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

[winston]

Before You Buy, Know When You'll Sell by Alexander Elder
06/07/08 - 10:25 AM EDT

Within the past four months, Apple (AAPL - Cramer's Take - Stockpickr) traded higher than $200 a share, collapsed to below $120 and levitated higher than $190 again, before its recent softness. This rollercoaster ride, so common among stocks, offered multiple opportunities to buy, sell and sell short.

We buy when we feel optimistic -- or are afraid of missing a good thing. Perhaps you read a story about a new product or heard rumors of a merger. Maybe you ran a technical scan or found a promising chart pattern on the screen. You had some money in your account and called your broker (or went online) to place a buy order.

You've received a confirmation -- now you own this stock. That's when the stress begins. If the stock stays flat and goes nowhere you feel restless. Did you pick a wrong one again?! Others are going up -- should you sell yours?

If your stock begins to rise, it creates a different kind of anxiety. Should you take profits now, add to your position, or do nothing? Doing nothing is hard, especially for men, who are trained from childhood on "don't just stand there, do something!"

When your stock drops, the anxiety becomes mixed with pain - "I'll sell as soon as it comes back to even."

Amazingly, the most psychologically comfortable position for most traders is a slight decline in their stock. It is not sharp enough to be painful, and with the stock near your entry price there is probably not much reason to sell. With no action required, you have a perfect excuse to sit back and do nothing. It feels good not to have to make any decisions. That is how a small loss can gradually become a bigger and badder loss.

If you throw a frog into a pot of hot water, it will jump, but if you heat it slowly, you can cook it alive. Traders with no clear selling plans can end up boiled alive.

The worst time for making any decision, including the one to sell, is when you feel under the gun. This is the reason why I urge you to write down a trading plan, as shown below, before you put on a trade. A good plan must outline your reasons for entering a trade, define your entry price, include a protective stop, and a profit target. Setting stop and target levels means making a decision to sell. Making those decisions before you enter a trade allows you to use your brain instead of jumping in response to heat like some poor frog.

Psychologists have proven that the quality of decisions we make under stress is lower than those we make in a peaceful and relaxed frame of mind. You are likely to make better decisions, increase your profits and reduce your losses if you write down your selling plan before you buy that stock.

A written trading plan accomplishes an amazing feat -- it increases your profits and reduces losses!

So, why not do it?

Two reasons. First of all, most traders have never been taught what you have just read. Beginners and outsiders simply do not have the knowledge.

The other reason is that people like to dream. A written plan cuts into their sweet daydreaming business. It feels nice to lean back and drift into a vague fantasy of riches. Sitting up straight on a hard-back chair and writing down your specific goals as well as a contingency plan robs you of that vague daydream.

We all like to daydream, but since you are reading this I will assume that you have chosen the pleasure of real money over that of daydreaming. You probably want to learn how to sell, so that you can make more money while risking less.

Writing down a plan and executing it from a sheet of paper helps you reduce tension by separating the two jobs you have: analyzing and trading.

Give your "analyst" the luxury of peace and quiet, as he thinks and writes down his plan. Give your "trader" the luxury of simplicity in the midst of action -- give him a map and let him run with it, focusing only on implementing decisions. Let the analyst think. Let the trader execute. Let them work as a team instead of stepping on each other's shoelaces in some crazy dance. implementing decisions. Keep the two jobs separate.

The Three Types of Selling

Whenever you plan to buy a stock, ask yourself whether you plan to own it for the rest of your life and leave it to your heirs. Since the most likely answer is "no," the next question must be - what will prompt you to sell this stock.

Obviously, you buy because you expect the stock to rise. How high does it need to fly for you to say "Enough!" and sell it? Do you have a specific price target or a range of targets where you will seriously consider selling? Is there a price or indicator pattern that will tell you the uptrend is at its end and it is time to take profits? Needless to say, the best time to answer such questions is before you enter a trade.

What if you are wrong about the rally, and the stock slides instead of rising? How low does it have to fall for you to pull the trigger and shoot the puppy? The worst time to make such decisions is when you own the falling stock. As it keeps sliding lower and lower, there will be signs of the stock being oversold, of the decline being at its end and about to reverse.

If you are unwilling to take a loss, you can delude yourself for a long time and suffer serious damage. The best time to make a decision about when to get rid of a stock is before you buy it.

Finally, you may decide to sell if a stock does not move within a specified period of time or if it traces a suspicious price or indicator pattern. What does this stock have to do to challenge your bullish outlook? I call this type of selling "acting in response to engine noise." As you become more experienced, your ears will become more attuned to such noise.

In summary, you can divide selling choices into three main categories:

1. Sell at a profit target above the market.

2. Be prepared to sell below the market, using a protective stop.

3. Sell before the stock hits a target or a stop -- because market conditions have changed and you no longer want to hold it.

Each of these selling categories deserves its own book, but I managed to make each of them into a single chapter. If what you have read so far sounds logical to you, we can continue our conversation on the pages of my latest book, Sell and Sell Short.

[winston]

This Is How Millionaires Really Trade
By Jeff Clark, editor, S&A Short Report

Joe is the financial version of a suicide bomber.

He's a veteran trader with great instincts and a sharp, analytical mind. And he'd be worth millions today if he'd just stop blowing himself up.

I hadn't seen Joe for a few months until I ran into him yesterday. He didn't look good. His face was pale and drawn, and sported the remnants of a three-day beard. His eyes were bloodshot. And his breath reeked of alcohol.

It was 10:00 a.m.

"I just got rolled by the market," he said. "Everything was going so well. I was having a great year scalping profits on small trades. I mean, I was really making some money. Then I bet big on this one trade and – BOOM – it blows up on me."

"I always make money," Joe continued, "when I bet small – ALWAYS. But whenever I bet big, I get killed. What am I supposed to do?"

<< Winston's comment: Sounds like me >>

It was a rhetorical question, and Joe didn't seem to be quite in the right frame of mind for a constructive answer, so I just nodded sympathetically. But the answer seemed obvious... and it's a lesson you can use immediately to become a better speculator: Bet small.

Big trades are emotionally difficult to handle. When a trader has the rent money on the line, he's more likely to second-guess his strategy. He'll watch over every tick on the stock and wonder if he should get out, add more, cut back, or whatever. That's when emotion takes over. Trading on emotion is never a good thing.

The thing of it is... every trader has blown up. Pain is part of the learning process. It's like how a toddler learns not to touch a hot stove. A big loss teaches a trader to minimize risk.

Some traders learn their lesson after one blow-up trade. Others, like Joe, turn explosions into a habit.

Personally, I've blown up three times. The last time was about 15 years ago. I took such a spectacular loss, and suffered so much pain, I swore it would never happen again.

Since then, I've adhered to three simple rules that minimize my risk, yet still allow the potential for spectacular gains...

1. Take 90% of your investable assets and lock them up in safe, low-risk investments with the objective of earning 8%-10% per year.

Of course, 8%-10% returns in today's market environment might seem difficult to do. But really, it isn't. Several strategies work well in a volatile market. In fact, selling covered call options against low-risk value stocks is hugely profitable right now.

2. Take the remaining 10% of your account and speculate with call and put options. Understand, I'm not talking about gambling here. I'm talking about speculating.

Proper speculating involves only taking on trades where the potential reward far outweighs the potential risk... and where the odds of success favor the trade.

The combination of 90% conservative investment and 10% speculation makes it hard to actually lose money. Think about it... If you can earn a 10% return on 90% of your money, then you can just about lose everything on the speculative side and still break even at the end of the year.

The real benefit happens, though, when you earn 10% on the conservative account and then knock the cover off the ball with your speculative trades.

3. Never, ever over-leverage a trade. Keep your "bet sizes" small.

Remember, the real purpose of options is to reduce risk. Options allow you to put up less money and still control the same number of shares. So, if you normally buy 1,000 shares of stock, then you can buy 10 option contracts and maintain the same exposure with just a fraction of the funds.

This is where most people make mistakes. They look at options as a tool for leverage. Instead of buying 1,000 shares of stock, they buy 100 option contracts, thereby gaining exposure to 10,000 shares – 10 times their normal position size.

The hope is they'll get more bang for their buck. Inevitably, leverage does create a bang. But it's usually an unwelcome explosion, like Joe's. For a rule of thumb here, remember that most of the greatest traders of all time won't put more than 1% of their investable funds into any one trade.

<< Winston's Comment: 1% sounds small. I read somewhere that it is 5% >>

I've been trading stock and options for a living for more than two decades.

So I know if you:-
1) keep the bulk of your money in safe, long-term investments,
2) use the rest to make intelligent speculations, and
3) keep your trades small, you'll always avoid the catastrophic loss that wipes out most investors.

And I'm sure these rules will keep you off the booze at least until happy hour...

[kennynah]

<<1) keep the bulk of your money in safe, long-term investments>>

and.... so that whould be ???

[winston]

<<1) keep the bulk of your money in safe, long-term investments>>

and.... so that whould be ???

In the article, the author mentioned selling covered call options against low-risk value stocks

[kennynah]

<<1) keep the bulk of your money in safe, long-term investments>>

and.... so that whould be ???

In the article, the author mentioned selling covered call options against low-risk value stocks

dear w : sorry, i just didnt completely read the article, just those bolded words, so missed out this portion...

my contention is safe, long term investments.... as if to imply that "long term = safe" becos in my mind, there's no such a thing.

and covered calls are not long term.... it can be recurring...but it would not be prudent to buy Far Out covered calls, for several reasons(little theta gains, compromising your Long stock position)

[winston]

Identifying the Emotion in Trading -- by Bill Kraft

Most of us have learned that emotions can be a serious enemy of successful trading.

Unfortunately, all too often, trades are entered and exited solely because of emotion. Thoughts like "if I buy XYZ, I'll make a bundle," or "XYZ went down 50 cents today, I better get out" are examples of entering for greed and exiting for fear without any pre-planning or underlying discipline.

I have often thought and am personally convinced that in the short to medium term at least the markets are ruled by the psychological rather than the logical. I place great emphasis on the need for discipline and the need and content of a plan. It is my contention that a trader can give himself or herself a better edge if they will follow the old adage of "plan your trade and trade your plan." To me that means map out the whole trade including the complete exit strategy before you ever enter. In that way, we can lessen the emotional pull and give ourselves a better chance.

After I sent out an alert recently, I received an email from a subscriber who advised that the stock I was trading was on his brokers "restricted list" that required a customer to call in and that made the subscriber "nervous about the trade." That email raised several important issues about trading.

The first thing that jumped out for me was that I don't believe anyone should enter a position that makes them "nervous." When someone says he is nervous about a trade, it tells me that emotion is already operating in high gear -- the trader is afraid of losing and that fear is already in control. The nervousness is easily avoided. Either don't trade, or at least don't make that particular trade.

The real question is how to remove the nervousness from the equation. The best way, in my view, is to have an exit strategy in place before ever entering the trade; know ahead of time where you are going to cut your loss before you get into the position. Every trade can lose so discipline the trade to cut the loss where you have made the determination ahead of time.

The next issue the email raised for me is who is the subscriber listening to and why? He was concerned because his broker had the stock I was discussing on some list that prevented the trader from making the trade on the internet and required him to make a phone call to place the trade. I'm not sure that the simple fact of having to make the call and talking to a live broker was the problem for this fellow or whether it was because he perceived some other negative from the requirement. One way to find out, of course, is to call and ask the broker why they have that stock on the "must call" list. It may simply be because it was a cheap stock. One of my brokerages requires me to enter a special PIN when trading the real cheapies, for example.

As I pointed out to the subscriber in my response to his email, many times analysts differ on their opinion regarding a stock. Where several analysts are covering a stock, it is quite common to have differing views sometimes as wide ranging as from strong buy to strong sell and anywhere in between. There is a disagreement every time an order is filled since the buyer expects the price to go up and the seller doesn't. That is why it is important for the individual investor to educate himself and make his own reasoned decision regarding entry to or exit from any position.

There is, as I have often written, no holy grail of trading. No commentator, analyst, broker, or system is going to be right all the time. Trading is a business that is inherently risky. As I describe before, understand the risk, exercise sound money management, be aware of reward to risk ratios, have an exit strategy and plan your trade. If you don't do at least those things, you have every right to be and should be nervous about all trades.

For the record, I closed the trade that made my subscriber nervous in just 6 days and realized a before commission gain of 3%. Of course, it isn't always that way. The key is to prevent your emotions from ruling the trade.

[winston]

Managing Trading Account Money -- by Bill Kraft

A couple of weeks ago, a subscriber wrote asking how someone who trades for a living manages money in their trading account. The subscriber was interested in whether profits are plowed back into the account or taken out or exactly how the money is managed. One of the most essential is the importance of an individualized plan.

Since each of us has differing amounts of money, different risk tolerance, different levels of knowledge, prefer different strategies, has different amounts of time to devote to trading, and so on, I believe it is important to create a trading business (whether full time or part time) that meets the specific needs of each individual.

It is the same for those, like me, who trade for their living. I use a specific plan that is designed for me and might not be appropriate for many others. For example, unlike most subscribers, I don't have a job other than trading. I do devote time to individual coaching, speaking engagements, and writing things like these articles, but my real job is trading. Therefore, when it comes time to answer the question will I trade full time or part time, the answer for me is full time.

I can give you an idea of how I go about handling money in my own trading account, but just because I trade for my living does not mean or even suggest that others who trade for their livings are going to do the same thing or even anything similar.

First, I want to note that I believe money management is a critical element to successful trading and I devoted time to that concept in in archived articles here. There are many ways to manage trading money as I have set out in those writings, but, for me, at least, the important point is to have a money management plan that keeps a trader in the game.

Betting it all on one position, for example, may be a money management plan, but it may not be a very good one. If you "bet it all on black" and black doesn't hit, you are no longer in the game. I've seen people do exactly that expecting to hit a home run only to lose it all. So, the first thing I do with my own trading account is have a money management plan.

The subscriber who wrote seemed most interested in what full time traders do with their profits and I can only answer for myself. I have several brokerage accounts, but only one that I identify as a true "trading" account. Among the things I do in that account is trade options and one of the issues with trading options is how large can a trade be.

If I am trading something like the "Q's" (QQQQ) (representing the Nasdaq 100 index) or the "Diamonds" (DIA) (representing the Dow) I might be able to take large positions because there is a great deal of open interest. However, if I am trading options in some less liquid options, I need to make sure that my position is not so large as to affect the market or spread in that option. For that reason, I place a limit on the amount of money I keep in the trading account.

By some standards, it is a fairly large amount, but it only represents a portion of my liquid assets. I will transfer funds out of the trading account to do things like pay some bills or enter other investments when the account gets above a specific level so I do not reinvest all the profits back through that specific trading account.

In another account that I think of as longer term investments (not buy and hold since I always have an exit strategy even if I'm guessing the asset will be a longer term hold) I generally do reinvest profits less living expenses as they are realized. I also use dividend reinvestment plans in that account to accumulate larger positions without commission over time. Of course, the funds in that account are also generally relatively liquid and are available for other large investments like real estate or for emergencies.

As I indicated, that is my own method and is only an illustration of what one trader does. What each trader does with his or her money is the product of their own plan. It may be similar or differ radically from what I do. Trading plans and money management like choosing strategies truly are personal to the trader.

I was happy to read the subscriber's question since it is evident that he is giving thought to the issue of what to do with profits. It shows that he is looking for at least a part of a plan and that, to my mind, is a good thing. Once again, I believe a trader can increase the chance of success by taking the time and expending the effort to create a plan that fits his or her individual circumstances.

[iam802]

Got this from Van Tharp's newsletter:

====
Why Knowing Yourself Is Important to Trading Success

* You don’t trade the markets, you trade your beliefs about the markets. Thus, it is important to recognize the beliefs you are trading and determine whether or not they are useful.

* There are optimal mental states for trading and there are very detrimental states for trading. The first step is to recognize your mental state so that you can determine whether or not it supports you. Most people just identify with their mental state and thus don’t even recognize that they are being run by it.

* In order to trade, you must know who you are. And when you know who you are, then you can develop or adopt a trading system that fits you.

* You must know yourself before you begin trading. And when you know yourself, you can develop objectives that fit you and you can then use position sizing to meet those objectives (and it is position sizing, not your system, that you use to meet your objectives). The quality of your system only indicates how easy it is to use position sizing to meet your objectives.
=====

[winston]

Some Thought Provoking Questions -- by Bill Kraft

After the article in the last Newsletter, I received some interesting questions on the blog. One full time trader asked a couple of questions I frequently hear from both full time and part time traders. The first question is how much money does a full time trader need to trade? I should add that this question is also an important one for part time traders as well. As with so many issues in trading, there is no general definitive answer. It is a question I often address in the one-on-one coaching sessions in conjunction with money management and expectation issues. Since we are all different, the question can only be answered for the individual.

For example, if an individual is wealthy and has no need for additional income, his answer is likely to differ substantially from the full time trader who is actually trading for his livelihood and needs regular income to pay the bills. For the full time trader who is earning his livelihood through trading, there are several issues he must confront.

One way to look at it is to determine how much money he actually requires for living expenses each month or each year and then make a reasonable and conservative approximation of the return he expects taking into account that some positions will, undoubtedly, be losers. If the trader needs $40,000 a year as a minimum for living expenses and predicts that he can reasonably generate a 10% net return a year, he will need a $400,000 trading account just to fulfill his cost of living requirements.

Great care must be taken in evaluating potential return and there is a great danger that a trader may overestimate the returns he will generate. In most cases, a belief that he can achieve a return much greater than the S&P, for example, is probably not realistic. The trader must also be aware that he could break even or lose money trading over the course of any given period of time so some cushion should also be maintained.

Recently, a friend who is approaching retirement told me he was quitting his job and going to trade for a living. He was earning about $65,000 a year at his job and has no pension. I asked him how much money he had to trade and when he told me around $250,000, I encouraged him to keep the day job. In order to equal the $65K a year, he would have to achieve better than a 25% a year return and while that is possible, it is highly unlikely in my estimation, especially for an inexperienced trader. Thankfully, he took my advice and is trading on the side.

The part time trader who has another job also needs to consider how much trading money he needs. Under funding can be a big problem because too large a percentage of the trading capital may be needed to enter a given trade. Consideration must also be given to the strategies being utilized since it is likely that someone who just trades stock may need a lot more in the account than someone who is trading options.

In my book, I emphasize that trading is a business and I devote a great deal of time to the specific and detailed considerations an individual must make in setting up their personal trading business plan. Formulating that plan is as critical to good successful trading as is a foundation to a good house. Remember the childhood story about the pigs who built houses of various materials from straw to brick and what happened to each when the wind came?

Spending serious time creating your plan can assist (though it is no guarantee) in the effort to build a solid trading business. Failure to expend the time and effort to create that plan almost certainly will lead to a "straw house" business that is much less likely to weather the storms of trading.

The other question the trader asked me to address was diversification and "how many issues are a good mix." I'll try to take a look at that next week.

Both of these questions are quite commonly addressed in my coaching sessions and I have seen that some traders tend to gloss over them. I suggest each is worthy of your study, consideration, and incorporation in your trading plan if you are serious about trying to improve your trading results.

[winston]

How Many Positions to Hold
Bill Kraft

Last weekend, in response to a subscriber's question, I discussed the issue of how much money a trader needs in a trading account. As is often the case with trading, the answer is "it depends" on the individual and his or her goals, needs, risk tolerance, time available to trade, and so on. That same subscriber had also asked how many positions to hold in order to have a good mix of issues. Again, the answer is completely dependent upon the individual.

One of the most important, if not the most important, factors to examine in answering how many positions a trader should have is how many can that individual manage. I often have as many as 30 positions working at one time, but I certainly would not recommend that high a number for the vast majority of traders.

Trading is what I do, so I am devoting a significant amount of my time to monitoring, entering, exiting, and adjusting positions. Clearly, that is a much different scenario from someone who can only look at the markets on the weekend or at night. I once had a student who traded for a living and only had one position at a time. I have lost contact with her, but the last I had heard, she was a successful trader.

Many factors influence how many positions a trader can manage at one time. They include the trader's level of knowledge, the strategies he is employing, and the time he can devote to his trading. Obviously, in terms of monitoring, it is one thing to buy a stock and place a trailing stop and quite another to trade near the money naked puts which might require relatively quick action to adjust, close, or roll the position.

I set out 15 strategies and compare things like the level of monitoring required for each as well as things like relative risk, capital required, time frame, desired market direction, and expected time frame.

Depending upon capital, a true buy and hold investor who has a full time job could hold a fairly large number of positions while that same person who pursued a different strategy like swing trading long options would probably hold a smaller number of positions.

As I have written in the past, these are considerations the individual investor should address when creating his individual personal business plan. The conclusions may well differ for each trader, but it is an important decision. Trying to manage too many positions can result in missing something on one or another -- believe me, I speak from experience.

In my early years of trading, I was so excited about what I was doing that I did make the mistake of having more positions than I could effectively track and I burned myself. That episode taught me to limit the positions to a number I can manage and I have been faithful to the concept ever since.

In the coaching sessions, I sometimes encounter students who have not considered a limitation on the number of positions and find it difficult to keep up with themselves. I try to suggest that they establish a comfort zone both in terms of risk and in terms of manageability. It is my personal belief that traders should confine themselves to strategies and amounts of risk that permit them to sleep comfortably at night.

Inability to manage positions whether it be from lack of knowledge, lack of experience, or just too many positions to manage does not lead to relaxed trading in my estimation and that, in turn, can lead to emotional and bad trading decisions that we all want to avoid.