The action this week got me thinking that I need to write a Duru-like missive on shorting. But since I don’t have a Ph.D you’ll just have to suffer through the following rant which I’ll try to keep relatively short. Yesterday Howard Lindzon wrote:

One thing I have always preached on the blog, less so on Twitter, where I bang out more trading ideas and market thoughts is that shorting stocks is hard. I think it’s harder than any aspect of learning the market. It’s dangerous. Let this morning be the only reminder you should EVER need.

Howard’s right about shorting being difficult. I think it’s so hard because it’s not simply the opposite of going long. (I won’t even go into the whole thing about your losses while short being theoretically infinite. Been there… done that. Use a stop to limit your losses, use proper position sizing, ONLY short LIQUID stocks and you’ll be fine.) What makes shorting tricky is that bear moves often have violent (short-covering) rallies because the psychology of the crowd trading a down market is different than that of a bull market. You have to be quick on your feet when shorting. My motto is “stick & move”.

Many traders love to buy breakouts in bull markets. (Whether that’s actually a good strategy is debatable). In my experience swing trading, the opposite of that strategy, shorting breakdowns through resistance, will often lead you right into a snapback rally and, as MaoXian used to say “the quickest loss ever”. That’s why I often make note of all the people who are initiating shorts after the market has already fallen to a major support level. We saw that this week as I noted in some of the morning watchlists.

My contention is that if you were caught short Friday morning you should consider your losses as tuition paid to the school of hard knocks. Learn from that expensive lesson, take your losses and hopefully survive to trade another day. I’ll stop short of saying that the losses were deserved but there were plenty of warnings to at least cover your shorts if not to get long. There are so many good sources of market information these days, both on the web and, yes, even on TV. I’m not saying to blindly follow somebody else’s opinion but it can be helpful to see what others are doing based on what they see. Here are just a few of the recent warning signs:

• T2108 dropping below 20 — Ah, good old reliable T2108. I’ve been watching it closely as we’ve sold off. On Wednesday I noted that it finally hit the point where wise shorts would want to cover. It pays to find a good overbought/oversold indicator and heed its warnings. (You may need different indicators or settings for different timeframes.) Sell at overbought and cover at oversold. A couple of years ago I decided to force myself to put some IRA money to work every time T2108 broke 20. It hasn’t failed me yet.
• The Fed (Plunge Protection Team) has interfered announced stimulus packages around the July lows a couple times. On Thursday and earlier in the week there was talk of more PPT action.
• The PPT took action earlier in the week and last week. Just look at the orchestration of the LEH and AIG situations, etc.
• Extreme Volatility — The moves all week were nothing short of violent. Positions were whipsawed all over the place. That in & of itself would be reason enough to lighten up on positions if not move to the sidelines. That kind of volatility is often a sign of a trend reversal, not of a continuation of the previous trend. That’s why so many traders watch the VIX. Tons of people noted the spike in the VIX on Thursday.
• Corey from the ‘Afraid to Trade’ blog warned ‘Use Extreme Caution in the Week Ahead.‘ He gave many good reasons, including the Federal Reserve interest rate decision, the quadruple witching options expiration and headline risk from troubled financial firms. His crystal ball was working well when he wrote “We could see a week ahead that will be discussed years later - as such, if you are a newer trader, it might be best to switch to simulation mode this week or use this week as a training experience, rather than risking real capital in an environment that could swing violently up and down due to market events scheduled to happen this week.”
• Bullish Technical Divergences — Dr. Brett pointed out some bullish divergences he was seeing in the market. Perhaps most important were what he called ‘those fuzzy indicators’ — “Traffic on the blog is way up, reflecting trader uncertainty and desire for information. I just fielded my fourth media interview request in two days. During quiet and bullish market periods, I don’t get four requests in a month.” On Tuesday morning I also noted my blog’s traffic spiked as did Barry Ritholtz. I’ve often joked about making some kind of sentiment indicator based on my site’s traffic ebb & flow & referral logs. It’s not a bad idea and I think it would be especially useful if it were based on a major financial site’s traffic data.
• Dennis Gartman telling folks to “be small” — Gartman was on CNBC’s ‘Fast Money’ early in the week saying that he was scared of the market’s movement and he was “being small” and planned to “get smaller”. His advice to others was to “be small” in this market.
• Jeff Macke, also on ‘Fast Money’ was warning people not to play (trade) if they didn’t understand the (changing) rules of the game. He was referring to all the headline risk from PPT action and the volatility caused by rumors — many of which were spread by CNBC during the trading sessions. Ironically, Macke was kicking himself Thursday night for not following his own advice and getting caught short.

I fully believe that had the PPT not acted on Thursday night the market was *destined* to move higher in the short term on its own. Still being short on expiration Friday in this environment was just asking for trouble. So what’s a trader to do? Like I said earlier, stick & move. I think it makes much more sense to short bounces back to a trendline or moving average. William O’Neil’s book on short selling talks about using retracements to the 50 and/or 200-day moving average as a place to initiate shorts. By the time the stock (or whatever instrument you’re trading) is extended from its moving average it’s time to cover. Then you can wait for another bounce to reload.

The strategy to cover & reload makes more sense when you’re short due to the fact that if you’re dead right with your call on the stock dropping the most you can gain is 100%. The odds of that happening are slim and if it ever did happen you’d likely have to ride out some severe short squeezes. But you might be able to stick & move your way to more that a 100% gain by reloading multiple times. In theory, you could catch 15 10% moves lower in a stock that’s falling, retracing & falling anew.

Short sellers need to be nimble, pick their entry and exit spots wisely and heed signs of impending reversals. Trying to short breakdowns of an already extended market is a sucker’s play — as is overstaying your welcome while short.

Post from: Trader Mike's Blog

Picking Your Spots When Selling Short

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I post real numbers as opposed to R values, I always have. I like real numbers, I understand real numbers and I see truth in real numbers and I think the reader does too. As a reader of many blogs I find zero value in any post or summaries containing R values, I don’t see any point in sharing that information. I suppose if I posted in R values I could look like a pretty good trader, but we all know I am a struggling trader. R can mean anything so why even bother with it… R stands for bullsh!t imo and that’s my rant (that and ads haha). The best blogs out there post real numbers, Boogtser, JC (NYSE), the Kirkster all come to mind.

He’s joined by folks like Paul who left this comment over on Ugly’s post about R multiples:

I believe dollar values are more important than R value. I agree that the actual $ value is meaningless. However, R values are subjective and don’t give you a true idea on how successful the trade was. If you defined your risk at 15 cents and made 30 cents on the trade, while another person made 50 cents but decided his risk would be 50 cents, R values would say the guy who made 30 cents was more successful. I have a problem with that. It could very well be that the guy who only risked 15 cents is playing it too safe and his 2R gain was a bad trade.

So that gives you an idea of the anti-R sentiment. I’m going to explain why I think R-Multiples are so useful and why I use them in my trading and on this site.

What is R?

R is simply the dollar risk per trade. It’s nothing but a reward-to-risk ratio. I first heard it called “R” in Van Tharp’s book “Trade Your Way to Financial Freedom“. In another of his books, “Financial Freedom Through Electronic Day Trading”, Dr. Tharp reveals the great secret of trading:

The golden rule of trading is to keep losses at a level of 1 R as often as possible and to make profits that are high-R multiples.

You often hear (read) that traders should only look for trades with a reward/risk ratio of at least 2 or 3 to 1. Expressing your results in terms of how many times your risk allows you to easily see how well your trades measure up to such a standard. So when I look at my results in terms of multiples of R I can easily tell how good or bad the trades were. I like to think of R-Multiples as telling you the efficiency of your system.

So why not just use dollars?

Expressing my results in dollars would achieve the same result if I always risked the same amount of money. But what if I triple my account and therefore trade larger positions compared to when I started trading? Or what if I hit a rough spot and decide to cut my share size down while I ride out the storm? Then the dollar results won’t easily tell me how trades from one period of time compared to another period of time. But if I use R making such comparisons is simple. Either my trades passed the risk / reward ratio test or they didn’t. The actual number of dollars at risk doesn’t matter, how many multiples of the dollars at risk does.

Along the same lines, recording trades in terms of R-Multiples allows you to easily calculate your system’s expectancy. (Follow the link for why you should care about expectancy.)

Also, as Rx said:

talking and thinking in terms of R-multiple when you discuss about profits is an excellent approach - that by itself makes you focus on risk and money management - the actual “grail” to successful trading.

That is a very important point. Whenever I see people posting dollar returns, especially losses, that are all over the place the first thing I ask myself is “I wonder what his risk per trade is”. It’s almost a certainty that those traders aren’t focusing on risk and as a result keep having huge losses. The mere fact that you have to define R and then place a stop to keep your loss to 1R is probably too constraining for those gamblers traders. Dr. Tharp says about determining your initial stop-loss point as soon as you enter a trade, which, by definition woud give you a 1 R loss:

This principle is so important that if you cannot follow it, then you might as well give up the idea of electronic day trading right away.

The reason I use R on the blog is because I don’t want to discuss dollars or my account size on the site (as Ugly stated). That’s nobody’s business but mine. Also, it makes it easy for people to figure out what they could have made or lost on a trade with their own account size and risk per trade amount. If you see a trade that returned 3R all one has to do is plug in their dollar risk per trade to figure out what they could have made / lost.

To the R Haters

Let me address the “alleged” issues which I quoted above…

Glenn thinks that R is just some made up number and could mean anything. He likes “real” numbers. While it may be fun to see that somebody made $10,000 on a trade that in and of itself doesn’t tell you how good that trade was. What if that person risked $30,000 to make that $10,000? Or what if they risked $1,000 to make that $10,000? Those are two very different trades. Sure they both made the same amount of money but isn’t the second trade a much more efficient use of capital?

What if somebody is trading $500,000 lots to make $1,000 in profit? It may be nice to see somebody saying that they made $1,000 here and $1,000 there but damn(!) that’s an inefficient use of capital. So while R could mean anything in terms of dollars, in my humble opinion what really matters is how many multiples of R were made or lost. That tells you the quality of a trade or system.

Glenn also states that if he reported his trades in terms of R he could appear to be a good trader. I’m sorry to tell him that’s simply not the case. If you lost money that means your expectancy, which is just your average return expressed in R-Multiples, was negative.

Paul said that “R values are subjective and don’t give you a true idea on how successful the trade was”. That is exactly wrong. R-multiples are the very thing that tells you exactly how successful a given trade was, if you choose to grade on a risk/reward basis.

Percentages vs. Dollars

This debate about R reminds me of a conversation I had a couple of weeks ago. I was in a presentation for Trade-Ideas’ new tool, the Odds Maker. They were showing how you could backtest all these different scenarios with the tool. The results were expressed in average dollars won or lost. Another viewer and I asked about seeing the results in percentages. They kept saying that perhaps they would do that in a later revision. I kept harping on it because to me seeing the results in dollars was of little use for the way I size my positions

The argument from the presenter was that all you had to do was multiply the average dollar return by your average lot size to figure out how much money you could have made with a given system you were testing. I had to disagree because my lot size can vary drastically depending on how far away my stop loss is. Here’s a situation which could be problematic — I trade Google with a 2 point stop (which is only about half of a percent) and get lucky and make 6 points of profit. All of my other trades are on stocks under $50 with stops less than 50 cents. I could have some combination of winners and losers mixed in there… most of them probably well less than $6. That $6 gain may skew the results when presented as average dollars won. That’s an over-simplification and there are all kinds of possible permutations. But I hope my point is clear that looking at the results in terms of average dollars won/lost may not tell accurately tell you the story.

So how can we make the results clearer? Simple, express them in percentages. That way, regardless of how many shares were traded or the prices of the stocks traded the results can be equalized across all the trades. I feel much better being able to say , “OK, this system would have returned X%” instead of “X number of points.

We debated the merits of each way of reporting for a few minutes and at one point somebody said, well , for this release we’re aiming for the “lowest common denominator”. In other words, the average person can’t think in percentages, so we’re just gonna report in points. I was like, F the average person, make it work the “right” way! The funny thing is that after debating all of that the software actually could express the results in percentage terms. We just had to switch a setting.

So my point of that little story is that I always prefer to think in terms of percentages in stead of points. I always see people talking about number of shares of point moves. For example, you might hear somebody exclaim “Google is up 5 points!!!” I don’t see that as anything to get excited about. That just over a 1% move — a normal fluctuation. You’ll hear similar things from reporters talking excitedly about the Dow being up some triple-digit amount. The Nasdaq may actually be up a lot more on a percentage basis but they’ll just say, eh, the Nasdaq is “just” up 30 points.

Looking at the percentages makes those kind of comparisons easier. R-Multiples do the same thing for traders. They can accurately compare their own trades and they can take another trader’s results expressed in R and easily relate them to their own system.

Post from: Trader Mike's Blog

R (R-Multiples) Defined

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I was just curious if you could share with us your trading objectives. Do you just let your winners run and protect your losses or do you consistently make small gains?

I basically try to perform a balancing act between several trading rules/axioms. I’ve listed four axioms in their order of priority although the bottom three may flip positions on any given day/moment:

1. Preserve Your Capital: This is always number one for obvious reasons — can’t trade with no capital. I do this by practicing sound position sizing and always entering (and adhering to) stop losses.
2. Take Big Profits and Small Losses (aka Let Your Winners Run and Cut Your Losses Short): In my experience the 80/20 rule is live and well with respect to trading. (It may even be more like 90/10.) That is 20% of my trades make up 80% of my profits. So my goal is definitely not to make small gains but to try to let the small gains grow as much as possible.
3. Never Let a Profit Turn into a Loss: This one is tricky. In order to get a big gain you have to give a stock room to fluctuate. So it’s impossible to never let the tiniest of gains slip into the red. But at some point (for me, a 1R gain) I will move my stop loss order to break-even and then keep trailing it to lock in more of my gains.
4. Don’t Try to Predetermine Your Profits: I don’t like to use targets for exits because you just never know when a stock will become a moonshot. At the same time, as long time readers know, I’ve given back too many gains by trying to adhere to rule #3 above. So I’ve compromised by taking partial profits along the way but still trying to get the maximum gain on a portion of the initial position.

As you can see some of these rules contradict each other. But the bottom line is that I’m trying to keep the losses small (1R or less) while giving stocks enough room to produce large gains. Hopefully the small gains that I get “stuck” with will be more than enough to cover the small losses and a few big gains will pop up along the way.

Post from: Trader Mike's Blog

My Trading Objectives

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Hopefully that will give you some good ideas about what to put in your journal. One thing that I found is that just the exercise of keeping the journal updated keeps me on my toes. Whenever I find myself thinking about taking a flyer on a trade that I know I shouldn’t, I ask myself how I’m going to explain my entry in my journal. That’s usually enough to keep me out of that questionable trade. Another nice thing is tracking the R multiples. You know that if you start seeing R multiples much less than -1.0 that you’re really messing up. There’s no justifiable reason for letting the stocks fall through your initial stop. It also becomes exceedingly clear how important it is to keep those losses small.

You may also want to check out the StockTickr Trading Journal which “StockTickr Pro gives you access to a trading journal which calculates the expectancy of your trading system, automatically captures charts for your daily chart review (it plots your entry, stop, and exit points for you), and helps you figure out what is working and not working in your own trading.”

P.S. If anybody has other ideas about what to put in a journal or knows of a good journal software package please leave a comment.

P.P.S. I forgot to mention that I also have additional sheets in my journal ‘workbook’ (excel terminology). One page I call ‘daily recaps’ is just my P&L for the day with whatever comments I feel necessary for that day. The other page is identical except the columns apply to the entire week.

P.P.P.S. I just took a (very) quick look at the archives of Tharp’s newsletters and found these articles: ” The Art of Journaling, Part One” and The Art of Journaling, Part Two.

Post from: Trader Mike's Blog

On Trading Journals

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I’ve been exclusively day trading for almost three months now. The switch from swing trading has been quite an experience and I’ve had a few ‘light bulb’ moments along the way as you’ll see below.

The switch was definitely the right move for me to make. I think most people will probably be surprised to hear me say that day trading is much less stressful than holding stocks overnight. Mind you, I never ‘lost sleep’ because of my overnight holds but it’s a nice feeling to be able to start the morning in cash and not care what the market’s doing at the open. One of the things that sucked the most about swing trading was walking into a morning move against my positions. I’ve also taken advantage of being able to just shut things down for the day if the market’s not acting well. When I was swing trading I’d typically just sit there watching all day on days like that because I had some positions on.

One of the biggest changes for me was switching my commission structure to a ‘per share’ basis vs. the ‘per trade’ structure I was on previously. Now I’m paying $0.006/share instead of my old $9.95 per trade. That change impacts my trading in a couple of ways. First, it’s just much easier to break even (or even to make money). I could easily do $100 to $200/day in commissions with the $9.95/trade structure (that’s basically $20 round-trip on a stock) With my new commission structure those same trades could cost me well under $40 depending on the number of shares. The per share structure also allows me to scale in or out of positions without racking up even more commissions. So that’s made it even easier for me to take partial profits or to just cut & run if I see danger on the horizon.

One thing I’d like to note here is that I should have switched my commission structure back when I was still swing trading. My broker (CyberTrader) announced the per share structure last fall but I never looked into it because I knew that I didn’t trade enough shares to qualify for that plan. They require you to trade 40,000 shares per month or you have to pay a $250 fee. Back in April I did the math on my commissions for 2004 and I was shocked and appalled to learn that I would have come out far ahead on the other plan even if I’d paid the $250 penalty each month. So the lesson here is do the math and keep those costs down!

The main ‘light bulb’ moment(s) had to do with position sizing, risk management and buying power. I’ve already told you that I’m now using the percent risk model to size my positions. It made perfect sense to me when I read about it and even when I started using it in real live trading. But it wasn’t until that Google trade that the light bulb really lit up for me. I remember when the SEC changed the margin requirements & rules for day traders several years ago. Part of the change was that day traders could have 4 times their equity as intraday buying power. I never understood why they gave people so much margin but even more than that, I couldn’t imagine who’d be foolish enough to use that much margin. Well now I try to be that fool as often as possible.

The thing that the Google trade taught me was that if I go after high-priced stocks I can put a lot of money to work. As long as I have a tight stop I can still risk X percent of my equity per trade. Here’s an example:

Let say there are two stocks that are setting up entries for me. One is $8/share (let’s call it ABC) and the other is $80/share (XYZ). For simplicity I’ll just say that I want to risk $200 per trade. So let’s say that the setup given by ABC dictates a 25 cent stop and the stop on XYZ is one dollar. In order to risk only $200 on each trade I can buy 800 shares of ABC and 200 shares of XYZ. That means that I have $6,400 worth of ABC and $16,000 worth of XYZ. Let’s assume that both stocks move 2% higher. So I’ve only made $128 with ABC but I’ve made $320 in XYZ. That’s 2.5 times the profit even though my risk was the same on both trades.

Hopefully you can see why I’m really trying to focus on high-priced stocks now. I’ve already had a few days in which I’ve used all of my intraday buying power on just a handful of trades. I would have never imagined myself doing that just a few months ago. Day trading allows me to use much more buying power compared with swing trading, yet my risk is actually much lower than it was when I was swing trading.

My decision to finally start keeping a detailed trading journal has been a huge help. (I guess I should also give credit to Getting Things Done (GTD) for convincing me that writing things down can be a good thing!) I went through June and most of July just breaking even. But I was noticing recurring problems in my journal that I’d work on correcting. One problem was me initiating positions when the major indices and other general market indicators were telling me to stay out. I remedied that by adding rules about market ‘tone’ to my trading plan. The biggest problem I had was getting out of winning trades too soon. I always like to push my stops up to break-even when I can but my journal was screaming at me that I was adjusting my stops too aggressively. I kept getting stopped out of stocks that would have been big winners for me. What I noticed was that those stocks would typically have strong moves in less than 30 minutes or so and I’d push my stop up only to get stopped out and then the stock would turn again. So I made a rule that I can’t touch my stops until at least 60 minutes after entry. It was one week after I made that change that I had my biggest day in years. And I haven’t had the ’stopped out too soon’ problem since.

For those that want some numbers — My expectancy since June is 0.23R, where R is my initial dollars at risk per trade. I made that change to how I manage my stops on July 21st. Before that day my expectancy was 0.09R, since that date it is 0.40R. So I feel good about the positive (and increasing) expectancy and I’m working on getting that number higher. My win ratio is 45.05% right now. (Yes, you really can be wrong most of the time and still make money!) As for P&L, I’m up 19% since June. (Note that I’m not trading bigger as I make more money. I try to keep my equity level the same so if I drop below my initial equity level I’ll work to get back to even and if I’m above that initial level at the end of a week I’ll pull the excess money out of the account.) I should add that August has been a very slow month. I’ve had 8 days with no trades at all.

Finally, here are some resources that I’ve found helpful in making this transition to day trading:

• MaoXian — You already know about his ‘Trading for Dummies’ lessons but I learned a lot more from him than that. His trading style taught me that day trading doesn’t have to mean scalping, which is something I’ve never found appealing. He also opened my eyes to using a real-time scanner.
• The trader (Allan) that I sat with for a week when I was considering joining his team as a proprietary trader. (He recently started a blog but it’s not very active. Hopefully he’ll figure out what he wants to do with the site.) Although his style of trading didn’t suit me very well I did learn some things from him and from being in that trading office for a week. All of those guys used real-time scanners (big clue!). It was also during that week that I finally did the math about my commissions. All of the traders in that office were on a low, per-share commission structure and it was really enlightening to me to see how they could trade with such low commissions.
• Stephen Vita for the daily reminders about the market’s tone and opening range among other things.
• Van K. Tharp’s “Financial Freedom Through Electronic Day Trading” — Don’t let the title of this book fool you! This book isn’t just for day traders, it has some great stuff about creating a business plan for trading as well as covering position sizing, expectancy, keeping a journal, etc.
• “Tools and Tactics for the Master DayTrader: Battle-Tested Techniques for Day, Swing, and Position Traders” — Tons of great info in this book. I’d actually flipped through this book years ago and didn’t think much of it. Allan highly recommended it to me so I decided to give it a second chance. I’m glad I did.
• A couple of books to help me get my mind right — Way of Warrior Trader and The Trading Athlete
• The Traders Affirmations CD from DayTradingCourse.com — I learned of this CD on Market Monk’s site. It’s a good reminder of a lot of the things that are in Mark Douglas’s “Trading in the Zone“. I try to listen to the CD at least three times a week to make sure my mind stays right.

Post from: Trader Mike's Blog

Thoughts on Day Trading

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Dr. Van K. Tharp did an experiment which shows the importance position sizing. In his book “Trade Your Way to Financial Freedom” Van gives the results of his testing of four different position sizing models. He tested the models on the same trading system, so the only variable was the position sizing. The simulations were run with an initial equity of $1,000,000 and took 595 trades over a 5.5 year period. The models produced drastically different results:

• The worst was the baseline model which just bought 100 shares of stock whenever a signal was given. That model returned $32,567 or 0.58% annualized.
• Fixed-amount model: This method traded 100 shares per $100,000 in equity. It returned $237,457 or 5.75% annualized.
• Equal leverage model: Each position in this model was 3% of the account equity. So at the start of the trial each position was $30,000. This method returned $231,121.
• Percent risk model: According to this model positions were sized such that the initial risk exposure was 1% of the account equity. So with $1,000,000 equity the initial risk would be $10,000. So if the initial stop on a trade was $1 the system would trade 10,000 shares. For an initial stop of 50 cents the system would trade 20,000 shares, etc. This model returned $1,840,493 or 20.92% annualized.
• Percent Volatility model: Positions were sized based on each stock’s volatility — the more volatile the stock the fewer shares are traded. For this trial positions were pegged at 0.5% volatility (initially $5,000 per position) — so if a stock’s average true range was $5 the system would trade 1,000 shares. This model returned $2,109,266 or 22.93% annualized.

You can see how important position sizing is by that simple experiment. Remember that’s the same trading system with the only difference being the size of the positions.

In the past when I was swing trading I used to simply divide my equity by 5 and that would determine my position size. I wanted my maximum risk per trade to be 1% of my equity so that dictated that my maximum loss per position was 5%. I still do that with my long term account but I’m seriously considering changing that.

Now that I’m daytrading it makes a lot more sense to me to use the percent risk model. I always liked that model but I never felt comfortable using it when I was holding stocks overnight. Now that I don’t have to worry about overnight gaps I feel much better about using this method. It allows me to put a lot of money to work when I have an entry with a tight stop. But despite the fact that I could have 2 or 3 times as much money in play versus my old position sizing model I can still keep my risk per trade very small. It’s also kept me out of trades that were just too risky because it forces me to really look at where my initial stop will be. Often the stop will be so wide that I can only buy a handful of shares so it becomes clear that the trade isn’t worth the effort. This method also allows me to equalize my 1R risk across all trades which helps in my expectancy calculations.

Here are some position sizing resources:

• Van Tharp’s books are by far the best work I’ve seen on position sizing, expectancy and money management. I’ve read “Trade Your Way to Financial Freedom” and “Financial Freedom Through Electronic Day Trading” and recommend both highly.
• Money Management or Position Sizing or Bet Size… No Matter What You Call It, Better Know It
• Michael Taylor on his position sizing trials.
• Stephen Vita on his position sizing model.
• Jon Tait’s argument for trading many small positions. (I don’t necessarily agree with Jon’s conclusion but he covers some important topics in this post.)
• Position Sizing: Why Size Matters to All Investing Greats
• TradersCALM - Introduction to Position Sizing
• Position Sizing - The Most Powerful Investment Concept
• Size Really Does Matter! Position-Sizing Management Can Make a Difference Between Profit and Loss - (Free subscription required)
• T.I.P.S. - Trading is Position Sizing
• My position sizing spreadsheet
• TradeStars’ position sizing calculator
• Dave Laplander’s position sizing calulators

Post from: Trader Mike's Blog

Position Sizing

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The book is a very quick read. It actually was released in pamphlet form back in 1976. O’Neil and Gil Morales updated it with many charts and examples from the recent bear market and the years between 1976 and now. Less that 40 of the 192 pages are textual, the others contain annotated charts of “models of greatest short sales”. There are certainly more than enough examples for the reader to get a good understanding of ONeil’s methodology.

The first chapter is entitled ‘how and when to sell stocks short’. It begins by giving an explanation of short selling. (I even learned something here — that you don’t pay margin interest on shorts.) The bulk of that chapter discusses how tops are formed and how to identify them. I found the ‘what to sell short’ section especially interesting. O’Neil suggests shorting the the big leaders from the preceding bull market. One important characteristic to look for is a huge amount of institutional sponsorship. Those institutions may represent a ton of supply of stock. He also warns of what types of stocks not to short.

Probably the most important section of this chapter is the part about timing your sales. A key part of this methodology is the recognition that tops take time to form. O’Neil says that often the ideal shorting point is ‘five to seven months after the absolute peak in the stock’. He recommends using the 50 and 200-day moving averages as timing tools as well as some chart patterns to look out for. There’s also a discussion of strategies for closing out short sales. I found it interesting (and curious) that he didn’t cover his 8% stop-loss rule in this book. All he says is that your profit objective should be double your stop loss target.

The next chapter, ‘Anatomy of a Short Sale’, prepares the reader for the onslaught of charts in the final chapter. It contains two diagrams which lay out the key things to look for in stock charts. After finishing this section the reader should have the theory of O’Neil’s methodology down pretty well. The final chapter, ‘models of greatest short sales’ turns that theory into reality by giving over a hundred examples of real-life stock charts. That chapter begins with a detailed textual walk-through of several charts, including Cisco (2000 - 2001), Lucent (2000 - 2001), Calpine (2002), Yahoo! (2001), Broadcom (2001) as well as some examples from 1970. The rest of the chapter contains the aforementioned annotated charts. There are examples of stocks from the 1960’s all the way up to September 2004. Some of those 2004 examples are Krispy Kreme, NetFlix, Sina, Netease, Corinthian Colleges and Career Education.

Clearly O’Neil is on to something if he can find examples spanning 40 years. As I read the book I kept getting ideas about specific stocks and sectors to keep an eye on for shorting opportunities (the housing sector, ANTP…). There are a couple of important things that I took away from this book. I’ll often identify stocks that are topping but then I’ll get tired of watching them thrash around for weeks. I usually end up taking them off of my watchlist and subsequently missing some great shorting opportunities. It’s clear that I need to keep a longer term list of potential shorts. My other take-away is that I need to look at weekly charts much more often. The book uses weekly charts almost exclusively. Given that these tops form over months, weekly charts make more sense than the daily charts that I typically use. I’m looking forward to seeing if I can find some good shorts using O’Neil’s methods.

Post from: Trader Mike's Blog

Trading 101: Recommended Reading - ‘How to Make Money Selling Stocks Short’

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First, the typical way people think of trading is to buy first, which is called going long, and then to sell at some later time. The profit or loss is the difference between the two prices. Obviously, when you go long you expect the price to rise in the future. Shorting is just the same thing in reverse — instead of buying first, you sell first (go short) and then buy back later, preferably at a lower price. Again, the profit or loss is the difference between the two prices. The natural question here is “How do you sell something that you don’t have?” The answer is that you borrow it.

The process works like this. Let’s say I want to short 100 shares of Microsft (MSFT). First I have to find 100 shares to borrow. I simply check with my broker to see if there are shares available to be borrowed. If there are none then I’m out of luck. If there are shares to borrow then I can short the stock. I can enter an order to sell 100 shares of MSFT short and once that order is filled I owe my broker 100 shares of MSFT. I’ll need to buy 100 shares of MSFT at some later time, hopefully at a lower price, in order to replace the borrowed shares and close out (cover) my short position.

Make sense? Here’s an example that many of you may be familiar with and may not even know it. For years after I first saw the movie ‘Trading Places‘ (buy from Amazon.com) I never understood how Billy Ray (Eddie Murphy) and Louis Winthorpe III (Dan Aykroyd) made all that money at the end of the movie. It wasn’t until I learned about short selling that I understood how they did it. Here’s how it went down:

• Billy Ray and Winthorpe intercepted the Duke brothers’ copy of the real orange juice crop report. They discovered that the crop was good, which would be bad for OJ prices.
• Next they gave a fake crop report to the Duke brothers, who were planning to make a killing off of their stolen report. The brothers, after seeing the fake report, were under the wrong assumption that the crop was bad and thus OJ prices had to rise significantly.
• The Dukes sent their trader into the pit to buy all the OJ he could — price be damned.
• Billy Ray and Winthorpe stood and waited for the crowd to bid the price of OJ up so that they could short OJ to all the frenzied buyers. They shorted all the OJ they could just before the real crop report was to be read.
• Once the real report was read and the world learned that it was a bumper crop, the price of OJ tanked.
• Billy Ray and Winthorpe waited for the bottom to fall out and then proceed to to cover their OJ position and made a fortune.

See, wasn’t that simple?

There are some important things to keep in mind about shorting that differ from going long. When you go long you can only lose 100% of your (assuming no margin) initial stake and your profits are theoritically infinite. Well the opposite is true for shorting — your profit maxes out at 100% and your theoretical losses are infinite. Of course in practice your broker will close you out long before you reach infinity. Nonetheless, you can see that you may not want to short stocks that are prone to big jumps (thinly traded stocks, small biotech or drug companies, mania stocks, etc.).

There’s certainly more that can be said on this topic but since this is supposed to be very basic I’m going to stop here. Below are some links for more information:

• Short Selling: Introduction [PDF/Printer-friendly version]


• What’s Wrong With Short-Selling?


• Short Selling is American

Post from: Trader Mike's Blog

The (Very) Basics of Short Selling

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I’d put ‘Trend Following’ right up there with other essential reads like the ‘Market Wizards Series‘ and ‘Reminiscences of a Stock Operator‘. (There’s a reason why the book has received so many accolades and is a top seller.) Like the ‘Market Wizard’ books, ‘Trend Following’ reveals the methods of some of the greatest traders in history. The difference being that ‘Trend Following’ examines the best of the best, who all happen to be trend followers. Some of the traders who are profiled are: Bill Dunn, who has returned 24% for 28 years; John W. Henry, owner of the Boston Red Sox, who returned 21 times the S&P 500 from 1998 through 2003; and Ed Seykota, who is very likely the greatest trader in history as evidenced by his just under 60% average annual return from 1990 to 2000. ‘Trend Following’ reveals the simple method which all of these traders used to achieve such spectacular results.

Covel takes no prisoners in showing why trend following is the superior trading methodology. He lays waste to all other styles of investing/trading — ‘buy & hold’ (Warren Buffett fans will just love chapter 9), fundamental analysis, or even (gasp!) technical analysis. I’ve always been a proponent of simplifying things and it’s the simplicity that I love about trend following. Trend followers focus mainly on price itself to determine when to enter and exit trades and they’ll go short just as easily as going long. The book illustrates how that methodology has allowed them to make huge profits from some of the greatest financial disasters of modern times such as the Enron debacle, the collapse of Long Term Capital Management, the 1997 Asian Contagion, the 1987 stock market crash, or the popping of the NASDAQ bubble. If you look at charts of any of those events you’ll see that the markets were already trending down before the events took place. Trend followers were already positioned to profit because price told them to be short — there was no magic formula.

The book also explores the mindset and traits of a successful trader via discussions of human behavior, decision making and the science of trading. The culmination of the book is a chapter devoted to developing a trading system, complete with a discussion of two topics that I’m always thrilled to see — position sizing and expectancy.

If you want to improve your trading results I highly suggest that you study this book.

P.S. One thing that the book left me wondering is how the average person can take advantage of the trend following money managers who were profiled. I’d like to know if there are trend-following funds that people could put their IRA money into, or does one need to be an accredited investor to buy into those funds. I plan to find some answers to those questions forthwith.

Update: Good news, apparently the average Joe can access at least some of these funds. Mr. Covel just sent me the following info about John Henry funds:

“But smaller investors can buy into a fund of funds that divides its money among several futures funds that may vary by risk profile and type of investment. The cost of entry is as low as $5,000 ($2,000 for an individual retirement account), with fees that run about 1% of assets and up to 2.5% of profits. The top performers this year in this group are John W. Henry’s Millburn series of funds, with a 29% return, and the Dean Witter Portfolio Strategy Fund, up 28%.”

BusinessWeek

DECEMBER 29, 2003

Post from: Trader Mike's Blog

Trading 101: Recommended Reading - ‘Trend Following’

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What MAs do is smooth out fluctuations in prices, thereby making it easier to spot trends. We’ve all heard the expressions “the trend is your friend” and “trade with the trend” but often it’s difficult to identify the trend. That’s because stocks don’t move in straight lines as well as the fact that the trend may be different depending on your time frame. For this discussion I’ll define three different time frames as follows:

• Short Term - A 10-day moving average. This is what short term traders would use.


• Intermediate Term - A 50-day moving average. People with a few weeks to few months time frame might want to use this average.


• Long Term - A 200-day moving average. Long term investors with a time frame of months to years.

Each of those groups could look at the same chart and see a different trend. MAs allow you to identify the trend by simply looking at the slope of the average. So if the line is slanting upward to the right the trend is up, and if it’s sloping downward to the right the trend is down. As an example let’s look at a chart of the NASDAQ for the first half of this year (10-day is blue, 50-day is red, 200-day is green):

You can clearly see how the just using those three MAs there several trends in effect at any given time. So the key is to decide which trend(s) apply to your style of investing/trading. Some observations from that chart:

• Moving averages have a smoothing or dampening effect on the price chart. The longer the average the smoother.


• Moving averages are lagging indicators. Notice how the shorter averages hug the actual prices closely. But even the 10-day MA doesn’t catch the exact turning points.


• A lot of money could have been made/saved by simply buying when prices crossed above the 10-day MA and selling when they broke below the average.


• In a strong uptrend the shorter term moving averages are above the longer term averages. See the left side of the chart. (The converse also holds true.)

How to Use Moving Averages

Here are just a few simple ideas for putting moving averages to work:

1. Only consider buying a stock if it is above your moving average. By definition, if prices are below the average they are trending down. One of the best pieces of advice I’ve read on this subject was from Trader Vic. He said

   When picking stocks, I never buy a stock when prices are below the moving average, and I never (short) sell a stock when price is above the moving average. Just pick up any chart book that uses a 35- or 40-week moving average and you’ll see why — the odds of being right are way against you.

Mind you, this is after Vic does all of his fundamental analysis on a stock. So even if the stock looks great fundamentally, he’ll pass if it’s below the moving average.

2. Use moving averages as an exit signal. Seriously consider selling a stock that closes below the moving average.


3. Consider buying stocks as they drop near an upward sloping moving average. You’ll notice when looking at charts that stocks often find support (bounce off of) moving averages. Buying on a pullback to a MA will often give you a good risk/reward entry point. You can put a stop-loss order nearby in case you’re wrong about the bounce.

Let’s look at some examples using some of the biggest winners and losers of this year. Here’s Krispy Kreme Donuts which is down 59% from the August 2003 high and down 48% from when it broke under the 200-day MA.

QLogic, which is 53% off of its November high and down 44% from the day after it broke the 200-day MA. As you can see after breaking the 200-day MA there was no good reason to buy for any of our time frames.

Next we have Novatel Wireless which is up 320% this year. It just so happened to rise above its 50-day MA on the last day of December.

And finally, here’s a chart of Taser which has had one of the strongest uptrends you’ll ever see. It’s up about 4,500% since it rose above its 200-day moving average. You can see, based on how the 10-day moving average, that short term traders have been in control of this stock. It continually found support at that average.

As you can see moving averages are very simple to use and can help to protect your capital. Even using the late signal given by a break of the 200-day MA would have gotten you out of Enron and MCI long before they imploded. You can add moving averages to stock charts at just about any site that provides stock quotes & charts, like I’ve done S&P 500 chart with moving averages here at Yahoo! Finance.

For more in-depth information about moving averages see the following resources:

• An Introduction to Moving Averages


• StockCharts.com’s article on moving averages.


• My article about Daryl Guppy’s Multiple Moving Averages


• A simple way to spot buys

Post from: Trader Mike's Blog

Trading 101: Moving Averages

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