My Approach to Financial Markets

[DarterBlue]

Preamble: At the end of January, I plan on taking at least a six month hiatus from the board due to both boredom and personal circumstances. Before doing so, I plan on making a few detailed, posts on topics important to me that I hope some of you will find interesting. This is the first of such. 

The objective of this post is to provide a high level overview of how one individual who has traded the markets for nearly three decades approaches the task. My reason for making it is to try and provide an understanding of what it takes to be successful in this game. I begin by trying to give a layman an understanding of the basic difference between a trader and investor. 

Trading versus Investing: A trader is a market participant who tends to be very active. The reason for this is simple. Traders attempt to profit from changes in the market's mood and direction. Investors on the other hand, tend to be more passive market participants and are typically associated with the buy and hold or dollar cost averaging approach to "playing" the market. The majority of participants in company retirement plans are by default investors employing a dollar cost averaging approach since each month or quarter their funds, as well as the company's match (if one is provided), get added to the account balance without regard to market conditions. Investors that employ any analysis in making buy or sale decisions generally use fundamental analysis to do so. Fundamental analysis refers to the use of company specific, industry or broader economic data to determine whether an investment is a good idea or not. Examples of data used by fundamental analysts are found in company filings with the Securities and Exchange Commission (forms 10F or 20F, as well as 10Q and S8 and other such filings); economic data put out by the government and various other sources relating to employment, filings for unemployment, consumer confidence and the like.; fundamental data is also contained in industry specific publications; finally, by working for a specific company one may also be able to obtain fundamental data of both a company specific nature, as well as an industry specific perspective. One needs to be careful in handling and using specific company data, as using it could possibly run you a fowl of securities laws. Insider trading, after all, is still considered a crime, though it hardly leads to punishment. 

Traders, on the other hand, while they may use some fundamental analysis to make buy and sell decisions, generally also use technical factors in making such decisions. Technical analysis makes use of data related to how stocks and averages have actually performed over specified time periods. In other words, technicians use the price and volume action of securities or indices exclusively or in addition to fundamental data addressed above to make buy and sell decisions. Traders, in addition to using price and volume data may also employ certain psychological data in making their decisions. Examples of such data are: investor sentiment (how many of a particular class of investor or adviser are bullish versus bearish); how much cash is on the sidelines; what is the mood of options participants (puts versus calls being bought, etc.). In general, traders have a much shorter term horizon with respect buy and sell decisions while investors tend to have much longer term horizons (at least the good ones).

Traders come in many different stripes and levels of competence. But typically, they can be broken down into three categories: 1. Day traders who are by far and away the most active in the market as their buys and sells are often accomplished in a matter of minutes or less. Traditionally, market makers (exchange professionals) are day traders in the sense that the very nature of their role (that of making and maintaining an active market for securities) requires rapid trading, since they are supposed to be the buyer and seller of last resort. 2. The second category of trader is the swing trader. Unlike the day trader whose holding period is often defined in minutes, a swing trader seeks to take advantage of short to intermediate term trends in a stock or index. Typically, a swing trade will last from two to five days. The objective is not to scalp profits as the day trader does but to get a more substantial move of several percentage points out of the trade. 3. Finally, the third category of trader is the trend trader who seeks to capture larger price moves in indices and individual securities obtained over a good part of a market cycle. The time horizon of trend traders can vary from weeks to years depending on market conditions and the type of vehicle being traded. The key thing to note about all traders is that they are not buy and holders and will cut their losses quickly (assuming they are disciplined and competent) when circumstances do not pan out the way they envisioned. (continued below)

[DarterBlue]

What am I: I define myself as a trend trader. My goal when active in the market, is to find a trend and ride it as long as my assessment of market conditions have not changed significantly from when the trade is first initiated. My goal is to identify emerging trends, buy an appropriate vehicle or vehicles to take advantage of the trend, and then ride the trend till I see evidence of a trend reversal. On occasion, for example when I deem a market extremely overbought or oversold, I may initiate a swing trade to take advantage of the expected snapback to more normal levels within an upward or downward band. Thus, I may still have the bulk of my trading positions long or short, as initiated but enter a trade with far less capital at stake to take advantage of a pullback or snapback from the primary trend.  

How do I approach the Game: Dr. Alexander Elder, Psychiatrist, Trader, Author and Trading Coach defines successful trading as adherence to the three M’s. He defines these as: Mind, Method and Money. Mind refers to developing psychological ‘rules’ that will keep you calm amidst the noise and constant temptation of the markets. Everything begins (or ends) with your trading mindset. You cannot make money over a period of consecutive months, let alone years, if you are not in the proper trading mindset. If you have a lot of personal problems or distractions, you will not make money consistently. Mind also addresses feelings of self-worth and self-confidence. You need to view yourself positively and have confidence but not arrogance.

Method addresses the fact that to trade the markets successfully over an extended period of time you must have a systematic method to your trades. Trading on gut and “feelings” will not work in the long haul. The method needs to be thought out, documented and assessed in real time either with paper trades or small trades that don’t damage your investment capital. Your final product should give you an edge in the sense that your expected outcome on any given trade should be positive. Now this does not mean you will not have losing trades. It does mean that over a decent sample of trades over an extended time, you will end up making money. Your method must also be periodically reworked as markets change over time. What works in this cycle may not work five years from now. Also of paramount importance, is the fact that your method must be compatible with your mind. What works very well for one trader will not work for another due to psychological incompatibility. Thus all successful traders will need to either develop their own methods to successfully trade the markets or adapt the method of someone who is essentially similar in personality.

Finally, money management is critical. Getting money management down is heavily dependent on having the proper trading mindset, as well as having a firm understanding of what money management actually means. Here is what it means in a nutshell:

·         You always think about risk before reward.

·         You know what your risk per trade is and you never exceed that amount.

(This should be a dollar and percentage amount that you are mentally and financially able to safely lose on a given trade.)

·         You understand how to manage your position sizes.

·         You have a clear understanding of how to place profit targets and an overall strategy for                    exiting trades.

·         You understand how to calculate the risk reward on a trade and this also means you know                sometimes a trade won’t be worth taking if the risk reward doesn’t make sense.

In short, if you don’t manage your money properly with adequate attention payed to controlling your risk, even if you are the best trader in the world you will crap out. (continued)

[DarterBlue]

I use all of the above in my trading methodology. For while I am not a mechanical, system trader, I employ a system that works for me; and I rigorously adhere to it. It is relatively simple and all of its key components are documented in a single Excel Workbook. It encompasses an oscillator, various moving averages, and a few key patterns. Because I have done this for many years without suffering devastating drawdowns, I have developed the confidence to do this while maintaining respect for the markets but not fear. The respect is due to my recognition that the markets are always bigger than me. And that would hold true even if I were trading a trillion dollars instead of the relative pittance I do trade. However, it is respect and not fear because I have the confidence to believe that if I adhere to my methods with sufficient discipline, I will over time extract profits from the market.

Trading is not for everyone. It takes a curious mind that is flexible, willing to adjust to the objective facts you are confronted with. If you are locked into a particular way of thinking, when that way does not work in the markets, you will bleed a lot of blood. Markets don’t provide tourniquets. It helps a lot if you are fascinated with the way markets work and truly enjoy the process of trading. However, it is not necessary to attain success. It also helps a lot (and this may sound counter intuitive) if you don’t “love” money. For by not loving money above all else, the pain of the inevitable loss that will occur regardless of your trading skill will not destroy your confidence or overly anger you. You will recognize if for what it is, part of the cost of doing business in this game. It will also enable you to learn from the mistakes you made that led to the loss. Sometimes the best trading lessons are from situations where you did not succeed.

Trading is also not for those that believe they are always right. The lie of this belief will confront you on a monthly basis as you lick your wounds from unsuccessful trades. If you are always right, then it must be the markets or your broker or your financial adviser that made the mistake, not you. Thus, you won’t learn a damn thing from the mistake since you never owned it to begin with.

There is a lot more I could say, but I will leave it there. I was prompted to provide the foregoing because of certain comments I have received over the eleven months I have posted on the financial markets. I hope you find what I have written helpful.

Peace!