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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.

There seems to be a lot of controversial over the concept of R-Multiples. I've been seeing people complain about them for months now and I've been meaning to write a post about "R". I really wanted to do it last week but I'm glad I didn't get to it because this week a raging debate about R has popped up. Glenn, at DehTrader can serve as the poster child for the anti-R crew. Here's part of his recent rant against R-Multiples (emphasis is mine):

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.

I was asked the following via an email:

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.

Last week the following question was asked of me about trading journals:

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.

(Edit: You may also be interested in my article detailing how I trade as well as my hardware and software setup.)

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.

Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it's rarely covered in trading books. A position sizing model simply tells you 'how much' or 'how big' of a position to take. Position sizing can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.

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

I just finished reading William O'Neil's book 'How to Make Money Selling Stocks Short'. I was rather surprised at the approach O'Neil professes. Given that he's such a proponent of using both technical and fundamental analysis when buying stocks, I expected him to do the same for short selling. That's not the case at all, in fact the book doesn't even mention fundamentals (which is fine by me). O'Neil's shorting method only takes the general market direction and stock charts into account. That shows the importance of the 'M' (market direction) in O'Neil's CANSLIM.

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.

This is a post that I've told several friends of mine that I would write. It seems that I often get blank stares when I mention shorting. This is an explanation of short selling for those who may not be that familiar with the financial markets.

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

From the moment I first heard about Michael Covel's 'Trend Following: How Great Traders Make Millions in Up or Down Markets' I knew I'd like the book. Now that I've read it I can safely say that this book is a classic and a must-read for anybody involved with the markets -- even those of you who are just blindly plowing money into your retirement accounts.

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.

Moving averages (MAs) are very simple, yet extremely useful tools for investors. A moving average is simply the average of a series of numbers over a period of time which is constantly updated by dropping the oldest value and then adding the newest value and recalculating the average. So a 5-day moving average of stock prices would add up the closing prices for the last 5 days and then divide that total by 5. After the next trading day, we would drop the oldest day and calculate the average with the latest days' price in its place. So over time the average moves as new data is added and old data is dropped. There are other, more complex, types of MAs (exponential, triangular, variable, and weighted are some of the more popular ones ) but for this discussion we'll focus on the type I just described, which are called 'simple (a.k.a. arithmetic) moving averages'.

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:

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.

There seems to be a lot of controversial over the concept of R-Multiples. I've been seeing people complain about them for months now and I've been meaning to write a post about "R". I really wanted to do it last week but I'm glad I didn't get to it because this week a raging debate about R has popped up. Glenn, at DehTrader can serve as the poster child for the anti-R crew. Here's part of his recent rant against R-Multiples (emphasis is mine):

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.

I was asked the following via an email:

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.

Last week the following question was asked of me about trading journals:

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.

(Edit: You may also be interested in my article detailing how I trade as well as my hardware and software setup.)

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.

Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it's rarely covered in trading books. A position sizing model simply tells you 'how much' or 'how big' of a position to take. Position sizing can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.

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

I just finished reading William O'Neil's book 'How to Make Money Selling Stocks Short'. I was rather surprised at the approach O'Neil professes. Given that he's such a proponent of using both technical and fundamental analysis when buying stocks, I expected him to do the same for short selling. That's not the case at all, in fact the book doesn't even mention fundamentals (which is fine by me). O'Neil's shorting method only takes the general market direction and stock charts into account. That shows the importance of the 'M' (market direction) in O'Neil's CANSLIM.

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.

This is a post that I've told several friends of mine that I would write. It seems that I often get blank stares when I mention shorting. This is an explanation of short selling for those who may not be that familiar with the financial markets.

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

From the moment I first heard about Michael Covel's 'Trend Following: How Great Traders Make Millions in Up or Down Markets' I knew I'd like the book. Now that I've read it I can safely say that this book is a classic and a must-read for anybody involved with the markets -- even those of you who are just blindly plowing money into your retirement accounts.

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.

Moving averages (MAs) are very simple, yet extremely useful tools for investors. A moving average is simply the average of a series of numbers over a period of time which is constantly updated by dropping the oldest value and then adding the newest value and recalculating the average. So a 5-day moving average of stock prices would add up the closing prices for the last 5 days and then divide that total by 5. After the next trading day, we would drop the oldest day and calculate the average with the latest days' price in its place. So over time the average moves as new data is added and old data is dropped. There are other, more complex, types of MAs (exponential, triangular, variable, and weighted are some of the more popular ones ) but for this discussion we'll focus on the type I just described, which are called 'simple (a.k.a. arithmetic) moving averages'.

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:

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.

There seems to be a lot of controversial over the concept of R-Multiples. I've been seeing people complain about them for months now and I've been meaning to write a post about "R". I really wanted to do it last week but I'm glad I didn't get to it because this week a raging debate about R has popped up. Glenn, at DehTrader can serve as the poster child for the anti-R crew. Here's part of his recent rant against R-Multiples (emphasis is mine):

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.

I was asked the following via an email:

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.

Last week the following question was asked of me about trading journals:

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.

(Edit: You may also be interested in my article detailing how I trade as well as my hardware and software setup.)

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.

Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it's rarely covered in trading books. A position sizing model simply tells you 'how much' or 'how big' of a position to take. Position sizing can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.

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

I just finished reading William O'Neil's book 'How to Make Money Selling Stocks Short'. I was rather surprised at the approach O'Neil professes. Given that he's such a proponent of using both technical and fundamental analysis when buying stocks, I expected him to do the same for short selling. That's not the case at all, in fact the book doesn't even mention fundamentals (which is fine by me). O'Neil's shorting method only takes the general market direction and stock charts into account. That shows the importance of the 'M' (market direction) in O'Neil's CANSLIM.

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.

This is a post that I've told several friends of mine that I would write. It seems that I often get blank stares when I mention shorting. This is an explanation of short selling for those who may not be that familiar with the financial markets.

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

From the moment I first heard about Michael Covel's 'Trend Following: How Great Traders Make Millions in Up or Down Markets' I knew I'd like the book. Now that I've read it I can safely say that this book is a classic and a must-read for anybody involved with the markets -- even those of you who are just blindly plowing money into your retirement accounts.

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.

Moving averages (MAs) are very simple, yet extremely useful tools for investors. A moving average is simply the average of a series of numbers over a period of time which is constantly updated by dropping the oldest value and then adding the newest value and recalculating the average. So a 5-day moving average of stock prices would add up the closing prices for the last 5 days and then divide that total by 5. After the next trading day, we would drop the oldest day and calculate the average with the latest days' price in its place. So over time the average moves as new data is added and old data is dropped. There are other, more complex, types of MAs (exponential, triangular, variable, and weighted are some of the more popular ones ) but for this discussion we'll focus on the type I just described, which are called 'simple (a.k.a. arithmetic) moving averages'.

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:

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.

There seems to be a lot of controversial over the concept of R-Multiples. I've been seeing people complain about them for months now and I've been meaning to write a post about "R". I really wanted to do it last week but I'm glad I didn't get to it because this week a raging debate about R has popped up. Glenn, at DehTrader can serve as the poster child for the anti-R crew. Here's part of his recent rant against R-Multiples (emphasis is mine):

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.

I was asked the following via an email:

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.

Last week the following question was asked of me about trading journals:

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.

(Edit: You may also be interested in my article detailing how I trade as well as my hardware and software setup.)

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.

Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it's rarely covered in trading books. A position sizing model simply tells you 'how much' or 'how big' of a position to take. Position sizing can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.

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

I just finished reading William O'Neil's book 'How to Make Money Selling Stocks Short'. I was rather surprised at the approach O'Neil professes. Given that he's such a proponent of using both technical and fundamental analysis when buying stocks, I expected him to do the same for short selling. That's not the case at all, in fact the book doesn't even mention fundamentals (which is fine by me). O'Neil's shorting method only takes the general market direction and stock charts into account. That shows the importance of the 'M' (market direction) in O'Neil's CANSLIM.

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.

This is a post that I've told several friends of mine that I would write. It seems that I often get blank stares when I mention shorting. This is an explanation of short selling for those who may not be that familiar with the financial markets.

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

From the moment I first heard about Michael Covel's 'Trend Following: How Great Traders Make Millions in Up or Down Markets' I knew I'd like the book. Now that I've read it I can safely say that this book is a classic and a must-read for anybody involved with the markets -- even those of you who are just blindly plowing money into your retirement accounts.

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.

Moving averages (MAs) are very simple, yet extremely useful tools for investors. A moving average is simply the average of a series of numbers over a period of time which is constantly updated by dropping the oldest value and then adding the newest value and recalculating the average. So a 5-day moving average of stock prices would add up the closing prices for the last 5 days and then divide that total by 5. After the next trading day, we would drop the oldest day and calculate the average with the latest days' price in its place. So over time the average moves as new data is added and old data is dropped. There are other, more complex, types of MAs (exponential, triangular, variable, and weighted are some of the more popular ones ) but for this discussion we'll focus on the type I just described, which are called 'simple (a.k.a. arithmetic) moving averages'.

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:

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.

There seems to be a lot of controversial over the concept of R-Multiples. I've been seeing people complain about them for months now and I've been meaning to write a post about "R". I really wanted to do it last week but I'm glad I didn't get to it because this week a raging debate about R has popped up. Glenn, at DehTrader can serve as the poster child for the anti-R crew. Here's part of his recent rant against R-Multiples (emphasis is mine):

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.

I was asked the following via an email:

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.

Last week the following question was asked of me about trading journals:

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.

(Edit: You may also be interested in my article detailing how I trade as well as my hardware and software setup.)

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.

Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it's rarely covered in trading books. A position sizing model simply tells you 'how much' or 'how big' of a position to take. Position sizing can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.

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

I just finished reading William O'Neil's book 'How to Make Money Selling Stocks Short'. I was rather surprised at the approach O'Neil professes. Given that he's such a proponent of using both technical and fundamental analysis when buying stocks, I expected him to do the same for short selling. That's not the case at all, in fact the book doesn't even mention fundamentals (which is fine by me). O'Neil's shorting method only takes the general market direction and stock charts into account. That shows the importance of the 'M' (market direction) in O'Neil's CANSLIM.

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.

This is a post that I've told several friends of mine that I would write. It seems that I often get blank stares when I mention shorting. This is an explanation of short selling for those who may not be that familiar with the financial markets.

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

From the moment I first heard about Michael Covel's 'Trend Following: How Great Traders Make Millions in Up or Down Markets' I knew I'd like the book. Now that I've read it I can safely say that this book is a classic and a must-read for anybody involved with the markets -- even those of you who are just blindly plowing money into your retirement accounts.

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.

Moving averages (MAs) are very simple, yet extremely useful tools for investors. A moving average is simply the average of a series of numbers over a period of time which is constantly updated by dropping the oldest value and then adding the newest value and recalculating the average. So a 5-day moving average of stock prices would add up the closing prices for the last 5 days and then divide that total by 5. After the next trading day, we would drop the oldest day and calculate the average with the latest days' price in its place. So over time the average moves as new data is added and old data is dropped. There are other, more complex, types of MAs (exponential, triangular, variable, and weighted are some of the more popular ones ) but for this discussion we'll focus on the type I just described, which are called 'simple (a.k.a. arithmetic) moving averages'.

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:

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.

There seems to be a lot of controversial over the concept of R-Multiples. I've been seeing people complain about them for months now and I've been meaning to write a post about "R". I really wanted to do it last week but I'm glad I didn't get to it because this week a raging debate about R has popped up. Glenn, at DehTrader can serve as the poster child for the anti-R crew. Here's part of his recent rant against R-Multiples (emphasis is mine):

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.

I was asked the following via an email:

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.

Last week the following question was asked of me about trading journals:

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.

(Edit: You may also be interested in my article detailing how I trade as well as my hardware and software setup.)

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.

Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it's rarely covered in trading books. A position sizing model simply tells you 'how much' or 'how big' of a position to take. Position sizing can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.

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

I just finished reading William O'Neil's book 'How to Make Money Selling Stocks Short'. I was rather surprised at the approach O'Neil professes. Given that he's such a proponent of using both technical and fundamental analysis when buying stocks, I expected him to do the same for short selling. That's not the case at all, in fact the book doesn't even mention fundamentals (which is fine by me). O'Neil's shorting method only takes the general market direction and stock charts into account. That shows the importance of the 'M' (market direction) in O'Neil's CANSLIM.

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.

This is a post that I've told several friends of mine that I would write. It seems that I often get blank stares when I mention shorting. This is an explanation of short selling for those who may not be that familiar with the financial markets.

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

From the moment I first heard about Michael Covel's 'Trend Following: How Great Traders Make Millions in Up or Down Markets' I knew I'd like the book. Now that I've read it I can safely say that this book is a classic and a must-read for anybody involved with the markets -- even those of you who are just blindly plowing money into your retirement accounts.

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.

Moving averages (MAs) are very simple, yet extremely useful tools for investors. A moving average is simply the average of a series of numbers over a period of time which is constantly updated by dropping the oldest value and then adding the newest value and recalculating the average. So a 5-day moving average of stock prices would add up the closing prices for the last 5 days and then divide that total by 5. After the next trading day, we would drop the oldest day and calculate the average with the latest days' price in its place. So over time the average moves as new data is added and old data is dropped. There are other, more complex, types of MAs (exponential, triangular, variable, and weighted are some of the more popular ones ) but for this discussion we'll focus on the type I just described, which are called 'simple (a.k.a. arithmetic) moving averages'.

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:

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.

There seems to be a lot of controversial over the concept of R-Multiples. I've been seeing people complain about them for months now and I've been meaning to write a post about "R". I really wanted to do it last week but I'm glad I didn't get to it because this week a raging debate about R has popped up. Glenn, at DehTrader can serve as the poster child for the anti-R crew. Here's part of his recent rant against R-Multiples (emphasis is mine):

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.

I was asked the following via an email:

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.

Last week the following question was asked of me about trading journals:

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.

(Edit: You may also be interested in my article detailing how I trade as well as my hardware and software setup.)

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.

Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it's rarely covered in trading books. A position sizing model simply tells you 'how much' or 'how big' of a position to take. Position sizing can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.

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

I just finished reading William O'Neil's book 'How to Make Money Selling Stocks Short'. I was rather surprised at the approach O'Neil professes. Given that he's such a proponent of using both technical and fundamental analysis when buying stocks, I expected him to do the same for short selling. That's not the case at all, in fact the book doesn't even mention fundamentals (which is fine by me). O'Neil's shorting method only takes the general market direction and stock charts into account. That shows the importance of the 'M' (market direction) in O'Neil's CANSLIM.

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.

This is a post that I've told several friends of mine that I would write. It seems that I often get blank stares when I mention shorting. This is an explanation of short selling for those who may not be that familiar with the financial markets.

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

From the moment I first heard about Michael Covel's 'Trend Following: How Great Traders Make Millions in Up or Down Markets' I knew I'd like the book. Now that I've read it I can safely say that this book is a classic and a must-read for anybody involved with the markets -- even those of you who are just blindly plowing money into your retirement accounts.

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.

Moving averages (MAs) are very simple, yet extremely useful tools for investors. A moving average is simply the average of a series of numbers over a period of time which is constantly updated by dropping the oldest value and then adding the newest value and recalculating the average. So a 5-day moving average of stock prices would add up the closing prices for the last 5 days and then divide that total by 5. After the next trading day, we would drop the oldest day and calculate the average with the latest days' price in its place. So over time the average moves as new data is added and old data is dropped. There are other, more complex, types of MAs (exponential, triangular, variable, and weighted are some of the more popular ones ) but for this discussion we'll focus on the type I just described, which are called 'simple (a.k.a. arithmetic) moving averages'.

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:

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.

There seems to be a lot of controversial over the concept of R-Multiples. I've been seeing people complain about them for months now and I've been meaning to write a post about "R". I really wanted to do it last week but I'm glad I didn't get to it because this week a raging debate about R has popped up. Glenn, at DehTrader can serve as the poster child for the anti-R crew. Here's part of his recent rant against R-Multiples (emphasis is mine):

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.

I was asked the following via an email:

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.

Last week the following question was asked of me about trading journals:

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.

(Edit: You may also be interested in my article detailing how I trade as well as my hardware and software setup.)

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.

Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it's rarely covered in trading books. A position sizing model simply tells you 'how much' or 'how big' of a position to take. Position sizing can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.

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

I just finished reading William O'Neil's book 'How to Make Money Selling Stocks Short'. I was rather surprised at the approach O'Neil professes. Given that he's such a proponent of using both technical and fundamental analysis when buying stocks, I expected him to do the same for short selling. That's not the case at all, in fact the book doesn't even mention fundamentals (which is fine by me). O'Neil's shorting method only takes the general market direction and stock charts into account. That shows the importance of the 'M' (market direction) in O'Neil's CANSLIM.

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.

This is a post that I've told several friends of mine that I would write. It seems that I often get blank stares when I mention shorting. This is an explanation of short selling for those who may not be that familiar with the financial markets.

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

From the moment I first heard about Michael Covel's 'Trend Following: How Great Traders Make Millions in Up or Down Markets' I knew I'd like the book. Now that I've read it I can safely say that this book is a classic and a must-read for anybody involved with the markets -- even those of you who are just blindly plowing money into your retirement accounts.

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.

Moving averages (MAs) are very simple, yet extremely useful tools for investors. A moving average is simply the average of a series of numbers over a period of time which is constantly updated by dropping the oldest value and then adding the newest value and recalculating the average. So a 5-day moving average of stock prices would add up the closing prices for the last 5 days and then divide that total by 5. After the next trading day, we would drop the oldest day and calculate the average with the latest days' price in its place. So over time the average moves as new data is added and old data is dropped. There are other, more complex, types of MAs (exponential, triangular, variable, and weighted are some of the more popular ones ) but for this discussion we'll focus on the type I just described, which are called 'simple (a.k.a. arithmetic) moving averages'.

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:

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.

There seems to be a lot of controversial over the concept of R-Multiples. I've been seeing people complain about them for months now and I've been meaning to write a post about "R". I really wanted to do it last week but I'm glad I didn't get to it because this week a raging debate about R has popped up. Glenn, at DehTrader can serve as the poster child for the anti-R crew. Here's part of his recent rant against R-Multiples (emphasis is mine):

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.

I was asked the following via an email:

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.

Last week the following question was asked of me about trading journals:

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.

(Edit: You may also be interested in my article detailing how I trade as well as my hardware and software setup.)

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.

Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it's rarely covered in trading books. A position sizing model simply tells you 'how much' or 'how big' of a position to take. Position sizing can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.

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

I just finished reading William O'Neil's book 'How to Make Money Selling Stocks Short'. I was rather surprised at the approach O'Neil professes. Given that he's such a proponent of using both technical and fundamental analysis when buying stocks, I expected him to do the same for short selling. That's not the case at all, in fact the book doesn't even mention fundamentals (which is fine by me). O'Neil's shorting method only takes the general market direction and stock charts into account. That shows the importance of the 'M' (market direction) in O'Neil's CANSLIM.

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.

This is a post that I've told several friends of mine that I would write. It seems that I o