Trader's Thread 01 (May 08 - Dec 08)

[winston]

Understanding Exits: Helpful Advice on Exit Strategies
By Charles LeBeau

Exit strategies for investors and traders are a much neglected subject. There are thousands of books that attempt to teach us about what and when to buy but I can count the books about selling on one hand and have a few fingers left over.

My fascination with the subject of exit strategies probably came about due to my very first "investment" in 1963. As a young college student I bought a contract of corn futures that was expected to expire in less than a month. Buy and hold was not an option in the commodities markets, so my immediate problem to solve was when to sell my 5,000 bushels of December Corn.

One of my college professors had taught me the strategy I had used to buy the corn contract. But when I sought his advice on when to sell it, he shrugged, smiled and told me I was on my own, but to be sure to sell it before it was delivered to me. I sold the corn contract a few days later simply because I had quickly made about a month's wages (I wasn't paid much) and I needed the money. After making a profit on my first investment, I've been trading and trying to figure out when to sell financial instruments ever since.

After more than 40 years of trading, I've managed to learn quite a bit more about selling in spite of not having had much help or good advice along the way. Apparently, my college professor was not the only one who wasn't clear about when to sell. I suspect that many of those reading this article are also looking for help, so I will briefly share some basic thoughts about what I have learned over my many years of focusing my attention on exit strategies.

Investment and trading results depend on exits – not entries. Everyone needs to realize that our exit strategies determine the outcome of our trades. Our exits directly control our profits and our losses so they deserve our full attention and effort. If you are reading this article – that's a good start. Try to find even more information about when to sell. (It's not easy. Good luck!)

When David Lucas and I were doing our research for our book Computer Analysis of the Futures Market, we were involved in testing a large number of popular technical indicators to see which ones produced the best trading results. It didn't take us long to discover that the results of the indicators, used for entry signals, depended entirely on what exit strategy we paired them with.

Based on our testing results it was obvious that the exits were more important than the entries. After some careful thought, our solution to the entry testing problem was simply: to exit every trade after a fixed period of time and to use the same period of time to compare the various entry methods. If we used any other exit method it had too much influence on our test results.

Don't default to Buy and Hold. Define risk and limit your risk. Attention to exits is important because it is our exit strategies that allow us to define and control risk. Without an exit strategy, risk remains undefined and uncontrolled. If you buy a thousand shares of stock at $50, what is your risk? If you don't have a black and white exit strategy that tells you where to sell, your risk defaults to being 100% of your investment (and even more if you are leveraged).

That amount of risk should never be acceptable but that is exactly what most uninformed investors are doing. Those investors who rely on Buy and Hold (or who have no exit strategy) should realize that they are using the most risky exit strategy ever conceived. The risk of Buy and Hold is completely undefined, uncontrolled and limited only by the amount of capital on the table. Buy and Hold ignores the fact that risk control is perhaps the most important problem in all of investing.

Rather than to solve this critical risk problem directly by employing a well thought out exit strategy, the advocates of Buy and Hold, resort to all sorts of creative but often complex measures involving carefully weighted diversification, asset allocation models, correlation studies, portfolio balancing and rebalancing and so on. It keeps a lot of "quants" busy designing and monitoring these sophisticated strategies simply so they can avoid getting wiped out by their steadfast commitment to Buy and Hold.

Why can't they simply keep their winners and sell their losers? Is that so difficult? Rather than adopting an intelligent exit strategy, in the first place, all of this extra effort is devoted to making a basically unintelligent and unlimited risk strategy less risky. In my opinion that is a serious waste of intellectual talent. But if you default to Buy and Hold as your exit plan, you will need all of the best intellectual help you can find to lessen the risk. (And then pray you don't run into a bear market just before you need to cash out.)

Let's make sure we control what we have the power to control. Unlike profits we have direct control of the size of our losses so why not make the effort to control those things that we know we do have the power to control. Unfortunately, profits are mostly beyond our control. If we go back to that earlier example of the stock we bought at $50; how do we make sure it goes to at least $100? I'm sorry but I can't help you with that. It simply can't be done.

But I can help you to make sure you don't own it when it goes down below $40. That's easy. Just be sure to sell it at about $41. Controlling losses is easy but controlling profits is impossible. Let's not worry so much about the size of profits we have yet to see and focus more on carefully limiting losses that we can and do see and then taking profits in a timely fashion once they materialize.

Many knowledgeable and professional investors control risk very precisely by a procedure commonly known as money management or more accurately "position sizing". However, in order to accurately decide the size of the position to buy, we first have to know where we will exit if we are wrong so that we can calculate our risk. Example: We are going to buy our stock at $50 a share and we know that our account size is $100,000. We want to limit our risk to a maximum of 2% of our capital or $2,000. Our exit point on the trade will be $40 so we are risking $10 per share. We then divide our $2,000 maximum risk amount by the $10 per share that we are risking and we know that our correct position size is 200 shares.

Once we know our exit point we know our risk on that position and it's a simple calculation to buy the correct number of shares that will prudently limit our risk to 1% or 2% or any % of our capital. This logical and very helpful process of accurate position sizing to limit risk exposure is not available to Buy and Holders because they don't know where their exit will be, therefore they have no way to calculate their risk or to calculate their appropriate position size.

The purpose of this article was to help you understand that exits are critically important to investors and traders of all shapes and sizes and to voice my strong opinion that Buy and Hold is not an acceptable exit strategy.

[kennynah]

w : great article above....one of the best...thanks..

[winston]

Ha Ha... Nothing new though. Same old advice. Just need to continuosly hammer it into the grey matters...

[HengHeng]

3 laws of trading where i always follow.

1. Future is unknown , don't waste your time predicting , anticipate what might happen and react to it.
2. Continuation is more likely than change. Follow trends not fight them.
3. Price fluctuates , my explaination , -- > beh ki jiu lou beh lou jiu ki .... ai bua mai kia ai kia mai bua.

[winston]

Times of the Year -- by Bill Kraft

As we reach Labor Day and the end of the summer vacation season, it occurred to me that it might be an appropriate time to examine some of the influences of the calendar on stock and option trading. While it may be surprising to some, time of year can actually have an influence on market behavior. I don't mean to suggest that the season should control our trading; I only mean that

For example, many investors are aware of the phenomenon of tax selling in early December, for example. That often is a good time to unload dogs and gain the benefit of a tax loss for the year. Often, following the tax loss selling there is what has become known as the "Santa Claus" rally leading into Christmas and the beginning of the New Year.

Another calendar related circumstance is the practice of "window dressing" in which many mutual funds and portfolio managers have engaged over the years. Funds generally report performance quarterly to their shareholders and, in order to make themselves look good, may sell the losers before the report is compiled and add some winners so that it looks like the fund is in great shape. Sometimes, stocks that are not readily recognized may be dropped and more well known names added to the portfolio so the investor can see what fine companies are held by the fund. This window dressing can lead to relatively heavy trading in some issues and is completed before the quarterly reports go to press.

Since many of the large players vacation at the Hampton's or in the south of France or some other wonderful place during the summer, that season can be marked by some low volume and, therefore, high volatility trading. It seems to me that the few weeks leading up to Labor Day are particularly prone to that type of activity.

Certain months of the year also seem to have a general tendency (though definitely not always) to experience dips or reduced volatility. Those are the months following earnings reports. Most U.S. companies report earnings on a quarterly basis and those reports are frequently released in the months following the end of a quarter.

As the release of earnings reports approaches, excitement can build and many trades may be made in anticipation of the report. Depending upon market conditions and investor anticipation, we may see price begin to run up as the earnings date approaches. Once the earnings are announced, there is no longer anything to anticipate so there may be a fall off in investor interest and in prices in general.

Since the quarters end in March, June, September, and December, many earnings are announced in April, July, October, and January. The months that follow those reports are months when the excitement has passed so we want to be aware of the possibility of reduced interest and market excitement in May, August, November, and February.

As with most things in the markets, there are no hard and fast rules as to what to do in those months. It is simply a factor about which an investor should have some awareness.

[kennynah]

cycles of buying and selling is even more evident with commodities related stocks and commodities themselves, such as corn, soybeans and wheat. the reason is simple. farmers sow seeds and harvest the produce at specific times of the year. given that weather plays a great deal in the year's harvest, hedges by farmers by going into the futures market to sell their crops happens during the early stages of crop cultivation; year in year out. it's only nearer the harvesting that they may choose to begin rolling their short positions or close them off.

when we see COT numbers, the bulk of these trades are really done by the crop farmers and institutions who have indepth knowledge of these crop cycles. and hence, almost like clock work, you will notice a discernable pattern of crop future prices

[winston]

Flipping the Switch
By Rick Pendergraft

As Tony Robbins says, you don't have to know how electricity works. All you need to know is how to flip the switch to get the light to come on.

The same can be said for many of the technical indicators that are available to investors. You hear about oscillators, regression lines and channels, and so on and so forth. You could spend the rest of your life learning about every indicator technicians have come up with trying to gain an edge over other investors.

Oscillators, for example, are nothing more than overbought/oversold indicators. Each one has a level that is supposed to mark a turning point for the stock - a level that screams that the stock is overbought or oversold.

There's nothing wrong with using indicators to help make your investing decisions. But I caution you not to get caught up in the mechanics of what goes into them. Just focus on the output you're interested in.

For instance, I use a 10-unit RSI as my overbought/oversold indicator. RSI stands for Relative Strength Indicator. It measures a security's price in relationship to itself on a scale of 1 to 100, with 50 being the norm. It's rather simple, but I find it to be more reliable than most other indicators. If the RSI reaches 70, that is a sign that the stock is overbought. If it reaches 30, that's a sign that the stock is oversold. I can buy when the RSI is at 30 and sell when it hits 70. Or I can sell short at 70 and buy back at 30.

It doesn't get any easier than that. The actual calculation behind those numbers isn't nearly as easy, but I don't have to do the calculating. What matters is that I know what constitutes overbought and oversold.

Remember, don't get caught up in the mechanics of technical analysis, get caught up in the results.

[Chiron]

Flipping the Switch
By Rick Pendergraft

I remembered the CANSLIM book that I have read recently, using RSI as a guage is a dangerous tool. Of cos different pple have different means to make money.

Personally, I do not like RSI as well. Cos of it, I missed buying Cosco before and during its spectacular run up last time. However, using RSI to measure its gradient between two points to spot divergence is a good tool to use for myself.

Oversold or overbought can remained so for a very long period.

cheers

[kennynah]

Oversold or overbought can remained so for a very long period.

chiron : you are right...

no single tool is perfect...most of us, do not know how to properly leverage the tools we use...including the technical details of the tool...

if RSI is problematic for you, i can also cite you reasons why CANSLIM or IKH or MA or MACD method is not as useful... every tool has its limitations.

[winston]

Treating Trading as a Business -- by Bill Kraft

How do you think of your trading and investing? Is it a hobby? Is it gambling? Is it something you do when Uncle Fred gives you a tip or when you see something exciting about a company on television? Have you devoted time to learning strategies or do you just buy a stock when you "think" or "feel" it is going to go up?

Do you have any exit strategy? Are you a buy and hold investor, and if you are, until when will you hold? Do you make your own investment decisions or do you rely completely on someone else? Have you defined certain times that you will devote to your trading or investing?

The bottom line is it is your money and you can do whatever you want with it. As hard as people work to make money, it never fails to astonish me how little time and effort so many are willing to devote to becoming good at investing. It seems like a lot of people I've spoken to about investing over the years do treat it as a hobby or as a gamble.

In the sense that all trading involves risk there is some gamble to it, but if done properly, the trader can try to give himself an edge and he certainly can manage risk if he is willing to make the effort. It is beyond me why so many people seem to make no effort to learn or understand investing or even their own investments when the truth is that they are risking hard earned money and have the opportunity to enhance their quality of life and potentially their retirement through sound investment practices.

If you were to open a business, it is likely that you would have done your due diligence. You would have studied the business, formulated a plan, determined where the risks lay, estimated the likelihood and size of potential successes, and decided when and how much time you would devote to the enterprise. Why? Because you wouldn't want to lose your investment and you would want to work to make the business profitable.

How is trading any different? It isn't. The investor who treats his investing or trading as a business has an important leg up on most others. It does mean some work as does the creation and development of any business, but the rewards can be fantastic.

In my first book, "Trade Your Way to Wealth", I emphasized the importance of making your trading a business. I set out, in detail, a way to create your own specific business plan and discussed specific elements to include in that plan. I explored risk awareness and risk aversion and concepts of money management.

All of these things can help you work to become successful. Who has a better chance to be a successful investor -- the person who has made it a point to learn at least the fundamentals of investing and who has created his own plan or the person who heard something about a company and buys the stock? Anyone can be lucky with an individual stock pick, but it is the knowledgeable trader who cuts losses, applies appropriate strategies, and exercises money management skills who is more likely to prevail in the long run.

Next weekend, I'll discuss a few simple principles that have helped some of my students improve their trading skills.