Category Archives for "Free CMU"

Oct 23

CMU: How much worse will this get?

By Jani Ziedins | End of Day Analysis , Free CMU

Free After-Hours Update:

Tuesday was another ugly open for the S&P 500 as overnight weakness in Asia and Europe pressured our markets. We crashed lower at the open and undercut this selloff’s prior lows near 2,710. But rather than trigger another avalanche of defensive selling, that early dip was as bad as it got. Supply of nervous sellers dried up after the first hour of trade and we recovered a majority of the losses by the close. Not very often does a 0.5% loss feel like a good thing, but that is what happened today.

Even though Trump’s tariffs haven’t done much harm to our economy, they are strangling the already weak Asian economies, most notably China. While this is Trump’s desired outcome, global markets are more intertwined than ever and what huts one is felt by everyone else. By taking down China, Trump is indirectly taking down our markets.

The biggest question is what comes next. Is the worst already behind us? Or are we on the verge of another tumble lower? I wish I knew for sure, but the best we can do is figure out the odds and make an intelligent trade based on the most likely outcome. For that, a look back at history is the most logical place to start.

The above chart shows pullbacks in the S&P 500 from all-time highs since January 1950. That gives us nearly 70 years worth of data to analyze.

One of the most notable things is how rare big selloffs really are. Over the last 69 years, only 11 times have prices tumbled more than 15% from the highs. We often think of big crashes like 1987, the Financial Crisis, or the Dot-Com bubble. But those events are exceedingly rare. All the other pullbacks over the last 69 years have been 15% or less. While 15% is a lot, it isn’t terrifying. And even better, all of those under 15% pullbacks were erased within a few months. Small and short. That sounds like something we can live with.

Currently we find ourselves 7% from the highs. Those losses are already behind us and we cannot do anything about them. But we can prepare for what comes next. Assuming we are not on the verge of another Financial Crisis or similar catastrophe, the most likely outcome is a dip smaller than 15%. From current levels, that is another 8%. But that is the worst case. The actual dip will most likely be smaller than 15%.

Over the last 69 years, the S&P 500 has tumbled between 10% and 15% 22 times. That’s about once every three years. Not unheard of, but not common either. The last pullbacks of this size were 15% in 2016 and 12% earlier this year. Are we due for another one? Maybe. But it definitely doesn’t seem like we are overdue given we already had two over the last two years.

More common are pullbacks between 5% and 10%. There have been 36 of these over the last 69 years, meaning these happen every year or two. From 7%, that means we could be as little as 1% or 2% from the bottom. And even better is most of these 15% or smaller pullbacks return to the highs within a few months.

We are down 7% and there is nothing we can do about that. But going forward we have a decent probability of only slipping a little further. And assuming the world doesn’t collapse, worst case is another 8%. While that wouldn’t be any fun, is that really worth panicking over?

The price action has been weak the last few days and that led to today’s weak open. And the market loves double-bottoms, meaning we could see a little more near-term weakness. But what is a little more downside if we will be back at the highs in months month? While I cannot say the bottom is in yet, the odds are definitely lining up behind buying this market, not selling it.

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Sep 05

CMU: To be a successful trader, don’t be like this guy

By Jani Ziedins | Free CMU

Cracked.Market University

Put yourself out there long enough and inevitably you run into the angry cynics that try to knock everyone down to their level. Rather than learn from the people who are more successful, these people criticize everyone doing a better job. That is their natural ego defense. When they cannot do something, they automatically assume everyone else doing it successfully must be a cheater and fraud.

I’ve had more than my share of hecklers over the years and I learned to ignore them a long time ago. But the comments I got the other day are great examples of the wrong way to approach the market. I wanted to share this with other readers so they could learn from them and avoid making the same mistakes:

This guy is a 100% jackass. A few months ago he was encouraging to “take profits” and now he’s saying “told you so”. Complete blowhard, waste of space. People like this need to disappear.

I will call you out again. Your blog is horseshit, always has been. Here you say “take profits” and previous blog “we are going much much higher”. This way you’ve covered both your bases..if it goes up, you say I told you so, if it goes down, you remind to take profits. Utter bullshit and this is what i would expect from a paid service. A self important blowhard who speaks from both sides of the mouth without committing to one or the other. Please, go into a cave and save us the trouble from reading this garbage.

The first thing I want to acknowledge is I have complete control over this blog and could easily delete negative comments like these. But that’s not who I am and I definitely don’t shy away from criticism. Instead, I embrace it. I leave these critical comments for everyone to see, even when I disagree. Recognizing a difference of opinion is always useful when trying to understand how other people think about the market. This is a zero-sum game and my profits come out of someone else’s pockets, just as his profits come out of mine. Understanding how the other participants think is a very valuable tool when figuring out what to trade next.

I don’t know who this guy is and I don’t care. I’m not going to cyber-stalk him and I don’t want anyone else to either. We’re traders, not bullies. In fact, we should thank him for giving us these great examples to learn from. Even though I don’t know anything about him, there are quite a few things we can learn by analyzing his comments.

This guy is definitely angry. Between the swear words and personal attacks, he is directing a lot of negative energy toward me. If there is one thing I noticed in all my years of trading, people who are making money are in a good mood. They don’t kick their dog and attack random people on the internet. If anything, people having a good year are far more likely to brag obnoxiously about their good fortunes than criticize other people. (A great topic for a future CMU post. Subscribe to Free Email Alerts so you don’t miss it.)

If this guy is angry, it is safe to assume he is losing money and he is looking for someone to blame. He mentioned what I wrote a few months ago, so it appears he has been reading my free blog for a while. That also tells me he is relatively inexperienced since most professionals come up with their own trading ideas, they don’t browse the free educational blogs.

Last week the stock market made all-time highs and everyone invested in this market is loving the ride. What that tells me is my heckler sold this strong market months ago and is bitter because it left him behind. And if it wasn’t already obvious, he made it clear when he criticized me for suggesting traders “take profits” during one of the market’s numerous up-waves this spring and summer.

I’ve seen this often enough to know exactly what happened. This guy was cynical about the market and was looking for an excuse to sell. He read my blog post suggesting people take profits and that is all the encouragement he needed to bailout. Unfortunatly for him, that is only half the story.

I’ve been buying weakness and selling strength all year. While the market is up a very respectable 10%, I’m up a lot more than that selling each surge higher and buying the inevitable dip that happens a few weeks later. Do that with leveraged ETFs and a good year becomes a great year.

The problem is this guy followed my advice to take profits, but that is where he stopped listening. Rather than buy the next dip, his bearish bias took over and he refused to jump back in. He missed the rebound and the higher the market went, the more bitter he became. But rather than acknowledge and correct his mistake, he decided he wanted to blame someone else. This time it happened to be me.

I don’t mind. It is been a good year for me and I’m definitely one of the traders that is in a good mood. There isn’t anything he can say that bothers me. The only reason I even acknowledged his unjustified accusations is to share his story so the rest of my readers could learn from his mistakes.

First lesson: Never get emotional about the market. Losses are a part of this game and are no different than inventory expense for a retailer. As long as we make more money than we lose, everything is good.

Second lesson: When things don’t go well, be honest with yourself and don’t blame other people. If you lost money, it isn’t Trump’s fault. It isn’t some CEO’s fault. It isn’t the Fed’s fault. Or some blogger on the internet. You and only you made that decision to place a trade. Own up to it and take responsibility. Sometimes things don’t work out and that is just the way it is. Learn from your mistake and move on.

Third lesson: Respect and learn from everyone around us. There are traders with a lot of experience willing to share their knowledge with others. Hecklers stroking their fragile ego by putting down other people will never get better. (But to be brutally honest, I don’t mind. My profits need to come from somewhere, so it might as well be their pockets.)

And just to remove any doubt about this heckler’s accusations, I charted the various calls I made this year. How did I do? (Subscribe to Free Email Alerts so you don’t miss any more calls like these.)

January 25th: “Enjoy this rally higher over the near-term, but stay alert and keep close to the exits.”

January 27th: “there always comes a point where we run out of buyers. And it looks like we reached that point last Friday”

February 5th: “For those of us that took risk off the table during this run-up and have cash to spend, this dip is extremely attractive.”

February 9th: “Risk is a function of height and this is the least risky point in several months. Traders should be embracing these discounts, not running from them.”

March 6th: “we should expect a lot more volatility over the near-term as the trade war rhetoric ramps up. We will likely see further weakness over the next week.”

April 3rd: “Even though prices could slip a little further, this is still a very attractive place to be buying. We were asking for a dip and the market gave it to us. Don’t lose your nerve now just because everyone else is freaked out.”

April 24th: “If this market was going to crash, there have been more than enough excuses to send us tumbling a long time ago. Instead of selling these bearish headlines, confident owners are holding for higher prices. When owners don’t sell bad news, it stops mattering.”

June 12th: “Things still look good for our medium-term stock positions and long-term investments and we should leave them alone, but for short-term swing-trades, this is a better place to be taking profits than adding new money.”

June 28th: “Two-weeks ago we should have taken profits into that strength and this week we should be buying the subsequent dip. Everyone knows markets move in waves, so get with the program and trade the waves!”

August 9th: “The risk/reward has shifted against us and this is now a better place to be taking profits than adding new money…..we cannot buy the next dip if we don’t have any cash. Buy weakness, sell strength, and repeat until a good year becomes a great year.”

August 14th: “While it already looks like the Turkish selloff is dead, we need to hold this bounce for a few more days to be certain. There is a chance this bounce could fizzle and we continue slipping back to 2,800 support. If that happens, that will be a far more attractive entry point.”

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Apr 04

CMU: Are you addicted to stock quotes?

By Jani Ziedins | Free CMU

Cracked.Market University

One-hundred years ago a person was lucky if they could find weekly stock quotes. Fifty-years ago most traders lived off of daily quotes from the newspaper’s financial section. Thirty-years ago we got 24-hour news networks. Twenty-years ago the internet gave us 20-minute delayed quotes. Five-years ago real-time and after-hours quotes came free with most trading accounts. And now countless phone apps give us access to global stocks and futures around the clock.

The question few are asking is if this abundance of information is actually helping the average investor? Given the success rates of the typical retail investor, the answer is clearly not. The question then becomes if this is not helpful, is it actually hurting investors? There is a pretty compelling case that information overload causes a person to make more mistakes, especially when it comes to something as tricky as the market.

Who among us hasn’t found themselves transfixed by an intraday move? We get an alert on our phone and stop what we were doing to read the linked article. Then we tune the TV to the financial news to find out what the “experts” think. All of a sudden we went from having a good day at work to being worried the latest selloff means will delay our retirement five years. But we won’t be innocent bystander. We won’t be a victim to the market’s wrath. Instead we take control of our financial destiny by whipping out our phone, logging into our brokerage app, and start selling. And best part is we do it all in the five minutes before our next meeting.

Unfortunately what started the day as a buy-and-hold investment quickly turned into a “sell everything before things get worse”. The problem for most long-term investors, turned spur-of-the-moment traders is that over the last 30 years, there have only been two instances when “sell now before things get worse” was actually a good idea. The 2000 dot-com bubble and the 2008 financial crisis. Two and only two times over the last 30 years was reacting to the fearful headlines a good idea. Compare that to the 1,000+ plus phony stock market crashes that spooked investors out perfectly good positions just before rebounding. Would you rather put your money on the 499, or the 1? Unfortunately most retail investors are so afraid of the next stock market crash that they have an irrational fear it is hiding around next corner. Combine those emotions with an endless stream of market headlines and stock quotes and that is the perfect recipe for over trading.

And I will be the first to admit this happened to me. I used to trade newspaper quotes. Buy something, forget about it for a few weeks or months. Check the newspaper and “wow, I just made 20%, cool!” Then the internet revolutionized trading and let me follow the market more closely. But the 20-minute delay kept me from obsessing over it too much since the prices I saw were already old news. I’d buy what I wanted to buy and then get on with my day. Then high-speed internet came along with real-time streaming quotes.  Now I could put charting programs and stock tickers on my second monitor (because one monitor definitely isn’t enough), and now I could start counting pennies. It would have been nice if it stopped there, but now my phone gives me access to S&P500 futures around the clock. (speaking of stock futures, they are up nicely in Asia as I write this at 10pm MDT) And the worst of all, if I wake in the middle of the night, it is hard to resist the temptation to see what the futures are doing in Europe. If my trade isn’t working, then I have to pull out my iPad and find out what happened. And people call this progress???

I’ve been there and done that, as have many of you. I can and will attest this most definitely didn’t help my trading. In fact, the access to endless information made me miserable and my trading suffered. These daily gyrations got to me, even small moves against me inevitably lead to second thoughts. Second thoughts lead to doubt. Doubt lead to anxiety. And anxiety lead to impulsive and emotional trading. All of this certainly makes me miss the old days of waiting for the daily newspaper, looking up my stocks, and then spending the rest of the day not thinking about the market.

More is most definitely not better and the addiction to endless streams of information is something we need to resist. Without a doubt the worst thing a person can do is check stock quotes in the middle of the night. Don’t do it. It doesn’t help and all it does is lead to crushing anxiety and sleepless nights. Same goes for getting alerts on your phone. Turn them off. If you are not a day-trader, you don’t need to have real-time quotes and charts on your computer. If you are a buy-and-hold investor, don’t look at daily quotes. Don’t even look at weekly quotes.

The most important thing to regaining control of your trading is only looking at the market with a frequency that is appropriate for your holding period. Retirement accounts? At the very most look at them quarterly and even then only for rebalancing. It would be better if you limited checking retirement accounts to once a year. Swing-traders who hold positions for days and weeks should limit themselves to daily quotes. Only day-traders need streaming quotes and live charts. For everyone else, all it does is shake your confidence and lead to impulsive and emotional trades. The first step to beating the market is getting your addiction to stock quotes under control.


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Dec 20

CMU: The dangers of trading sentiment

By Jani Ziedins | Free CMU

Cracked.Market University

All too often we hear the cynics claim the market is “too bullish”, or the optimists shout the market is “too bearish”. What they are really saying is they believe the market has gone too far in one direction and it is about to reverse. And they will be right…..eventually.

Without a doubt the market will reverse because it always does. Prices move in waves and I will cover the psychology behind these waves in another CMU post. (Sign up for Free Email Alerts so you don’t miss it) Unfortunately the key to making money is timing those waves exactly right. This is where popular sentiment indicators often let us down.

“Too bullish” or “too bearish” are vague and subjective. There are quantifiable sentiment measures like AAII’s weekly sentiment survey, but it is far from comprehensive and it tends to jump around. Stocktwits measures real-time sentiment in its $SPY stream, but that only tells us what a very small and highly active group of traders thinks. Other tools look at option premium, but they are equally flawed. That’s because sentiment can sustain extreme levels for months, even years.

It is best to think of sentiment as a secondary indicator. It tells us when to start thinking about something, but it doesn’t tell us when to make a trade. It is dangerous to say we should buy every time a sentiment indicator goes under 30 and sell every time it goes over 70. That’s because a 30 can stay a 30 for months or fall to 25, all while the market continues to selloff. Buying a dip a month or two before the bottom can definitely be a traumatic experience.

On the opposite end of the spectrum, sentiment has been “overly bullish” almost this entire year. It started with Trump’s election and continued all year based on hopes of tax cuts. Anyone who sold early in the year because the market was “too bullish” missed out on a nice rally. And anyone who was foolish to short this “overly bullish” market had a very painful year.

The reason sentiment measures can stay elevated for so long is they often only measure a subset of traders. For example highly active traders that fill out weekly surveys. Or the options market. While these give us a good idea of what short-term traders think, it leaves out the opinions of 401k investors who don’t follow the market. These passive investor’s opinions change much slower and this year it was their gradual warming up to the benefits of tax cuts that allowed us to rally so consistently and for so long. Even though active traders were “overly bullish”, the wider pool of investors was only beginning to warm up. And it is buying that kept pushing us higher even though most sentiment measures told us we were topped out months ago.

I love trading against extremes in sentiment, but I need the price-action to confirm my trading thesis before I will stick with a sentiment based trade. If the market doesn’t act the way it is supposed to, I bailout quickly because I know how unreliable these signals can be. Don’t let a stubborn opinion about “too bullish” or “too bearish” lock you into a losing trade.


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Dec 18

CMU: Why it is too late to buy the tax cut rally

By Jani Ziedins | Free CMU

Cracked.Market University

Many times you hear market commentators claim an event is “already priced in” even though it hasn’t occurred yet. What does this mean, how does it happen, and what does that mean for trading? Read on to find out.

The most important thing to keep in mind is people don’t make trading decisions based on what has already happened, they trade what they think will happen. That’s because it is too late to profit on the past. If a stock already went up 10%, then it is too late to profit from that 10% rise in price. But if you think a stock will rise 10% and you buy it now, you make 10% when it increases in price. Successful traders buy before something happens, not after. This concept is obvious, but it has profound implications for how we approach trading.

As traders we are always trying to figure out what will happen before it happens. Will the next iPhone be a hit or a flop? If we know the answer before everyone else, we can profit from that insight. But since we are trading based on speculation of something that hasn’t happened yet, there are risks we could be wrong. And that risk is what creates the profit opportunity. Some people will bet the next iPhone will be a hit, while others believe it will be a flop. The current market price balances these two extreme views and every shade in between. And when sales numbers are announced, one side makes money and the other side loses.

If the outcome is random, then by rule this event cannot be priced into the market because the crowd doesn’t have insight into what will happen. But this rarely occurs because someone always knows something and eventually that knowledge spreads through the market.

Sticking with the iPhone example, we only know for sure how many iPhones were sold in a quarter when the company reports its earnings several weeks after the quarter ends. But there are plenty of ways to get ahead of the news and figure out what those sales numbers will be good or bad. The simplest is your personal opinion. Does the new iPhone excite you? Are you tempted to upgrade? How about your friends? Are they talking about the new iPhone? Do tech writers recommend upgrading or keeping your existing model? What about the lines at the launch? Bigger or smaller than last year? How quickly does the iPhone sellout? How long are backorder times? What are suppliers telling analysts about the size of Apple’s component orders? Even though we won’t know what the official iPhone sales numbers are for several months, traders paying attention to these clues will have a good idea of what the sales will be. And these traders start buying or selling based on what those clues tell them. Once those clues are obvious to the crowd, it is too late to buy or sell the news because it has already been priced in. Great reviews and the stock’s price shoots up. If most reviewers say it isn’t worth upgrading, then the price falls in anticipation of a bad earnings. If you wait to trade the earnings announcement, you will be too late.

This phenomena occurs naturally because traders are always trying to get ahead of each other. Getting there first is how we make money. We buy before the price goes up and sell before it goes down, but we can only do that if we make our trades before everyone else. And to trade before everyone else means we need to be early. And we’re not the only one who trades this way. When the crowd trades early, the expected result gets priced in long before it happens. And if the crowd is right, which it usually is, then the stock market only moves a small bit when the news becomes official. That’s because the bulk of the move occurred in anticipation of the news.

A current example is Tax Reform. Traders have eagerly been looking forward to tax cuts since Trump won the election last November. The S&P500 has risen nearly 30% since Republicans won the White House and maintained control of Congress. In finance class we learned stock prices are based on corporate earnings, but S&P500 earnings are only forecast to be up around 10%. That’s a pretty big gap between earnings growth and stock market gains.  The bulk of the stock market’s gains over the last 13 months are based on hope and anticipation of regulatory relaxations and tax cuts.

If a person was waiting until Trump signed the tax cuts into law, they would have missed 30% in gains over the last 13 months. Thirty percent is a tremendous number and reflects almost all of the tax cut gains. Congress will vote on and approve the bill within days and Trump will sign it into law before Christmas. Without a doubt we could see a one or two percent pop when this happens, but one or two percent pop is peanuts compared to the nearly straight up 30% move we’ve witnessed over the last 13 months.

If a person is waiting to buy until after Tax Reform is signed into law, they are really, really late. And not only did they miss almost all of the gains, they are putting themselves at risk because following highly anticipated headlines we often run into a “sell the news” phenomena. If everyone bought in anticipation of a widely expected event, then there is no one left to buy the news when it finally happens. And the law of supply and demand dictates that if no one buys the news, ie no demand, then prices fall. So not only is the person who waits for the news too late to profit, they could actually end up losing money in the subsequent pullback. There is solid science behind the market cliche, “Buy the rumor, sell the news”.

Without a doubt the stock market can rally can continue in 2018. But we need new reasons to rally once Tax Reform becomes law.


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Dec 13

CMU: The part of Technical Analysis no one talks about

By Jani Ziedins | Free CMU

Cracked.Market University

Pick up any Technical Analysis textbook and you are bound to find countless examples of highly profitable chart patterns. Most books include a plethora of real-life charts showing a pattern developing, the buy signal, and the predicted move. The general idea is to memorize the various patterns, look through charts to find them, place a trade, and profit. Easy-peasy. Repeat over and over until fabulously wealthy.

Or at least that is how it is supposed to work. Unfortunately nothing in the market is ever that easy. While most of these patterns are valid and have sound human psychology principles backing them up, the problem comes from false positives. When a chart starts with the perfect setup, but it fails to complete the pattern. The idea of false positives is further complicated because so many patterns look similar. While this wouldn’t be a problem if similar setups told us to do the same thing, unfortunately most setups can give us conflicting advice.

  • Buy the higher-high, or sell the double-top?
  • Buy the dip, or sell the violation of support?
  • Cup-with-handle, or stalling at resistance?
  • Meaningful pattern, or random noise?

There are countless examples where a pattern works beautifully and any Technical Analysis writer worth his salt can find charts showing the pattern working exactly as it should. The problem comes from all the false positives. How many times did this exact pattern show up and fail to behave as predicted? False positives are the bogie no one talks about and is the biggest challenge in trading with Technical Analysis.

The pure technical trader claims nothing matters except the price-action. The company name, industry, financials, profitability, news, and all the rest doesn’t matter because the market has already incorporated all of that information into the price. The pure technician believes fundamentals are redundant and he ignores them.

Unfortunately ignoring everything except price leaves out a lot of useful information. Take one of the conflicting examples I listed above, higher-high or double-top. Nearly identical setup, but much different outcome.  One interpretation tells you to buy, the other tells you to sell. What should you do? Like everything in the market, the answer depends.

Most of the time the answer lies in the pieces of information the true technician ignores. Namely the news and the market’s reaction to it. No matter what the chart tells you, a stock that goes up on bad news is a great buy and a stock that stops going up on good news is one to run away from. I will dig a lot deeper into interpreting the news in another CMU post. Sign up for Free Email Alerts so you don’t miss it. 

Now don’t get me wrong, I’m not bashing the usefulness of Technical Analysis. It is a great tool and I use it every day. But like any tool, it has its limitations. Successful traders recognize profitable patterns, but they also recognize the false positives. Or which pattern is more meaningful when similar setups are giving conflicting recommendations. Learn and use Technical Analysis, but always be aware of the risks posed by false positives and develop a process to weed them out.


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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.


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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.


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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. 


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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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