Category Archives for "Free CMU"

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 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 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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Nov 29

CMU: Why most people will lose money in Bitcoin

By Jani Ziedins | Free CMU

Cracked.Market University

A person would have to live under a rock if they haven’t heard Bitcoin breached the psychologically significant $10,000 barrier today. What started as a libertarian experiment a few years ago has gone mainstream. It launched as a proof of concept. Morphed into drug dealers’ favorite payment tool. And has now become the latest speculation frenzy. And what a frenzy it has been, up well over 1,000% this year alone. Everyone expects it to keep running and so far everyone has been right.

The financial media barely acknowledged Bitcoin 12-months ago. Now every financial outlet devotes significant coverage to cryptocurrencies. Given how strongly prices shot up, it isn’t a surprise everyone wants to get in. And so far everyone is getting rich. Despite plunging more than 50% half a dozen times over the last several years, it keeps coming back. Jump in any BTC forum and fanatics acknowledge and expect this volatility. But they are not worried because every dip bounces. Rather than fear the next dip, they cheer because it allows them to load up on even more BTC.

Bubbles happen all the time. Dot-com stocks, real estate, oil, gold, and even Dutch tulips. It doesn’t matter what it is, if people are making money on it, others want to get in. Humans are herd animals and we cannot help but be infected by the enthusiasm of the crowd. What starts as a good idea often spirals into a buying frenzy where greed conquers common sense. People are more worried about being left behind than what could go wrong.

While everyone is getting rich in Bitcoin, unfortunately it won’t end that way. Read accounts of any financial bubble and it always lays waste to everyone who believed in it. And sometimes it goes even further and takes out entire economies. There were a lot of dot-com millionaires in 1999, but there were very few dot-com millionaires in 2002. For every millionaire who survived the dot-com bust, there were a thousand who ended in tears. It was no different in real estate. Lots of real estate millionaires in 2006. In 2009 most of those millionaires were financially ruined. And Bitcoin will be no different. Those who are most excited about BTC’s rise will be the same ones who bear the brunt of its collapse.

The psychology that inflates bubbles is also what makes them so destructive. Right now the only mistake anyone made in BTC was selling. This goes all the way to the beginning when someone paid 10,000 Bitcoins for two pizzas. In today’s prices that is $50 million per pizza!!! And the same feelings of regret are felt by anyone who sold at $100, $500, $1,000, and $5,000. If there has been one thing anyone learned trading Bitcoin is that you never, ever sell because it always goes higher. And to this point that has been correct.

Now don’t get me wrong. I’m most definitely not calling this a top because bubbles always go so much further than anyone thinks possible. And to be honest, I thought Bitcoin was overpriced when it was $100 several years ago. While I don’t know when BTC will top, I do know a top is coming because it always comes. Maybe we peaked today, or maybe we peak at $50,000 or even $100,000. I don’t know and it really doesn’t matter how high it goes. That’s because almost no one will get out at the top and everyone who rode the ride higher, will ride it back down again. The same behavior that turned people into BTC, real estate, and tulip millionaires is the same behavior that will cause them to lose everything in the crash.

The most successful BTC investors are the ones who held through every dip and even had the courage to add more. While that approach works brilliantly on the way up, it is suicide on the way down. Those who were lucky enough to take profits near the top will be seduced into buying the dip so they can make even more money on the next bounce. Between riding prices down and reinvesting in the dips, most of the people who made money on the way up will give it all back on the way down. That’s the way every bubble ends and this one will be no different. Good luck.

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Nov 27

CMU: The only way to make money

By Jani Ziedins | Free CMU

Cracked.Market University

While there are many different strategies in trading, there is only one way to make money, selling our winners. As obvious as that sounds, all too often people forget this fact, especially during periods when prices have done nothing but go up.

A person feels wealthy when they own a bunch of expensive stocks. But this person doesn’t have money, they have stocks. And the quirky thing about stocks is they are only worth what someone else is willing to pay for them. Same goes for any other asset whether it is real estate, commodities, or cryptocurrencies.

If a person has 50 bitcoin, it would be easy to assume that person has half a million dollars at BTC’s current price of nearly $10k each. But that person doesn’t have half a million dollars, they have 50 bitcoins. The person only has half a million dollars if they sell their bitcoin for $10k each.

After prolonged rallies people naturally become emotionally attached to a position that has done really well. They held through several dips along the way and were rewarded for their patience when the stock rebounded even higher. This positive feedback loop encourages long-term holders to keep holding no matter what. But the thing to remember is every dip bounces……until the one that doesn’t.

Markets overshoot. That’s what they do. The hotter the stock or commodity, the larger the overshoot. That’s because people love chasing winners. They see other people making money and want to jump on the bandwagon. Who doesn’t love a good bandwagon?

What starts as a fundamentally sound investment quickly turns into pure speculation. After a while gets to a place where even the most optimistic fundamentals cannot support the current market price. But it doesn’t matter because people are no longer buying it because of the fundamentals. They are buying it because the price keeps going up. Buyers assume someone else will come along and pay even higher prices.

This happened in internet stocks, real estate, oil, 3D printing stocks, and now it is happening in cryptocurrencies. Disagree with me all you want, but people are not buying BTC because of the underlying fundamentals. They are buying it because it doubled in price this month. At some point we run out of new fools willing to pay even higher prices and that is when the house of cards collapses. But it gets worse. What started as an irrational overshoot to the upside quickly turns into an irrational overshoot to the downside. When these bubbles finally pop, prices plunge an average of 80%. That’s not speculation, that’s fact. Anyone who claims “this time is different” has not been doing this very long.

Most of us are in this to make money and the only way to do that is selling our winners. That means overcoming our attachment to our favorite positions and saying good enough is good enough. People who become irrationally attached to their favorite stocks inevitably hold too long. The dip that was supposed to bounce doesn’t bounce. But that is not a big deal because they just need to wait a little longer. A little bit later prices fell even further. But this happened before and they just need to keep waiting. Eventually prices fall so far that fear, regret, and hope are driving a person’s trading decisions. Actually “decision” is the wrong word, it would be more accurate to call it “indecision”.

Remember, we’re in this to make money, not own stocks. We only make money when we sell our best positions. Don’t make the rookie mistake of holding too long. While some people will make staggering profits on AMZN and BTC, even more will watch eye-popping gains devolve into heartbreaking losses. The only way to avoid becoming one of those people is to sell your favorite positions.

Jani

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Don’t miss future posts:
Free Market Analysis:
 Tuesday and Thursday evenings
Cracked.Market University: Mondays and Wednesdays
Weekly Analysis and Scorecard: Every Friday
Monthly Scorecard: End of each month
Premium Analysis: Every day during market hours. Includes my personal trades.

Nov 15

CMU: Either you sell too early, or you hold too long. 

By Jani Ziedins | Free CMU

Cracked.Market University

Coming up with good trading ideas is easy. The hard part is deciding when to take profits.

All of us come to the market with unique insights and experiences. These allow us to see opportunities others miss and is the basis for our best trades. But all too often we fail to capitalize on our best ideas because we botch the second half of the trade, taking profits. There are few things more frustrating than selling a large move too early, or holding too long and allowing those hard-earned profits to evaporate.

Often it is hard to let go of a big winner because we become emotionally attached to our best trades. The success of a great idea seduces us into thinking there is even more to come. Greed kicks in when good enough is no longer good enough. But a great trade is cannot be great trade until we lock-in our profits. We’re in this to make money and the only way to do that is by selling our winners.

While it would be lovely if there was a consistent way to identify tops, unfortunately only a fool believes this is a realistic goal. Those of us that know better realize every time we take profits we have to make a conscious decision between selling too soon, or holding too long. What strategy a trader chooses large depends on their personality, risk tolerance, and approach to the market. Personally I prefer selling too early, but there is nothing wrong with holding too long if a trader does it in a deliberate and thoughtful way. The least effective approach is leaving the selling decision to undisciplined and impulsive urges.

I’m a proactive trader and that means I prefer making my move before the price-action forces me to react.  Owning stocks involves the risk of holding the unknown and is why I only want to own stocks when I’m getting paid, i.e. they are going up. Holding a sideways consolidation in my trading account doesn’t make sense to me because I’m at risk of losing money if the unexpected happens. I’m okay with that risk if someone is willing to sell me their stocks at a steep discount, or if prices are rallying. But once the profits start slowing down, my preference is to get out and start looking for the next trade. My favorite trade is buying dips and I cannot do that if I’m fully invested during the pullback. But that is not the only way to do this.

The problem with selling proactively is sometimes I get out too early and miss a big portion of a much larger move. Personally I’m okay with that, but other people like maximizing their trades by selling after a move has reached its peak. The most common way to do this is using trailing stops. Every time the stock moves higher, you raise your selling point. If the sell point is far enough away from the current price, the trader will be able to ride through the normal dips and gyrations that occur during every move higher. But if the trailing stop is too far away, a trader gives up too much profit when the rally eventually pulls back.

The advantage of a trailing stop is it is automatic and many brokers let you enter an order that automatically adjust your selling price so it becomes a truly hands-free trade. This is great for people who cannot follow the market every day or have a hard time pulling the trigger when it is time to sell. The disadvantage is markets move, that’s what they do. If you put in a 10% trailing stop under current levels, there is a good chance you will end up selling at that 10% lower price. If the time to sell is getting close, it could be better to sell now and collect 100% instead of 90% later when the trailing-stop is inevitably triggered.

The point of this article isn’t to say whether one approach is better than the other. The reasons to do one or the other depends on each trader’s approach to the market. What matters is that we arrive at this decision thoughtfully and deliberately before it is time to sell. The best time to plan your sale is before you buy the stock. Many books and courses stress the importance of using a stop-loss, but just as important is planning when to take profits. Decide now if you are a sell too early or hold too long type. And then stick to that approach when your trade turns profitable.

In another post I will explain how to tell if there is still upside left in a trade, or if the upside momentum is stalling and it is time to take profits. Sign up for Free Email Alerts so you don’t miss it.

Jani

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Don’t miss future posts:
Free Market Analysis:
 Tuesday and Thursday evenings
Cracked.Market University: Mondays and Wednesdays
Weekly Analysis and Scorecard: Every Friday
Monthly Scorecard: End of each month
Premium Analysis: Every day during market hours. Includes my personal trades.

Nov 13

CMU: Why experienced traders don’t brag

By Jani Ziedins | Free CMU

CMU: Why experienced traders don’t brag

Spend any time on trading social media and a person is bound to come across braggarts. Traders who are so supremely confident in their prowess they feel compelled to harass everyone who disagrees with them. While their partisan views are obnoxious, the thing to keep in mind is almost all of these braggarts are novices. Veteran traders have been humbled by the market far too many times to be so bold about their winning positions.

I wrote a previous CMU post about beginner’s luck. In it I described why beginner’s luck is a very real thing in trading circles. The Cliff Notes version is new traders who get lucky keep trading while those who lose money abandon the market and never look back. Many of the internet’s biggest braggarts are those riding a wave of beginner’s luck. Their early success fools them into thinking they are smarter than everyone else and they feel the need to boldly tell the world how great they are.

This is the polar opposite of a veteran trader who learned the hard way (often many times over) that one moment’s fortune can easily turn into the next moment’s failure. Experienced traders know the best time to sell is often when they feel the most confident. They are the last ones to run around telling everyone how great they are because they know what the market does to people like that.

As a way of giving back to the community that has given me so much, I share my experience and insights in order to help other traders. Being a contrarian by nature, that means I am frequently on the opposite side as these braggarts. I warn readers when move has gone too far, but these bold novices are fooled into thinking the good times will keep rolling because that is the only thing they’ve known. They make the fatal error of mistaking luck for skill and keep doubling down because they assume they have this game figured out. Unfortunately emotional and bold trading strategies rarely end well.

I freely admit I often enter and exit trades too early. That means the previous trend continues for another few days. These bold traders love to use that initial period of being too early as proof they are right and I am wrong. But it doesn’t affect me. In fact the more criticism I receive, the better it makes me feel because nothing scares me more than when everyone agrees with something I’ve written. I make a lot of money starting wrong and finishing right, and will always take that over starting right and finishing wrong.

I’ve been doing this long enough to know most hecklers are novices and their opinions are not worth the ‘paper’ they are written on. But newer traders don’t have the same level of confidence when it comes to hecklers and often the doubts turn into second guessing. It is smart reevaluate your positions on a regular basis, but never let the hecklers get to you. Remember they are some of the most inexperienced and emotional traders in the market. And that’s not a bad thing. Our profits come from someone else’s pockets and this game would be a lot more challenging if everyone knew what they were doing.

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Nov 08

CMU: Timing is everything

By Jani Ziedins | Free CMU

Cracked.Market University

Knowing what the market is going to do is easy. Predict a bear market for long enough and eventually you will be right. Telling people a dip will bounce is a no brainer because every dip goes too far and then bounces. Predicting is easy because the same things keep happening over and over again.

Without a doubt AAPL and AMZN will either fail or be acquired at fire-sale prices. How do I know? Because it happened to countless other innovative and disruptive companies. Amazon’s disruptions are minor when compared to what the Sears catalog did for rural consumers 100 years ago. At one time Sears was the largest employer in the United States, but now it is struggling for survival. More ‘experienced’ readers remember what Sears used to be, but there are also contemporary examples too. Only the youngest millennials cannot remember the ubiquitous ‘Crackberry’. Of course not even ten years later I cannot remember the last time I saw someone using one. There are a few still out there, but they are definitely on the endangered species list.

The challenge isn’t knowing if AAPL and AMZN will crumble, but when they will crumble. Don’t get me wrong, I’m not criticizing Apple and Amazon’s near-term prospects because both companies are at the top of their game and I am a happy and loyal customer of both of them. But I am also not naive enough to think their success will last forever.

Far and away the hardest part of trading is getting the timing right. Never forget this is where all our profits come from. Even over shorter timeframes, the difference between good timing and bad timing is the difference between making money and losing money.

People love to tell everyone they know how bearish or bullish they are, but what they often fail to mention is their timeframe. Bulls and bears often get in bitter arguments. One claims something is a fantastic buy while the other accuses it of being a house of cards. But you know what? Often they are both right!

In trading, timeframe is the only thing that matters. Your profit and loss is determined entirely by when you buy and when you sell. End of story. Good timing on a bad idea results in a profitable trade. Bad timing on a great idea ends in tears. If the bull is a swing trader, he could be totally right that the stock is poised for another breakout, but the bear could also be right that the longer-term demand for a company’s products is deteriorating and it will only be time before it shows up in the earnings. In this example the Bull hauls in a nice profit this week and the Bear’s trade reaps big profits next quarter.

This is why people should not get hung up on Bull and Bear monikers. Too often people treat this like a sporting match and they stick with their side through thick and thin and they hurl insults at the other side. The market doesn’t care what we think and we definitely shouldn’t let these false allegiances and counterproductive biases skew our perception of the market and other traders in it. I’ve seen way too much bitterness and hostility primarily from inexperienced traders who are way too emotionally committed to their positions. Most of the time the differences in opinion are easily be explained by different timeframes.

One of the most fatal mistakes traders make is changing their timeframe in the middle of a trade. For example they buy a company because they like its long-term prospects, but chicken out during a near-term test of support. Of they buy it for a quick bounce, but it turns into a long-term holding when it keeps going down. Never, ever change your timeframe in the middle of a trade. If a trade is not working, get out. If this is a normal gyration and your trading thesis remains intact, stick with your position. It is okay to admit defeat when a trade is not working, but never change your timeframe simply because the market’s price-action is making you second guess yourself.

In another educational post I will dig deeper into identifying when you should stick with a trade that needs more time, and when you should proactively bail out of a position before your losses get worse. Sign up for Free Email Alerts so you don’t miss it.

Never underestimate the importance of timeframe. Getting it right is only thing separating those that struggle and those that are successful. I wish there was some easy trick to getting it right, unfortunately the market is never that easy. This definitely falls under the art of trading and it takes time and experience to master. Don’t get discouraged. Keep at it and this will definitely get easier.

Jani

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Nov 06

CMU: Money Management and Position Sizing

By Jani Ziedins | Free CMU

Cracked.Market University

Making money in the market is easy. Even trained monkeys with darts can find winning stocks. The challenge is not giving those profits back in the next losing trade.

Losses are inevitable. Anyone who believes they can achieve a 100% win-rate is not realistic and coming to the market with unhealthy expectations. Losses to a trader are like inventory for a retailer. They are simply a cost of doing business. As long as revenues exceed expenses, the business is profitable and everyone is happy.

There are two ways to make money in the market. One is taking small profits from a large number of trades. This is how market makers, high frequency traders, and option sellers make their living. The challenges in this business model are avoiding big losses that wipe out all the small profits. The other strategy is capturing huge profits from just a few trades and breaking even or taking a small loss on everything else. These are the black swan traders betting on the next big crash, or high-growth speculators targeting the next big thing.

The small profit trader typically has a laser focus in one area of specialization. The market maker specializes in just a few securities or stocks. High frequency traders find a niche and exploit certain pricing phenomena. Option sellers focus on one stock, index, or strategy. Each of these specialists has the knowledge and experience necessary to avoid taking a big loss and can comfortably concentrate his entire portfolio in a single area, idea, or strategy. This is the proverbial doing one thing and doing it well.

The big-hit strategy is on the other end of the spectrum and makes a lot of small bets in the hope that a few will pay off huge. Rather specialize, this approach requires diversification. The rate of success is abysmal and successful traders often lose money more than 60% of the time. But they can sustain these high failure rates because the losses are small and the winners huge. Since the big-hit trader doesn’t know which one will work, he has to try lots of different things.

But no matter what approach a trader uses, money management techniques are similar. A good rule of thumb is never risk more than 3%-5% of your total account value in a single trade. The reason for this is quite simple, it is easy to recover from a 3%-5% loss. Even a series of them. In fact it would take 24 consecutive losing trades to cut your account value in half. While losses are normal and expected, 24 losses in a row is an extraordinary stretch and highly unlikely. But even following a historically improbable string of bad luck, the trader still has 50% of their account balance remaining. The key isn’t avoiding losses, but ensuring we live to fight another day.

Now I will clarify what I mean when I say never risk more than 3%-5% of your account value in a single trade. This doesn’t mean everyone should use 3%-5% stop-losses on all of their trades. Several examples are the easiest way to explain this concept.

Bob has a $100k trading account. He has his portfolio diversified across five different trades in equal amounts of $20k each. Bob tends to be conservative and uses the 3% loss limit in this trading. Losing 3% of this $100k account value equates to $3k. When applied to each $20k investment, that $3k loss means he can afford to take a 15% loss on an individual trade without doing serious damage to his account.

(A word of warning, diversified means dissimilar trades. Five airline stocks or five 3D printing stocks is clearly not diversified since a failure in one trade likely means a failure in all five.)

For an index trader, if his entire account value is in a single trade, then he can only afford to lose 3% to 5% on that single trade before he should be pulling the plug.

Another way to use the 3% to 5% loss limit is to help you size your trade. Let’s say John is an aggressive options trader also with a $100k account. John is willing to risk 5% of his account value on a single trade, which comes out to $5k. His strategy uses a stop-loss if the option value falls to 50% of what he paid. That means his position size should not be more than $10k. If John is willing to let his premium go all the way to zero, he should not put more than $5k into any single trading idea.

Losses are an inevitable part of trading. But it will never be a problem if you manage your money properly and ensure you always live to fight another day.

Of course the above assumes a worst case loss. Successful traders learn to recognize their mistakes long before a stop-loss is reached. I will cover closing a losing trade proactively in another CMU post. Sign up for Free Email Alerts so you don’t miss it.

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Oct 18

CMU: Why most traders screw up counter-trend trades

By Jani Ziedins | Free CMU

Cracked.Market University

Counter-trend trades are one of the hardest ways to make money.That’s because traders fight an uphill battle and their timing needs to be flawless, otherwise they get run over. Despite these overwhelming odds, all too often traders cannot resist the temptation to argue with the market. In this post I will help you understand why counter-trend trading is so difficult, when it is okay to go against the trend, and the risks you face when doing it. Knowledge is power and the more you know going in, the better chances you have of coming out the other side alive, and maybe even with a little extra money in your pocket.

As I wrote in a previous educational post, most traders don’t understand contrarian investing. Too many people mistakenly believe contrarian trading is going against the trend. Nope, the trend has nothing to do with it. Contrarians go against the crowd, not the trend. Big, big difference and if you are a little unsure, check out my previous post.

There is nothing wrong with a stock or index that goes up. That’s how the S&P500 went from 100 to 200, 500 to 1,000, and why we currently find ourselves above 2,500. If an investor knows nothing else, smart money bets on the market going higher because that is what it does. Blame inflation, productivity, money printing, or anything else, it doesn’t really matter. Markets go up more than they go down and that’s all that matters to the long-term investor.

But we’re traders and we want to trade. We don’t want to sit idly through every gyration. Not only do we want to skip the next pullback, we want to profit from it by shorting the decline. Everyone knows markets go down, especially after it goes up “too much”.  Unfortunately that overly simple logic costs a lot of smart people a lot of money.

Markets move in waves and I cover this another educational post, but suffice to say every bit of up is followed by a normal and healthy bit of down. Trading these waves is not a bad thing as long as we keep selling high and buying low. Unfortunately that is a lot easier to say than it is to do.

For beginners, the best way to swing-trade is to ride the wave up, sell when after a nice run, and then wait to buy the next dip. This way you are always trading alongside the trend. If you buy a little too early or late, it doesn’t really matter because mistakes are fixed by waiting it out. Did the market keep going down after you bought the dip? No problem, just wait for the rebound to erase your losses. Hold a little too long and the market fell under your buy point?  No worries, simply wait for the next wave higher.

Counter-trend traders don’t have these same protections. If they screw up and don’t exit immediately, the losses only get bigger as the market marches away from them. Short an uptrend at the at the wrong time and the more stubborn you are, the more money you lose.

I will be honest, I short bull markets. But I also acknowledge this is a low-probability trade and am doing it more for entertainment than to make money. But as long as I pick the right entry point, the risks are manageable.

The key to surviving counter-trend trades is to assume a trend will continue and it requires proactive timing. Short a move to the top of the range, not a violation of the lower end. As I said earlier, markets move in waves and the best short opportunities are when everyone is fat and happy. By the time traders are nervous and the headlines dire, it is too late. At that point a smart traders is thinking about buying the dip, not shorting the weakness. And when counter-trend trades show a profit, get paranoid of a rebound and start looking for an excuse to cash-in.

Remember trends continue countless times, but they reverse only once. The odds always favor a continuation of the previous trend and smart traders stick with the high probability trade.

There are ways to identify a trend that is dying and about to reverse. That sounds like an excellent topic for another blog post! Signup for Free Email Alerts so you don’t miss it.

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