Tuesday, September 26, 2006

My Trader's Manifesto

I've been investing for 6 years now, and it's been an expensive lesson. At first I was a very enthusiastic advocate of researching the fundamentals of a company, and buying on the fundamentals. I used to write some great articles about a company named JDSU, and discussed how great their fundamentals were, and how great their market was. But that approach only led to below average results.
Then I turned to the technical analysis approach. I started learning about many of the TA indicators, beginning with the exponential moving average, then onto more complicated indicators like stochastics and Williams %R. I also dabbled in some Elliot Wave Theory, and went to the clearstation website. Still, I was not having too much success with TA. So I changed my approach again, although I am still sticking with TA for the underlying mechanics.

For me, the hardest part about making money with stocks was learning how to sell. At first I would buy on the TA signals, but when the purchase went into the red, for some inexplicable reason, I could not bring myself to sell the stock. I would hold onto the stock because I thought the fundamentals were great. No really, I literally thought, "I'll buy this stock, and if the trade doesn't work out, I'll hold it because the company behind the stock is a great company." When a purchase I made turned from green into red, I went from feelings of victory to feelings of defeat. What an emotional rollercoaster !
So now, I have forced myself to learn how to sell. This has led me to my own trader's manifesto:

1) Capital Preservation supersedes maximizing capital gains.
In other words, fear is more important than greed. Although fear prevents the maximization of profit, greed promotes the maximization of loss, and is therefore, more damaging. This is a hard lesson to learn, because many times, you want to keep holding a stock on the hopes that it will rebound. Also, many times, I want to hold because the greedy side of me sees visions of a multi-bagger potential in the stock. Greed drives me to hope for the turnaround, hope for the home run. Because of that, many times I have overlooked the fact that the pain of losing money on a trade is a far greater pain than the pain of not buying a stock and then watching it run away from you. That is the real key to this point - Capital preservation seeks to minimize the pain of losing money on a trade. Attempting to avoid the pain of taking a small loss early on causes me to make more mistakes, like holding it too long, or doubling down on a losing position, which leads to greater pain of dealing with potentially bigger losses.

2) Pride must submit to making money as a trader.
In more ways than one, my own pride and ego is in conflict with the notion of making money on a stock. Who wouldn't want a perfect track record in their trades? Who doesn't want to be known as the trading guru whom others turn to for trading advice? Who doesn't want to be known as the one who correctly called the top or the bottom on a stock/sector/market? So I kept holding on to a losing trade because I wanted to be right every time, I could not bring myself to admit that I would not be the trading guru that everyone admires. Least of all, I did not want to admit that I was wrong on that trade. But that is the one single thing that every trader must come to terms with if he/she wishes to continue on the path towards becoming a successful trader. There simply isn't any other way around cutting my losses and moving on. As long as I didn't learn this lesson, I could not make progress towards become a successful trader.

3) There is only one hat to wear - the trader's hat.
Warren Buffet's mindset of equating the purchase of a company's stock to being a part owner in a company is a romantic notion which has its own place in the investment world, and has its use, but mix FA and TA into a trade is a dangerous game to play. Back in 2000, JDSU, PMCS, NT, AOL, KIDE and CMGI were all great companies with great fundamentals, and great growth stories, but that sure as heck did not prevent all of their stocks from diving off a cliff. If I invest in a company's stock because of the great FA, and plan to hold it 5 years and actually follow through with that plan, then that's one thing, but then don't question a trade you made "....because it had great fundamentals." You trade stocks based on the technicals, and invest in a company based on the fundamentals. The key is in knowing the difference between the two.

4) Elminate all the other emotions before, and after entering a trade.
Greed, hope, and love are three of the worst emotions that can quickly destroy a successful trade. When a trade goes in your favour and you've already made a handsome profit, it's time to reduce your exposure in that trade (by locking in some profits), or time to bump up your stop loss level. It's certainly not the time to continue to hold and do nothing in the hopes of making that home run windfall that will strike you rich instantly. Nor is it the time to hold because you just fell in love with the company/stock. Anger, greed, hope, love are all the kinds of emotions which can cloud your judgement and reduce your ability to make pragmatic, objective trading decisions.
By keeping your emotions in check, and remaining objective at all times, you'll be able to make intelligent trading decisions and avoid making rash trading decisions out of love, anger, greed, hope.

5) Practice Patience and discipline.
This is still a work in progress for me, especially the patience part. There is nothing to be gained by making a trade just because you haven't done any all week. And it can even be dangerous to enter a trade without waiting for it to meet your criteria. When you make a trade because a stock a stock has met your criteria, that means it has proven itself to you, it IS showing you what it is doing, and that's when it is the right time to enter. Waiting for confirmation of a top/bottom, or waiting for those very good trading patterns or "set-ups" to come to you instead of chasing after them will reduce the risk in entering a trade. Act upon them in a prudent and pragmatic way when the "set-up" or criteria is met, and don't second guess yourself. The market will do what the market wants to do, and nobody can force the market's hand.

6) Plan your trade, and trade to your plan.
At first, I didn't know what this advice meant. I plan to make money on my trades, so what's the problem ?? The key is that you need to have a detailed plan about how you will trade the stock even before entering the trade. If it goes down, but doesn't hit your stop loss, what will you do? If it goes up, what will you do? Know how much equity you are putting at risk before even making the trade. In other words, it's not the size of the trade that matters, but the percentage amount at RISK that matters. This is such an important point, that I would say my failure to fully comprehend what it really meant caused my many mistakes in the past 2 years of trading. One trader advocates setting up certain rules which provide a framework for trading. He also explains risk/reward pretty well in this article. The gist of it is that I should always know what percentage of my total equity is at risk in any given trade. The difference between the stop loss point and the entry price represents the amount of risk on a given trade. As a general rule, I should risk only 1%-2% of my total equity on any given trade. I still don't follow this consistently, but I understand where I need to improve so that I can get the results that I want.

7) You MUST make the Trend your friend
Don't fight the trend, don't fight the tape. I've heard this advice mentioned many times, and this is my perspective on that sage advice. In the absence of any news affecting the stock, the overall market trend and sector trend are the two biggest influences on that given stock. Unless you are very sure of what you are doing or have intimate knowledge about the stock's price pattern, buying a stock when its index/market is trending down, or shorting a stock when its sector/market is trending up is just inviting more unecessary risk. When looking at a potential trade, never lose sight of what the stock's competitors, overall sector, and overall market is doing. The market has proven time and time again that it can stay wrong and/or irrational longer than you can stay solvent. So, not only does this mean that the market is always right, but regardless whether you love or hate the market or sector, you MUST make it your friend, because your survival depends on it.

8) Understand how to use Time Frames
Looking at the daily candlestick chart provides a short term perspective on the stock's trend. However, looking at the weekly, or even monthly candlestick chart for that same stock can and often does reveal a completely different perspective on that stock.
Always start with looking at the weekly chart before looking at the daily chart for a stock. This is very important because it gives you insight into where the largest forces of supply and demand are. Are they just beginning a bullish trend, or are they nearing a top? Once you have this bigger picture view, it will help to give you confidence in any other decisions you may decide to make on the stock in question.
Longer term time frames always have precedence over shorter term time frames. For example, say that the monthly MACD is showing a bullish crossover, but at the same time the daily MACD is showing near term selling pressure. Even though the shorter term outlook is bearish, in the back of your mind you should be thinking that the stock is still modestly bullish and at the worst case will enter into a basing pattern before eventually turning higher to start a new up trend.

9) Be at Peace with Letting Go
This point actually ties together points #2 and #7. Hoping for the turnaround, or not being able to admit to your mistake consumes energy, and causes you to dwell in the same undesirable place. To me, selling when a stock hits your stop loss represents the fact that either you made a mistake on your trade, or that your trade criteria for entering/exiting a trade turns out to be wrong. Once you attain ability to accept the fact that you made a mistake, or that your criteria was wrong, you can then free up your energy to search on the next trading plan. It's actually refreshing to be able to move on, and put those mistakes/wrongs behind you, instead of having to fight with them constantly because of your pride. This is analogous to the new age spiritual mindset of surrounding yourself with positives in your life.

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