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Tharp's Thoughts Weekly Newsletter (View On-Line)

December 16, 2009 - Issue #454

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Trading Education

End of Year Sale

Article

Trading Smarts by Curtis Faith

Workshops

January Workshops

Trading Tip

Stock Market Seasonality: Broken Model or Notable Exception? by D.R. Barton Jr.

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What Type Trader Are You? Take 3 Minutes to Find Out

Mail Bag

Minimum System Quality Number

 

Trading Education

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Feature

Trading Smarts

Excerpted from Trading from your Gut

by 

Curtis Faith

“Intuition and concepts constitute…the elements of all our knowledge so that neither concepts without an intuition in some way corresponding to them, nor intuition without concepts, can yield knowledge.” —Immanuel Kant

When I started trading, Richard Dennis trained me in methods he had carefully researched. Then he gave me a $2 million trading account to manage after only a month of trading a smaller practice account. I was lucky.

Most of you reading this book won’t be so lucky. You’ll have to develop your own techniques.

Don’t leave your left brain behind in this process. If you want to trade with both your intuition and your intellect, you need to pick trading strategies that work for your whole mind. Systematic intellectual traders who ignore their intuition are losing out on great potential benefit. So are discretionary traders who attempt to bypass or override their intellect—those who neglect to provide a firm rational basis for their trades.

Every trading method should be grounded in a firm intellectual framework.

Every trading method should be grounded in a firm intellectual framework. In this chapter, I show the basis for a specific method that I use as an example in the next several chapters. I like to start with the basics, such as the rationale for the method, and build my strategies from there. The first step in building a rationale is choosing a type of trading method that works for you.

Step by Step

When I resumed trading in 2001, I started an online trading discussion forum. Traders, and those who wanted to become traders, could post questions to more experienced traders. Many questions were directed to me. Some were specific questions about the methods we used as Turtles, which were easy to answer. Traders who wanted to emulate our success asked the more difficult questions. They wanted to be long-term trend followers.

I had to tell them the truth: For most people, long-term trend following is not a viable way to trade because

  • Most people don’t have the necessary amount of money to have a reasonable chance of earning good profits.
  • You can’t earn the 100% average annual returns I earned as a Turtle using the same methods we once used.
  • Trading using a long-term trend-following approach requires the ability to stomach sizeable drawdowns, which most people don’t have the emotional constitution for.

Trying to trade with a system that you can’t get behind with your whole mind is pointless. You need to find a method that harmonizes with your whole mind and your psychological makeup. For most people, the old Turtle-style method is not that system.

So if trend following isn’t suitable for most people, what sort of trading is?

Is it swing trading, in which the trades last for days or a few weeks; or day trading, in which the trades last for minutes or hours? Fortunately, most traders can easily make this decision because the process of elimination leaves them with only one viable choice. For most traders, swing trading is the obvious choice.

Day trading requires that you devote the entire day to trading. This is not an ideal scenario for many traders who maintain a full-time job and trade a small account on the side. Most traders need an approach that won’t take up all their time—one that they can do part-time while supporting themselves with another job until they have honed their trading skills and built their trading account to the level required to earn a living from trading itself.

Day trading also requires quick judgment and decision-making skills. Many traders don’t possess these skills. Active traders have a hard time reacting quickly enough to make money while competing against professional day traders that have generally been trading 24/7 for years, if not decades. Some people like the speed of day trading. I don’t. From my personal perspective, it requires too much attention during the day and doesn’t leave me much time for other interests.

For these reasons, swing trading is the most viable option for most traders. You can trade with a smaller account, it won’t consume all your time, and it doesn’t require lightning-quick reaction. Swing trading also fits my personal lifestyle better. You can pick up trading for a while and then stop while you are doing something else. Because the trades normally last only a few days, you can start and stop more easily. During the day, you usually just need to wait for market alerts to fire, so you can be doing something else. I have many other interests, so this style suits me well.

Swing trading is also a type of trading that benefits from a whole-brain trading style. If you use your intuition, you will be able to find many more opportunities than you would if you use only one part of your mind. Swing trading benefits from both intellect and intuition.

The Source of Opportunity

If you want to be one of the few who reliably and consistently make money from the market, you need to find a strategy that gives you an advantage, an edge. To build such a strategy, you combine the building-block basics we learned in Chapter 4, “The Structure of the Markets,” in particular ways to extract profits. In this chapter, I put those building blocks together in a strategy that enables the left brain and right brain to do what they do best.

My rationale for this trading approach draws from the basics. First, recall that human psychology is the foundation upon which all successful trading is built. Markets are made up of large numbers of interacting Homo sapiens, each with their own individual agenda. Even when they use computer networks and programs to execute their trades, somewhere behind the scenes for every trade is an individual trader who directed the computer to execute that trade using a specific set of algorithms. To beat the markets, you first need to understand these traders’ motivations, the impetus behind the direction and timing of the trades. Then you need to find times when the markets participants in aggregate have mispriced the market—when the market does not reflect the “right” price.

Many people, especially economists, are fond of saying that markets always reflect the “correct” price. This is one of the conclusions of the efficient-market hypothesis: Markets already reflect all known information, so they quickly respond to new information. Therefore, these economists believe that it is impossible to consistently win money by trading the market because the market already reflects all known information. They attribute any success by traders to mere random chance—the lucky monkey theorem.

Master traders know that Homo sapiens are not completely rational. We have emotions, are sometimes afraid, are sometimes overconfident, and display cognitive biases. For these reasons, we sometimes overreact or underreact. Therefore, the price is not always “right.”

The way to reliably make money from the markets is to identify repeatable psychological market phenomena in which market prices appear to already reflect an overreaction or underreaction on the part of market participants, and trade against that reaction or anticipate an overreaction or underreaction based on previous market behavior. You can make money from both overreactions and under-reactions, either by predicting them or by reacting to them. Predicting market prices themselves is very hard. Predicting human reaction to market prices is somewhat easier. But easiest of all is detecting what has already happened and reacting to that existing market condition.

If the market overreacts, you can make money by anticipating a return to “correct” price levels. If the market underreacts, you can also make money by anticipating a return to “correct” price levels. In each of these respective scenarios, the meaning of “correct” is different. In the case of an underreaction of a price toward the upside, the “correct” price level is above the market price, so you can profit by buying at the market price and anticipating an eventual return to the “correct” price. In the case of an overreaction of a price toward the upside, the “correct” price level is below the market price, so you can profit by selling at the market price and anticipating an eventual return to the “correct” price.

About the Author: Curtis Faith earned more than $30 million as a member of the legendary Chicago trading group, the Turtles. Faith has developed a “whole mind” approach that gives traders at all skill levels the tools to become master traders.

Combining insights on trading psychology, managing risk, and trading methods, Faith delivers a method that is as much art as it is science and gives traders the tools to use all of the weapons at their disposal...namely, instinct and analysis. His most recent book is Inside the Mind of the Turtles.

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Trading Tip

Stock Market Seasonality: Broken Model or Notable Exception?

 by 

D.R. Barton, Jr.

“Sell in May and go away…” Old Stock Market Saying

In November of 2008, I wrote about stock market seasonality.  In particular, we looked at the concept of the “Six Best Months” indicator also known as the Halloween Indicator.

In short, the concept is summarized by today’s quote: “Sell in May and go away…”. 

As shown in the chart below, if you stay out of the stock market from May through October each year and stay invested November through April, you capture almost all of the positive movement in the markets.  This chart from the Chart of the Day website that is actually quite dramatic.

As this chart shows, the lion’s share of returns is made in the six months starting at the beginning of November (as indicated by the dark blue line above).

There is a peer reviewed study that shows this tendency holds for 97% of global markets.  The same study also demonstrates the effectiveness of this simple concept in England’s markets dating back to 1694!

Perhaps not surprisingly, no one has come up with a definitive reason for why the effect occurs, though the thought of crop seasonality and the associated credit cycle may come closest.

However, this seasonal tendency has been notably inversed in the past 12 months.  The traditionally strong fall and winter time frame (November 2008 – April 2009) showed a strong decline in the markets and the usually weak or flat period from May 2009 – October of this year showed a strong rally.

Does this mean the seasonality model is broken?  Not at all.  Seasonality is a concept that holds with “all other things being equal."  And unless you’ve been under a rock, you’ll know that this year hasn’t been a “normal” one.  A recent Barron’s article gave a great explanation for understanding one significant outside influence that can disrupt the seasonal tendency.

When huge liquidity is dumped into the markets, all bets are off.  The same break in seasonality happened in 2003 when a record stimulus package injected cash into the system.  The chart below shows the similarities.

If 2003 leading into 2004 is any guide, then we can expect more upward movement in the markets.  And with the U.S. government injecting even more liquidity to try and sustain the rally that has little fundamental underpinning, that’s probably the most likely intermediate term scenario.

Great Trading,

D. R.

About D.R. Barton, Jr.:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  "drbarton" at "iitm.com".

Disclaimer 

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Mail Bag

Minimum System Quality Number

Q: Can you advise as to what the minimum SQN [System Quality NumberTM) would need to be for a system to have a 90% chance of its return being twice as big as its drawdown over say a 100 trade period? For example, a 10% chance of a 25R drawdown and a 90% chance of 50R profits over 100 trades.  I can then use position sizing to get the results that I am after. 

Do any of the systems that are going to be taught in New Zealand next year meet this standard over a 12 month period?

A: First, there is no minimum SQN to have a system return twice as much as its drawdown. You can do that with high SQN systems and acceptable SQN systems. "Returns twice as big as a drawdown" is an example of an objective and you achieve your objectives through position sizing, not through your trading system. Your trading system needs to have a positive expectancy, but it is the SQN that determines your potential effectiveness and efficiency in applying position sizing strategies to meet your specific objectives. For systems with higher SQNs, you will find it easier to achieve, you will have more flexibility in choices, and you will be more likely to meet your objective through position sizing. To learn more, I would recommend reading the Definitive Guide to Position Sizing in which I provide a full explanation of the SQN and explain a multitude of position sizing strategies. A number of readers have replied to us that the book completely transformed their trading by changing how they thought about trading systems and position sizing.

To your second question, we will present a number of systems during February's Great Systems for Bear Markets and Systems That Outperform the Global Markets Long Term workshops in Auckland. The systems in these workshops have great SQNs and offer numerous (even daily) trading opportunities within a year's timeframe. 

The best traders apply their deep understanding of position sizing to a good SQN system and combine that with the proper psychological mindset to make great returns in the market. You can learn to do that too with a strong commitment and the proper training. I wish you the best of luck. 

Van

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Copyright 2009 the International Institute of Trading Mastery, Inc.

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“You have to leave the city of your comfort and go into the wilderness of your intuition. What you'll discover will be wonderful. What you'll discover is yourself.” Alan Alda

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