Thursday, August 31, 2006

Value Investing

Value Investing is Back in Vogue. With the markets state of turbulence, investors are scurrying to find those hidden gems that are not only trading at bargain prices, but which also have some hope of surviving - relatively intact - from the ups and downs of market volatility. Thats why an increasing number are tapping into that old standby that can be counted on through thick and thin: value investing.

Value investing is simply investing in companies whose shares are temporarily trading at lower prices than their true worth.

In 1934, Benjamin Graham, with his colleague David Dodd, co-authored Security Analysis, the primer for value investing. Many editions later, the book has become the bible of security analysts nationwide.

Graham felt that too many investors were speculators - buying or selling simply because a stock or the market went up or down, investing in hot stocks, and margin buying - all trends of the era in which he grew up. He lived through the debacle of the 1929 crash, the bank closings and the utter loss of confidence in Wall Street. He knew for confidence to be restored, and for corporate America to obtain the funding needed for expansion, individual investors would have to be brought back into the fold.

Graham proposed that the foundation of sound investing should not change with the whims of trends or the winds of time, but should be altered only as a result of important economic and financial changes. Such events might include changes in interest rates, inflation, the trend toward mega-corporations, or significant bankruptcies - all occurrences which might alter the way a stock is to be valued - quite a different train of thought than what was currently espoused by the professionals. You might imagine how popular that advice was with the Wall Street crowd!

The father of value investing felt that a good investment should be a company that was worth considerably more that what its stock was selling for. He calculated this value of a company by estimating its future earnings as well as taking into account the worth of its assets - what would be the value of this business to someone interested in buying it. And although even during Grahams day, there were always analysts ready to build a mountain out of a molehill, cranking out scores of ratios to analyze one company, Graham felt that just a few - the most important - criteria would do the job.

Graham especially liked to invest in companies whose earnings were reasonably stable, with good growth prospects. Additionally, he required that they be conservatively financed, large companies that paid dividends, and had price-earnings ratios of less than 25. And he found legions of such companies - many that were selling for less than their net working capital (current assets - current liabilities). But for some reason, the stock market and the market pros were underestimating, or undervaluing the potential of the companies' earnings, resulting in an undervalued stock price.

Grahams success was legendary. During his most active years - from 1936-1956 - he consistently posted annual returns of 20% plus, while the S&P 500s performance ran around 14%.

And his legend lives on. One of his most diligent students at Columbia University was Warren Buffett, who followed Grahams teachings and became even more famous than his professor.

While Benjamin Graham introduced value investing to the investment community, Warren Buffett actually formed a company whose sole purpose is to value invest. He is chairman of Berkshire-Hathaway (NYSE: BRK-A) - a holding company that is essentially a portfolio of the stocks of businesses he has bought over the past 50+ years. And along the way, he has expanded on Grahams version of value investing.

Like Graham, Buffett seeks those companies that are undervalued in terms of todays numbers. He certainly looks at future earnings but doesnt rely on them to make a buying decision. He expresses this concept by saying, Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. His secret to Wall Street riches is simple: You try to be greedy when others are fearful and you try to be very fearful when others are greedy. Alternatively stated: Dont follow the crowd.

Buffett believes that research is the key - nothing beats old-fashioned elbow grease. He disregards hot tips, sets his goals and targets for the company at the time he buys the stock and believes that too much diversification - what he calls the Noah School of Investing, or buying two of everything - is not prudent. In fact, Buffett tends to take rather large positions in the companies that he owns in his Berkshire-Hathaway group, and keeps his portfolio fairly lean, in terms of numbers of companies.

That focus on a smaller group of investments led to one additional criterion that Buffett added to Grahams model and ultimately made his trademark - he believes in really getting to know the companies in which he invests. That means personal visits and conducting ongoing communication with the decision-makers. But Buffett takes that step even further. He also gets to know the company's customers, suppliers, and its competitors.

Another expansion of Grahams strategy is Buffetts addition of qualitative factors to the investment equation. While Graham certainly considered whether or not management was strong, efficient, and cost-conscious and that the company's products seemed worthwhile, Buffett also looks at more intangible qualities, such as franchise or brand name value. For example, before he bought Disney stock for the first time, he factored in the value of Disneys huge movie library, which did not show up on Disneys financial statements at that time.

This led to Buffett changing Grahams concept of the worth of a business by adding such intangibles to a companys book value, which is basically defined as a companys assets minus its liabilities, or the capital that has gone into a business, plus retained profits. Together, the actual balance sheet figures plus the intangibles, add up to the intrinsic value of the company.

And lastly, Buffett enlarged Grahams definition of risk to include the risk of paying more than a business would prove to be worth.

Buffett has often been maligned in the media for his conservative investing practices. He has always avoided what he calls fashion investing, or buying into go-go stocks. And he has stated more than once that investors should only buy stocks within their circle of competence, meaning if you cant explain it to your 90-year old grandmother, you shouldnt spend your hard-earned money on it. His portfolio has always consisted of household-name companies, including Coca-Cola, American Express, Disney, the Washington Post and GEICO.

In the late 1960s, he was attacked for staying out of the hot electronics sector and retaining his old-line retail stocks. But he had the last laugh there, just as he had during the recent technology boom. At the turn of the millennium, Buffett was crucified in the media and called a has-been for admitting that the business of most of the hi-tech stocks was over his head and he was sticking to his knitting. As time would tell, he was right again.

And Buffett has the juice to back up his strategy. For the last 200 plus years, the stock market has averaged 11% annual gains, while Buffetts average annual return since 1951 is around 31%. And he inspired countless other value investors, including Peter Lynch.

Click the Value Investing header link above to learn how to invest like Warren Buffett.

Good day and good value investing.

Wednesday, August 30, 2006

Straddle Options

I often get questions about the right time to use different option strategies. Read on below for more on why now may a good time to consider the straddle options strategy.

Question: Will the straddle work or even make sense with index options like OEX? I would given up on individual stocks and have been trading OEX options exclusively for a few months now. I notice that, except for the price of the premiums, it seems to make little difference in volatility, etc. if I buy the OEX options in or out of the money, so I buy them out of the money for the cheaper premiums. I remember reading about straddles and spreads once, and correct me if Im wrong but the behavior of options on individual stocks seems to depend on whether they are in or out of the money, and I thought that was the key to straddle/spread strategies. Am I correct in thinking that these strategies wont work for index options? If not are there similar strategies that can be employed that do work to hedge risk and make money both ways with index options like for OEX?

Answer: First, heres how a straddle works. Lets say XYZ shares are trading at 50 and you expect the stock to be volatile, up to the 60 area of higher or down to 40 or lower over the next several months. The only issue is that you dont know which way its going to move first. The straddle purchase is an option strategy which can get you on board the start of a big move.

By purchasing both the 6-month XYZ 50 call and simultaneously buying the 6-month XYZ 50 Put, we now have a position that can benefit as long as XYZ shares are volatile as predicted. When you buy the same strike price on both sides, its known as a straddle. If the strike prices are different, its called a strangle. The key to success in buying straddles is what you pay for the call and put option, relative to the volatility which actually occurs. There are several factors to consider in getting the cheapest straddles which can offer the greatest leverage in a potential volatile move:

1) Time Decay - When we buy an at-the money straddle (where the strike prices of the call and put are roughly equal to the stocks price), we are buying all time premium on both sides of the market. That means that if the stock does not move very quickly in either direction, then our decay rate of the options will accelerate as we get closer to options expiration. As a result, you dont want to be a buyer of options with 1-2 months before their expiration. The time decay is simply too great to overcome. But if you buy options with 4-6 months of time remaining, the premium lost in the first month will not be as dramatic if you have to wait initially before the anticipated big move occurs.

2) Current Volatility compared to Historical Volatility - You dont want to buy a straddle on a stock that is currently near its highest ever volatility, as the risk is too great that the stock will become less volatile and the options premiums on both sides will collapse. You want a tool to tell you the percentage ranking (0% being low and 100% being high) of the stock's current volatility compared to its historical volatility. Larry McMillans website has a nice volatility calculator which can tell you the volatility percentage ranking, so you can make sure to buy your options when they are historically cheap.

3) Volatility Can Behave Differently on the Way Down vs. the Way Up - Typically the volatility in a stocks options will be priced higher as the stock drops. But as the stock trends higher, I have often seen the stocks volatility stay stable or even go down well into a steady rally. So you may want to be more careful about putting on straddles after a meaningful decline, which being ready to jump on steady uptrends when you think they appear to be peaking out.

Answering the question more specifically now, I prefer to buy straddles on individual stocks instead of the indexes. With 100 to 500 stocks in an index, it makes the really volatile movement in the index less likely than the individual component stocks that make up the index. As a result, my favorite options strategy for the indexes tends to be the credit spread. Ive often found that the index does not move as far in either direction as the volatility would suggest. This makes for a better situation selling options instead of buying them.

With the CBOE Volatility Index (VIX) currently hanging around the 12% level, thats a relatively low reading in the last several years. So with a seasonally weak approaching in September & October, I encourage you to look for stocks which should be volatile but their total premiums are still attractive. I generally would like to be able to at least double my total investment in a straddle to justify the capital risk. Another strategy is to sell one side when that side hits a 50% loss and seek to let the other side run (assuming that remaining side is still profitable). So you can convert a non-directional strategy like a straddle into a directional play once the trend starts to assert itself.

Click the Straddle Options header link above to learn more about option trading strategies.

Good day and good trading.

Tuesday, August 29, 2006

ADX Indicator

ADX is an indicator developed by Welles Wilder and introduced back in 1978. For long term trend followers, ADX is so important, such a key to the kingdom, that I have decided to treat it by itself.

ADX (Average Direction Movement Index) is, at its core, a measurement of the strength of trend. The calculations are not overly difficult, and if you want to understand the math, it is described on many financial websites.

ADX: The Trend Followers Best Friend

Chuck Le Beau is one of the worlds leading authority on ADX. He has built some classic systems around this indicator, that have stood the test of time including systems that have been top-rated in the Futures Truth rating service.

Chuck uses ADX alternately as a set-up and entry criteria in various systems. The power of ADX lies in its smoothing and its persistency. The smoothing minimizes false signals from whipsaws and the persistency comes from being able to stick with a trend through modest pullbacks.

If you have any desire to be an intermediate to long-term term trader, you really owe it to yourself to spend some time with Chuck, and study ADX with the master.

Lets look at our market model questions for ADX:

Is it theoretically credible? Absolutely. This indicator has very strong technical support. And it tests well across many time frames.

Whos it most useful for? Clearly this is most useful for long term trend followers. However, I have read some articles where ADX is used in shorter (even intra-day) time frames.

How Fanatic are the fans? A very behind the scenes bunch. With the notable exception of Chuck, very few people are out there touting ADX.

Is it being used by real-life traders? Yes. Many folks keep this on their charts and use it in system building.

Click the ADX Indicator header link above to learn more about how the ADX Indicator can help you in your trading.

Good day and good trading.

Monday, August 28, 2006

Trade System Development

Being Overwhelmed & System Development

By Dr. Van K. Tharp

My research suggests that the problems people have in developing a trading system fall into five different categories.

The first three areas prevent traders from ever starting (or finishing) the development of a trading system. These include computer/technology phobia, procrastination, and being overwhelmed by the whole process. The last two problems tend to prevent the trader from coming up with a workable system. These include: perfectionism and judgmental biases in your thinking.

In an earlier article we covered procrastination. This week lets take a closer look at the feeling of being overwhelmed.

Being Overwhelmed

The most difficult thing to overcome, at least when you are in the middle of it, is being overwhelmed by any particular task. And when it comes to developing your own trading system, I see traders get overwhelmed again and again. In this case, your energy is probably low and your head is just swimming with details. Moreover, you dont understand all of the concepts you need to and you dont know what to do next. Heres an example,

John was in the process of developing a trading system. He would read about ten books on systems and indicators that are used in futures and stock trading. All the indicators confused him and when he thought about varying the parameters of each indicator his mind started spinning. He would also attended several seminars in which various systems were recommended and taught, but he was not sure they were for him. He was feeling even more confused. The costs were mounting up and taking a toll on his trading capital and that added more pressure. He would just bought a computer system with all the software to make developing a system easy. But there were so many details to learn. There were at least three manuals to read for him to operate the computer system and they didnt even tell him where to begin his own development work. The details just kept piling up. John was feeling more and more stressed and soon all he found himself doing was going over everything he had to do without seeming to accomplish anything. He felt desperate to get something done soon or he’d run out of money!

Johns problem is typical of what happens when people are overwhelmed. However, the problem can be solved when you realize there are basically three aspects to being overwhelmed: 1) the concentration on details as opposed to the big picture; 2) being out of balance in your life in some way so there is undue pressure on you; and 3) the lack of a plan to get out of the mess.

The average person has a processing capacity of seven, plus or minus two, chunks of information. When people start concentrating on details, then their capacity is quickly exceeded. When your focus on the details becomes uncomfortable, because of pressure from some source, the feeling of being overwhelmed really starts to set into the mind.

Most people can easily handle a lot of details. In fact, you do so all of the time. However, if your life is out of balance and conflict is created because your needs are not being met, then the details take on a different meaning. Small details that were once trivial seem very important. The pressure to sort out the details multiplies because you create more details as a result of your imbalance. Soon it all builds into a vicious cycle of being overwhelmed! Yet it all started from the pressure of life being out of balance in some area. Maybe just one area is throwing your life out of balance? Is it your finances? Your relationships? A family crisis? A health problem? Balance your life and you’ll be amazed how overwhelming problems suddenly disappear.

Lastly, when people are overwhelmed it is because they dont see the big picture and thus lack a plan to get away from the details. Probably the sense of being overwhelmed just came over you. You didn’t realize how much your financial pressure (or whatever the pressure) was taking a toll on your ability to think. You also didn’t realize how much you were getting bogged down by the details of system development. Because you dont have an overall plan, you dont know how to deal with the details.

Getting Out of Being Overwhelmed.

If you are in the process of developing a trading system and are currently feeling overwhelmed, then the first thing to do is take a break from the task that is giving you the feeling. Take a day off, or perhaps even a week, and just relax. Go to a beach or a lake and just relax looking at the water.

The next step is to determine what aspect of your life is giving you so much pressure. Where is it coming from? (Finances? Relationships? Health? etc.)

Find out what part of you (aspect of your personality) is responsible for the pressure. Once you know which part, you can negotiate with it. Find out how to meet its needs and if it will agree to let you continue with the task of developing a trading system. For example, you may have (1) to agree to give so much time each day to meeting the needs of that part (2) to set a deadline for the development of your trading system and/or (3) to agree to devote full attention to that part once the deadline occurs. Perhaps you have a part of your personality that finds the system development no fun. We can call that your fun part. To negotiate with your fun part you could agree that once you meet an objective or a deadline then the fun part can have it’s chance to do whatever it is that you think of as fun. [Parts work is covered extensively in the Peak Performance Home Study Course.]

Lastly, you must develop an overall plan for developing your trading system. Work out your objectives in detail! Once your objectives have been written down, you can then develop a plan for meeting those objectives. Divide the plan into various tasks and set a deadline for meeting each of those tasks.

Click the Trade System Development header link above to learn more 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.

Sunday, August 27, 2006

Weekly Stock Market Outlook

NASDAQ Outlook

The NASDAQ Composite lost 3.18 points (.15%) on Friday to end the week at 2140.29. That's 23 points (1%) lower than the prior Friday's close Bearish Factors..

The NASDAQ hit the brakes big time this week as you can see in the chart, the NASDAQ continues to hit resistance at short-term highs and has done this in early June, July, and now again in late August.

The stochastics lines are still around those overbought marks and this week showed that the stochastics provided a good warning of eventual choppiness and bearishness. Specifically, there was a bearish crossover of the K and D lines right in overbought territory, which is usually a bearish sign. The NASDAQ is still below the 200-day line and that means that conditions are mostly bearish. Most of the time the NASDAQ and the market as a whole tends to have lots of failed rallies while under the 200-day line and this trip under the 200-day line is no different.

If you look at the VXN right below the NASDAQ, you will clearly see that there was resistance at the bottom band and this points to the downside more in the market than the upside. Last weeks extremely low readings were a warning sign that the market was overconfident and perhaps greed was at excessively strong levels. As most of us know, this is usually a sign of bearishness to come.

Nasdaq Chart

Nasdaq Chart

S&P 500 Outlook

The S&P 500s .97 point loss (-.07%) on Friday dropped the large-cap index down to 1295 a close for the week, which is a 7 point loss (-.50%) over the previous weeks close. That close was also above both of the key resistance lines (1280 & 1290) we have been watching.

The Bullish Case for the SPX is much stronger than for the NASDAQ because the SPX has just performed better than the NASDAQ and there is no sign that this will change soon.

Bearish Factors.....

Our suspicions last week were confirmed this week, and that's not changed a great deal. The daily ranges for the SPX have narrowed after the large rally and thats not changing a great deal.

The argument here, ironically, as about the same as the bullish case - stocks moved higher last week...thats the problem. The market has not been able to string together two really bullish weeks in months, opting to slide backwards each time a little upside progress was made. In fact, you can already see how the rate of gain is diminishing; each successive gain last week was a little weaker than the previous one. The degree of higher high also shrank each day.

Plus, look at the VIX. It's just meandering at this point. Although not quite to the persistently-low readings of just under 10 like we saw in the spring time, the current level is still oddly low.

That being said, as with the NASDAQ, you may want to see how the market reacts when the 10 day (and 20 day) line is retested as support. Its currently at 1285, while the 20 day line is at 1277. If the S&P 500 pulls back and starts to recover there, then the rally may actually stabilize and move forward. But, being as over-extended as we are right now, the pressure may just be too great. If the SPX slips under the 200 day line again (currently at 1273), it will probably spook the market into even heavier losses. Watch closely.

S&P 500 Chart

S&P500 Chart

Dow Jones Industrial Average Outlook

The Dow dropped .18% (20.41 points) to close at 11284.05 . For the week, the blue-chip index dropped 0.85% , or 97 points.

The Dow managed to move sideways the whole week. The blue chips got some decent support and like the other indices, we're not seeing any follow-up from last week's run-up. Lets keep an eye on the 11,300 area, where the Dow has met with some resistance the last couple of months. As far as the major moving averages go, they are serving well as lines of support for the Dow. Overall, the outlook on the DOW is more bullish than bearish unlike the other major indices.

Dow Jones Industrial Average Chart

Dow Jones Industrial Average Chart

Friday, August 25, 2006

Trading & Risk Reduction

Do day traders typically trade a few stocks over and over again or do they usually pick any stock that rolls around? Most day traders trade just a few stocks and many day traders work with just a single stock. Whats the benefit of trading just one stock or just a few? Its more manageable and eventually you will become familiar with the personality and behavior of the stocks that you are trading and your trading effectiveness often increases. Today we will discuss a more simple trading system and we will also discuss risk reduction.

I Know Sandisk

A great case for trading a smaller list of stocks is that you will also be dealing with the same stocks over and over and it will become easier to keep up with events like earnings and news events. For example, I once knew a trader who was trading SNDK very often. He only traded a handful of stocks and SNDK was one of them. One typical Tuesday, SNDK went up 5%. Lots of traders sold the next day but not my friend. He was extremely familiar with the stock and took at least a moments glance each day at headlines on the stock. Instead of taking profits like other traders on the stock, he held and the stock catapulted over 100% in less than 3 months! He later told me that he knew historically that in additional to the technical indicators he used, he also held on because 5% surging days were normal for SNDK and not reason for alarm or profit taking. This is a great case study of how being familiar with a stock can be beneficial.

Trading vs. Investing

In addition to the above example, you have to ask yourself this question: How do I benefit from trading a list of 1000 stocks? I think thats where most traders confuse trading with investing. Many investors take a bottom up approach when selecting investments. That means that they first look at companies and they care less about broad economic trends and sectors. Because they are looking at companies first, they need a huge list to choose from so that they can find the few gems that exist. But when it comes to trading, we typically are looking for short term fluctuations that have little or nothing to do with fundamental, long-term changes in the company. That means that a huge list of stocks may not be necessary.

So heres what part-time and some full time traders can do to narrow down their lists of stocks. Consider specializing in one industry or just a few. One of our traders likes to specialize in about 9 industries each with about 6 stocks in them. Instead of coming up with a single system that works across all industries, he finds it effective to develop an individual system (using computer tested indicators) for each industry. If you are a trader who uses a 1000-strong stock list, consider shrinking that list down to 200, 100, or fewer stocks. The advantages of the large stock list often do not outweigh the benefits.

The Mysteries of Risk Reduction

We all know that most of the time gold is inversely correlated with the market and oil stocks often move the opposite way of airlines. We can use this knowledge to trade non-correlated stocks and reduce overall risk in our portfolios. Which industry has very low correlation and sometimes an inverse correlation with tobacco? Is it semi conductors or life insurance? The answer is semiconductors. In fact, these 2 industries are often inversely correlated. Life insurance stocks on the other hand are often highly correlated with tobacco stocks. Its hard to explain, but its true. This knowledge is very valuable whether you are trading a large list or a small list of stocks. I find that sometimes, I have 2 stocks that I want to buy and it comes down to a split decision. Which one do I choose? Well, if I currently had Altria (formerly Phillip Morris) in my portfolio, then I would choose Intel over Prudential to add to my portfolio. The overall portfolio risk would be much lower because the assets have low or inverse correlation most of the time. 2 more industries that have low and sometimes inverse correlation are biotech stocks (such as Imclone) and pharmaceuticals stocks (such as Merck). Most people would guess that these stocks are highly correlated, but they are not. The point of all of this is that if possible, pay attention to correlation so that you can reduce risk in your portfolios while reducing returns only marginally and sometimes not at all.

Have a good weekend.

Thursday, August 24, 2006

Evaluating Your Mutual Funds

Make the most of your 401(k) program by reviewing the various types of mutual funds that might be available in your plan, including equity, fixed-income, balanced, foreign, and money market funds.

Additionally, investment strategies that may be available through a 401(k) - such as conservative, growth, value, blended, income, or balanced. Its ver important to determine the best strategy for your personal financial goals.

Once you have completed this review and analysis, you are well on your way to customizing your 401(k) plan and creating a foundation that will help you fulfill your long-term financial requirements and goals. All that's left is to compare your plan's available fund selections to determine which ones are the optimal investments given your objectives.

And, as with any investment, several critical factors must be examined:

Performance: The funds actual returns (investment appreciation + dividends) are key comparison measures. In a great market, a large percentage of mutual funds will do well; thats why it is extremely important to look at a funds returns over a multi-year period. I would suggest that you compare returns on a 3-year, 5-year and 10-year basis. And it is best to look at the annual numbers, not the cumulative figures, as they will disguise the true fund returns and wont tell you a thing about the consistency of the performance. For example, if the fund had one really great year, but 9 so-so years, the 10-year return might look pretty good, but that would not give you the accurate story of the fund.

It also makes sense to review not only at the returns of the fund, but also the track record of the fund manager. Since some funds frequently change managers, the funds performance alone may not paint a true picture of what the future may hold under the direction of a new investment manager.

There are many companies that offer these statistics, but here is one of the best:

And very importantly, please be aware that just like any other investments, past performance is not a guarantee of future success.

Another important consideration when looking at funds is the associated Costs & Expenses. These costs come in several forms.

Loads: Some funds charge front-end loads, ranging from 2-6% of the monies you initially invest. Note that funds may also charge a front-end load for reinvesting your dividends back into the fund.

Back-end loads may range from 4-5.75% of the funds you redeem or cash out, in the 1st year of ownership, but then may subsequently decline until they reach zero, in about the 6th year.

Some funds do not have front - or back-end loads, and are called No-load funds.

Expense ratios: These expenses are the cost of doing business, and include administrative and management fees. They are calculated as a percentage of net assets managed. The current average for domestic funds is 1.4%, bond funds, 1.1%, and international funds, 1.9%.

12b-1 fees: These fees are marketing and distribution expenses. They are included in the funds expense ratio, but often separated out as a point of comparison. They are charged in addition to loads, and even no-load funds may have them.

Taxes: When a fund manager sells a stock from the fund at a profit, the gain is taxable. Short-term gains (for investments held less than one year) are taxed at a higher rate, at your individual income tax rate, while long-term gains (for investments held more than one year) are currently taxed at 15%. Many investors tend to forget about taxes on funds since they arent privy to the fund managers everyday buying and selling of investments and the losses and gains accrued, and are often surprised by the tax bite at the end of the year. Consequently, it would be wise to pay attention to the next important item on our list.

Turnover: This refers to the frequency of trading undertaken by the fund manager. The more buying and selling in a fund, the higher the turnover rate, and the greater the potential tax bite. This is another area in which index funds are advantageous, as their managers generally trade less than actively-managed funds, so they usually accrue lower tax bills.

Portfolio Strategy is of utmost importance when comparing funds. It will do you no good to compare the returns and expenses of a growth equity fund with that of a bond fund; you must compare apples with apples.

And one warning: It would be to your benefit to double-check the funds holdings and see if they are in line with the stated portfolio strategy. I am rarely surprised to find the majority of holdings in something other than what the funds prospectus dictates.

Now, you can find all of this information on the Morningstar web site. And for additional help in calculating mutual fund fees and expenses and comparing them, try these sites:

Here are just a few more helpful hints when deciding on the funds you want in your portfolio:

You might want to avoid smaller funds, or those with less than $50 million in assets under management, as their expenses may be too high. For the same reason, steer clear of new funds unless they are part of an established fund family, as investors often find themselves subsidizing a new funds startup costs.

Think twice before buying larger, over $1 billion equity funds, as they may be so unwieldy to manage that their returns may not be as good as similar, smaller funds.
Take a look at the experience and tenure of the portfolio manager. If he is new to the fund, find out if he came from another fund and what his experience and performance was at his former employment.

Compare the holdings in the funds portfolio with similar funds, as well as with the other funds you are considering. I have often found that many funds overlap their holdings and investors are frequently investing in very similar funds although their stated strategies may be very different.

Beware of funds that rationalize their high costs just because of the type of funds they are. For example, the expenses at some growth funds are higher than value funds, for no reason that I can come up with. Similarly, sector funds often cost an investor more than diversified funds, which makes absolutely no since since they require fewer analysts with expertise in different sectors.

Now, pull out that packet your 401(k) administrator gave you and just follow these steps and it wont take long before your retirement plan is underway or back on track. And dont forget, as your lifestyle changes, you may want to tweak your plan here and there to maximize your personal investment goals.

Have a good friday.

Wednesday, August 23, 2006

Perfectionism & System Development

By Dr. Van Tharp

My research suggests that the problems people have in developing a trading system fall into five different categories.

The first three areas prevent traders from ever starting (or finishing) the development of a trading system. These include computer/technology phobia, procrastination, and being overwhelmed by the whole process. The last two problems tend to prevent the trader from coming up with a workable system: perfectionism and judgmental biases in your thinking.

In earlier articles we have covered procrastination and the feeling of being overwhelmed. This time lets look at perfectionism.


Perfectionism, in contrast to what some might expect, has an extremely negative impact on performance. People often strive to be perfect in what they do because their parents demanded they be perfect as children. Unfortunately, these lofty standards sometimes keep them from ever coming close to achieving them. Perfectionists waste time with unnecessary tasks. Businessmen make less effective decisions, traders make less money, and athletes perform poorly—all because of the high standards they set for themselves.

But the vicious problem perfectionists have is not just created by lofty standards. You can have lofty standards without being a perfectionist. Instead, perfectionism means those standards are tied into your self-esteem. If you dont achieve those standards (and for most perfectionists, those standards are all‑or‑none), then you feel like less of a person. The perfectionist has trouble tolerating a mistake or handling a distraction. Perfectionists tend to have all‑or‑none thinking; so everyday little setbacks lead them into a world of despair.

Here is how the perfectionist mind-set can create lowered performance — the opposite of the desired result. The likelihood of a person achieving any outcome depends on two primary beliefs: 1) the belief that the behavior attempted will produce the outcome and 2) a belief that you are capable of producing the necessary behavior. The perfectionist has extremely high standards, by definition, which suggests their outcome may not be directly obtainable as a result of the behavior. More importantly, the perfectionist tends to be his or her own worst critic when these high standards are not achieved. At first, the perfectionists criticism drives him forward towards his goals. But as he repeatedly fails to achieve them, the self‑criticism gets much stronger and the person begins to create a wall around himself making the task impossible. As a result, the desired result of nearly impossible standards frequently creates below‑average performance.

Lets take a look at Elmer:

Elmer was a perfectionist who was trying to develop a trading system that would win in nine out of ten trades and would make five times as much money as he was risking on any given trade. When he first tried to develop the system, it was just profitable after commissions and slippage. But when he saw the results — only a 2% gain each year — he wanted to beat his head into the wall. How could you be so stupid to think that an approach like that would work? he wailed. After three failed attempts, he was beside himself. His family found him hard to live with — he was uncivil and didnt spend any time with them. He just locked himself in his computer room doing more testing and feeling more and more unsatisfied with himself. Normally, Elmer would have just given up after about six months. But in trading, he was exceptionally committed to find something that would meet his standards. He would abandon a lot of good ideas before testing them because of his self‑criticism. Those he did test, no matter how well they turned out, would not meet his criteria for acceptance. Eventually, Elmers wife left him and Elmer found himself broke, without a family, or even a trading system that met his standards.

Poor performance among perfectionists is well documented in many fields. Psychologist David Burns, for example, found that perfectionist insurance agents, those who linked their achievement to their self‑worth, earned on the average $15,000 a year less than their non-perfectionistic counterparts.

Similarly, highly successful athletes tend to show a lack of perfectionist tendencies. For example, elite male gymnasts who qualified for Olympic competition tended to give much less importance to past poor performance than did a group of highly talented gymnasts who failed to qualify. The latter group, in fact, would rouse themselves into near panic states by dwelling on the images of past failure and turning those failures into excessive self-doubt and thoughts of impending tragedy. Think about it—the best baseball hitter in any given year will only get a hit about 3.5 times out of ten. If that player dwelled on the 6.5 times he didnt get a hit, his chances of getting exceptional performance would be slim.

Perfectionists tend to find themselves under a great deal of emotional stress. They drive themselves hard, while at the same time, being their own worst critic. For example, when a perfectionist falls short of a goal, he or she is probably screaming criticisms at themselves for not meeting his/her own lofty standards.

Joe was a trader on a diet. One day he ate a tablespoon of ice cream and scolded himself by saying, I shouldn’t have done that. I’m a pig. His self-critique so upset him that he went on to eat the entire quart of ice cream. And, of course, by the time the quart was finished, he had berated himself so much that the whole idea of a diet seemed hopeless.

How does this cycle of lofty standards tie into a persons self esteem development? One theory holds that perfectionism develops when a child is regularly rewarded with love and approval for outstanding performance, but severely criticized for substandard performance. The child, in order to gain parental acceptance, begins to take on the parents high standards. And, in order to avoid criticism from the parents, the child begins to criticize him/herself. Soon the young child begins to anticipate mistakes that will lead to a loss of acceptance and starts criticizing himself for the slightest mistake. The logic is, If I criticize myself, I’ll do better and then my parents will love me more. But, of course, self‑criticism leads to feeling bad and then even poorer performance. And suddenly, the vicious cycle of high standards leading to poor performance, common to almost all people with this trait, ensues. A perfectionist has started down the road to ruin.

Getting out of the perfectionist trap. The best solution to getting out of perfectionism is probably to seek professional help to get rid of the perfectionist decisions that you made some time in the past. However, there is a five-step program you can do on your own to help you make progress.

First, make a list of the advantages and disadvantages of being perfectionist with respect to your trading (or in anything for that matter). Once you have the list, notice how the advantages may not be as great as the disadvantages. This should give you some insights about your standards and what you are doing to yourself.

Second, since your perfectionism comes from all‑or‑none standards, spend a day investigating how well the world can be evaluated by such all‑or‑none standards. For example, notice what happens when you decide that food must either be terrific or awful. What happens when you decide that a room is either totally clean or totally messy? What happens when you decide that a person is either beautiful or ugly? Intelligent or stupid? Or fat or thin? And, of course, as you are doing this notice how distorted all-or-none thinking is and then think about your perfectionist standards.

Third, keep a daily written record of self-critical statements you make. You might notice how irrational some of these thoughts are, even though they may seem quite plausible when you think them. Give yourself a reward for being able to write down at least 50 such thoughts in a day. Your reward, of course, is for your self‑awareness—not the negative thoughts. At the end of the day, examine what you’ve written down and notice the distortions in the thinking.

Fourth, for several days keep a record of the activities you do. Before you undertake each activity, estimate how satisfying you think the activity will be. When you finish the activity, record how satisfying you felt it actually was and how effectively you performed. What will happen is that you will notice your personal satisfaction is not necessarily correlated with superior performance. When you learn to move toward what gives you satisfaction, rather than superior performance, you will be on the road toward making your life work. And quite often-superior performance will follow.

Lastly, each day while you are developing a trading system, set behavioral standards that are about 10% of what you would normally expect of yourself. When you accomplish those new standards, agree to be proud of your performance and congratulate yourself. If you achieve more than that, fine! But always celebrate when you achieve your new standards. If necessary, get help from someone close who is not a perfectionist in setting your standards. Most people, when doing this exercise, find that the lower they set their standards, the higher their productivity suddenly becomes.

Click the Perfectionism & System Development header link above to learn more about Van Tharp and his excellent trading training programs. Dr. Van Tharp is the Traders coach, and well known author widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors.

Good day and good trading.

Tuesday, August 22, 2006

Trade Selection

Today I would like to address a topic that seems to be a hot button about the trade selection process. The solution really is simple, but too often overlooked. You have to have have some sort of methodology or system to find the best opportunities. It doesnt need to be a complicated system - it just needs to show positive results over time. In fact, the best trading systems are usually quite simple. Besides profitability, the only other thing your system needs is a means send you a signal, to let you know to place a trade. While this may sound like common sense, too many traders seem to forget these basics.

You must have an edge:

Ever notice that the market seems to zig just when its completely obvious that it should zag? The markets direction typically defies conventional logic about half of the time. Theres nothing wrong with using assumptions and logic to make market forecasts. However, you must absolutely concede to the fact that an assumption or a logical conclusion may be wrong. We are human, and as such, we are going to be swayed by fear and greed. That fear and greed, though, can warp our logic so much that we will rationalize anything - even the wrong thing. When that happens, our logic becomes flawed and we become less profitable traders.

So how does one get around the problems that fear and greed can create? A trading system! Most readers may be assuming that by system, we are saying that you need a highly complicated piece of software that can test certain trade signals, and dozens of charts on your computer screen. These things are nice if you are a highly active investor, but you dont really need them. All you really need is a method that you know works for you. These may be moving average crossovers, momentum signals, or sector-based strength signals. It doesnt matter which one you use - you just have to become proficient at one of them and trade it consistently. In fact, one of the most famous trading systems is Bill ONeils CANSLIM method. You dont even need a computer to use that one, and its a very passive method.

The point is, logic can be flawed, but a trading methodology can overcome flawed logic.

You must be able to receive a trade signal from your system:

If you only remember one thing today, remember this - most charts are ambiguous. Its especially critical that the pure technical traders understand this. These market technicians are completely reliant on chart data. This can be a problem, since at any given time, about 90 percent of charts are neither bullish nor bearish.

How many times have been looking for trades, and started to hunt just by looking at individual charts? You start with the symbols you know, then you go to the news to see if anything looks hot or cold to the media. After you look at twenty or thirty stocks, boredom and frustration set in, and you just start picking ones that look like they will do. Thats a mistake - you softened on your trade criteria and may have bought or sold a stock for a poor reason. You want to limit your trades to those 10 percent of stocks that are actually doing something. So how does one do this?

You have to have some method of receiving trade signals from your proven system. Its extremely inefficient to look for stocks that fit your criteria. Rather, you want these stocks to present themselves to you. This will not only save you time and frustration, but will provide you with opportunities you may have never seen on your own. There are many ways of getting the data, but the point is this - give yourself an efficient way to actually get the data you need.

Bottom Line:

Systematic signals and signal scans go hand-in-hand. By taking fear and greed out of your selection process, you wont suffer from the problems of flawed logic. And by freeing up your time and focus spent on hunting for trades, you can focus on trade management.

Good day and good trading

Monday, August 21, 2006

The Forex Market

The largest financial market in the world is FOREX, the Foreign Exchange currency market. Over $1 Trillion USD in value changes hands every day on this exchange, making it much larger than all the other US financial markets combined.

Its called the market that never sleeps, because from early Monday morning, until late Friday night, the currency market is trading continuously. There are four trading centers set up around the world: Sydney, Tokyo, New York and London. They each take a different part of the trading day. This is one of the major advantages of the financial markets, you do not have to trade during normal business hours. It is possible to trade at any time during the day and make money.

The vast majority of all trading, especially the speculative trading, in the currency markets happens in the majors. These are the most widely traded currencies and consist of the United States Dollar, the British Pound, the Euro, the Swiss Franc, the Australian Dollar and the Canadian Dollar.

When you trade the currency markets, you buy long one currency and sell short another currency against it. The symbols are called crosses. For example, the EUR.USD cross is the Euro against the US Dollar, with this you would buy Euros and short Dollars. If you were to short the EUR.USD cross, you would be shorting, or betting against, the Euro and expecting the Dollar to rise in relative value.

Most FOREX brokers do not charge a flat commission, but instead widen the Bid/Ask Spread slightly and make their money that way. So instead of having to worry about beating both the spread and the commission charge on each trade, you just have to focus on the spread, which is still usually smaller than either stocks or options.

Leverage and low account minimums are two more great qualities of currency trading. With some FOREX broker accounts you can get up to 200:1 leverage and you can open an account with as little as $250. So with that $250 you can control up to $50,000 worth of currency positions.

Despite its unique advantages, however, FOREX can be just as risky if not more risky than the stock or options markets. With currency you are not buying ownership in a company that has real value as with stocks and you cannot use advanced techniques such as straddles that you can with options trading. When you buy or sell a currency cross you are basically betting on the economic strength of the counties involved. However, FOREX provides a unique trading experience and is at least something that all traders should be aware of.

Good day and good trading.

Sunday, August 20, 2006

Trade System Development

Heres some more tips on Systems Development

Systems development with the use of computers is very important. It helps us prove to ourselves that certain methods work and others do not. It is better to find out if your strategies have worked consistently in the past rather than just randomly hope that they will work in the present. Below are some tips to keep your systems development strong and effective.

1. Use logic first - The first thing to do is to observe the markets and the movements of individual stocks. Do you notice recurring patterns? When you think of stock market logic, is there something you think will work yet you have not tested it? Test it. Also, periodicals and industry websites such as, Yahoo finance, and many other trading sites can offer unique ideas to test. If someone brings up an interesting point about trading, test the validity of their claims.

2. Test Objectively - Its okay to hope that you will find a good strategy, but its not okay to hope too much. If you do, you will jump to conclusions too quickly. Also, forget about your favorite indicators. Dont have favorite indicators. Just have indicators that test well and ones that dont test well. That way if your favorite no longer tests well, you wont be married to that indicator.

3. Form test lists - First of all, you want to test long periods in the stock market (from 2-10 years). It would be good to have 2 bull markets, 2 bears, and a sideways market. In the 20th century, there were 33 down years and 66 up years for the SPX. With that in mind, you could test multi-year periods when there were 2 years for every down year. For example 2002, 2003, and 2004 where there were 2 years up and one down. Although we dont expect there to be 66 up years in this century, we base our testing on some sort of logic. For it would not make since to assume that there would be 66 down years this century, unless you have some strong logic to back it up. Also, you will need to put together random lists of stocks to test your strategies on. I recommend lists of 30 stocks. That is enough to have statistically significant results. Test those lists of 30 stocks over those same time periods you plan on using. Then look at net profit, percentage profitable and other factors you deem important and compare the results using different systems and indicators. You can answer the age old question - which indicators are most effective? You can also throw away the indicators that dont work.

4. Decide on pertinent data - We have already mentioned net profit and percentage profitable as relevant measurements of the strength of various systems. There are other important factors such as win to loss ratio, standard deviation and max drawdown. I use these and so should you. Also, be on the lookout for other factors, such as a smooth equity curves in tests and stay away from strategies that never trade or trade too much. Also remember this: Dont use biased data. You see, many traders in the late 90s and early in the 21st century used the data from just the 90s to back test. Do you think those same strategies worked will in the last few years? No, they havent. The market has been different since 2000 and we must test all sorts of markets so that your system does not depend on particular market conditions to survive.

5. Be sure that the data is good - When you form lists of stocks and start testing, be sure to properly label each list. I use Excel and then I am sure to label each stock list properly. Also, I encounter bad data all of time. I see unusually low numbers mostly or zeroes where they dont belong and can see quickly that the data is bad.

6. Test simple indicators first - Before you start testing the strategies that require the stars to line up for entries, test the simplest indicators first. For example, avoid testing a stochastics, RSI, ADX, volume combo at first. You should just test ADX first and then decide if it is effective and then later you can test ADX in combination with other indicators to form a strategy. Don?t try to be unique. Just try to make money. Thats the purpose of trading. Use these tips and make money!

Be disciplined - and trade well. Good day and good trading.

Saturday, August 19, 2006

Choppy Market Trading

With the market for the most part directionless so far in 2006, we would like to respond to a request we have received plenty of times recently. A reader asked: I know the market fluctuates, but it seems like the fluctuations eat away at all the gains I may have had before the market dipped. I own good quality stocks, but is there a way to minimize the effect of the pullbacks without just selling out of stocks? It seems like my defensive selling occurs right before the market rallies back. Is there something else I can do?

The answer is yes, there are some techniques you can use - we list a couple of our favorite strategies below.

1. Buy a put option.

While most of you may be well versed in options, lets just start at the very beginning. There are two basic types of stock options. A call option gives you the right to buy a stock at a certain price within a certain period of time. A put option gives you the right to sell a stock at a certain price within a certain period of time. For instance, a Microsoft February 30 put option gives you the right to sell 100 shares (one put option controls 100 shares of the underlying stock) of Microsoft at 30 dollars per share until the option expires in February. You dont even have to own 100 shares of the underlying stock to buy the put option. Remember, you are the one buying the put option, so you are the one who can choose to exercise the option. Of course, nothing is free. If you want to buy the put, you will have to pay for it. Currently Microsoft is trading at 27.40. So, the February 30 put is inherently worth 2.60 per share (or a grand total of $260). However, you would have to pay about 2.80 for the Microsoft February 30 put right now. That extra 20 cents is just the premium you have to pay for having the right to choose.

The point? Think about this. If your 100 shares of Microsoft fall from 27.40 to 25.00, then you will have lost $240. But, the February 30 put will have gained $240 in value. The two positions offset each other. You may not have gained, but you will certainly not have lost. If instead, shares of Microsoft go to 31.50, then the put option (the right to sell them at 30) would be worthless. But that wouldnt be all bad - you will have lost the whole $240 you paid for the put option, but you will have gained $410 on your 100 shares.

The downside? There's a time limit on this option. You're hedged until Februarys option expiration, then you'll either have to sell the option and take the profit, or it will expire. Either way, you're back to just owning the 100 shares. But at least the downturn wouldnt have hurt your portfolio's value during that time.

2. Sell a covered call.

The other option is to sell a covered call. This strategy is a bit more complex, so lets start at the beginning. Remember from the example above how we bought the Microsoft 30 put? We were looking to buy it at a low price, then sell it later at a higher price (if Microsoft shares did indeed go down in value). Its the old buy low - sell high rule. But its not the only way of doing it. You can also sell high, then buy low....or even not buy at all.

If the put option gains in value as Microsoft shares decline, then a call option would decline in value as Microsoft falls. For instance, if Microsoft shares are at 27.40, then the February 25 call is worth $240 (or 2.40 per share). How much is the February 25 call worth if Microsoft falls to 24.30? Well, basically nothing - who would want to buy shares at 25 each when they can buy them in the open market for 24.30? In a case such as this, we would look to sell the call at the higher price, then buy it back later at a lower price, or better yet, let it expire worthless without even needing to buy it back.

Why would this be any better than just buying a put? Two reasons. First, remember the extra 20 cents we had to pay as premium to buy the put. Rather than pay it, why not receive it? It may only be 20 cents, but in this case, it represents almost an extra 10 percent worth of gain on the option trade. Second, you save big on commissions. Option trades arent exactly cheap to begin with. If you have to pay commissions to buy one, then sell it later, it can really eat at profits. If instead you can sell an option and then never have to buy it back, you'll cut your commission costs in half.

Is there a downside? Potentially. When you are buying an option, you're in control of whether or not you exercise the option. When you sell an option though, you are selling someone else the right to exercise the option against you. This is where the term covered call comes in. If you are selling a covered call, that means you have 100 shares of the underlying stock to cover the option in case the buyer of the call option decides he wants your shares. For example, if Microsoft shares go to 29.20 (or any price above 25.00), then the call you sold will be exercised against you, and you will have to sell your Microsoft shares at 25.00. Again, its not all bad. You will have missed out on 4.20 worth of gain, but you will have at least pocketed the $250 from selling the call. On the surface that may not seem like a great proposition, but there are two huge benefits to selling covered calls. First, it puts real cash into your account right now - actual dollars. Second, if you originally paid 14.00 for Microsoft shares, you still netted $1100 (plus the $250 on the option trade).

So, those are two basic strategies to help overcome market pullbacks. The first one puts you in control, and you dont have to own any shares of the underlying stock. The downside of the put-buying strategy is that you will (hopefully) have to pay commissions twice, and you will have to pay a little extra premium up front. The covered call strategy, on the other hand, gives someone else control. You will need at least 100 shares of the underlying stock. However, the potential returns on these option trades are greater, if you dont mind selling your shares on occasion. Look at it like this - if you have 100 shares of a stock you were going to sell anyway, then selling covered calls is a nice way to try and generate a little more income before liquidating the position. Its the optimal way to own long-term, high-quality stocks but take advantage of short-term market downturns.

Have a good weekend.

Friday, August 18, 2006

Trading Psychology

I recently re-read a great book on trading psychology, called MindTraps by Roland Barach. This book is recommended by trading psychologist Dr. Van Tharp. MindTraps focuses on how the average person tends to think, compared to how we need to think to make money over time in the markets.

Heres a summary of points that can benefit you as a trader:

Before entering any trade, you should consider the other side of the trade and state the reasons you would take the other side of the trade. This helps you objectively enter a trade with a full understanding of the major risks that involved.

Analyze your behavior from the beginning to the end of the trading process (from idea generation to entry and finally to exit) - what are the areas you can improve to help your trading profitability the most?

Keep a trading journal of your thoughts on open positions and new ideas - writing things down helps you objectively look back and see where you went right and wrong.

Fear blinds us to opportunity; greed blinds us to danger - emotions cause perceptual distortion where we only see the part of the picture that our beliefs allow us to see.

We are likely to continue doing things for which we are rewarded. This can cause us to get too bullish after the bulk of the uptrend has occurred, or get too bearish near the lows.

Fear of regret slants stock market behavior toward inaction and conventional thinking. The person who is afraid of losing is usually defeated by the opponent who concentrates on winning. An analogy for sports fans is the Prevent defense in football - playing not to lose only prevents you from winning.

Dont have a personal agenda to prove your self-worth in the markets. The focus must be on following your plan to maximize the ability to make money.

Dont get overly attached to any one view on a stock or market. Dont talk to others about open positions; it just makes it that much harder to exit when your plan says it should.

Our predictions are only as good as the information available to us. Objectively look at the indicators and data you use, to get the best quality of information and focus available

People prefer for gains to be taken in several pieces to maximize their feeling good about their ability, while they prefer to take all their losses in one big lump to minimize the pain they feel.

People prefer a sure gain compared to a high probability of a bigger gain, so they can say they made a profit; in contrast, people will speculate on a high probability of a bigger loss over a sure smaller loss, because they dont want to feel like a loser. In trading, we must flip around the conventional emotions to allow us to let profits run while cutting losses shorter.

Click the Trading Psychology header link above to learn more about this subject. To win in the markets its all about Knowledge Goals Plan Action to reach success.

Have a good weekend.

Thursday, August 17, 2006

Back Testing Trade Systems

The Truth about Testing

Today, we will be discussing the dos and donts of back testing. Back-testing is a highly practical and a very real way to test the strength of certain beliefs and ideas you have about the market. Do you think that a market above the 200-day is bullish? Test it. For instance, we have found that short-term bottoms in the SPX tend to perform worse when below the 200-day line, but much better when above the line. We will discuss how to choose time periods to test and to evaluate the strength of you system.

The first thing traders should understand is that in this day and age, we have the technology to remove much of the subjectivenesss and mystery about the market. You need to answer these questions before you trade:

How will your system react to drawdowns?

Is your trading system practical (i.e. do you have time to use this system?)
Can you tolerate inactivity if your system suggests doing so?
Testing also benefits the trader psychologically and many would argue that psychology is more important than market knowledge when trading. After all, an uninformed conservative trader often does better than an intelligent, reckless trader. Testing fills a trader with confidence and decreases the likelihood that he will be too scared to trade when the moment is right. Also, testing makes the trader aware of what drawdowns might look like and what sort of weaknesses his system has. Let's move on to the do's and don'ts of testing procedures.

Dos and Donts

Make sure that you dont mix your in-sample data with your out of sample data. For example, the best way to test is to form a list of stocks, and test them. Then optimize on a different list of stocks. Finally, test the strategy on a completely different set of stocks in a different time period from the original test. If there is no overlapping in the data then you wont' have to worry so much that you have overfit the data for the past. Remember that one danger of optimizing too much is that the strategy might not work unless markets behave exactly the same as they did during the optimization period. Another effective means of testing is to do simulated trading for a multi-month period. You can then test your strategy without risking money on it. Also, since you will be more emotionally detached at this point, it will be an opportune time to hone the sytems.

You should also decide how you will treat outlier trades in your system. You may want to include outlier trades if your system depends on them. Otherwise, your results may suggest that the system is not profitable when in fact it is. Be sure to keep in mind that there is more to a good system than net profit. I like to pay attention to standard deviation or coefficient of variation as measures of risk. Return is always relative to risk. Keep these points in mind when developing a system and be sure to stick to the system once you start trading. Large run-ups and drawdowns tend to cause system traders to change their systems to their dismay.

Good day and good trading.

Friday, August 11, 2006

Championship Traders

With major league baseball starting to paint a clearer pennant race picture, this is when we start to see team and athletes shine, or fall apart. The interesting part (to us) is that champion traders have the same characteristics as champion athletes. What should we be learning from these teams and players? Read on.

1) The Power of Belief - Do you ever notice how good teams can go on a cold streak, while even mediocre teams can get on a roll? Why do these streaks happen? I believe it has to do with the feedback mechanism similar to how stocks trend: when the ball is going in the bucket, you believe more strongly that the next one will go in too. When the rim seems to have a lid on it and shots arent made, this breeds a doubt or tentativeness that takes the shooter out of the zone and increases the odds that the next shot wont be a score. As a trader or investor, I am sure you join me in having experienced the feelings of both hot streaks and cold streaks. But both can be dangerous to you due to the swings in emotions. When traders are hot, they can tend to overcommit their capital after a series of wins only to give much of the profits back too quickly. Or when traders are cold, they tend to move to the sidelines out of doubt and fear, and often watch in disbelief as the trade they didnt make proves to be a big winner. What would happen if you could take the mindset of confidence you feel when things are going well, and have that same level of belief and self-esteem consistently? If you can apply a sound trading approach with confidence and without emotion, you will be able to follow your rules when most other traders are getting blown out by their emotions.

2) Winners Are Defined by Survival - The reality is that some days will be better than others. The key to success is not just profiting from the good days, but it is also about not blowing up on the bad days. When a good team is not hitting its shots on offense, it makes up for that by playing better defense. For traders, this means you must keep your stops reasonably tight so that you can come back to play another day. It also means that you should not react passively, but must resolve with determination to control what you can instead of feeling resigned and out of control. This will allow you to survive the tough days to stay in the game for the profit days to follow.

3) Winning Teams Have Great Coaches - Sure, some teams have more skill as a sum of the individual parts. But the teams that advance have outstanding coaches who know how to take the individual pieces and make a better team. As a trader, you want to identify your unique strengths as well as weaknesses. Consider getting a trading coach or investing in resources that can help you maximize your unique combination of trading skills and allow you to win against any competition or any market environment.

4) Bet Against the Obvious - I have seen too many examples where the expected best team did not win it all. The obvious pick is more and more likely not to go all the way because expectations run too high. This puts pressure on the top team while also increasing the desire of the underdog to pull the great upset. Relating this to trading, you have to be careful that the trade you are making is not too obvious already. If it is widely expected that good news is coming, then most traders have already reacted by buying that stock in front of good news. This reduces the future upside while at the same time increasing risk in the position upon even a mild disappointment. Remember that the stock market is a supply and demand game, and if the demand dries up as everyone is already in the market, then you have more risk of selling once the news comes out that you do of any new buying. In sports there are underdogs. In trading there are unlikely trades. And in sports as well as trading, anything is possible.

Have a good weekend.

Thursday, August 10, 2006

Bid Ask Spreads

The Bid/Ask Spread is important factor in stock trading. The Bid Price is the current highest price at which someone in the market is willing to buy a stock. The Ask Price is the current lowest price that someone is willing to sell a stock. The difference in these two amounts is called the Bid/Ask Spread.

The Bid/Ask Spread is determined mainly by liquidity. If a stock is highly liquid, meaning there is a large volume of shares being bought and sold, the Bid/Ask Spread will be much lower. A low Bid/Ask Spread is important to traders because that extra cost will eat away at your profits.

For example, on the stock PALM, the Bid Price is $22.70 and the Ask Price is $23.06 so the current Bid/Ask Spread is $0.36. If you were to buy 100 shares and then immediately sell them using market orders (assuming everything stays the same and not factoring in commissions) your loss would be $36 just because of the spread. Remember though that the spread can change throughout the day depending on orders that are coming through.

You can also easily see how volume affects the Bid/Ask Spread by comparing different stocks. The exchange traded fund QQQQ is probably the most liquid asset. The average daily volume for QQQQ is almost 100 million shares, which brings the Bid/Ask Spread down to $0.01 at all times. PALMs average volume is just over 4 million shares a day so it is still very liquid, which makes the Bid/Ask Spread pretty small. Stocks that trade only a few hundred thousand shares or less will start to show spreads much larger then PALM.

The Bid/Ask Spread can cut into your trading profits slightly with stocks. With the PALM example, the stock has to show a gain of about 1% for you even make any money but this isnt a huge problem. Options are where spreads can really start to hurt. With options, the difference between the Bid and the Ask will almost always be at least $0.05. If the option only costs $0.70 then the spread is a fairly large piece of the trade. This is one good use for limit orders, to make sure you get in where you want. But if the market moves too fast a limit order might keep you out of a profitable trade.

Overall, the spread shouldnt be a huge concern for most traders, a good trading system should have no problem overcoming the spread. You should be aware of it though and how it effects your trades.

Good day and good trading.

Wednesday, August 09, 2006

Trade System Basics

Before you buy a home to live in, its best to decide on what you need before you fall in love with the wrong house. For instance, you might need 3 bedrooms. In the same way, its extremely beneficial to figure out what you need in a trading system. Today, I will show you exactly what you need from your system before you embark on the quest.

Method of Entry

Be sure to develop a system which details exactly how you will enter and also takes into account commissions and slippage. If a system cannot overcome slippage, then why trade it? Remember that short-term trading is affected more by transaction costs than long term investing because of the increased activity. Therefore, commissions and slippage is an important factor when developing your system.

Risk Control

Almost any system can be ruined if risk control is not considered. After all, Warren Buffet didnt buy $40 billion worth of Anheuser Busch, but $2 billion instead. Even Warren uses a certain risk control, because after all, its possible that Anheuser could go bankrupt. In life, its good to be an optimist. But excessive optimism in system development can easily lead to ignoring the risks and the weaknesses to you trading system. All systems have weaknesses. Make sure your systems has a risk control element to it.

Systems sometimes have a limited lifespan. For instance, if you would have developed a system using data from 1991 to 1999, that system probably didnt fare as well from 2000-2002. Its important to consider how your system would be affected by a bear, bull, or sideways market. When should your system do well? When should it perform poorly?

The Right Data

Beyond the obvious data that you need such as price and volume, you can consider much other data as well. For instance, you might be looking at ADX and RSI, but what about the SPX and the NASDAQ? What are they doing? You can use software such as Trade Station that allows you to test how ADX performs while the SPX is above the 200-day line, for example. Think about other data that you can use in conjunction with your normal historical price and volume data. But, be careful, because too much data, may leave you overwhelmed and could force you to quit. Monitoring You are not off the hook after developing your system. You should outline beforehand exactly how you will monitor and improve your system. You should also answer this important question in advance: what must happen in order for me to change my strategy? This will protect you from changing your strategy based on whims. We also recommend getting a trading buddy to report to once a month. Its amazing how much insight you can receive from having a friend ask you questions about your system and make comments on your trading. There are some of the aspects of a good system that you should look for, but there are more as well.

Good day and good trading.

Tuesday, August 08, 2006

Money Management

Most traders put their emphasis on determining the best entry and exit points, but smart traders also consider how their money management rules will affect their performance.

Money management is probably the most overlooked area in trading and investing. Here are some questions to answer as you determine the most effective money management plan:

1. How much capital will you need to invest effectively? In todays markets, you should have at least $10,000, and preferably $20,000 or more in risk capital to trade. If you try to trade with less capital, the economies of scale diminish. For example if you traded once per day at $20 round trip in commissions, thats $5,000 in 250 trading days, or one year; so right away a $10,000 account needs to make 50% to cover these fees, while a $100,000 account needs to make just 5% to cover these commission costs. You should also factor in any other costs you incur to trade, such as quote vendors, trading software and computers, if dedicated. You can see that the more you invest on the front end, the bigger your account should be to make back these costs more easily.

2. What percentage of your capital will you invest in each trade? The amount of capital I typically use is 10% per trade in my own accounts. I know traders who commit anywhere from 5% of their account per trade to 20% of their account per trade. But the bottom line is what you are truly willing to risk of the amount you invest. If I invest 10% of my equity for an options program, I only want to take a 20% loss as I seek not to risk more than 2% of my total account equity on any losing positions. I generally prefer not risking more than 1% of my total account equity on a losing trade, which would require a maximum 10% loss when investing 10% of my capital in a new trade.

The Kelly formula shows another way to determine the optimal percentage of capital to risk per trade:

The formula is: Kelly % = W - (1-W) / V
W = Winning Percentage
(1-W) = Losing Percentage
V = Average Winning Trade / Average Losing Trade
If W = 60%
If average winning trade = 500
If average losing trade = 250
Then Kelly % would = 40%

The Kelly formula suffers from a drawback in that it assumes all profits and losses are equal, which is not the case. However, it can help a trader get an approximate assessment of the percentage to invest once you know your systems winning percentage and the size of its average winner and average loser.

3. Are you at risk of committing too much to each trade? Most traders tend to overcommit their capital allocation per trade, and then go through an inevitable drawdown which knocks both their financial capital and takes their emotional capital out of the game. Look at the table below showing the odds of a string of losers over 100 trades. If you have a 50% winning percentage, odds are that you will see two losers in a row 25% of the time. If you are committing 20% of your capital per trade in an options portfolio with no risk control, you could experience a 60% drawdown in your capital which would likely knock you out of the game. Low winning percentage systems are not necessarily bad, especially when the size of the average winner is many times greater than the size of the average loser. But some traders may not be psychologically equipped to ride out the higher volatility that can come with a lower winning percentage. The best way to address this is start out more conservatively than you think you need to until you get comfortable with a method's upside and downside (general rule of thumb: cut your normal allocation per trade by half when you first get started).

Odds of a Losing Streak Over 100 Trades (Column Shows Win Percentage)

4. How many positions will you focus on at one time? I recommend you trade only a handful of stocks at any one time. I like to concentrate my portfolio in my best ideas, plus I like to stay focused on how each stock is acting. If my portfolio is too big (I would say more than 10 stocks is too many to focus on, and I prefer to keep my open positions at 7 or less per dedicated portfolio), then I will lose focus and invariably miss an exit on a trade that I should have previously exited. When looking for new opportunities, I use computers to boil down thousands of stocks to ultimately the top three stocks or options I want to add to my portfolio at pre-defined levels on any given day. If my systems still leave me too many stocks and too many factors to look at, I will be unable to keep up with information overload. This will leave my mind overwhelmed, which will lead to an inability to pull the trigger, also known as analysis paralysis. Famous analyst Richard Wyckoff suggested that look for signals that you might need a break from trading: The first is a technical warning - the situation in which your analysis gives unclear, confused signals. The other two are emotional - relying on instinct rather than research and a growing or chronic indecisiveness about executing trades. Stay focused on a small number of top-performing stocks as an antidote to avoid burn out from information overload.

Click the Money Management header link above to learn more about correct position sizing to not over leveraged your trading account.

Good day and good trading.

Monday, August 07, 2006

Option Terminology

I have been posting a little information on option trading in past articles. Below is option terminology explained. In the future I will be placing more articles on option trading so stay tuned.

American-Style Options: An option contract that may be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style.

Assignment: The receipt of an exercise notice by an option seller (writer) that obligates him to sell (in the case of a call) or purchase (in the case of a put) the underlying security at the specified strike price.

At-The-Money: An option is at-the-money if the strike price of the option is equal to the market of the underlying security.

Call: An option contract that gives the holder the right (but not the obligation) to buy the underlying security at a specified price for a certain, fixed period of time.

Closing Purchase: A transaction in which the purchasers intention is to reduce or eliminate a short position.

Closing Sale: A transaction in which the sellers intention is to reduce or eliminate a long position.

Covered Call: A strategy in which one sells call options while simultaneously owning an equivalent position in the underlying security.

Covered Put: A strategy in which one sells put options and simultaneously is short an equivalent position in the underlying security.

Delta: The change in price of an option given a $1 change in the underlying asset and the mathematical probability that an option will finish in-the-money.

Equity Options: Options on shares of an individual common stock.

European-Style Option: An option contract that may be exercised only during a specified time just prior to its expiration.

Exercise: To implement the right under which the holder of an option is entitled to buy (in the case of a call) or sell (in the case of a put) the underlying security.

Exercise Settlement Amount (Index): The difference between the strike price of the option and the exercise settlement value of the index on the day an exercise notice is tendered, multiplied by the index multiplier.

Expiration Cycle: An expiration cycle relates to the dates on which options on a particular underlying security expire.

Expiration Date: The day in which an option contract becomes void.

Gamma: Measures the change in delta of an option as the price of the underlying asset rises.

Greeks: The different ways risk can be measured as it relates to a particular option or position. (Delta, Gamma, Theta, Rho).

Hedge: A conservative strategy used to limit investment loss by generating a transaction which offsets an existing position.

In-The-Money: A call option is in-the-money if a strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security.

Intrinsic Value: The amount by which an option is in-the-money.

LEAPS: Long term Equity AnticiPation Security. Long term stock or index options.

Long Position: A position in which an investor's interest in a particular series of options is as a net holder.

Margin Requirement: The amount an uncovered (naked) option writer is required to deposit and maintain to cover a position. Also, the amount a trader is required to maintain a credit spread position.

Opening Purchase: A transaction in which the purchasers intention is to create or increase a long position in a given series of options.

Opening Sale: A transaction in which the sellers intention is to create or increase a short position in a given series of options.

Open Interest: The number of outstanding open option contracts in a particular option's strike price.

Out-Of-The-Money: A call option is out-of-the-money if the strike price is greater than the market price of the underlying security. A put option is out-of-the-money if the strike price is less than the market price of the underlying security.

Premium: The price of an option contract which the buyer of the option pays to the option seller for the rights conveyed by the option contract.

Put: An option contract that gives the holder the right to sell the underlying security at a specified price for a certain fixed period of time.

Rho: Represents the impact of the prevailing interest rate on an options value.

Short Position: A position wherein a persons interest in a particular series of options is as a net seller.

Spreads: An options position utilizing at least one long option and one short option. There are credit spreads and debit spreads. Also, horizontal and diagonal spreads.

Strike Price: The stated price per share for which the underlying may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract.

Theta: Measures the impact of time on an options value.

Time Value: The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever value the option has in addition to its intrinsic value.

Type: The classification of an option contract as either a put or a call.

Uncovered Call Option Selling: A short call option position in which the seller (writer) does not own an equivalent position in the underlying security represented by his option contracts.

Uncovered Put Option Selling: A short put option position in which the seller does not have a corresponding short position in the underlying security or has not deposited, in a cash account, the equivalent to the exercise value of the put.

Underlying Security: The security subject to being purchased or sold upon exercise of the option contract.

Volatility: A measure of the fluctuation in the market price of the underlying security. There are two types of volatility - historical and implied.

Writer: The seller of an option contract.

Click the Option Terminology header link above for more information on option trading.

Good day and good trading.

Saturday, August 05, 2006

Weekly Stock Market Outlook

Nasdaq Outlook

At one point on Friday the Nasdaq Composite was the markets biggest winner. By the end of the session, it ended up being the biggest loser by closing 7.29 (-0.35%) lower, to end the day at 2085.05. For the week, the composite closed 9.09 points lower (-0.43%) than the prior week's close, despite a higher high and higher low.

At the end of last week we mentioned the big gain over those five days didnt really mean a whole lot, as the Nasdaq really didnt have any major hurdles to overcome. This weeks tepid movement verifies the concern - when really tested, the bulls didnt seem quite as serious. That hesitation, ironically, may be the very reason stocks fall in the coming week rather than resume their bullish push from the prior week. The pause has essentially given a key resistance line enough to time to sink down right on top of the Nasdaq. Plus, while the market was spinning its wheels, the stochastic overbought indicator kept creeping up into overbought levels. Thats just one more thing that will be weighing in on the minds of disappointed traders from last week who were counting on more upside gains. Lets take a detailed look at both.

The long-term resistance line (red, dashed) is currently at 2094, and falling sharply. The Nasdaq actually traded above that line briefly on Friday, getting as high as 2119. But by the closing bell, we were back under that line. Its a slightly-mixed signal, in that we saw trades above there on an intra-day basis, but its still mostly bearish. Of course, in support of that bearish possibility is the 50 day line (purple) which is exactly where the composite got rolled over during Fridays session. The close ended up just a hair above the 20 day average.

Also take a look at the stochastic chart. Its always possible the index could get overbought and stay overbought for a long while, but given that it hasnt happened all year, we have no real reason to think this time could be any different . . . especially with the sudden weakness and brush with resistance.

At this point, we would have to recommend using the 50 day line as the make-or-break level, rather than the longer-term straight-line resistance. But as we said, the path of least resistance is still to the downside.

Nasdaq Chart

Nasdaq Chart

S&P 500 Outlook

The S&P 500 closed 0.90 points lower on Friday than it did on Thursday, but that 0.07% dip is small enough for us to call it a breakeven. And speaking of, the SPXs 0.8 point gain for the week (0.06%) is also pretty much a breakeven. Of course, the chart looks about as indecisive as the weekly net movement suggests that it should be. In fact, the bull bear arguments are almost both equally valid. We will take a look at both sides of the coin.

First and foremost, note that the resistance at 1280 has been broken - a major victory for the bulls who had struggled there more than once in recent weeks. True, the close under there for the week has more bearish implications than bullish ones, but the two-month high we made on Friday means that there has to be at least some buying interest out there. Of course, that two-month of 1292.90 is also above another key resistance level...1290.

The problem is, the index has done a very poor job of hanging onto gains, especially in recent days. Fridays reversal left the S&P 500 under the 100 day line - a line that has become increasingly problematic.

On the other hand, the SPX does have a couple of things going for it. First, the VIX is technically falling, and still has more room for downside movement. Fridays close of 14.34 is well above the lower Bollinger band line at 12.56. Plus, the 10 day moving average is also sloped lower, verifying the downtrend. Second, the S&P 500 is still above every other key moving average. In fact, some of those averages have actually provided support in the last couple of weeks . . . even of the market made no net gains on a closing basis. In that light, we cant get too bearish just yet.

The coming week will obviously be critical, as the indices are all at pivots. For the SPX, a close back under the 20 day line (at 1266) is bearish, while a couple of closes above 1290 would set up some more upside movement.

S&P 500 Chart

S&P 500 Chart

Dow Jones Industrial Average Commentary

The Dow Jones Industrial Averages 3 point dip into the red on Friday was only an undetectable loss of 0.03%. For that matter, the 0.18% gain for the week (+20 points) was also mostly meaningless. However, the Dows close at 11,240 is still the second - and higher - weekly close above all the key averages. Technically speaking, that has to be bullish. However, there are still some pitfalls that need to be recognized now rather than after the fact.

The 11,286 line was the very last resistance level we had marked, which happened to be breached with Friday's high of 11,368. So, to some degree, the bulls are chipping away at the Dows barriers too. But, the close at 11,240 says the effort may not be good enough. Making it even tougher for the Dow to go any higher is the stochastic overbought condition we are now in.

However, never say never. Like the S&P 500, the Dow is still above its key moving averages, including the 100 day line. In fact, it too is finding support from them. We would have no problem getting bullish despite all the potential bearish pitfalls one can find on the current chart. We just want such bullishness to be proven to us for a few more days than usual . . . we are seen similar patterns like this before, with no follow-through to any of them (take June, for example). On a day-to-day-basis we cant take anything for granted, but by the end of this week, we should be able to make something of a bigger picture call.

In any case, two unique notes about the Dow.

1) Regardless of what happens next (up or down), we think the Dow will still have the most relative strength.

2) Things are likely to remain choppy on a daily basis, even if a trend starts to develop on a weekly basis.

DJIA Chart

DJIA Chart