October 16,2011- The Perfection Trap and Trading Probabilities

I finished Edwards and Magee’s “Technical Analysis of Stock Trends 9th Edition” this weekend, and wanted to highlight the most memorable ones applicable to today’s current markets, as well as my most favored articles as a guide for plans with the financial market days ahead of us.

On Possibilities of Success Despite Unexpected Outcomes:

It is possible to know, within reasonable limits, about what might be expected in certain situations.  And it is also possible to find ways of coping with these situations, including the exceptional cases that persist in doing the unexpected.  To repeat: It is possible to deal successfully with the unexpected and with that which cannot be precisely predicted.   To put it another way, it is possible to be wrong part of the time, and still to be successful on the balance.   (Chapter 37:The Same Old Patterns) 

Infinite precision is only achievable by the writers of academic treatises working with excellent hindsight. (Chapter 41: Application of Capital In Practice)

On Idealized Setups:

You realize of course that you don’t want to be so conservative that you’ll rule out practically all opportunities for making gains.  If you decide never to oppose the Primary Trend, you’ll have to be inactive during long secondary trends, and may be left waiting, sometimes for weeks on end, for a continuation of the Primary Move.  Naturally, you’ll pass up all weak signals and convergent trends, and shun new commitments after very active blow-offs or Panic Climaxes.  You could, no doubt, carry your refinement of caution so far that your percentage of successes, instead of being a mere 60, 70, or 80% to approach 90%, you might actually be right 95% of the time in your decisions.  But this extreme conservatism would also mean that you would trade only in the very finest possible situations, when every factor was clean-cut and favorable. You wouldn’t have such opportunities very often.  The result might be a profit, but too small a profit to justify all the work and study you would be putting into your charts, for you can obtain nominally respectable returns on your capital without very much study and without much risk, and you’d expect a higher rate of return if your efforts are to be worthwhile.  

 On Position Sizes:

Better to figure how much you can spare, how much you’d afford to spend for experience, considering the amount you start with is in the same category as money you might use for taking a special course of instruction, or for improving property you hope to sell.  Or to take another example, it would be similar to the salary you might lose in accepting a lower paid position in a new kind of work that eventually should be worth more than your present job. 

The important thing at the start is not how many dollars you can make, but what percentage of an increase per year you can average with the capital you’re using. 

If you approach the serious business of trading in this frame of mind, you’ll not be afraid to take losses when it’s necessary (and there are times when that’s the only wise course to adopt).  You will not be straining to make an unreasonable or impossible profit (with the usual disastrous results!), and you’ll be able to calmly build your trading policy in the sure conviction that the market will still be there next year, that opportunities will still be waiting for you and that the basic procedures you’re developing are more valuable than any “lucky break” you might pull out of thin air or a boardroom rumor.  (Chapter 40: How to Use Trading Capital)

On Scaling in:

You’ll proceed slowly and cautiously, not risking all your capital on a single move in a single stock.  Errors and plain bad luck when they hurt you, will not hurt you too seriously.  You’ll be prepared for false moves, wrong interpretations and complete reversals of expected developments. 

The law of averages will bring you continually greater success.  You’re not gambling blindly in this work, you’re intelligently using past experience as a guide, and it’s a dependable guide. 

Your operations are part of the competitive workings of a free market; your purchases and sales are part of the process of interpreting the trend, checking inflation and crashes, and determining the value of an industrial plant. 

Your technical knowledge will save you from buying at the top, in the final climactic blowoff, and it will save you from selling everything in a fit of depression and disgust when the bottom is being established.  In studies of past market action, you have a strong shield against the sudden thrusts that surprise and often defeat the novice trader. (Chapter 39: Trial And Error, Putting Experience to Work)  

***************

Great Reads:

1.) Joshua Brown : All-In is a stupid investment posture, so is All-Out.

When you go to 100% cash, something changes in your mind. You get to this place where mentally you won’t be satisfied unless you pick the perfect entry point. It’s harder to do some buying at 100% cash than it is at 75% cash or 50% cash – at least then you’re “adding to positions” rather than taking a stand from scratch. Price will drive you crazy without an existing position or average cost to anchor you, whether it’s higher or lower than the current quote. 

If you’re endeavoring to be 100% on the timing of your equity purchases and sales then you’re playing the wrong game. The average investor should be striving for maximum upside capture with minimum drawdowns and volatility.  Easier said than done, but for most people that’s the game 

But the rest of us don’t have those restrictions, we can be 30% in, 50% in, 65% out, 28% long and 44% short etc. We can modulate our exposure as we go, assuring that we’ll never be fully exposed to a nasty fall or completely on the sidelines during a rip-your-face-off rally.

This isn’t just market sense, it’s common sense.

2.)  Howard Lindzon : What Does a Market Bottom Look Like Revisited

It is hard to buy with the markets up a straight 10 percent. It is really hard when they are up this fast after a nasty 3 month correction.  The rally may end tomorrow and I may be stuck with these two new stocks in my portfolio. That happens.

3.) CSS Analytics: The Jack Welch Portfolio Algorithm

Jack Welch fired the least productive employees in his workforce. In fact, he chose to let go roughly 10% of his workforce each year.

The most obvious is that historical performance is predictive of future performance, and thus momentum or relative-strength investing should be effective. Of course this is well-supported in the academic literature. But what is interesting to me is the concept of “firing” C players–or the bottom 10%, and also the concept of considering the B players to be vital to the organization. What this implies is that we should “cut our losers”–a concept validated by “trend-following” and many of the greatest traders of all-time. But the concept of keeping the B players is counter-intuitive, and yet for portfolio management this implies that one should keep most of the middle-performing holdings as a base of diversification to support the top 20%.

4.) Chess N Wine -“It’s Nice When The Market Is Convenient”

I will not become aggressively long until we consolidate and/or make a higher low as charts across the board firm up.

 The market might cooperate with that scenario or it might keep going vertical. I have no control over that. What I do have control over is where I pick quality entry points to deploy capital.

5.) Also, good video to watch from Mr. Chess N Wine  http://ibankcoin.com/chessnwine/2011/10/15/trading-ideas-video/

You can correct the “overbought” condition by simply consolidating. 

The broad market can go sideways, benignly pullback, but underneath the surface, some stocks can breakout which will mark a constructively bullish market for a fresh uptrend. 

The idea is to be prepared for that scenario.  Whether that happens, you have to prepare for it.  

*****

Personal Useful Pointers, Practical Applications and Conclusions:

1.) During turning periods it is often hard to make the decision to buy or sell.   The problem can be met first of all by not taking an unreasonable amount of risk at any time.

2.) Trades taken at breakouts are more successful than those within the patterns, as the favorable in the match is now determined.

3.) Weight of evidence should be updated constantly.

4.) Overbought signal is not a sell signal, just as oversold is not a buy signal.

5.)  To turn from bearish to bullish requires a turnaround. Trends cannot accelerate forever, they need a period to consolidate, go sideways and digest the excesses.

*****

There are three possible scenarios:

1.) We consolidate, then go up – (Perfect scenario to buy the pullbacks, and most likely scenario)

2.) We collapse, fall back and continue with a sideways trading range. – (Currently the chance of this happening is low)

3.) We shoot straight up in a vertical ascent – (Low probability, but anything is possible)

How to Enter This Market Without Taking Too Much Risk:

An entry in today’s markets will have a volatility of 10% loss, in case the entry timing technique is mistaken, so we need to accomodate this in the risk we are taking.

Start the Apple-a-day program (i.e. Scaling in, dollar cost averaging) setting a maximum of 2.5% risk for the portfolio.

1.) Choose 3-5 stocks that have exhibited the best relative strength in the indices (Read Which stocks bounced best during this Rally to have an idea in the Philippine Markets’ best trading performances)

2.) Invest 1% of your portfolio in each one of the stocks (you can put 1% of your capital in 5 days and 5 stocks to achieve this).  You will in effect be deploying 5% of your portfolio in 5 days, achieving a 25% exposure to equities and 75% to cash.

Example: Theoretical Portfolio is 1,000,000

Purchase 10,000 today and the next 5 days for each of the 5 favorite stocks.

3.) Risk a possible 10% drawdown on your portfolio’s averaged cost prices, and stay rigid with the discipline of cutting when it doesn’t meet the expected outcome (i.e. stocks purchased loses more than 10% from your entry price).  Risk warning: for some stocks such as MA,MAB who exhibit 15-20% volatility, you need to adjust the sizes accordingly.

Conclusions:

Above is simply an alternative solution of getting exposed in a rising market, without having to be too bullish, nor too bearish at the same time.  Higher prices paid is validity of the rising trend.  Commit to the allowable risk, and stick to it.  Adopt Jack Welch’s Portfolio algorithm, in selecting stronger than average stocks, in order to outperform the market.  With the proper frame in mind, you don’t have to be afraid to take losses when it’s necessary.

Greed is not new to Wall Street, and the market is rigged against human emotions.

The market has spoken and in this instance, we need to listen to the changing weight of evidence presented to us.

– Faceless Trader

 

 

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