Sunday, July 30, 2006

Spreads & Pairs III

I spent two weeks ago looking at spread or pairs trading. Last week I reviewed the pros and cons of spread and pairs trading in general. This week I will look at a couple of specific styles of spread trading using market model questions.

Futures Spreads: Limited Only by Your Imagination (and common sense)

Futures spreads: As a re-cap, this method looks to take advantage of historical price ratios. The gold vs. silver spread is a common one. Recently, gold versus crude oil has been popular. In general, when the ratio between the commodity prices gets out of its historic norms, like when crude prices appreciated faster than gold last year, traders will sell one side and buy the other, expecting prices to revert to the mean. In this case, people would buy gold futures contracts and short crude oil contracts, expecting the ratio to return to its historic norms.

While it is conceivable to trade almost any futures contract against another, there are a great many spreads that have historical precedent and/or physical significance. For examples, comparing the prices of similar futures is common: corn vs. wheat, T-notes vs. 30 year T-bonds. Clearly, there are spreads that dont have physical or historical significance and are even uncorrelated. It would make little sense to trade pork bellies vs. cocoa for example.

Lets look at our market model questions for Futures Spreads:

Is it theoretically credible? Sure. There are historical ratios that have held for decades or centuries for good reason. And in general the concept of arbitraging prices when they get out of whack is very credible.

Whos it most useful for? Folks who want to specialize in particular spreads. If you try this as a passing fancy, you’ll be up against folks who know every little gyration in the supply and technical moves of your chosen pair.

How Fanatic are the fans? Not crazy really. Futures spreaders are usually quiet grinders operating under the radar.

Is it being used by real-life traders? Yes. But its not very pervasive. Again, this is a specialized discipline.

Seasonal Spreads: The Compelling and Logical Trade

Seasonal futures spreads: For re-cap, these spreads try to take advantage of seasonal tendencies. An example would be going long a spring/summer unleaded gas contract and short a spring/summer heating oil contract. More driving and less heating takes place in the summer; so if you looked at this spread over a long period of years, there is a positive correlation. Again, there are many examples based on harvest cycles, freezing seasons, etc.

Seasonal spreads are very compelling because they make so much darn logical sense.

Here’s a look at our market model questions for Seasonal Futures Spreads:

Is it theoretically credible? Quite. Many of the seasonal futures spreads are driven by the physical realities of weather and harvest cycles.

Whos it most useful for? Again, this is best suited for people who would like to really dig into the seasonal tendencies of particular spreads.

How Fanatic are the fans? Seasonal traders tend to proselytize a bit more than most.

Is it being used by real-life traders? Yes. But its not very pervasive. Again, this is a specialized discipline.

There are lots of fly-by-night companies that offer all kinds of different research for seasonal trading. Do your own research on service firms well. One reputable firm that I have used in the past is Moore Research Center, Inc.

Good day and good trading.

Friday, July 28, 2006

Sell Targets

Its interesting that so many of us will spend a great deal of time studying the perfect time to buy, yet so little time on when to sell. Ironically though, we may be better served by focusing our efforts on the latter, since the sell side of the transaction actually puts money in our pocket. There is plenty of literature available on the subject of when to sell, but today I would like to highlight some of the most helpful sell rules that you can take and apply immediately.

1) I never buy at the bottom, and I always sell too soon. As difficult as it is, you want to sell stocks when things look like the stock may soar forever. As we all know, all good things do come to an end, and its far too easy to let a 30% gain turn into a 20% loss because you are trying to squeeze out a 35% gain. You may ultimately leave some profits on the table, but better to leave some profit on the table than none in your pocket.

2) Keep in touch with a companys fundamental data. All of the fundamental research that we do typically comes prior to making the investment, but many times the companys financial statements after you invest in it will clue you in on a pending downturn. If earnings or revenue taper off, you want to be one of the first ones aware of that, prior to a sell-off.

3) In Bill ONeills Book How To Make Money In Stocks, he summarizes good money management (capital protection) with this simple quote, The whole secret to winning in the stock market is to lose the least amount possible when you are not right. While its always more enjoyable to dwell on winning trades, its important that you protect your investment capital. If you allow yourself to take large losses, you have diminished the amount you can put into your next winning trades. This is why its crucial to use trailing stops, exit rules, and be willing to accept that every trade is not going to be a great trade.

4) For those of you who use technical analysis to generate automated signals, you dont necessarily have to use the opposite of your entry signal as an exit signal. You may find that an entirely different technique than your buy signal gives you better, and more profitable, exits.

Remember, selling is half of the challenge, and you should devote half of your efforts to making sure you are selling at the right time. You will find the results are an efficient, more profitable portfolio.

Have a good weekend.

Thursday, July 27, 2006

Chart Reading Basics

One type of technical analysis is the process of reading stock charts. Basically, this involves looking at a chart to try to observe patterns in the price movement that could help you determine what a stock will do in the future. The concept is simple, but it takes many hours of study and observation to learn. However, one problem that still exists after you master this is that just looking at charts for your trades is a very subjective judgment and usually not backed up by scientific-style testing. But whether you use it for making trades or not, it is still a good thing for all traders to understand.

First you need to know what you are looking at. For analysis, you should either use a bar setting of OHLC or Candlesticks. These settings turn every day on the chart into a vertical bar that shows the open, high, low and closing price of that day.

Some of the most common patterns that you will see involve Trend Lines. Trend lines are simply lines that are drawn on a chart to connect several relative highs or lows. They can either be directly horizontal or diagonal upward or downward. If a stock has clear trend lines then these points can be a good indication of places to buy or sell. Lines where stocks hit bottoms and move higher off of are called Support Lines while lines that the price moves downward from are called Resistance Lines.

Other types of patterns that chart analysts will look for involve more complicated price formations. Some of these include: Triangles, Head & Shoulders, Elliott Waves, and Rounded Tops/Bottoms. Head & Shoulders (bearish version) is common pattern in which a stock will reach three relative highs, with the middle one being higher than the other two. This usually indicates the coming of a strong downward trend. With a Triangles pattern, the price of a stock is moving up and down inside clearly definable trend lines that are narrowing. When the price reaches the point of the triangle it breaks suddenly either up or down, depending on the type of triangle and the previous trend. Rounded Tops and Bottoms are instances where a stock slows down in movement just before it reverses. Usually these happen after strong upward or downward trends. Elliott waves involve a complex set of specific upward movements followed by a set of downward movements.

Click the Chart Reading Basics header link above for all the many different books available on this subject.

Good day and good trading.

Wednesday, July 26, 2006

Dividend Reinvestment Plans

DRIPS are one of the best-kept secrets on Wall Street. Many would-be investors are put off investing because they dont think they have enough money to begin. Its not their fault. Wall Street pros have created this mystical aura around investing, making small investors think that 1) investing is too complicated for the average person and 2) you must be rich to make money in the stock market. Neither assumption is at all true.

We have already begun addressing the first myth in Financially Fit by discussing the most important ratios investors can utilize to analyze stocks. We have also talked about making sense out of annual reports and how to allocate your portfolios as you move through different stages of your life. And we will continue to help you break the science of investing down into manageable parts in the coming weeks and months.

But today, I want to focus on the second myth and show you how DRIPs can make investing available even to the very smallest investors by eliminating many fees and commissions. Because with DRIPs, investors can start small, buying as little as one share of stock, at vastly reduced commissions - a very cheap way to start a portfolio.

There are more than 1,500 DRIPs available for investing. Many are household names, including Coca-Cola, Dominos Pizza, Dell, Pep Boys, and Pepco. Created by companies seeking new investors, DRIPs allow investors to invest small amounts of money on a regular basis. The companies (or the DRIP administrator), then pools those monies to buy whole shares of stock, splitting them into fractional shares for each investor based on the amount of money each person has contributed. Then, when the company pays its dividends, those monies are applied to purchase additional fractional shares of the company's stock.

For example, you may decide to join Wendys (WEN) DRIP. To enroll in their plan, you will need to purchase $250 of Wendys shares, which you can purchase through the company. (Note: many DRIPs require a smaller initial purchase and many also require that you buy the first share through a broker (more about that later). After that, you may send in as little as $25 for additional share purchases. The plan administrator will pool your funds with those of its other DRIP investors, and buy whole shares, then divide them up among the investors, according to how much money each person had sent in.

Today, if you sent in $250, at the $59.35 per share price at which Wendys shares are currently trading, you would be buying 4.2 shares of WEN (minus any fees you may incur in the purchase). Then, when Wendys pays its quarterly dividend, currently $0.17 per share, those 4.1 shares would accumulate another $0.714 (4.1 x $0.17) which would then be used to purchase .012 ($0.714/$59.35) of a share of Wendys stock.

Over time, if you sent in $25 per month to Wendys DRIP, in five years (all things being equal, including the price of Wendy's shares), you would have accumulated $1,500 ($25 x 60 months) and own 25.3 shares of Wendys stock - if the company didnt pay dividends. But because it does, each of those shares is going to receive the quarterly dividend, which will then be used to purchase more shares, quickly building up your portfolio of Wendy's stock.

And your account will continue to grow in two additional ways, as Wendy's shares - hopefully - appreciate, over time, and also as the company increases its dividend per share.

Its that easy. And with more than 1,500 DRIPs currently in existence, there is no reason why you shouldnt begin building your investment portfolio right now. But first, you need to know a little bit more.

DRIPs are not as liquid as buying and selling shares in the open market. Thats right, just as you buy your shares through the DRIP plan, you must also sell them the same way. That means you cant call your broker up and sell them the same day; it might take a few days before they are sold. Consequently, DRIPs are tailor-made for the long-term investor, not the trader.

Many companies, like Wendys, that offer DRIPs also offer Direct Stock Purchase Plans (DSPs). That means you can enroll in the plan through the company, not through a broker. If the company does not offer a DSP, the first share must be bought through a broker or another company that facilitates DRIP investing (more on this later). Then, later purchases may be made through the company or DRIP administrator.

You will pay a fee to buy shares. It is generally a very small one to set up the account and buy your first share. Now, if you buy through a broker, you will most likely have to purchase more than one share to enroll in the DRIP. If the company has a DSP, you can usually start with one share.

However, you do want to make sure if there is a fee on additional shares purchased that it is reasonable for purchasing small numbers of shares. In other words, if the fee is $5 per transaction and you are only investing $50, that would be 10% of your total investment, too high. So watch out for those.

Some companies even offer discounts on shares purchased through them. You will need to investigate this.

Click the Dividend Reinvestment Plans header link above to learn more about investing with DRIPS.

Good day and good investing.

Tuesday, July 25, 2006

Trader Types

In the wide world of directional trading there are basically two species - trend followers and contrarians. Trend followers take the hitch your wagon to a star kind of approach. When they see a stock moving in a particular direction, they figure that someone smarter than they are must know something. So, they jump in the fray and hope for the best. Whether they profit or not depends largely on when they have this epiphany. If they get in early in the trend, they may make a few bucks.

If they come late to the dance, all the pretty girls are already dancing and the song is almost over. So, you either dance with a Linda Tripp look-a-like, or you go home. You have lost your pride, the cover charge, and then some. A few stiff drinks may make your Linda Tripp look like Brittany Spears, but when you sober up, the reality is there (ugghhh), and your money is still gone.

Contrarians are a different breed. They believe that when too many people agree on a direction, they are simply confused, dont understand the situation and are in for a rude financial awakening. Contrarians believe that an overwhelming majority of retail traders tend to buy high and sell low.

Instead of jumping on a bandwagon (trend), contrarians try to determine when the euphoria will end and then short the herd of traders who will be scrambling to get out. There are a number of mutual funds who use contrarian strategies to take advantage of the follies of retail traders.

A Contrarian Story

A friend of mine is a daytrader, and a very successful one at that. At the office where he plies his craft, there are currently five other traders with him. They are the few survivors of their past mistakes. Each office had 15 to 20 traders before, plastered to computers, making money hand over fist. But, remember, that was in the day when monkeys throwing darts at the Wall Street Journal stock pages outperformed analysts and an embarrassing number of professional traders.

When the irrational market hit the wall and fell like ton of manure, so did the mass of irrational daytraders. They only knew one style of trading, couldnt make the adjustment, and watched in amazement as they gave back most, or all, of what they made.

An occasional visitor to the office is a former daytrader named Little Richard. A great guy, he was affectionately known as their contrarian indicator.

There are some people in this world who have the Midas touch. Whatever they touch turns to gold. Then there are those who, whatever they touch turns to something you wouldnt want to step in. Well, Little Richard was the latter.

Whenever Little Richard would enthusiastically announce that he just bought 500 shares of XYZ stock, the other traders in the office would immediately short XYZ stock. It worked about 80% of the time. Notice I said Little Richard is a former daytrader.

Identifying A Trend

Lotsa luck! Its not easy. Technical analysis may give you some guidance. But, the question is, once you have identified the trend, how much trend is left? Thats the $64,000 question.

Look at the trend line. The steeper the trend line, the more powerful the trend may be. Some traders look for crossing moving average lines or other momentum indicators.

Throw a few support and/or resistance lines on the chart. Then, add some moving averages. Toss in another an oscillator and, before you know it, the chart looks like last nights spaghetti. A good knowledge of technical analysis can make some sense of it. Some say it gives traders an edge.

Both the momentum and/or contrarian approaches can work. It all depends on the trading skill, the chart reading skills and self-discipline of the individual trader. Developing these skills is not like Minute Rice. It takes time, effort, practice and a commitment. The market is a non-forgiving animal that eats up traders for lunch and spits out what little is left. You dont want to take a knife to a gunfight. Be prepared.

The Online Trading Academy offers probably the best and most comprehensive technical analysis and trading courses in the industry. When you complete the OTA courses, you will have the information you'll need to give you an edge in identifying trends as well as evaluating and selecting directional, non-directional, short and long term strategies.

Click the Trader Types header link above to review purchase the CD Rom courses. Your trading account will thank you later.

Good day and good trading.

Monday, July 24, 2006

Credit Spread Trading

Investors who like a steady cash flow should look into the credit spread strategy using options. In a choppy, directionless market, credit spreads can be a great strategy.

Most of the time, when we think about establishing a bullish position using options, we think about buying a call. But another bullish strategy that is more conservative is to sell a put. By selling a put, we are now incurring the obligation to buy shares from someone else at a specific price (the strike price), up until the expiration date. We can close the position early by buying back the put if we wish. But this put selling strategy is known as a naked put, in which a big overnight plunge in a stock could obligate you to buy the stock at a much higher price.

A credit spread makes the naked put strategy more conservative, by purchasing a cheaper option than the one you sold, for insurance to lock in a much lower risk should the worst-case scenario occur. While I mentioned Wednesday that I dont like to use index options like the S&P 100 Index (OEX) for straddle buying, I love to use the index options for credit spread trading. You have better liquidity and better risk management compared to using most individual stocks. For example, if the OEX were at 497.09, a mock trade for bulls might be to sell the 1-month 480 put at 5.60 and simultaneously buy the 1-month 475 put at 4.60. This allows you to collect the 1 point credit, or $100 gross before commissions. You want to make sure you are getting reasonably low commissions from your options broker when you do credit spreads, since there are two sides to the transaction on the way in, and also two sides on the way out in the minority of cases where both options don't expire worthless.

Did I mention you want both options to expire worthless? Ideally if you are neutral to bullish, the credit spread strategy will work out unless the OEX starts dropping much under your 480 strike price you sold. Actually you can be wrong on the market by 18 OEX points, about 3.5%, and still make money with this strategy. Contrast that to buying calls where the index must rise for you to profit, and you see you have many more scenarios where you can win with credit spreads. Your breakeven point is 479.00 here (the 480 strike price you sold minus the 1 point credit you collected). Your maximum loss is the 5 point difference between the strike price, minus the 1 point credit you collected, or 4 points. So your fixed maximum return on a winning trade here would be 25%. Some traders dont like the idea of risking 4 to make 1, but if you try to get more aggressive with this strategy by doing a closer credit spread like the 490/485 instead, your risk of losing will go up.

If you are bearish, you can do the same thing with call credit spreads above the market price. I always look at out-of-the-money credit spreads because you want to take advantage of the time decay in options. The time decay is greatest in the front-month options that are about to expire. Ideally I would like to do a credit spread with 2-4 weeks until expiration, and then see those options expire worthless and look to do it again in the following expiration month. Credit spreads can give you market exposure with a high chance of winning. They are not foolproof, but they offer a better consistency get on base mentality for the conservative trader versus the home run mentality for the aggressive options buyer.

Click the Credit Spread Trading header link above for more information on trading credit spreads.

Good day and good trading.

Sunday, July 23, 2006

Fear of Trading

Todays article is on how you can create a consisent routine to be able to execute your investment and trading plan without hesitation after a losing trade.

Suffering from the fear of trading after a string of losses that many traders experience at one time or another is hard. The reality is that human beings tend to do things that either maximize pleasure or minimize pain. And not pulling the trigger on trades becomes a way for traders to minimize pain, as mentally the thought is that we are not causing ourselves any more damage if we do not trade. The problem is that we then remain stuck in a state of fear until we can trust our method again and start taking trades. This is why its so critical to have a trading plan that is tested and then be able to stick with it. Heres a game plan for getting yourself back on track:

1) Define Your Trading Plan - If you already have a plan, reexamine it. Are you following your rules for entry, exit and money management? Does your plan still have an edge in the current market conditions?

2) If In Doubt, Get Out - Who says you have to trade every day? If you are not pulling the trigger on your trades, it is because you lack confidence in yourself or your plan. Try taking a step back for a short while, where you consciously decide not to trade real dollars, but that you will work on paper trading your buy and sell signals. Sure, its not the same as trading real dollars, but this step allows you to work on executing your trading plan. I have found systematic trading to be much easier than discretionary trading, because it helps take my ego out of the equation. I focus instead on the execution of buy and sell signals, as opposed to my ego wanting to be proved right. Paper trading will allow you to get refocused on execution of your ideas.

3) Measure Your Results - Too often traders may have a good plan but then lose sight of measuring their results on a regular basis. What this leads to is that 90% of your trades may be done properly, but it is those 5-10% of your trades that eat you up with big losses. If you monitor your results closely, you should start to develop a Success Profile which defines what your best trades look like. Once a trade doesnt fit this Success Profile anymore, you should look to exit (whether at a profit or a loss) as your edge no longer exists.

Good monday and good trading.

Saturday, July 22, 2006

Asset Allocation

Make an Investment Plan For Your Life.

As we grow older and enter different stages of our lives, our financial requirements radically change. Therefore, investments that were perfect for us in our 20s, when we were just starting our careers are almost never the same vehicles that are best for us during our retirement years. To ensure that you have the resources you need for every stage of your life, it is imperative that you have an investment plan for each of those periods.

That is why no portfolio should be without an allocation strategy. Allocation simply means the mix of stocks, bonds and cash in your investment portfolio. A couple of rules of thumb:

1. Stocks tend to be more volatile than bonds, but have historically experienced higher returns.

2. The greater your expected return, the more volatility and risk you can expect.
Portfolio allocation will and should change as dictated by your personal lifestyle requirements. Here are some examples of typical allocations during different life stages:

Single, 25-year old, in first job after college.

Typically a renter, this investor would have no major financial responsibilities, except possibly the repayment of student loans. With 40 years of work and savings in front of her, she can afford an aggressive investing strategy. A portfolio of 80% stocks and 20% cash might suit her needs perfectly.

Upwardly mobile, single, no children, 35 years old.

Generally, this investor is a first-time homeowner, seeing healthy annual income increases, and beginning his prime earning years. He should concentrate on growth investments with the ideal portfolio consisting of 80% stocks and 20% cash.

Married couple, dual careers, 35 years old, 2 small children.

Will most likely have a mortgage and are trying to save for their childrens college education. In their prime earning years, they should maximize their growth investments, yet begin to consider some fixed vehicles. The ideal portfolio for them may be 70% equities, 10% fixed income, and 20% cash.

Example Married couple, 55 years old, with grown children.

Staring retirement in the face, this couple should begin thinking about preservation of capital and income needs. A portfolio of 60% equities, 20% fixed and 20% cash may be just what they need.

Retired couple, 70 years old.

A few years into retirement, with a life expectancy of maybe another 12 to 20 years, this couple wants to make sure their money lasts as long as they do. Thus, they need income as well as continued growth in the portfolio. They would do well to structure their portfolio to include 30% equities, 50% fixed income and 20% cash.

Widow, 80 years old.

A decade or so since retirement, this investor will generally have a life expectancy of another 5-10 years. In her years of retirement, she has probably figured out exactly how to live on the monies she and her spouse accumulated. Yet she is also concerned with rising medical expenses. After those two needs are met, she is most interested in preserving her capital for her heirs. Thus, she would continue to invest for income and want to remain very conservatively invested, with a sufficient cash position. Her optimal portfolio might consist of 10% equities, 60% fixed income and 30% cash.

No matter in which category you fall, you will need to go through the following process to determine the best allocation for your portfolio.

I. Determine your investment goals - What do you hope to achieve by investing?

Growth, or appreciation of value, is best achieved by investing aggressively in equities. The Dow Jones Industrial Average (DJIA) has averaged 11% per year since its inception. But remember: The higher your expected return, the greater the volatility in your investments.

Income-oriented investors should consider less aggressive equities such as mature companies with stable earnings that pay dividends. Additionally, they should consider adding fixed income investments such as bills, notes and bonds that provide a steady stream of income to their portfolios.

Fixed income is an excellent way to balance out the volatility of stocks and also helps hedge against stock deflation during times of higher interest rates.

Capital preservation is for investors who just want to make sure they dont lose their principal. The most conservative of strategies, it results in a portfolio that is defined as close to cash. Your returns wont be spectacular, but your principal will stay intact in spite of market fluctuations. An investor may choose certificates of deposits, government guaranteed investments, or money market funds.

Note: There are certainly more asset classes in which you can invest, including real estate, art, limited partnerships, commodities and many others, each with their own particular characteristics. You will need to decide if any of those investments meet your personal guidelines.

II. Your time horizon - How long before you need to access your money? Will you need it in five years for a downpayment on a home, in ten years to pay for a childs education, or in thirty years when you retire? And if the money is needed for retirement, how long do you expect your retirement to be?

Short-term. If your time horizon is less than 5 years, you should keep your investments as close to cash as possible.

Medium-term. If you dont need your money for at least 5 to 10 years, you can afford to consider a mix of equities, fixed income and cash - perhaps a 50%, 20% and 10% combination. This will be more volatile, but gives you the potential for much higher returns.

Long-term. The longer you hold an investment, the better off you will probably be. Although you will see bear and bull markets in the long run, historical statistics tell us that staying put through the lean times will result in a positive overall return for the market and your investments. A long time horizon lets you take more risk by investing in a heavier equity-weighted portfolio - perhaps as much as 80% -- and thus increases your return potential.

III. Your risk tolerance. Risk doesnt mean that you are going to lose your investment. It simply means the amount that your investments value will fluctuate over time. Risky investments rise and fall more at a more rapid rate than safer investments. The relationship between risk and return is direct - as your potential return increases, so does your level of risk. Remember that diversification among assets and categories within those asset classes reduces your risk.

Low - If you would not be able to tolerate a short-term decline in your assets of 10% or less, equities should make up no more than 25% to 30% of your portfolio.

Medium - If your risk tolerance is a little higher, and you could stand to watch your portfolio decline by 20%, keep no more than 50% of your portfolio in equities.

High - If you are more of a risk-taker and can bear a 30% to 40% short-term decline in stock prices, your portfolio can afford a 70% equity allocation.

Now that you have considered all of the above possibilities, it is time to develop your personal portfolio allocation.

I'll leave you with just a few reminders:

An investment plan is crucial to your long-term financial well-being.

Diversification among asset classes and investments within those classes is extremely important.

Err on the side of conservatism.

Start early and be disciplined in contributing regularly to your investment program.

I wish you the best of fortune in your investing future.

Have a good weekend.

Friday, July 21, 2006

Spreads & Pairs II

Yesterdays article I gave an overview of different types of spreads and pairs trading, and we looked at the myth (or at least partial myth) that spread and pairs trading is safer than going only long or short one side of the trade.

Today, lets look at the pros and the cons of spreads trading in general. Then next week we will look more in depth a the individual strategies for spread and pairs trading and see which ones are really being used, and which ones are just fodder for literature.

The Positives of Spread and Pairs Trading

Lower volatility: I mentioned that many folks are drawn to spread and pairs trading by the promise of lower risk. Whether you have lower risk vs. taking only a long or short poison in one instrument is really based on your position size. But what you really do achieve through spread and pairs trading is lower volatility. This is reflected in the margin rates that exchanges set for trading different instruments. Take soybeans for example. The Chicago Board of Trade sets the margin for one contract of soybeans at $750. But a for a month-to-month spread of soybeans (say short the November contract and long the January contract), the margin is only 135 dollars.

Most traders put on larger spread positions precisely because the volatility is lower. So be sure you manage your risk through normal position sizing practices instead of just assuming that lower risk will occur because of the nature of spreads and pairs.

Well established historical norms: For many types of spread and pairs trading, there is a good history of price relationships that traders can use to guide their strategies. Ratios between gold and silver and the typical price of a soybean crush (soybean prices versus a combination of soybean meal soybean oil) have been well established for years and the outer boundaries of those relationships are well known. Likewise, the price ratio between two stocks in a takeover arbitrage pairs trade is well established, allowing traders to speculate on the likelihood that the deal will fall through or on psychological factors that affect the ratio.

The Negatives of Spread and Pairs Trading

Transaction costs: The simple math is that you pay double commission and slippage for most types of spreads and pairs trading. In the height of the day trading feeding frenzy back in 2000, one of the biggest day trading brokers was extolling the benefits of pairs trading and doing everything they could to get their clients to do rapid-fire pairs trading. This, of course, was very self serving; what they were really interested in was doubling their commissions.

When things go wrong, they can go really wrong: One of the strengths of spread and pairs trading is that relationships between well-established spreads and pairs tend to move in very narrow price channels, but when those relationships are temporarily broken, they can move very far, very fast. And since this style of trading is done because its typically a low volatility trade, when volatility picks up violently, people get caught with large positions. An extreme example of this is in takeover arbitrage pairs trading. When company A buys company B, the ratio of their value is set by the terms of the takeover. The ratio usually trades at a slight discount to take into account the uncertainty that the deal might fall through. When the ratio gets a little wider people bet that it will return to a tighter ratio. However, when there are rumors that the deal will fall through or if it actually does fall through, anyone who is arbitraging the deal gets taken to the cleaners. It doesnt happen often, but when it does, it can be devastating.

Have a good weekend.

Spreads & Pairs

Spread or pairs trading takes many forms, but all with basically the same promise. The promise is for reduced risk because you are long one instrument and short another at the same time. That problem is usually not realized, as we will see later in the article.

All of the different styles of trading spreads and pairs have a common characteristic: they play one instrument versus another. Here are just a few of the many possible examples for this type of trading:

Futures spreads: This method looks to take advantage of historical price ratios. The gold vs. silver spread is a common one. Recently, gold versus crude oil has been popular. In general, its when the ratio between the commodity prices gets out of it historic norms, like when crude prices appreciated faster than gold last year. In that case, people would buy gold futures contracts and short crude oil contracts, expecting the ratio to return to the historic norms. There are as many futures spreads as your imagination can conjure!

Seasonal futures spreads: These spreads try to take advantage of seasonal tendencies. An example would be going long a spring/summer unleaded gas contract and short a spring/summer heating oil contract. More driving and less heating takes place in the summer, so if you looked at this spread over a long period of years, there is a positive correlation. Again, there are many examples based on harvest cycles, freezing seasons, etc.

Stock takeover arbitrage pairs: When one company announces the purchase of another, a purchase price is set. However, the stock still trades under its own name and symbol until all of the legal wrangling is completed. During this time, the ratio of two companies stock prices should theoretically be fixed. However, market and psychological factors allow the ratio to narrow and widen, and people then play the spread to again revert to the logical norm.

Highly correlated stock pairs: In this type of trading, highly correlated stock pairs are selected. Again, historical norms are developed (long and short-term) and then the one side of the pair is bought and one side is sold short in expectation of a return to normalcy. Typical pairs are SPY vs. QQQQ (though this has had a poor correlation lately) and semiconductor stocks like ALTR vs. XLNX.

Lets debunk one myth this week, and then we will look at whos looking at these different type of spreads next week.

First of all, lets look at the look at the myth of lower risk. From an absolute perspective, spread and pairs traders are right: if you buy 1000 shares of ALTR and simultaneously short 1000 shares of XLNX, you will get a smaller absolute range of movement or volatility than if you were only trading one side of the pair. The problem is, while you limit your absolute liability, you also limit your potential profit. So, what almost everyone does is trade bigger size to make up for the lower volatility! So practically speaking, most traders take the same amount risk trading spreads or pairs as when they are trading individual instruments.

Good day and good trading.

Wednesday, July 19, 2006

Trading Workspace

Now into the second half of 2006, what better time than now to address one of the most common questions we get - how does a trader setup his or her workspace? The reality is that we could write books on that topic alone. Today, though, I will just hit the key points you need to think about between now and next year.

Any Structure Is Better Than No Structure

One of the first questions everyone faces in trading is whether or not any kind of workspace/software/analysis tool is need to be a trader. Theoretically, no, all you need is a broker. But in reality, this game is just too hard to be winging it. So, at the very least, there has to be some sort of core process or focal point for your trading activity. I would estimate that for 99% of us, our core resource is our software and/or our data feed from our brokerage firm. Since we all can (hopefully) agree on that much, I wont belabor that point. However, there are some key components that every piece of software must have.

These are 1) The ability to simultaneously display multiple charts in multiple timeframes. If you cant do that, doing complete analysis can get real old real quick. At a minimum, we are looking at daily and weekly charts at the same time, and even intra-day charts when applicable.

2) A watchlist is essential. There are always more potential good ideas than actual good ideas, but you never know immediately know which ones are which. If you dont have an easy way to track them all, you'll probably miss most of the good ones.

3) A portfolio tracker of your real trades is also essential. Managing your open trades is half of this battle, but if you dont know what's going in, then you cant properly manage your account.

4) Finally, there has to be some sort of consistent way of getting trade signals within your workspace software. If you have to leave your workspace to go look for trade ideas, you're apt to wander aimlessly....and waste time.

Less Is More

That list of essentials seems like a pretty big one, but its really not. In fact, we have gotten most of our portfolios boiled down to just four screens.....two for charts, one for the watchlist, and one for the actual portfolio of open trades. And all four of them can fit on one computer screen at a time. The only other thing we don't have up all the time is our trade signal scanner, but thats just one click away in most cases.

We use several pieces of software, but one of the key ones we utilize is TradeStation.

Over the last few years, trading software has become tremendously powerful. Anything you can even think you would want, you will find it. In fact, there are more trading bells and whistles out there than anybody could ever fully explore in a lifetime. However, I caution you against being enamored with bells and whistles. In my observation, using complex software is almost becoming the focal point of trading, rather than making money. And as such, trading software has almost becoming more meaningful for computer programmers than traders. Tools are great, but never forget that your goal is to buy low and sell high. If knowing that the Detrended Price Oscillator is under zero helps you make more money, then great - use it!. But, nothing really says bullish quite as much as a chart thats moving higher. Thats why we try and keep things as simple as possible. Remember, less is more.

Less Typing, More Clicking

Every barrier you put up for yourself just makes it that much more difficult to trade effectively. And, using a keyboard can indeed be a barrier. Even if the only typing you do is typing in a ticker symbol for a chart, then its still too much. Hows that? While the physical motion of typing may only seem minor, its not. If you have to do it several hundred times a day, you will eventually stop doing it. The mouse is a much more effective way to navigate through your software, so, use it whenever possible.

Perhaps you're wondering how. In most of the newer trading software, there is a linking option between charts, watchlists, and portfolio positions. That just means when you click on a stock symbol, all of the charts (and maybe even a news or data screen) reloads for that particular symbol. Literally, you can sort through an entire watchlist, look at multiple charts, and even scan news headlines without ever touching the keyboard! What took several minutes (or longer) now just takes a few seconds......which means you will actually do it. If you have a linking option, and if you have workspace tabs. Please set them up so you can view everything you want to with little or no typing.

Sound crazy? I dont blame you for thinking it, but I promise you, once you do it, you will never go back. It's a huge help.

Things That Are Nice

While I dont consider any of these items essential, we highly recommend them if its at all possible for you to have them with your workspace.

1) A technical system builder or system tester. Are you trading on a hunch, or is a particular technical signal a proven winner?

2) The ability sort or scan by technical or fundamental criteria. Can you actually find the viable trade candidates?

3) Real-time data. Actually, real-time data is a two-edged sword. If you are going to see it and then act upon it, then its great. But, if you are just going to be hypnotized by it and watch the quotes stream by, then it's a liability. In that sense, real-time data can be over-rated. Ive known plenty of delayed data (or end of day) traders who have outperformed real-time traders.

Things You May Not Really Need

1) Level 2 data. Ive always felt that bid sizes and imbalances in the buy/sell balance are reflected in price changes, which makes level 2 data somewhat unnecessary. The exception may be for the scalpers or institutions who are trying to scrape up a few pennies.

2) Expensive software. In general, you get what you pay for, but there are a lot of exceptions to this rule when it comes to trading software. Ive seen overpriced, underpowered software, and Ive also seen free software that works very well. Be sure to test drive everything you are considering before actually paying for anything. And, dont assume you have to spend a ton of money to use effective software. The only thing your workspace has to do is work for you, which means it could cost little to nothing. That said, dont be afraid to spend a little money to own software that can make you a better trader - it will pay for itself.

Good day and good trading.

Tuesday, July 18, 2006

Efficiency Trading System

By Van K. Tharp, Ph.D.


This system was created for someone with good market knowledge but not a lot of time. It was designed for someone who can do a thorough analysis of the markets each weekend, who doesnt need to spend much time on the markets. This basically fits my position as a traders coach who has a little time to spend on trading.

Because many aspects of this system are discretionary, I have elected to present the portfolio monthly for the next 12 months to test it. This portfolio is being tested purely for educational purposes and it should not constitute investment advice.

In 2001, I followed a similar portfolio in Market Mastery for a little over a year. However, this was a long-only portfolio and part of my purpose was to show that you could find good long candidates in the heart of a bear market. There were some great examples in 2001 such as Deluxe Checking (now a probable short for this portfolio) and Autozone. However, by the end of the bear market, there was not a single stock with an efficiency rating above 10 and I abandoned the project. Since this project will have both long and short stocks, we should not have any such problems.

My Key Beliefs Behind this System

1) Trend-following works, so buy whats going up and sell whats going down.

2) Smooth uptrends (or downtrends) are more likely to continue than any other and one can find these through an efficiency filter.

3) Whats simple will work.

4) Let the market tell you what to do. If the market is mostly going up, then one should be mostly long. If the market is mostly going down, one should be mostly short. If the market is mixed, one should have a strong hedged position reflective of the overall market.

5) Have tight stops to begin with, but once a particular market proves itself, then let it run. (i.e., start out with a tight stop of about 10% of the price and then substitute a 25% trailing stop when that is closer than the original 10% stop).

6) When you find a better idea, get out of the dogs (the losers).

How the System Works

Market Filter:

Each weekend I will do an efficiency analysis of the market. I will determine the overall condition of the market by determining what percentage of the market shows a positive versus negative efficiency. For example, right now the market is 54% positive and 46% negative. This means my long and short positions should be equivalent (i.e., about 54% long and 46% short).

Since I generally plan to only have 10 stocks in the portfolio I will use the percentage of stock above +10 efficiency and below -10 efficiency to help in the decision. Right now there are 55 stocks above +10 (59%) and 38 stocks below -10 (41%). As a result, the portfolio will have six long positions and four short positions.


My long entries will be chosen from those stocks with efficiencies above 10. I will look at all of these stocks, beginning with the highest, and find those whos charts I think are the smoothest, but are not parabolic or into a major correction. This will be a discretionary process.

The specific entry will be to look for a retracement (in the hourly bars) and then a recovery during the week after the screening (hopefully one will occur on a Monday) and buy as the stock starts to recover.

My short entries will be the inverse of the long entries. However, Im not concerned about parabolic stocks on the downside. I am concerned about stocks in which the price is too low and gives us little price potential. As a result, we will not short any stocks below $3 and be very careful about any stocks below $5.


The initial entry will be a 10% stop. Thus, if I buy a stock at $30, I will sell it if it drops below $27 or 10%. This stop will not be moved as the price goes up.

The 10% stops will be replaced by a 25% trailing stop once we have a 3R gain. For example, if the $30 stock moved to $39, then a 25% trailing stop would take over (that is, the stop would now be $29.75 (i.e., instead of $27).

This system will give us a lot of small losses and some huge gains which fits my personality.

Other Exits:

Whenever our end of the month analysis of the market suggests a change in the long/short allocation, we will exit out of our weakest stock (even if it is showing a profit). For example, suppose that we start out buying six long positions and four short positions. In one month, the market shows us that we should be 70% long, instead of 60%. Under those conditions, we will exit our weakest short position and enter in a seventh long position. Similarly, if the market suggests that we should have a larger short position, then we will simply exit the weakest long position. This aspect of our strategy might mean exiting a position that is profitable or one that is slightly unprofitable.

Each weekend we will continue to do the efficiency scans. When a new stock appears that seems to be a better long or short than any of our current active positions, we will again exit the weakest position on that side of the market. Thus, if we find a great new long position, we will exit our weakest long position. And, similarly, if we find a great new short position, we will exit our weakest short position. This aspect of the system will also be discretionary. We will certainly exit 1) a barely profitable position, 2) a slightly losing position, or 3) a position whose efficiency has worsened dramatically for a better looking stock. However, we may not exit a strongly profitable position (even if it is weakest) to add a new position.

Position sizing:

We will risk 1% in each position. Since our initial stop will be 10%, this will allow us to have ten total positions. Ten total position is very easy to keep track of at any given time.


We will start with a $20,000 portfolio because I believe that this system can be done with fairly small size. That means that each position, initially will represent a $2000 investment with a $200 (10%) risk.

We will introduce the portfolio next week and update the portfolio on the third issue of the month each month. This process is being done for educational purposes and it will be based upon our end of the month analysis (so we may have entered into positions several weeks earlier). Should you decide to invest in any of the positions, please do your own due diligence and remember that the portfolio information will be two weeks old. Furthermore, since I do actively trade similar systems, I may or may not have some of the recommended stocks.

About Van Tharp: Trading coach, and author Dr. Van K Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors.

Click the Efficiency Trading System header link above to learn more about Van Tharp and his trading techniques and training programs.

Good day and good trading.

Monday, July 17, 2006

Parabolic Sar Trailing Stops

Every so often, the technical pundits try to kill off an indicator. This has definitely been the case for Welles Wilders beleaguered Parabolic Stop And Reverse (SAR) indicator system.

Introduced in Wilders landmark 1978 book New Concepts in Technical Trading Systems, it was presented as an always in the market system that, as its name implies, stops and reverses when the trigger point is hit.

The Parabolic SAR is basically a trailing stop system that starts far away from the price action (to give the trend time to develop), and then moves parabolically toward the price action as the trend matures.

As with all trend following indicators, when the stock was trending strongly, it was great at keeping you in the trend for most of the move.

However, during choppy markets, this indicator gets whipsawed in a real and serious way.

Now lets look at our market model questions for the Parabolic SAR:

Is it theoretically credible? Yes – it keeps you in long enough for a trend to develop and then does a good job trailing to catch most of the action of a big trend move.

Whos it most useful for? Long term trend followers. Could be useful as a stand alone system in strongly trending markets. But most use it as a trailing stop, not as an entry indicator.

How fanatic are the fans? Weak, actually. Many more people trying to shoot it down than carry its banner.

Is it being used by real-life traders? Yes. A surprisingly large number of traders use this as a trialing stop in a strategy with multiple complementary profit taking exits.

Take a look at Parabolic Sar for extending existing position profits.

Good day and good trading.

Saturday, July 15, 2006

Weekly Stock Market Outlook

NASDAQ Outlook

The NASDAQs close at 2037.35 last week was the result of a 92.71 loss...a 4.35% dip, which was the second-worst weekly decline we've seen all year. Along the way, we hit a new year-low of 2027.11, so clearly, the bears are going strong. However, although the momentum is technically bearish, could there be other signs that a bullish reversal is in the works? It's a real possibility.

In terms of momentum, we have to give the edge to the sellers. However, the tumble last week may have been a little too much, too fast. As a result, the odds favor at least a short-term bounce, which even has the potential to turn into a long-term rally. There are two key pieces of data we see that cue that possibility, but the philosophy of both is the same - last week was so bad, it may have been the final culmination of the selling effort.

Take a look at the lower Bollinger band (blue, dashed). The lower band line has been a reversal point, as we say in February and March. Or, the lower band line has been a guideline, allowing the composite to slide lower as we saw in May. But now, we are seeing something we havent seen this year. The NASDAQ is well under the lower band line, having almost made two bearish gaps on the way there. Either this is the beginning of a major breakdown, or we have finally hit rock-bottom with one major plunge. Either is possible, but given what we see with the VXN, we tend to expect the latter.

The CBOE Volatility Index (or VXN) is also dancing with its upper Bollinger band. It surged up to it on Thursday. Even though we actually saw the VXN close even on Friday - and slightly above the upper Bollinger band - its clear that the pace of VXN gain has tapered, even though the markets didnt. In fact, the VXN was pulling well off its highs from Friday, suggesting that investors were planning for bullish days, even though stocks were still sinking on Friday.

At this point its still too soon to call, but we do want to affirm that these charts are so overwhelmingly bearish, its a little suspect. It may well be a short-term capitulation. We will have an answer by Monday or so.

Nasdaq Chart

Click Here For Larger Chart

S&P 500 Outlook

The S&P 500 lost the least last week, only giving up 2.32%. The 29.3 point loss left the large-cap index at a close of 1236.20 on Friday. Unlike the NASDAQ, the SPX did NOT hit new lows, but being under all the key moving averages is bearish all the same. Yet, like the NASDAQ, there are some obscure clues that a bounce may be in our very near future.

Like the NASDAQ, things were awful last week for the S&P 500, yet there are a couple of signs that could mean we are at a bottom. The S&P 500s Volatility Index (the VIX) is also struggling with its upper Bollinger band line after reaching it on Friday. This suggests traders are easing out of the bearish positions they were in on Thursday, and scaling into bullish ones - albeit to a minor degree. Note how the VIX closed well under its highs from Friday. Simultaneously, the S&P 500 closed well above its lows from clearly somebody was buying then. Its particularly bullish, since the week was one of the worst in a long time, and should have spooked most everybody out of stocks. Instead, it looks like fear peaked, and now the bulls are trying to test the waters.

One of our other clues that we may have finally just hot a bottom is the extreme readings we have in our new NYSE highs and new NYSE lows from Friday. The data appears in the middle of our chart (in two separate sections). The levels were 25 and 217, respectively, which has historically been levels where bounces started. See early June for an example of how things can get so bearish, only buyers are left. The tricky part is a timeframe. Sometimes the uptrend is small and short, like Junes. Other times, we have seen it last for weeks, and generate some major gains. We never really know that for sure. What we do know is that a bounce is very very likely.

One last thought on the SPX...although we traded under this line on an intra-day basis on Friday, theres some loose support around 1236. Thats right where we closed out for the week, and its also where the S&P 500 found support several times in June. Just keep that line on your radar.

S&P 500 Chart

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Dow Jones Industrial Average Commentary

The Dow closed at 10,739 on Friday, or 352 points under the prior weeks close. Thats good for a loss of 3.17%. However, the Dow didnt make a new low for the year either. In fact, the Dow seems to have found support at the 10,700 area for the fourth time this year (with the first instance occurring in January). The bulls - whether they even realize it or not - have drawn a line in the sand at that mark. So, for the Dow, its truly a do-or-die situation right now.

Nothing really new here - the Dow got hammered like everything else, and the current momentum is bearish. But, like everything else. it got so bad last week, it would be surprising to not see an upside move.

The one thing we want to add (ok, need to add) here is the support at 10,700. Thats basically where we bottomed on Friday....and in June...and close to where we made short-term bottoms three times in January. That support is also what kept the Dow from making new lows for the year. So yeah, we think its a very important line. In fact, as far as support goes, its the one and only line to watch. If it breaks, and the other indices follow suite, stocks could continue to deteriorate.

Fortunately for the bulls, being stochastically oversold at the same time support at 11,700 has become obvious makes it much easier for other buyers to justify taking a chance on getting back into the market now.

Dow Jones Industrial Average Chart

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Friday, July 14, 2006

Trading Preparation

Ever wonder how some athletes get to be great, while others with much talent remain only good? While some talent is in-born, I believe the great ones cultivate a work ethic that is superior to those in the good camp. As the saying goes, the harder I work, the luckier I get.

Think about your preparation process as a chance to open you up to new opportunities. Do you prepare by rolling into the office soon before the market opens and glancing through the headlines to see which hot stock you are going to trade today? If so, I submit your preparation process is lacking, and as a result you are becoming too reactive as a trader.

Instead, do your preparation after the markets close the prior day, which allows you to get out of the heat of the moment and develop a plan to trade stocks based on your indicator setups. Then you can look for confirmation the following day as necessary. This allows you to be in a more proactive mindset, which makes you feel more in control of your trading destiny. Self-confidence is directly correlated with the traders perception of his level of preparation coming into the trading day, which leads to his ability to perform successfully. Good preparation also influences the skill level that a trader believes he possesses. You need defined time to prepare for the next trading day to build up your trading feel and confidence.

After the close, I run my computer systems for new entries and exits, open positions first, then look at my plan and trading rules. The next morning I like to get in earlier than most, when things are quiet and peaceful. I find this leads to a more serene and calm effect on my trading for the rest of the day, versus getting in late and feeling like I am rushing. Its like the common metaphor of believing in abundance versus believing in scarcity. By getting in earlier without the rush into work, I pre-program to execute trade with visualization techniques, do my self-analysis described above to make sure I am ready to trade, then I take action. After the close I then review that days trades, asking did I follow my rules? Then I run my computer systems and the cycle begins again.

One of the keys as a trader is that you must spend the time necessary to make trading skills automatic and create winning trading habits. If wishing to be immersed in total focus, you cannot be thinking about technique or strategy. As a beginning golfer I used to think a variety of swing thoughts Keep your head down, Left arm straight, etc. and then hit a rigid, weak shot because so much thinking was occurring that I could not unleash my fluid swings true inner power. Preparation and practice make for proper skill development. By making these actions automatic, the mind can be more purely focused on trading actions necessary to generate profits or reduce losses.

One final thought. Lets say the average trader prepares for an hour each day. If you prepared for an extra 30 minutes each day (90 minutes per day total), in a week you would have prepared an extra 2-1/2 hours, in a month 10.5 hours extra and in a year 126 hours or an extra 19 trading days worth of preparation. This extra focus on your trading goal will create new opportunities for you that you never before seemed to find in a timely way. Extra practice and preparation can give you a serious edge if you are willing to commit the time. Most arent willing to do this, and that is what separates the great ones in their commitment to superior performance.

Good day and good trading.

Wednesday, July 12, 2006

Demo Paper Trading

Paper trading will not teach you to be a successfull trader. Paper trading will only give you a false sense of security to lose your entire trading stake. Real money trading is the real true cost of admission to trading school and the best investment new traders can make when starting to trade. Forget practicing with demo trading accounts or doing it the manual way we call paper trading. Open a real live account, fund it, and trade it with the smallest positions possible until you become a successfull wining trader, and then you can begin to increase your trade size.

Practice does not make perfect. Only perfect practice makes perfect.
- Hall of Fame Football Coach Vince Lombardi

Many beginning traders and investors when using demo accounts or paper trading as we call it, find themselves thinking they have mastered trading. They have practiced and practiced using the technique called paper trading, but when they start trading for real with real money, they find that the vast imaginary wealth they amassed while paper trading has very little to do with trading in the real world.

Lets take a look at why paper trading is a poor way to practice. And then I will suggest some simple but effective ways to make big improvements in the way you play the trading and investing game.

Everyones A Genius When They Paper Trade

I have heard countless stories of people who racked up fantasy fortunes while paper trading. Theres nothing wrong with that. The problems come when people put real money in the market after their magical run-up in the paper world. Lets look at why paper trading often does more harm than good.

I use a model for understanding the process of trading and investing. There are three pillars to this model: trading psychology, trading systems and trading craft. Lets look at how paper trading prepares you, for better or worse, in all three areas.

Trading too big, too soon. The place where I believe that paper trading does the least to prepare a trader is in the area of tradecraft. I consider position sizing and trade execution to be parts of this broad area. The number one problem with paper trading is that it gives people a false sense of security. They see huge profits racked up and then jump right in with huge positions, looking to grow their account as quickly as possible. This is the exact opposite of the best trading practices. And it has led many accounts to a quick demise if other problem areas pop up while these huge positions are on.

Its also easy to see that paper trading does little to help you learn the execution side of the business. Learning a trading platform and how to enter orders is not rocket science. But almost everyone I know (including me!) has hit the buy button when they meant sell or vice versa, or entered 5,000 instead of 500 shares. These kinds of mistakes cost real money. But the real execution costs that are not captured in paper trading are slippage (the difference between the price you wanted and the price you actually got) and the cost of not getting executed at all. While these costs can be estimated in paper trading, most people dont have a good feel for the effect these costs have on the bottom line. And until you get caught trying to get out in a fast market thats moving against you, its hard to really understand the frustration of watching money slip away.

Trading psychology - you cant learn to control your emotions if you never have any. In the area of trading psychology, paper trading falls far short as a teaching tool. You really wont know how it feels to trade until you have some money on the line. There is a huge difference between writing down a trade on paper and seeing it move against you, and watching a real loss rack up against you. Many people feel that the most important aspect of trading and investing is maintaining discipline through the emotions that are generated while trading. You just dont get even 1% of those feelings when you are paper trading.

And speaking of discipline - when paper trading, it is far too easy to fudge the data, give yourself favorable fills, play the I meant to do that game and take advantage of other hindsight biases that make your trading results much better than they would have been in real life. Lets face it, when paper trading, we yearn to succeed. We want to prove how smart we are, and that we can conquer this difficult task. And this leads to conscious and subconscious bending of the rules. And all of the problems that come up in real trading can easily be overlooked by skipping an entry on the trade log or by a quick flick of the eraser.

Applying system rules - at last a place where paper trading is useful! The last pillar of good trading is developing and applying a trading system or strategy. And finally, we see the one area where paper trading is helpful. But to make paper trading a beneficial tool here, it really needs a new name, and a modified function. Lets call it paper testing. And lets use it to track system performance in real time using some other measure than money. I like to track points when I am following a new set of system rules to see how it performs in real time. I can track points in stocks, commodities or Forex trading. And when I'm compiling my data and looking at points won or lost, I can be more objective because my mind doesnt immediately think about the house at the beach I can buy with all of those paper profits.

A Much Better Alternative to Paper Trading

So if paper trading isnt the best way to test a new system, what should you do? Try this five-step approach:

Develop and back test your system or strategy. This can be done with computer software or by hand, looking back at charts.

Do real-time testing on live data. Keep track of points won or lost and not dollars and cents!

Instead of paper trading, use real trading, in very small size, to practice. Stock traders can trade 10 share lots. Commodity traders can trade e-mini contracts and forex traders can trade mini forex contracts.

Once you have been consistently profitable, only then can you ramp up your trading size.

Ramp up slowly.

Paper trading is not evil. It just isnt the best way to practice trading. Just like playing a video game and playing the real game, you can only learn the real game if you step onto the field.

Good day and good trading.

Tuesday, July 11, 2006

Trading Systems

Today, I will discuss the facts about trading systems.

When moving from one market to another, you surely must reoptimize if using the same system.

Fiction - Many of our systems that work for domestic stocks also work well when used with currencies and with international stocks. If you have the time, try to reoptimize though. The reason many systems work across different markets is the human factor. If the system is based on sound logic and human behavior, its likely that it will work in many different markets. After all, humans tend to fall into behavioral patterns.

Drawdowns and profits during testing are the same once you start trading.

Fiction - In our search for systems, we tend to look through biased glasses. That is, system-testers tend to over-fit and over-optimize systems to fit history TOO well. Therefore, the only way for the profits to be just as good, is if history repeats itself exactly as it did during the test. For this reason, back-tested results tend to be worse than actual results. Occasionally, unusual market conditions do occur like during 2000-2002. During this period, bear systems worked even better than most back testing just because of the market conditions. But in most instances, back-tested profits tend to be higher than actual profits. As far as drawdowns go, they tend to be larger in real life than they are in back-testing. Part of this reason is that the computers cannot perfectly simulate actual market conditions including slippage in fast moving markets.

Profiting from markets is not that extremely complex, therefore simple approaches often work.

Fact - If you specialize in trending markets, its not that hard to tell whether or not the market is trending. All you must do is pick a security (for example the S&P 500), test and find the average length of a trend. Since history tends to repeat itself (particularly in short-term periods) you can use the average length of trends to determine when the market is trending. You can also use indicators like ADX, to determine when the market is trending based on trading rules that can be programmed into your computer. If you specialize in overbought/oversold markets, simply test just as mentioned above on specific indexes or else on broad lists of random stocks and watch for recurring patterns. Oversold and overbought can be defined using averages over many stocks over many different time periods.

Since there were 66 up years in the 1900s and 33 down years, we recommend testing periods where there were 2 years up and 1 year down. Will history repeat itself exactly in the 2000s? Probably not, but think about this: almost every decision you make is based on historical probability. For instance, you are expecting the sun to rise tomorrow because it has for the last 300 million years or so. Probability is on your side. You are expecting there to be 12 inches of rainfall this year in your city because for the last 10 years, the average has been 12.1 inches. Probability is an excellent tool, even though there are no guarantees.

Since markets are constantly changing, you should reoptimize constantly.

Fiction - If a strategy is truly based on sound logic, reoptimization to fit recent data is unnecessary and potentially hazardous. Current market conditions may not last long and its difficult to gauge this regardless. If you have done a good job with the original tests, that is you have tested during bear, bull and sideways markets, then your system should enter the market with a high probability of success.

All this being said, it does not hurt to reoptimize using larger amounts of data. For example: If you optimized length for ADX across 100 stocks to determine the optimal levels, then it only helps you to go back and test across 300 stocks instead. There is such a thing as a diminishing return on time invested time though, so keep this in mind. This basically means that going from 10-30 stocks improves optimal levels a great deal, but going from 250-300, does not improve the levels to the same degree.


Try your best systems across various markets - it often works. Be more conservative with your expectations after back-testing. A healthy skepticism is good for traders.
Simple systems work. Develop them and use them. Reoptimize, but don't over do it.

For more information developing and back testing trading systems, click the Trading Systems header link above.

Good day and good trading.

Monday, July 10, 2006

Trading Resolutions

At the beginning of this year, I talked many times about regarding how to improve ones trading. One of them was a set of new years resolutions, while the other was a set of guidelines on the establishment of a trading plan. Now at the halfway point for the year, its time to look in the mirror and own up to your actions and subsequent results.

Mid-Year Reality Check

If you are not satisfied with your trading in the first half of the year (or even if you are satisfied), facing these truths will put you much further along the road to improvement. The trick here is to be honest with yourself. Nobody else has to know your answers, but I do recommend putting your responses down on paper. After all, seeing the reality on paper has a special way creating the necessary change. Ask yourself the following questions:

1) Did I apply a proven trading system to all of my trades?

2) Did I apply a disciplined stop-loss approach to every trade?

3) Did I track my results on a daily, weekly, or monthly basis?

4) Did I review my winners and losers to determine exactly why they were winners or losers?

5) Did I invest in myself or my trading knowledge?

6) Did I find and develop my own ideas, or did I let the media determine what I would focus on?

7) Did I set specific goals that would in turn determine my trading activity?

If you said yes to all of these things, then congratulations - you probably did better than about 98 percent of traders. If you said no to three or more of these questions, you probably already know that you are not yet reaching your full potential. But dont worry, since the years not over yet. I make this challenge to you. Before the end of the day, write down exactly how you are going to turn your no into yes. And I cant stress enough, it has to be done today. If you put it off until tomorrow, it will be too easy to put it off again until Friday, and so on. Plus, you will be training yourself to be a procrastinator. If you do it today, you will be training yourself to be pro-active, and to take action. Your decision to write down this plan before you finish your day is a powerful indication of just how committed you are to trading success.

The New Year Resolutions

OK, we mentioned above that the mid-year checkup was largely based the new year resolution list sent out in January. To make sure you have the right foundation in place to even go through todays exercise, its worth reprinting them here. These are just a few possible resolutions, but the important part for you as a trader is to set self-management rules that you are committed to, and that are acheivable.

1. I will not trade every day just because I feel as if I have to.

2. I will develop a proven trading system, and realize that one bad trade does not negate the system.

3. I will set profit targets, and will take those profits when they are achieved. I will not change targets in an effort to create just a little more profit.

4. I will not let emotions sway my trade decisions.

5. I will approach trading as if it is a business. I will be strategic, and logical.

6. I will learn something every day, no matter how small, that will give me a greater trading edge.

7. I will keep a trading journal, and note when and why my analysis failed and succeeded. I will review this journal weekly.

8. I will not fight the market. I will capitalize on whichever direction the market is going.

9. I will take small losses rather than let them become large losses. I dont have to be correct with every trade.

10. I will become an expert in one area of trading, whether it be options, one certain stock, or an index. I will master every detail particular to those trades.

11. I will invest in my success, whether it be a book, market data, or a trading coach.

12. I will act upon what the market is doing, rather than what I think it should be doing.

Good day and good trading.

Sunday, July 09, 2006

Market News

It was an interesting past couple of weeks with alot of gyrations and news. At the top, the Fed had another meeting and concluded with another rate hike. Number seventeen in their series. Some interpreted the language in their statement as somewhat dovish, which stoked a heavy rally on Thursday. There is a clear sense of relief, likely short-lived. The intermediate trend is still down, but may have shifted short-term neutral. Gold put in another strong performance as did oil. Rates dropped after the rate hike, as bonds are speculating the end of rate hikes are near. Sentiment cooled to a more subdued level as the VIX dropped sharply. End of the quarter window dressing along with short covering pretty much covered the action. All major indices are still below significant resistance, and until a major breakout occurs...must be considered in context. We will get some more data in the coming weeks on the economy.

The Fed on inflation today and tomorrow.

Inflation, as consumers and investors, we all fear it. It decreases buying power and weakens currency, among other things. In extreme cases, prices spiral out of control and puts incredible pressure on the economy. The Fed tries its best stay ahead of the curve by increasing rates and pulling the plug on monetary supply. In the past, this has worked to squash inflation and its expectations by controlling growth. Another way to view inflation is from a commodity perspective. A general rule is: as commodities rise, inflation tends to follow. Why is this? Generally, commodities are inputs that go into the manufacturing of products. As these input costs rise with a solid demand, manufacturers must pass these higher costs onto the end user or they will suffer net margin erosion. Competition will certainly keep a lid on extreme price increases, however if the margins are not to the liking of equity investors, then capital will flow away from these investments (companies) into others more appealing. Another sign of inflation comes by way of employment. As the job market tightens, there are few available workers in the pool for businesses to hire. The old adage of supply and demand holds...strong demand coupled with dropping supply means prices this case, the 'prices' are wages, which cuts against the bottomline...much like the rise in inputs, firms must raise end user prices to offset the hit to margins.

So, what are these signs telling us and the Fed? Well, certainly Fedspeak over the last couple of weeks has been quite hawkish. The recent data on CPI have pointed to higher rate of inflation (core) than is comfortable. In fact with the rencent rate hike, the language of the statement still seemed rather hawkish toward inflation. Commodities had a huge run in May and pulled back, but look to resume their uptrend. Money supply is still rather loose, regardless of what the pundits are saying. We will get a reading on employment data this week, but the markets have been tight for several months.

How will all this affect the markets? If the data is clear, it wont be a positive. But with the proper spin, markets can dodge the facts in the short run. Money continues to chase assets, and when the money flow spigot is turned off. In other words, when the buyers are done, sellers will re-appear. And as we saw in May, they will show no mercy.

Good week and good trading.

Saturday, July 08, 2006

Weekly Stock Market Outlook

Nasdaq Outlook

The NASDAQ was all over the map last week, hitting a high of 2190.44, and a low of 2126.64, before settling into the close at 2130.06. That was 42.03 points (-1.9%) below the previous weeks close. And more than that, things ended on a sour note, or heading lower. Yes, the composite is in some serious technical trouble...again.

At this time last week, we were talking about some bullish hints from the NASDAQs chart. But, a missile test in North Korea started a selloff that ended up snow-balling into something pretty rough. The composite fell back under its 10 day moving average, and is pressing into the 20 day line as of Fridays close. The volume behind the move wasnt higher than usual, but it wasnt weak volume either. As of right now, the bears have the momentum.

Plus, the CBOE Volatility Index (VXN) is back on the rise. After hitting its lower band line two Fridays ago, support was found, which pushed the VXN from 17.89 to 20.17...with more room to go higher. The VXNs upper band line is at 25.58, and based on the way its been ranging between those bands, theres a real possibility the VXN could end up retesting the 25 area. If it does, it will coincide with weakness for the NASDAQ.

The other side of the coin, though, is this...we're still above the 20 day line, and its not clear if last weeks bearishness will persist. It was mostly caused by a combination of geopolitical worry, and choppiness associated with summer months. We dont want to count it out yet, even though the chart looks a little ugly right now. If the 20 day line fails to act as support, and/or if the VXN creeps higher, then it will be easier to justify a cancellation of our prior bullish stance and the issuance of a bearish one. Stay tuned - we may have our answer by Wednesdays MidWeek Update.

Nasdaq Chart

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S&P 500 Outlook

Despite the bearish Friday, the S&P 500 only gave up 0.37% last week. The close at 1265.50 was just 4.7 points under the previous Fridays close, and perhaps more importantly, NOT under some key support levels. The bulls still need to do some work if they hope to survive, as the momentum is clearly to the downside. But, they will at least have the help of long-term and short-term moving averages.

In fact, from a technical perspective (and unlike the NASDAQ), the SPX is still in an uptrend. The 10 and 200 day lines that were crossed on the 29th of last month are actually acting as support now. Both are currently at 1263, which also happened to be the low for the week (from Friday). And like we said, the S&P 500s loss was week was minimal.

Whats interesting here is the CBOE S&P 500 Volatility Index (VIX). Unlike the VXN, the VIX isnt really moving higher with any conviction. It gained only 0.89 points last week, ending Friday at 13.97. More than that, where the 15 area had been support, its now acting as resistance. For that matter, the VIXs 10 day average is also acting as resistance, so we cant be too quick to say the VIX is heading higher. Its obviously not going lower, but at this point, we cant get bearish on stocks based solely on the VIX. So, unlike the NASDAQ, the SPX isnt fighting an uphill battle.

All the same, we do have a lot of bearish concerns. The NASDAQ usually leads the market (both up and down). Seeing it do so poorly last week, we have to think it will begin to be a drag on the rest of the indices soon. We reserve the right to cancel that stance at any time, but in general, its an accurate indication of whats in store...despite the S&P 500s generally bullish chart.

S&P 500 Chart

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Had it not been for 3Ms (MMM) 9% selloff on Friday, the Dow may not have lost the 1.2% that it did, and the blue-chip index would have once again been the strongest index (on a relative basis). But, thanks to 3M, the Dow lost 0.53% (-59 points) for the week. It ended at 11,091 on Friday...and under a couple of critical moving averages.

For a few days, it looked like the Dow might topple the 50 day line...the last of the key moving averages standing in the way of a breakout move. But, as of Friday, we are back under it. We are also back under the 10 and 100 day moving average lines. All of them are bearish omens.

However, there is one last bastion of hope for the Dow bulls. After hitting this years low of 10,698.90 on the 14th, straight-line support has been established by three distinct lows (one of which was Fridays low of 11,066). Its the upward-sloping dashed line on our chart. Its partially significant, but we dont expect it to be a major factor in any decision the bulls may make about staging a rally now. The more important support line is the 20 day line, at 11,011. As for resistance, its at 11,280. Thats (roughly) the area where the Dow began to struggle after two of the last three rally efforts.

In the meantime, the Dow is a above the 200 day line, currently at 10,920. Thats bullish. However, the bulls faded quickly last week, and set some mild bearishness into motion. We still think the Dow will lose the least in a broad market selloff, but a loss is still a loss. We wouldnt expect to see the Dow move any lower than the 200 day line though. If resistance is broken at 11,280, the bearish view will be retracted, as it will probably indicate a bullish breakout.

DJIA Chart

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Hedge Funds Update

There was a reversal by the District of Columbia Court of Appeals on the SEC requirement for hedge funds to register. If you read the brief 19 page ruling, it is clear that the Court did not buy into the argument of the SEC about the meaning of the word client, which was the legal basis for the SEC to require hedge funds to register. While I am neither a lawyer nor the son of a lawyer, it appears to me that they did not offer any other suggestions for the SEC to take another tack in their effort to regulate hedge funds. It will be interesting to see if the SEC tries to appeal what the court felt was such a clear cut case.

That should put it back where it should have been three years ago, squarely in the lap of Congress. Congress needs to re-visit the whole body of rules surrounding hedge funds. They were written in a bygone era when hedge funds did not exist, and have forced what is now a significant portion of the investment world into participating in unnatural business practices in an effort to remain legal in the US.

What other industry would limit the number of customers or not be allowed to advertise when they have good results, let alone be required to discriminate based upon the wealth of their clients? These are just of few of the unnatural acts which I think should be eliminated.

Testimony before Congress three years ago that we needed to create a Hedge Fund Investment Company Act which would normalize the industry and allow for hedge funds to come out from in the cold. It would provide practical business incentives for even a small fund to register (rather than being very punitive as the recent ruling was), allow for common sense regulation where needed and level the playing field for all investors.

Take care and have a good weekend.

Thursday, July 06, 2006

Open Interest

What is open interest and how can we profit from it? As you know, the more tools you have, the more opportunities you have in different market environments. Lets start by defining open interest: open interest is the total amount of contracts held by buyers or short sellers at a given time on an option or futures contract. Open interest goes up and down when new contracts are created by buyers and sellers. On the other hand, open interest falls when both the option buyer and seller close out their positions and the contract disappears. Keep in mind that open interest only changes when new contracts are created. For instance, when a bullish trader sells his calls to another bullish trader, open interest remains the same because a new contract is not created.

Today we will talk about options on major ETFs like the SPYs and the QQQQs, and also options on large cap stocks like Microsoft and Google. First, lets look at options on major indices such as the QQQQ, and SPY. Options on these securities are often used as hedges. Believe it or not, open interest often changes according to seasonality and according to the calendar on some securities. This is due to large hedging positions that certain institutions use. For example, many tech-heavy portfolio managers buy QQQQ's puts at the beginning of each quarter for hedging. The same goes for SPY's.

Open interest tells you about the battle between bears and bulls and its important to take a note of changes in open interest in the midst of rises and falls in the underlying security. When open interest goes up for calls, this is a bullish sign when you are in a bull trend. The opposite goes for puts. Watch trends closely because if open interest rises for calls during a bull trend in the stock, its likely that the bullish trend will continue. However, if open interest begins to decrease, its likely that a trend will end soon. Also, if the rise in open interest stops during a bull trend, it tells you that a trend is starting to weaken and may reverse soon.

Rules to Profit From (QQQQs, SPYs, and other securities used for hedging)

Here are some rules you can use that apply to call options. You can reverse them and use them on puts as well. When open interest increases on calls during a bull trend, the uptrend is confirmed, and it often a green light to add new call positions. When open interest rises during a bear trend, it means that a lot of value-buying is occuring and it may be a great time to buy puts because many of the value buyers may force stock prices down as they bail out of their losing bullish positions. If open interest rises on puts while the underlying security is in a trading range, this is often a bearish sign. This means that savvy institutions are likely to sell short at least in the short-term.

Rules to Profit From Stock Options

The rules on stock options are different because most options on stocks are used for speculation rather than hedging. Because of this speculation, most option buyers are wrong. They often buy puts as stocks go through powerful bull trends, and they buy calls when they are in powerful bear trends. Ultimately, you will notice that option buyers switch their sentiment from calls to puts or vice versa at exactly the wrong times. Follow these rules to gather profits: When a stock is in a powerful bull trend, and the put to call ratio on the stock remains steady or increases, put buyers are non-believers in the trend. It is likely that the trend will continue. When the put/call ratio on a stock suddenly changes in powerfully trending stocks, the trend is likely to reverse. This change in the put/call ratio indicates that the trend is probably weakening. Use these contrarian tools to profit from open interest and equity put to call ratios.

Good day and good trading.

Tuesday, July 04, 2006

Risk Reward

Its important to quantify your expectations for how much risk you will take in each position, and how much reward you think that position will offer you. Its also important to follow your stops and your targets, as these reward and risk levels set in place the expectancy you have on the ultimate success of your trading method.

It seems many traders have been so beat up by the market volatility over the last couple of years that they are doubting their methods and looking for new techniques.

The first recommendation I have for you is to read one of Van Tharps books that deals with the concept of expectancy. The one I read was Trade Your Way to Financial Freedom. Van Tharp is a well-known trading coach dealing with many of the issues most traders most overlook, particularly trading psychology and money management or as Tharp calls it, Position Sizing. The concept of expectancy is often misunderstood by many traders, as I get questions all the time asking about my various services winning percentage. Win percentage is half of the equation; the other half is the size of the average winner compared to the size of the average loser. If I can win 5 times as much on average as I lose, then a 1 in 3 winning percentage will still make for a very profitable system over time. This is a typical profile of most systems, as time decay and stops will reduce winning percentage but the size of average winners should be 3 or more time the size of the average loss.

Another key point I took from Tharps expectancy discussion is that good trading comes down to low-risk entry. This means that you should put your positions on at points at which you will know quickly whether you are right or wrong. If you are wrong, thats OK, but the key is to be wrong in a small way, take your loss quickly and get out. If you are right, then you can have the 10-bagger or more situation where you are winning more than 10 times what you could have lost. That again allows you to take a series of small losses and still make money over time.

As far as trading techniques that give me a positive expectancy over time, here are some of my favorite indicators that allow me to define the best opportunities:

1. Fibonacci Retracement and Extension Levels
3. Stochastics Confirmation
4. Average Directional Movement
5. Momentum Divergence
6. The Volatility Index (VIX)

To learn more about Van Tharp and his excellent trading books and courses, click the Risk Reward header link above.

Good day and good trading.

Trade Types

There are four terms that describe different types of trades: Day, Swing, Short-term and Long-term. For todays article, I thought it would be good to go over each of these different types and discuss the unique aspects of each.

Day Trading includes trades with very short holding periods. These trades are entered and exited during the same trading session, lasting anywhere from a few hours to just a few minutes. Sometimes the trader is attempting to make money off the bid/ask spread or inconsistencies in price that develop for other reasons. Sometimes the trader is simply using technical analysis practices similar to what is used for any other time period; day traders are just looking at much shorter intervals. One of the problems with day trading is that you will be subject to pattern day trader rules that are imposed on all brokers, and therefore private traders, by the SEC. You are classified as a pattern day trader if you enter and exit a trade, on the same day, four or more times in any five-day period. Pattern day traders generally must keep a minimum amount of equity in their margin account of $25,000. This is a bit more money then the average trader has to work with, so most of the time people who day trade often are professional traders with plenty of capital to work with.

Swing Trades are held overnight for at least one night but can last for up to about a week while short-term trades usually up to about a month or two. Most of these trades are completely based on technical analysis of some kind. Usually this is a system of oscillators or overlay indicators such as Stochastics or Parabolics that the trader has devised to provide quick gains in a short period of time. Sometimes these trades are event driven, meaning that the trader takes a trade based on what he/she thinks might happen after an earnings report, for example.

Long-term trades can last for several months or sometimes for even more then a year and often blur the lines between trading and investing. The difference being, that trades are based on historical patterns of a stock while investments are entered based on an evaluation of the companys current and future business prospects. Sometimes fundamental data, such as P/E Ratio or Market Cap can be used in a way similar to technical data (i.e. your system works best with small cap stocks so that is one of the filters on your system).

This is a very basic guide. Ultimately your trading style is based on the system that you develop for yourself, how much risk you want to take, how much money you can devote to trading and how much time you can spend on it every day.

Don't forget about the $9.99 video sale at the Invest Superstore. It's on till the end of July. Click the Trade Types header link above to see the big selection of the videos on sale.

Good day and good trading.