Monthly Archives: December 2017

Dec 11

CMU: The fallacy of “more buyers than sellers”

By Jani Ziedins | Free CMU

Cracked.Market University

Spend any time following the markets and you are bound to hear the phrase, “The market went up today because there were more buyers than seller.” You hear the opposite on down days when “there were more sellers than buyers.”

While that shorthand works well enough for casual market commentary, it is factually inaccurate. The first thing to realize is the market doesn’t create or store stocks. The stock market doesn’t have printing presses or storage vaults in the basement. At its core, exchanges only do what their name suggests, act as a meeting places for people to exchange stocks and money.

One hundred shares arrive at in one person’s possession, some money changes hands, and they leave in another person’s account. After the market closes, all the money and stocks go home with their owners. There is nothing left behind but an empty trading floor. Stocks and money was created or destroyed, all it did was change owners.

The fact stocks cannot be created or destroyed means for every stock sold, there is one and only one stock bought. To further complicate the situation, the number of buyers and sellers can vary and doesn’t have a bearing on whether prices go up or down. A large buyer can buy from dozens of sellers, or one seller can sell to dozens of buyers. The only thing that matters is the number of shares available for sale and the amount of money willing to buy those shares.

So as a matter of rule, there can never be more stock bought than sold. But there can be more people interested in buying than selling, or selling than buying. This is where market price plays the role of matchmaker and finds the exact balance point between buyers and sellers.

If a good piece of news comes out that creates additional interest in a stock, all these excited buyers start looking for sellers. But sometimes there are not enough sellers to meet demand. In these cases, buyers start offering a premium price to persuade owners to sell their stock. When enough buyers bid up the price, the rising price changes the supply and demand dynamic. At a the new higher price, some people are less interested in buying and drop out of the market. Other owners find the new higher price irresistible and are now converted into willing sellers.

The thing to remember is the number of stocks sold is always exactly equal to the number of stocks bought. The driver making this exact balance possible is the ever-changing price. Every time the price moves, even a penny, it is finding the exact balance point where the amount of stock for sale matches the amount of money willing to buy it. Prices might seem to wander randomly, but there is a very real purpose for every tick of the tape.

Jani

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Dec 07

Struggling to go higher on good news?

By Jani Ziedins | End of Day Analysis

End of Day Update:

The S&P500 finally broke a string of four down days and put together a respectable gain. While four down-days sounds bad, the losses were relatively modest, only giving back a portion of last week’s breakout.

Tax Reform is marching ahead, but the market is struggling to keep up. The lack of further price increases suggests the Tax Reform rally is running out of steam. We can continue creeping higher over the near-term but anything much above 2,700 seems like a stretch. If there was a lot of upside potential left in the market we would still be racing higher. Instead the breakout stalled and even dipped after the Senate approved their version of Tax Reform. Few things make me more nervous than a market that stops going up on good news.

News gets priced in quickly, that’s how markets works. Once the crowd started assuming Tax Reform was going to happen, the bulk of the upside had already been realized. If someone is still waiting to buy the headlines, they will be late to the party. At this point it looks like the actual signing of the bill will be anticlimactic and could even trigger a sell-the-news dip.

The path of least resistance is still higher and I expect the glide higher will continue over the near-term, but we are definitely approaching the end of the Tax Reform rally. Hope over tax cuts fueled the Trump rally over the last 12-months, but to keep marching higher we need to find a new standard-bearer. At this point I don’t know what it will be. Maybe blow-out earnings reports next month. But whatever it is it needs to be big to keep beating these ever higher expectations.

Switching gears to bitcoin, it shocking how high this has gone over the last few days. Last week we broke through $10k for the first time. Tonight we hit $17k. Two months ago we were under $4k. If anyone still believes this is not a bubble, clearly they don’t have any experience with bubbles. Without a doubt this thing will continue higher, but we are in the frantic part of the climb and the crash is not far away.

The problem BTC will run into is a lot of people are following this surge in price with a trailing stop. BTC passes $10k, they move their stop up to $8k. We surge past $14k and they move it up to $12k. That is actually a very sound strategy, unfortunately it doesn’t work when everyone else is doing the same thing. Without a doubt the price gains over the last few weeks are littered with countless automatic stop-losses. Once BTC starts dipping, sell orders are going to get triggered, which further pressures prices, which triggers even more sell orders. It won’t take long for a tidal wave of sell orders to overwhelm the dip buyers.

The scary part is the these things go down so much faster than they go up. $7k in gains over a week will be undone in an hour. I won’t pretend like I can call the top in BTC and this thing can easily continue past $25k and $35k over the next few days or weeks, but this rate of gains is most definitely not sustainable and it will come crashing down soon. If a person is planning on selling, get out on the way up because you will not be able to find a buyer once this thing starts going down.

Jani

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Dec 06

CMU: How much money should you keep in your trading account

By Jani Ziedins | Free CMU

Cracked.Market University

On Monday I wrote about how many stocks a trader should keep in their trading account to protect themselves from unexpected drawdown while also making the most from their best ideas. Today I will cover another portfolio question I frequently get from subscribers, how much money should they keep in their trading account. Again I start with the same disclaimer the following are just guidelines and only a licensed investment advisor can give you individual advice specific to your situation, goals, and risk tolerances.

The first thing to understand is trading is risky. You can and will lose money. But this isn’t always a bad thing. Losing trades are simply an expense of trading and is no different than the cost of inventory for a retailer. And just like a small business, the goal is to keep our revenues larger than our expenses.

Making a profit is an obvious goal, but it is more than just making money. We need to make more money than the alternative, which for most people is buy-and-hold index funds. A 20% return sounds great, but what if the S&P500 made 25%? Does that 20% still sound good?

And more than that, our goal is to make enough extra that it is worth our time. Beating an index fund by $30k sounds great, but if you traded full-time, is $30k enough to be worth your time if you could make $150k doing something else?

Trading is definitely a tricky business and for most people it makes more sense to keep it a hobby and not rely on it as their primary source of income. Trade because it is fun, not because you think you can replace your day job. Beating the market is hard enough. Beating it by enough to pay all of your living expenses is a much larger task.

As I already alluded to, there are different ways to make money in the market. The first is trading. The other is diversified, buy-and-hold investments. What does a savvy person do, trade or buy-and-hold? That’s a trick question because this isn’t an either/or question. Both is the best option for most traders.

It is hard to beat the stability and consistency of buy-and-hold investments. Even after market crashes like the dot-com bubble or the 2008 housing meltdown, the market always comes back. Sometimes it takes a while, but buy-and-hold investments have long time horizons and patient investors are always rewarded for at the end of the day.

That said, a trader can do better than buy-and-hold during sideways and down markets. The hard part is knowing precisely when the market is transitioning from up to sideways or down. But just because something is hard doesn’t mean it isn’t worth doing.

I will assume everyone reading this blog is doing so because they are interested in trading, so that means a portion of your investable funds should be allocated to a trading account. The key question is how much. This is where things get highly individualistic and many of these decision need to be made between you and a financial advisor, but here are some guidelines to think about.

Buy-and-hold is the safest and most proven way to grow rich slowly. This should be a cornerstone of everyone’s long-term investing plans. For most people this comes in the form of a 401K retirement plan. This is the slow money that you will live off of after you stop working. And because this money is so important to our financial well-being, we need to be careful with it. That means not taking unnecessary risks. For the average person, that means keeping at least 80% of your investable assets in safe, long-term, buy-and-hold investments. Something that you put away and only trade once every few years.

With a big portion of our retirement money invested safely, that means we can put the rest into more speculative investments that can produce much higher returns, but also come with greater risk. For a new investor, I would suggest allocating no more than 5% of your investable assets to trading. For more experienced traders, 20% to 25% is reasonable. But even the best traders should not speculate with a larger percentage of the money they will need later in life. While it is possible to produce larger returns in your trading account, it is also possible to crash and burn. The key to surviving the market is always protecting yourself in such a way that you can live to fight another day. That means making sure you always have plenty of money left over even if a trade fails in a spectacular way. 

The thing about the market is sometimes one strategy works better than another. In years like 2017, buy-and-hold works brilliantly because every dip bounces and any defensive sale turns out to be a mistake. But other years the market is flat or even declines. That is when our trading accounts outperform buy-and-hold investments. But the great thing about using both strategies is we benefit when either one of them are doing well.

Jani

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Dec 05

Searching for direction

By Jani Ziedins | End of Day Analysis

End of Day Update:

It’s been four trading days since my last free blog post and what a ride it’s been. Volatility has come back with a vengeance as breakouts fizzle and breakdowns rebound. The S&P500 continues hovering near all-time highs, but the market is anything but certain about what it wants to do next.

Republicans are marching toward the most significant Tax Reform in decades. At this point it is more a question of when, not if it will happen. There is a lot of agreement between the Senate and House bills and it is simply a matter of resolving those minor differences.

The reason the market has not reacted strongly to Republicans making further progress toward tax cuts is by this point most traders have started assuming this is going to happen. When the crowd believes something will happen, then it becomes priced in even if the event hasn’t occurred yet. Those who wanted to buy the Tax Reform pop have already bought and anyone waiting for the news to becomes official will be too late.

That said, the market has become increasingly volatilite over recent days. Last week we surged to record highs. Then Friday’s intraday price-action produced some epic gyrations, briefly erasing the entire week’s gains. And then Monday’s surge to record highs fizzled and reversed. The closer we get to Tax Reform, the more uncertain the market becomes about what comes next.

A big chunk of this rally has been built on hopes of Tax Reform. Now that is about to become a reality, what is the market going to hang its hat on? What do we have to look forward to? Some market pundits speculate corporate tax cuts will lead to a surge of reinvestment and hiring. That argument claims economic growth will pay for the tax cuts, but I’m suspicious. Over the last few years we have seen record amounts of corporate profits given back to shareholders in the form of dividends and stock buybacks. If these companies already have more money than they need for reinvestment, giving them even more isn’t going to change anything. Of course new dividends and stock buybacks will boost the stock market and as stock traders, that is what we care about. But as far as stimulating economic growth, I wouldn’t count on it.

At this point it seems like most of the Tax Reform upside has already been priced in. We will see a pop when the final deal is struck between the House and Senate, but we are talking about a handful of percent, not tens of percent of upside. And maybe a lot less if recent weakness devolves into a sell-the-news event. Risk is a function of height and at these record highs, the market has never been riskier. Tread carefully.

Jani

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Dec 04

CMU: How many stocks you should trade

By Jani Ziedins | Free CMU

Cracked.Market University

A question I frequently get from readers and subscribers is what percentage of their portfolio should they allocate to each trade. While only a licensed investment advisor can give a specific answer after conducting a thorough interview with each investor, I will share some of the basic concepts involved in making this decision.

Most people are familiar with the saying, “don’t put all your eggs in one basket”. If you drop that basket, then you lose all of your eggs. The same principle applies to the stock market. There are plenty of unknowns in this world and any one of them could trigger a debilitating blow to your account if all of your money was concentrated in a single stock. A management scandal or shockingly bad earnings report could devastate your savings overnight.

If you only owned a single stock and it fell 50%, then you just lost half of your savings in one blow. And worse, to recover from that 50% loss you need a 100% gain just to breakeven. In the best of times it takes multiple years to double your money. But if you were diversified and owned 10 stocks in equal amounts, if one of them fell 50%, then you only lost 5% of your total account value.  It only takes one or two good trades to bounce back from a 5% loss.

I won’t get into the statistics involved, but an account will be nearly perfectly diversified if it has between 20 and 40 independent securities, with independent being the key word. Independent means each stock is not correlated to the others in any significant way. A beverage maker, toy company, and airline are in much different industries and are largely independent from each other. On the other hand, five 3D printing companies, five airlines, or five tech companies are most definitely not independent. These companies are highly correlated because often what affects one company will affect all the others in the same industry. For example all airlines would be hurt if there was a sharp rise in oil prices.

Owning more than 40 stocks moves into the realm of diminishing returns and does almost nothing to improve diversification. All it does is add expenses and complexity to your portfolio. At this point you are better off buying an index fund and forgetting about it.

While 20 stocks provides us with nearly full diversification, there is also a cost to being diversified. If we have five stocks and one of them doubles, our account value jumps 20%. But if one of twenty stocks doubles, that is just a 5% gain. And if one of 40 stocks doubles, we only made 2.5% from that great trade. So while diversification protects us from the unknown, over-diversification diminishes our returns because our best trades get watered down.

The other issue with investing in too many stocks is each of us only have so many good ideas. Most of us can come up with three or five great trades a year. But how many of us can come up with 20 great trades? Most likely we will have three great ideas, five good ideas, and maybe eight decent ideas. The deeper we reach, the less potential each additional idea has. Most of the time we are better off-putting more money into our best ideas than investing in mediocre ideas just for the sake of diversification.

The goal for the savvy trader is finding the right balance between prudent diversification and watering down. For most investors this falls between four and eight stocks at any given time. Fewer than four and one mistake can prove costly. More than eight and the gains become too watered down. Account size is also a factor. If a person only has $10k to invest, they are better off on the lower end of the range. If a person is trading $100k, they have the resources to spread across more trades.

Almost every single traders would be better off if they held at least four stocks, but no more than eight stocks in their trading account. Putting too much of your savings in one or two stocks leaves you vulnerable to the unknown. Investing in more than eight stocks means some of your ideas are not very good and you should cut those out and add that money to your better ideas.

The above focuses on individual stocks in a trading account. The situation is different if a person is trading an index fund that is already providing a good level of diversification. Other strategies apply when deciding how much money to put in an active trading account, versus how much a prudent investor leaves in buy-and-hold investments. These are equally valuable topics I will cover in a future CMU post. Be sure to sign up for Free Email Alerts so you don’t miss those useful posts. 

Jani

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