay for services I did not even know I receive. 

Even the greatest trader to have lived, Jesse Livermore (search him on Google and get the book Reminiscences of a Stock Operator), had countless days like these. His teachings are now maxims in the trader world and yet he made and lost millions, going broke twice in his life. I reminded myself that this was just a bump in the road, that my system was still profitable overall and that all I needed was one good trade to at least wipe out this market spanking. Livermore himself recounted countless times in which he was given a teaching lesson by the market in the form of a "tuition bill" he had to pay and was glad, no matter how much was given up, that his bill was not larger. Basically, his attitude is to learn from his mistakes and to never make it again. I am sitting here today on a great position that on paper, has already wiped out 80% of my mistakes yesterday, with the potential to actually bring me some profits for the week.

The cliche of how you rise up from a fall is absolutely true in whatever you do in life, and none truer than in the market, where even the best traders can slip up once in a while. All it takes is one trade to put you back in the game, to regain that self-confident swagger (but not reckless arrogance like my Thursday showing) that is needed to take on a position. Even in tough trading markets like this February has shown, at the very least a trader must believe that great opportunities with present themselves sooner or later and must be ready to pounce on them. I was lucky that my opportunity came the day after catastrophe.

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. If there are any questions on the lingo used in this post, feel free to ask as well.

Discipline and Risk

As per Steve's comment and interest on discipline and risk, I will delve into what they mean and why they are incredibly important to trading.

First, what do I mean by risk? Risk is the amount of capital you are willing to lose if the trade does not go your way. It is where you place your stop loss for your whole position. Why is this important? Because you must always prepare for the worst before you enter into a position. You must always assume the worst and if you are wrong, you must limit your loss to preserve capital for another trade, for another day. The reason why buy and hold strategies do not work in the long run is that even though this investor's "win percentage" is very high, the one time that he holds onto a stinker (I will illustrate an example), he will lose it all.

Without using an extreme example, in the cases of extinct companies like LEH and BSC, I will use a company like Yahoo (YHOO) that is alive and well. Let' say an investor thought the prospects of the company were looking up as recently as 2 years ago and believed its pricing between the 20s and 30s was cheap. He would enter into a position in the 20s. He would check his portfolio several months later and see the stock hovering in the same price range. He would either buy more or let it ride. Now Q3 2008 arises and he sees the stock slipping to the low 20s. He would buy more because the company is "cheap," since he viewed it as cheap in the 20. And then fear hit the market late 2008. He views all his positions in his portfolio all down double digits. Will he give up on his positions, or will he buy more? And if he does buy more, does he use the same position size as before, or more or less? Those are all questions that a buy and hold strategy do not cover, because that strategy assumes that your choices are never wrong, that your opinion on the pricing of the company is accurate and that stocks tend to rise in the long run. You are playing the role of "smartest in class." You can see how this situation becomes destructive if you so happen to invest in a failing company.

Even though I am biased towards a certain way of playing the game, this blog is not about pitching a certain system. You can certainly play the smartest guy role if you so wish but more importantly, my point was to show the importance of having a stop-loss. Using this powerful tool let you know exactly how much you are willing to lose, barring an overnight gap or liquidity issues. Everyone knows that most people lose in the markets, so people should play in a way to limit these losses. You must also be discipline with following through with your stop-loss. This means, after your preparation, you will not move your stops to give it a "little more room" because you have already accounted for that through your preparation. I have done this a few times and my original plan always worked out for the better. How to properly use stop-losses so that you won't be "shaken out" before the real move is a different story that requires study and preparation on the stock, but that only comes with experience. Finally, one must be at peace with losing when it happens (and it most definitely will happen). If you cannot accept losses, do not play this game. If you only want to win, play a video game.

If you are fortunate to be holding onto a winning position, it takes discipline to hold onto such a position without cutting your profits short. The only way you make up for your small losses are through big winners. Many inexperienced investors will hope for a rebound in a losing position but fear for profits in a winning position. How many times has your parents or friends complain about how they sold their position too early but smiled about how they were "long-term" investors once they were out of the money? Your mindset needs to be the exact opposite. Stocks that are acting well tend to stay that way, and vice versa because markets tend to trend. Until you have a reason to exit your position, which is different for everyone and will come with experience as well, you have to hold onto your position. Otherwise, you cut yourself and your hard work short of what the market could have rewarded you. Another aspect of trading to keep in mind is that the entry and exit points of the greatest traders are almost never at the top and bottom. Think about it. You never know if a certain price is the top for a stock until it is.

Discipline with a position cannot be exactly replicated unless you have experienced the emotional rollercoaster, but there are ways to practice. The most effective way is to be in control and strong-willed in your life. Do the things you set out yourself to do and accomplish those goals. Trading, in many ways, is a reflection of who you are in life. Your risk tolerance, your emotions will all affect your trading system and style. Do not think for one second that if you have a breakup with your boy/girlfriend, you will not be affected by it. One must maintain a strong mind and body to trade.

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.