Category Archives for "Free CMU"

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.

Jani

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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.

Jani

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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.

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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Oct 16

CMU: Are You a Victim of Beginner’s Luck?

By Jani Ziedins | Free CMU

Welcome to the new Cracked.Market University educational series. Look for new articles every Monday and Wednesday.

CMU: Are You a Victim of Beginner’s Luck?

Hang around trading circles and you inevitably hear of a phenomena called beginner’s luck. This is where a new person experiences unusually good fortune. How can a new person be more lucky than the experienced traders around him? Let’s investigate.

Statistics make a compelling argument a beginner has no better odds of success in a game of chance than someone who has been doing it for a while. Let’s simplify it to a game of betting on a coin-flip. If he predicts heads and the coin lands heads, he wins. If the coin lands tails, he loses. Simple enough.

Assuming a fair coin and toss, we would expect the outcome to be totally random for both the novice and the experienced coin-flip guesser. If there is zero ability to predict the outcome, skill has nothing to do with it and the result is down to random luck. Under these rules, a beginner and an experienced coin-flip guesser will have same level of success, on average winning half the time. Despite superstitious beliefs to the contrary, in games of chance a beginner has no more opportunity to be lucky than the experienced coin-flip guesser.

In a game of skill, you would definitely expect a more experienced participant to do better than a novice. An 18-year-old who has been playing football since he was six would most likely enjoy more success in a pickup football game than another 18-year-old foreigner who has never seen a football game.

It doesn’t take a genius to know the more you practice something, the better you get. This makes sense and no doubt applies to trading. But the skill that comes from experience implies the exact opposite of beginner’s luck. In most instances the novice will vastly underperform the experienced professional.

So where does this notion of beginner’s luck come from? Is there a way it can still be true despite these logical and compelling arguments against beginner’s luck?

The one thing we haven’t considered yet is human nature. A person who loses a lot of money in their first handful of trades will most likely quit in disgust. After losing $5k, $10k, or $20k in their first handful of trades, they will most likely come to the conclusion the market is rigged and it cannot be won. They quit and never look back.

But the opposite is true for a person who experienced early success. If a person makes $5k, $10k, or $20k on their first few trades, they think they have a knack for trading and become addicted to the thrill of winning. Without a doubt the people who experience early success are far more likely to stick with it and keep coming back. That early success will even convince traders to stick with it after a period of losses because in their heart they know they are good at this. It is only a matter of time before their cold streak ends and their luck improves.

So while it is true a beginner has no better odds of success in a game of chance, and a worse odds of success in a game of skill, beginner’s luck is still a very real phenomena in trading circles. That is because of survivor’s bias. Early losers quit and only the traders who enjoyed early success stuck around. Tha means in any groups of experienced traders, most of them started with a hot streak.

Unfortunately beginner’s luck is not sustainable and all too often trader’s mistakenly believe their early good fortune was due to skill, not luck. Rather than dig in and learn from more experienced traders, they assume they have this game figured out and don’t need any help. Their early success convinced them they already know everything they need to know. Only after they lose their first stake do they start looking for outside guidance.

If you are reading this, most likely you experienced some early success and that encouraged you to keep at it. But now things have gotten harder and losses are more common than profits. While it hurts, realizing trading is not easy is actually a good thing. And if you figured this out early, count yourself lucky. Traders who experiences too much early success keep upping the size of their trades until inevitable fall goes from emotionally demoralizing, to financially ruinous.

I’m glad you found this blog and my goal is to help other traders learn from my years of struggles and successes. No matter what the late night infomercials claim, trading is hard and it takes work. The first step is educating yourself. The second step is gaining firsthand experience by trading smaller sizes. The goal isn’t to make money, but to learn how to trade. The best way to approach the market in the beginning is viewing your account as the amount you are willing to pay in tuition. If you have $100k, start trading $20k. If you have $10k, start trading $2k. This way when you get wiped out, you have the ability learn from your mistakes and start over. Give yourself enough time to learn from your mistakes and your chances of success go way up.

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Oct 04

CMU: The obvious trade everyone screws up

By Jani Ziedins | Free CMU

Welcome to the new Cracked.Market University educational series. Look for new articles every Monday and Wednesday.

Everyone knows the market moves in waves. Unfortunately most traders forget this important fact when planning their next trade.

All of us come to the market with biases. Extrapolating trends is human nature and we cannot help ourselves. Bulls insist the economy is fine and the rally will continue for as far as the eye can see. Bears believe wholeheartedly the economy is a sham, the market has gone too-far, too-fast, and we are on the verge of collapsing.

While all of us feel one way or the other, the question we must ask ourselves is how often does the market actually rally for as far as the eye can see? How frequently do prices collapse? If these are such rare events, why do most traders think extreme events are around every corner? The rarest predictions is the market will go a little higher before it goes a little lower, or a little lower before it goes a little higher. Who dares make such boring predictions?

I have read claims the market trades sideways 60% of the time. While I haven’t verified it myself, twenty-years of experience trading stocks tells me this number is definitely in the ballpark. Prices go up for a while, then they go down for a bit. Sometimes they make higher highs, other times lower lows, but the market always moves in waves.

The problem is most traders convince themselves every move higher or lower will continue indefinitely. When the move goes the direction of their bias, their confidence swells as the market’s price-action confirms their ideas. This confidence causes them to rush headfirst into a big position before they miss the trade they have been waiting for. Unfortunately most of the time their confidence doesn’t come until the market has already made a sizable move in the direction of their bias. In the bull’s case, when the market is making a higher-high. The problem is confidence is highest just as the last of the buyers are rushing into the market and prices are about to slip back into the trading range.

When a new trade falls into the red so quickly, confidence is shattered and replaced by uncertainty and fear. Traders initially convince themselves they can hold through a brief pullback because they are still believe they are right. When that doesn’t happen, doubt grows until vulnerable traders bail out because the pain of regret grows too strong. This selling pressures prices further, causing more nervous owners to sell, further pressuring prices. The downward spiral continues until we exhaust the supply of nervous sellers. Unfortunately for these reactive sellers, prices rebound not long after they bailout.

On the other side, bears have been emboldened by this dip and they start loading up on shorts just as the market starts making fresh lows. Their predictions of a collapse are coming true and they don’t want to miss out on all the money they will make. Yet just like the bulls, their timing is all wrong and no sooner than they jump in, prices rebound and they start losing money.

These waves of greed and fear occur in every timeframe from minutes to years and they suck in novices and pros alike. But it isn’t all bad. The stock market is largely a zero-sum game, meaning one person’s loss is another person’s gain. Those of us who us who understand the psychology behind these moves and can control our impulses profit by selling greed and buying fear. While that sounds easy, executing it successfully is one of the hardest things to do in trading.

The problem is we are herd animals and our survival instincts wired us to adopt the mood of the crowd around us. When everyone is happy, those feelings of calm and complacency are hard to resist. When everyone is scared, we grow fearful and the fight/flight instinct dominates our thoughts.

The most important thing to remember about dips is they always feel real. If they didn’t, no one would sell and the market wouldn’t dip. Cognitively acknowledging most dips bounce is the first step in overcoming our primitive instincts. Same goes for surges in price. Just when everything feels the most safe is when we should be the most nervous.

In August the crowd was predicting doom-and-gloom. They were wrong. Several weeks later we are making new highs and everything looks good. That said, I have little doubt these gleeful bulls will prove to be as wrong as the overconfident bears were several weeks ago.

Never forget the market moves in waves. It always has and it always will. After several weeks of nearly non-stop gains, it is normal and healthy for the market to slip back to support. But just like how this breakout isn’t racing to the moon, don’t fall for all the predictions the next few down days will lead to the next market crash.

There are so many exciting ideas I only briefly touched on in this post that I look forward to expanding on in future posts. No matter what the fundamentalists and technicians claim, market prices are driven by human psychology and understanding that is the first step in unlocking the market’s next move. Sign up for Free Email Alerts to be notified when my next piece is published.

Jani

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Sep 27

CMU: Why popular investing strategies don’t work

By Jani Ziedins | Free CMU

Welcome to the new Cracked.Market University educational series. Look for new articles every Monday and Wednesday.

Why popular investing strategies don’t work

The library, bookstore, and late night TV are filled with “surefire” investing strategies that will allow you to quit your job and live a life of leisure. At least that is what the flashy dust jacket or energetic pitchman promises us. Follow their extra special fundamental screen, chart pattern, or buy a piece of software and you are well on your way to printing money. Sounds great, doesn’t it? If only it was that easy.

The first thing to realize is the stock market is largely a zero-sum game. That means under most circumstances, one trader’s profits come directly out of another trader’s pocket. This isn’t always a bad thing and both of sides can earn handsome profits in a rising market. But like every pyramid scheme, the last person loses out.

Profit opportunities arise in the stock market when prices are not where they are supposed to be. This is commonly referred to as an inefficiency. For one reason or another a stock’s price is out of alignment. Maybe sentiment is overly bullish or bearish. Maybe the public doesn’t know the company’s sales are about to miss expectations by a wide margin. Or maybe a secret product is about to be announced. Whatever the reason, the stock is about to experience a large move and owners are rewarded for being in the right place at the right time.

One of the most important things to realize about these profit opportunities is they are limited in potential. Not everyone can profit from the same opportunity. If too many people buy a discounted stock, their buying increases the stock price until the discount disappears.

Think of these profit opportunities like a $100 bill lying on the street. If I find it by myself, I keep all $100. If a good friend and I see it at the same time, we split it and both of us are $50 richer. If five friends come across the $100, each person benefits by $20. If 1,000 people find the $100, each person gets ten cents and at that point it is hardly worth the effort.

This same phenomena occurs with popular investment strategies. Let’s say a hypothetical formula identifies stocks that are undervalued by 20%. If we keep this strategy to ourselves, we make a lot of money. But if we publish a book with our strategy, a lot of people are going to start chasing the same 20% discounts. The more people looking for them, the harder it will be to get there first.

After missing out a few too many times, some investors decide they are perfectly happy with a 19% profit. Rather than wait for the stock to fall 20%, they jump in early so they don’t get left out again. Soon a lot of other people start doing the same thing and because of all the early buying, the stock never falls to a 20% discount.

Then some people decide 18% is good enough and they start buying even earlier. This process repeats over and over again until the discount shrinks from 20% to 10% to 5% and even 1%. The process of beating each other with the same investing strategy only stops once the profit opportunity is so small it isn’t worth the effort.

The above describes value investing, but the same process occurs in momentum stocks too. Let’s say there is a great stock screen that identifies companies with the largest profit growth. The strategy tells us to buy these momentum stocks when they breakout from a consolidation because that is when they have the most explosive upside. But soon everyone is chasing the same growth stocks at the same time and the breakout moves so fast few people can buy it before the stock is too far extended to buy safely.

Frustrated investors who get left behind a few too many times commit to buying the stock a little before it breaks out so they don’t get left behind again. It doesn’t take long before more and more investors are buying the stock before it breakouts and soon the buy early crowd is causing a breakout before the stock is ready. Without a sufficient consolidation, the breakout fizzles and tumbles back into the consolidation, triggering everyone’s stop-loss. Rather than make money using this surefire investing idea, all the followers are sitting on losses.

Every popular investing strategy stops working once too many people start using it because the crowd quickly distorts the price-action that made it work in the first place. They sucks up all the profit potential and it is hardly worth the effort. Or the crowd triggers fake breakouts that suck everyone in and then spit them out with less money than they started with.

Dogs of the Dow, value investing, momentum investing, technical analysis, candlesticks, cup-with-handle, etc, etc. When any strategy gets too popular, it stops working. The very act of people following a strategy changes it and that is enough to destroy the profit potential.

But don’t despair, there are a million different way to profit from the stock market. The key is to find a strategy that fits the way you look at the market and then add your special sauce. There is nothing wrong with starting with an existing strategy, but you must bring something extra to the process to make it profitable. Maybe you are a technophile and have a knack for knowing which products will be a hit before Wall Street figures it out. Or maybe you know which laggards are about to turn things around. Something, anything, but you absolutely must have that special sauce otherwise you are just one of clones fighting over the same $100.

In future Cracked.Market University pieces I will help you find unique ways to look at the market that will help you find your special sauce. Be sure to come back for more free CMU posts.

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Sep 25

The most powerful technique for analyzing the market

By Jani Ziedins | Free CMU

Welcome to the new Cracked.Market University educational series. Look for new articles every Monday and Wednesday.

Many traders approach the market by trying to predict the outcome of an event and profit the market’s expected reaction. If the Fed raises rates, then the market will respond this way. If unemployment misses expectations, the market will move that way. Cause-and-effect analysis works well in everyday life it is natural to bring this line of thinking to the market. Unfortunately this method fails to account for how markets work and this omission explains why so many people lose money.

Traders often predict the outcome of a market moving event correctly, unfortunately they are not as good at figuring out the market’s reaction. This leads to the popular misconception the market is “fixed” and “rigged”. This couldn’t be further from the truth and I will cover this fallacy in another blog post. In the meantime just take my word for it the market is an equal opportunity humiliator and does a fair and equitable job screwing over both retail and institutional investors. When you lose money, it isn’t because some cunning market villain stole your money, it’s because your analysis is missing key ingredients.

In my two decades of trading, far and away the most effective tool I use in identifying market’s next move is studying what it is NOT doing. Almost everyone obsesses over what the market is doing and tries to to fit these moves into their narratives, whether that is fundamental, technical, or a hybrid of the two.

The problem is looking at what the market is doing inevitably leads us to thinking about what it “should” be doing. When the market doesn’t do what we think it should be doing, rather than admit we are missing something, our natural instinct is to argue with the it. This response is incredibly counterproductive and leads to more lost money than every other mistake traders make.

Take the current situation with North Korea. This is obviously a bearish development and there are grave consequences for everyone involved if this situation escalates beyond words. Despite these ominous warning signs, the market continues to hover near all-time highs. This leads many people claim the market is complacent, stupid, and worse. Common sense tells us the market should have sold off dramatically on these dire headlines. But we didn’t. That mean either the market is wrong, or god forbid, we are wrong. We couldn’t possibly be wrong, so obviously the market is wrong.

Rather than acknowledge the market’s strength, these critics double down and claim it will only be time before prices crash and they are proven right. The problem is these traders are missing the incredibly powerful signal the market is giving us. This market is not selling off, not because it is stupid, but because it is unbelievably resilient and strong. There are few things more bullish than a market that refuses to go down on bad news. Everyone who is spending all their energy arguing with this market is about to get run over.

If this market was fragile and vulnerable, it would have crashed a long time ago. Rather than argue with it, we should acknowledge it. Better yet, let’s profit from it! A market that refuses to down will eventually go up.

The same thing happens on the opposite side. A market that fails to go up on good news is a clear warning of potential exhaustion. A recent example is AMZN spiking on the acquisition of WFM. Since then the stock is down 13% and it definitely looks like it is struggling to find new buyers.

Asking what is the market is not doing gives a trader great insight into which direction a stock is inclined to go. A market that refuses to go down on bad news has a lot of upside potential in it. A stock that fails to go higher despite all the praise it is getting is a clear sign new buyers are scarce and at the very least it needs to rest and consolidate recent gains.

I have a large assortment of tools and techniques I use to evaluate the market, but this is far and away the easiest, most powerful, and most profitable tool I use.

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Sep 20

Contrarian Investing: Why most people screw it up

By Jani Ziedins | Free CMU

Welcome to the new Cracked.Market University educational series. Look for new articles every Monday and Wednesday. 

Spend any time following the market and you will come across the term “contrarian investing”. For those that don’t already know, this investing strategy takes a position in the opposite direction as the larger crowd. If the crowd claims something is a sure-thing, the contrarian sells it. If the crowd is rushing for the exits before things get worse, the contrarian jumps in and buys the dip. That description is simple enough to understand, but less clear is why this counter-intuitive trading strategy works so well and how come the crowd gets it wrong so often.

The first thing to realize is the crowd’s ideas are not wrong. Wisdom of crowds is a very real and powerful phenomena that I will cover in another blog post. For the time being, trust me when I say the crowd is smarter and more insightful than any of us can ever hope to be. But where following the crowd’s ideas gets investors into trouble is these ideas are already priced-in. That means most of the profit from investing in these ideas has already been made. I will use the following basic supply and demand model to show you how this happens.

The first thing to understand is stock prices are set exclusively by active buyers and sellers. I will dig deeper into this topic in another blog post, but for the sake of this discussion, people who sit in a stock or stay on the sidelines don’t affect the price. Only traders actively trying to buy and sell the stock determine the current market price. The price they agree to is the exact balance point between supply (sellers) and demand (buyers) at that precise moment in time.

The other key concept in this illustration is people trade what they think. If an investor loves Apple and he believes the stock is going to double or triple, we can be fairly certain this investor is already fully invested in AAPL. It doesn’t matter if a trader uses intuition, fundamentals, or technicals, as soon as he is convinced a stock is a good buy and he has the money, he buys it.

But the thing to realize is no matter how much this investor believes in this stock, once he buys, he places his bet and from that point forward is simply a passenger on the market’s rollercoaster.

If this is early in the process and the investor’s point of view is unique, he can spread the word and encourage other investors to follow his lead. But as his view becomes more and more popular, it is harder to find new people who don’t already believe in the idea. At this point the crowd of believers is so large that new recruits are hard to find. Even though owners have never been more optimistic, serious problems arise when there is no new money left to buy the stock.

Remember, price is the exact point where supply and demand are balanced. If we cannot find new buyers willing to join this party, it doesn’t matter how enthusiastic the crowd is, demand shrivels up and is overwhelmed by supply. The crowd is still extremely excited about this stock’s future, but without new buyers to keep pushing the price higher, supply and demand forces punish the stock.

This is an example of a bubble forming and the subsequent climax top, but the exact same process happens in reverse during capitulation bottoms. “Sell now before things get worse”, but the scariest point is usually the bottom of the dip because that is where we run out of sellers. Once that happens, supply dries up and prices bounce. Headlines stop mattering when no one is left to sell the bad news.

While these are extreme examples of climax tops and capitulation bottoms, the same process happens to a lesser extent every day across every timeframe. It’s no secret prices move in waves and almost everyone acknowledges this on a cognitive level. Yet every time prices move too far one direction or the other, rather than acknowledge this is just a normal and healthy gyration, human emotions take over and we assume this small move is the beginning of the next big move.

We can call the previous section Part 1. This is most obvious example of contrarian investing because it goes against the market’s price trend. But just as important to the contrarian investor is Part 2, when he goes along with the market’s trend.

All too often people mistakenly think they are contrarian investors when all they are doing is arguing with the market. If a price is going up, they sell it. If the market is going down, they buy it. At this point many of you are scratching your head because that sounds exactly like what I described in Part 1. Isn’t it?

Nope, not even close. Don’t feel bad, this is an easy to mistake to make and it costs a lot of smart people a lot of money every day. Contrarian investing is not going against the price or the trend. Never forget price and trend have nothing to do with contrarian investing! The only thing that matters to the contrarian is what the crowd thinks.

More often than not the contrarian trade is actual follows the market trend and buys something that has gone “too far”. Or sells something that has gone “too low”.

I will use AMZN as an example. Two years ago the stock was “unbelievably expensive” at $400 and its valuation was widely viewed as “unsustainable”. Yet today AMZN is trading near $1,000! How did that happen? Quite simply,  the crowd didn’t believe in Amazon. Rather than have too many people buy the stock at $400, too few people were buying it and there was a lot of upside opportunity left in it.

Never forget contrarian investing is going against the crowd, not the price. Don’t make that costly mistake when you are tempted to short something that is “too high”, or buy something that is “too low”. More often than not the right trade is the exact opposite of the one you want to make. That’s because our primal instinct compels us to become a member of the crowd and believe what the crowd believes. This is a fascinating topic that I will save it for another post. Stay tuned!

I’m excited about this new series because my head is overflowing with ideas and insights that came from two-decades of trading experience. I hope you come back for the next post. 

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