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.

"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.