Capitulation - how you recognize and trade it

One of the well-recognized terms from the tape reading terminology is Capitulation - often mentioned and often misunderstood. Many apply it in an overly broad sense, labeling any new low as capitulation; some believe that buying into selloff makes them winners almost by default - after all, everyone heard about necessity to go against the crowd, right?

There are two important things to keep in mind about this concept.

First is, bottoms are not always being formed by the capitulatory selloff (V-shape). Sometimes it's a slow grind shaping as a dish; sometimes even with capitulation it's still not that easy - weak initial bounce often leads to another drop  and new low is being made sending a stock into panic.

Second, and most important to remember. You  probably noticed that wherever you find the description of the concept of capitulation, it's still just a concept - meaning, there is no measurable component to it. There is, to my best knowledge, no percentage of the drop that quialifies selloff as capitulation. Name any particular number, and you will inevitably find a whole lot of cases where it was exceeded. There is a good reason for that: if there were a certain measurement for capitulation that guaranteed ultimate low, everyone would be insanely rich waiting for it and buying it... and no one would be buying a second earlier. But then again, why would anyone SELL at that ultimate low which has been already proven to be an ultimate one?... And if the answer is "no one," then from whom the bottom hunters would buy at that same bottom they were hunting?

Thus, capitulation is either:

- can not be computed and quantified as it's an emotional state, panic, total disarray leading to a free-fall - but not being quantifiable, it's in the eye of a beholder, which meakes "getting a read" on it quite discretionary; 

or

- can be computed to a certain degree IF you somehow know the amount of shares that were held by different stakeholders, and see that roughly that amount is being traded in a very short period of time (again, discretionary component) during very steep selloff (once again, steep by what standard? on what chart?).

No doubt, sometimes experienced traders get it right by gut feeling which is a product of vast experience. By no means it's a fool-proof process for any of them, and you will always see arguments about whether this particular selling already constitutes capitulation or not yet, whether capitulation is going to be the case on this particular bear market or not. This concept is necessary to understand, but it doesn't mean that once you understand the concept you can spot the capitulatory type of bottom. That's why I am always advocating for a different type of bottom-fishing - one that is based on:

- letting go of the idea of buying THE low, 

- waiting for a stock to come out of free-fall, form a recognizable reversal formation,

- buying when such formation offers chart-based opportunity free of emotions.

Such approach will never get you in on the exact low - leave that to amateurs to try and brag about those rare instances when they get it right. In exchange, such approach will give you a repeatable reliable method of trading the trend reversals.

Simplicity: why don't we appreciate it?

There is one curious phenomenon that I observe for a long while. You see, my trading approach is fairly simple (let's make a distinction at once - simple doesn't always mean easy). It's a few chart formations, reading the volume, assigning a transparent and logical structure to the setup and following the standard procedure once a trade is triggered. I admire the simplicity, I enjoy it, and I am a fan of an old phrase by Leonardo: Simplicity is the ultimate form of sophistication.

Yet time and again I encounter people disappointed by how simple my trading approach is. Yes, disappointed and skeptical - even though they see for themselves that it works. Imagine my amazement when I hear something to the effect: "Yeah, I observed you in action, followed some of trades, made money... read trading logs, see that you are fairly consistent... But come on, market is much more complicated than this! There is macroeconomics, there is stochastic, there is this, that, oh and that - and you ignore all this stuff. It makes no sense. Hundreds of pundits devote their life to all the analysis, and you are telling me you can do without any of that? It makes no sense. It makes no sense."

- "Okkkay... but hey, you do see that it works, right?"

Awkward silence. Pause. Blank stare. Then life returns to my counterpart's eyes as the needle finds the familiar groove: "See all these blogs? magazines? TV channels?..." Etc. You get the idea.

So, why do we do this? Why is simplicity not enough? Worse yet, why is it not enough even though it's proven as an effective approach to trading?

I have my answer to that. See if it's something you can relate to. It goes to the root of the very reason for our trading. Why do we trade? Sure, everyone immediately answers "to make profits" - but is it really so? Or rather, is it true for all of us? In my experience, no. For many of us, it's an intellectual challenge that we are after - we enjoy analysis, arguing points, proving our points to others... and all this stuff may or may not be relevant to trading in its purest form (which is Enter, Exit, add to your Profit or Loss column). If one's motivation is such intellectual exercise, my approach won't satisfy that person. More than that, to some it feels almost as insult!

We discussed earlier how such analysis can and often do lead to entrenched opinion which triggers Ego and leads to stubborn defense of one's losing position. It's also a point emphasized in A Taoist Trader course. Let me cite a quote from that course:


Much overcomplicated thinking obfuscates the simplicity and clarity of the real
world. Knowledge must be useful and practical.
...................

In comprehending all knowledge,
Can you renounce the mind?
In Taoist philosophy, there are two types of knowledge: useable knowledge that
contributes to the achievement of a goal (daily contentment), and knowledge that
does not. The only knowledge worth pursuing is the knowledge that serves the
purpose. Our ability to adapt to changes in an environment is a double-edged
sword. Our mind sometimes accepts external values without skepticism. These
values often conflict with our core nature and represent dysfunctional knowledge.
However, by using Taoist principles, we can accurately evaluate which knowledge
is worth keeping and which should be discarded.

The amount of information surrounding the markets is mind-boggling. Some of it is useful in the process of decision-making and some serves no useful purpose at all. A trader carefully observes which information helps him navigate the markets and which wastes his time and adds to confusion. Practical usefulness measured by actual performance is a trader’s criterion to evaluate which sources should be taken into account and which should be dismissed. A trader must avoid paralysis caused by endless and contradictive information flows..

If you ever catch yourself questioning simple trading approach merely because of its simplicity, ask yourself: Why are you trading?

Blog Summary Updated

Trading Philosophy – General Understanding of the Markets.

Ø Market and Logic

Ø The Dual Reality

Ø A Trader’s View of the Market

Ø Information vs. Price

Ø Trends and Reversals

Ø Changes and Consistency in the Markets

Ø Manipulation in the Markets

Ø News and Price Interaction

Building Trading System

Ø Role of Technical Analysis

Ø How to Start

Ø Paper Trading

Ø Type of Movement

Ø Structure of the Setup

Ø If-Then Scenarios

Ø Types of Entries
Ø Capitulation - how to trade it

Risk Control

Ø Role and Necessity of Stops

Ø Stop Loss vs. Sitting It Out

Ø Averaging Down

Ø Basics of Stop Loss

Ø Deeper Look into Stop Loss

Ø Protecting Your Profits

Trading Psychology

Ø Basics of Trading Psychology

Ø Novice

Ø Intermediate

Ø Experienced

Ø Sophisticated

Ø Psychology of a Stop Loss

Ø Psychology of Relapse

Ø A Trader’s Mental State

Ø Staying on a Sideline
Ø Simplicity in Trading

Day Trading, Scalping and Tape Reading

Ø What Is Scalping

Ø What Is Scalping II

Ø What Is Tape Reading

Ø Basics of Tape Reading

Profit: how do you handle it?

                                               Consistency is a sign of professionalism.

Weird question, isn't it? You pocket it, you smile, brag, drink, spend on that even bigger screen TV or even smarter phone... right? Well, yeah - under one condition: after making that profit you managed to keep it. If you are anything like 99% of the rest of the players then the following complaint will sound very familiar to you:

I started the day so nicely, got this and that trade right, and if I just fainted right then it would be the best day of the month... but I pushed for more, lost some, felt regret, wanted to get it back, pushed again, lost all my profits... then I just couldn't accept that it all evaporated, and tried again and again... only to finish the day deeply in red. WTF?? (which as we all well know means Why The Failure??)

If you can't related to the above, just skip the rest. You are not human, why bother with our human problems. If you can though, here is the advice I regularly give in the room when someone hits great winning streak in the morning. Make it your standard operating procedure, and you will never find yourself in that frustrating situation.

1. Decide for yourself how much of your today's profit you keep no matter what and put a "stop on your account" so to speak at that level. My rule of thumb is 75%.
2. On all further trades manage the stop level and position size in a way that doesn't jeopardize more than the rest of the profit made earlier (in that rule of thumb it will be 25%).
3. Each time you make another profitable trade, move your account stop up to protect some of this additional profit as well. My rule of thumb is 50% of new portion. This is not unlike trailing stop, only applied to your trading account.
4. If your "trailing stop" is hit by a losing trade, you are done for the day. Go enjoy life or switch to paper trading if you want - but no more actual trades. Switch to demo mode if your software allows it. Go away from your computer altogether if you suspect you have weak discipline and may give in to temptation.
5. If your winning streak continues, close to the end of the day start trailing even tighter - 75% of all new profits (again, not unlike trailing stop principle where you tighten it more and more as price advances in your favor).

To put it all into numbers for illustration purposes:

Let's say you made $1000 in the morning trades. Your stop is at $750 now (if you want to go with my management; adjust to your risk tolerance if it's different from mine). Now, if your next trade loses $150, you have only $100 to lose before you stop trading for the day. You lose $250 - you are done, no live trades today anymore. Your next trade made $300 - trail your stop by $150, so now it's at $900. The next one made $400 - trail the stop by $200... etc, you got the idea.

This approach will save you a lot of frustration and make you much richer. Don't let the idea of "but what if I miss a great trade" tempt you - there will be a market tomorrow too. Trading is continuous process of many trades, and it's a combined result of them all that matters. Consistency is a sign of professionalism.

I can't remember, nor can I find on the fly, who said this: market is the easiest place to make money and the hardest place to keep it. Very true. If anyone knows the author and gives me a clue, I will add the name.

News - Trade'em or Fade'em?

Having commented lately on the influence the news flow from Europe has on the market and how sensitive this market is to those headlines, I received a very good question which made me think that I should have written on this topic long ago. Here is this, very valid, question:

"Vad, I am trying to reconcile these comments (on market sensitivity to Europe news - V.G.) you made in your trading log and on your Facebook page with the idea that you promoted many times before - that the news is usually priced in by the past movement and by the time the news is known to everyone it's too late to act on it, and a trader should start looking for info-price divergence to fade the news. Sure enough, I've seen many times that this idea worked like charm - and I do see now how market reacts on any peep from EU, just as you suggest. Could you comment on this contradiction?"

To be able to tell these situations apart, we must define two different kinds of news from the point of view of interaction between news and price.

First, and the most traditional for the "normal" market developments is what I call FSN - Fleece Sheep News. This is exactly what it sounds like. The scenario is old as the market itself. You've seen it 1000 times, and quite possibly were on a receiving end of it at some point early in your trading career. Smart Money starts buying while no one's even looking, it figures out the coming developments and accumulates before these developments become common knowledge. Price moves up slowly at first, then speeds up as an advance starts attracting attention and new passengers climb aboard. Finally the news comes, price spikes sharply and Smart Money feeds previously accumulated shares into such euphoric spike. No more buyers left, the last crop of late arrivals is left holding the bag as the price declines - and it does so against the background of a good news, with no single negative word, all to the amazement, resentment and accusations of manipulation by those who never bothered to study how the market really works... Examples of such news is introduction of a new technology, new product or drug, changes in demand, general industry trends, etc - things that keen observers can figure out with this or that degree of accuracy well before they become obvious to the masses. FSN may be a cruel name somewhat for this phenomenon but can you think of a more precise one?

Second, and more rare kind is what I call GN - Genuine News. This is an event that is either a) a surprise for everyone or b) known to come but with an outcome impossible to predict. This is where Smart Money has little if any advantage. More than that (although this is a somewhat side observation), often Big Money is at disadvantage here because of bigger exposure and lesser mobility in moving in and out... but this is separate topic. Example of the news catching everyone unprepared? Earthquake; fire; sudden death of a key figure... you get the idea. It's just "here is what happened," and no market participant could have taken the right position before the event other than by an accident or an unrelated reason. Thus, news is not discounted by the prior movement and causes genuine market reaction. Example of an event with unknown outcome? Why, EU latest developments... everyone knows something is going to happen, no one knows what. This is where some stay away and some bet on a certain outcome - counting on their opinion being correct, relying on their ability to calculate the most probable course of events or simply gambling.

In the former case (FSN), a trader uses price - information divergence as his most powerful weapon. I have written about this in the past (here and here for instance, not even speaking of here and here), to show how a trader takes position with Smart Money and stops being a part of the Crowd. As difficult as this concept may be for a layperson, for a trader FSN is a normal trading environment, like water for a fish.

GN on the other hand introduces huge uncertainty - instead of moving accordingly to street signs, traders have to wait for new and often temporary signs to be erected. In a news-driven market instead of smooth market flow we have lurching movements in stop-and-go fashion. Time frame shortens to "between the soundbites" - and those often come at unpredictable times.

This, in the latter case (GN) - be nimble. Be flexible. Keep your commitment light, do not form an opinion and do not let your Ego lock you in that opinion. Don't be afraid of missing the move by not being in before the move. Remember, newbies chase potential - professionals control risk.

Trade what you can read

One of the common mistakes among newer traders is the idea that a good chart reader must be able to read ANY chart - that is, be able to create trading scenario, analyze odds and so on. They tend to be surprised by "I have no idea" answer when ask an opinion about certain situation they are interested in. Yet this is my fairly frequent answer - and I don't hesitate to give it when I see nothing recognizable in the chart I am shown.

You see, trading is not about being able to trade each and every movement. Trading is about to be able to pick the right opportunity - right in terms of YOUR trading approach, right in a sense of YOUR ability to read and understand the movement and right in a sense of fitting YOUR risk and objectives profile. What good a perfect breakout chart to you if you are a reversal trader, specializing in trend change setups and having little knowledge of and experience with trend continuation? It's not unlike a hunter who sits patiently in his hide waiting for his prey, waiting for the right moment and acting only when everything is in place for a successful shot.

Then there are situations which present no or almost no opportunity for anyone, whatever their trading style is. If the chart is a mess with no pronounced levels, no volume clues, no clear configurations - it's safe to assume that we are facing an uncertain situation where nervous traders flee the risk, don't commit and engage very carefully if at all. There will be a resolution of this situation, and that's when you will get your signals, setups will shape up and trades will come your way. Until then, feel confident in your lack of confidence - it takes a real trader to say "I don't know." Good teacher teaches humility - and the market is a GREAT teacher. To quote A Taoist Trader:


"The vulgar are clever, self-assured;
I alone, depressed.
Patient as the sea,
Adrift, seemingly aimless.


It’s much more common 
for a really knowledgeable experienced trader to sound reluctant, to be 
unsure of the future developments and admit it openly. Knowing how 
uncertain the market is, he is not so quick to express full confidence; he 
accepts that events may develop in unforeseen way, and such acceptance 
makes him better prepared for an unexpected turn of events. A Taoist 
Trader’s plans and prognosis are usually tentative, with provisions for 
various conditions. They will include many “ifs” and “buts.” He would 
rather plan for multiple scenarios than put his full confidence in a single 
one. "

Tao, photography and trading

So, being a trader, a photographer and a student of Taoism, what am I to do when I run into the (excellent) book named Tao of Photography? Why, look for analogies with trading of course. I mean, two of the components are there, gotta look for the third. Didn't take too long to see the similarities in how Tom Ang applies Taoist principles to photography and I - to trading. Read on:

"The technique of the wise is ever-present, but never evident... Technique empowers the individual but it does not dominate. It must be learned and absorbed via a process of long training, but then falls from consciousness. The aim of technique is to provide fluency - an unbroken movement flowing from thought and conception through to production..."

Sounds familiar? It should. Automatic reactions on whatever market does - reactions seemingly so instant as if events were foreseen... that's how experienced trader's actions look to a side observer. Did he really foresee sudden news that just hot the marketplace? Of course not - it's years of training that instilled this ability to react instantly and unconsciously. Re-read this description of the third stage of trader's development, and you will see the same motives.  Re-read this post about gunslinger in Stephen King's novel, applying templates to be ready to any development (If - Then scenarios for traders?) Remember my often-said motto: "Trading is simple, but it is through many complications that you arrive to this simplicity." Finally, our trading room members will remember the slogan they see when enter the room: Don't interrupt your brain's work by thinking.

WARNING TO THE BOTTOM FISHERS

I know I've written about this a few times in the past. But it seems never enough.

Considering the market over the last few sessions and panic over last two, I thought it was high time to scream it out loud once again. DO NOT guess on the bottom. What you think is low today can seem awfully high tomorrow. Selloffs can and do go for much longer than the "common sense" indicates. So do euphoric spikes for that matter. Premature bet on reversal will cost you dearly; correct guess will still be just that, lucky guess. NO ONE ever was able to pick exact reversal points consistently. Attempts to nail exact reversal is second most common reason for traders demise. Oversold gets oversolder, then oversoldest, and then sells some more before reversing.

Bottom line: if you want to trade reversal, trade it on the RIGHT side of the reversal - AFTER it happened, price retested the low and confirmed the strength. Trading it on the left side is a childish bravery - cemetery of traders' accounts is sprinkled with tombstones saying "He was a brave trader."

Disclaimer: this warning will be ignored by majority, just like 1000 similar warnings before. If you, a single reader of this - yes, you - heed it and play it right, that's all reward I count on. If there are two of you, I accomplished a lot today.

Culprits and scapegoats

Over last few months, on several occasions  I found myself involved in the (often heated) discussion of High Frequency Trading (HFT), Liquidity Providers (LPs) and related topics, ranging from false bids to flash crash. The exchange  almost invariably involves angry accusations of HFT as the cause of many market ills. Since I get involved by pointing out the flaws in those accusations and errors in technical assessments of HFT impact, I've got asked a few times: Why do you insist on defending HFT and LPs, what's in it for you?

Here is the deal: because I've seen it already and I know where it's going. Let me expand on that.

Remember tech boom of 1998 - 2000 and consequent crash of 2001-2002? As in all boom-bust cycles, a lot of people lost a lot of money; as always in such cases, blame game followed. Now, do you remember who was chosen as a guilty party and what measures were taken? Funds chasing prices to stratospheric highs, throwing newly contributed money in to support the run created by old(er) money, thus creating what can be called an unsustainable pyramid? Market commentators and TV personalities hyping "new economy" and promoting useless companies with no substance? Monetary policies leading to yet another bubble? Lack of any meaningful oversight allowing any hack with computer in the basement to create a website and call himself a company? Yeah right. Powers That Be elected day traders as a scapegoat. They, day traders, run the market up to those insane and unsustainable highs, you see. In the process they also caused abnormal volatility, those bas****s. And of course, they don't contribute anything to society, ya know... darn parasites.

Stunned day traders meekly objected. We can't run the market anywhere in any more or less meaningful time frame, they said - being very short term participants we are generally net neutral by the end of the day, thus fully eliminating our directional impact. If market goes up day after day, it's surely someone else's buying that causes it. And we jump in with out bids and offers on intraday basis, thus providing liquidity for longer term players, narrowing the spreads - after all, each lower time frame players serve as liquidity providers for higher time frame ones, isn't it ABC's of the market?

It all made perfect sense for anyone who understands what market is and how it functions. But since when making sense mattered any? Blame had to be assigned, fingers had to be pointed and measures had to be taken. Scapegoat was chosen. What did we get as a result? Why, $25K rule. Remember? Can't day trade unless have $25,000 in your trading account. What a fix, eh? Mission was accomplished - as far as political expedience of the moment required.  Did anything got fixed in reality? Well, we moved right to the next bubble; market went through another run-up and consequent crash; volatility during that crash reached unprecedented magnitude; destruction of wealth occurred at the breathtaking scale and speed. Oh, and just to add insult to injury - those same TV personalities continue their hype, never bothering to acknowledge ever being wrong. Can you call that blaming day traders anything but distraction?

Fast forward to these days. Is it time for new blame game to start? You bet. Will Powers That Be try to find another scapegoat, allowing real culprits escape spotlight once again, thus dooming us for another boom-bust cycle? That's exactly what is happening in front of our very eyes, with the same arguments and purpose. This time it's HFT. They cause unsubstantiated  direction (never mind that they scalp tiny spreads, often less than a cent, not causing any direction). They cause volatility (never mind that in order to earn their rebate they must ADD liquidity by putting in bids and offers, not taking someone's; thus they do provide liquidity for higher time frames as design intends). They cause crashes when withdraw their orders (never mind that if it were so then forbidding their activity would have caused crash right away). There are many other accusations, most of them based on complete lack of understanding how market mechanisms function. There are probably valid ones  too but it's hard to hear them in the choir. Nor there any interest in meaningful discussion - just as there wasn't any back then, after tech boom. Just as back then, there are those who fuel all this finger-pointing with purpose of shaping up yet another scapegoat and diverting the spotlight from real culprits, while imitating activity instead of resolving real problems. Then, there are those who simply misdirect their anger, believing that it's HFT that really causes troubles in the market...

So, there you go. Instead of real solutions we are going to get tweaks to what needs no tweaking. Blood-thirsty angry crowds will be satisfied. Officials charged with market oversight will demonstrate that the measures have been taken. Mission will be accomplished - once again.

That's why I express contrary view on this topic so adamantly. I've seen it already. Same arguments, same volume increase, reaching crescendo soon. Same purpose. Same outcome, too.

Market reversal setup

On Apr 30 I made this post describing my conditions for the market reversal:

Today's selling

Submitted by Vadym Graifer (1179 comments) on Fri, 04/30/2010 - 15:12 #61968

... is much closer to what I'd like to see for a trend reversal than anything we have had in quite a while. Slow, orderly, sustainable... Not ready to call it full blown reversal yet, but if SPY doesn't go over 121 and loses 118.20, that should do it.

Let me show the setup I had in mind making that call. To provide a background which is fresh in memory today but will be a bit murky for readers in a while, the market had huge rally for about 13 months, and last couple months we had almost no pullbacks - just day after day of relentless upward climb. Search for the reversal and calls for the top, made all too often during whole rally, became almost hysterical. Time and again asked if "we are there yet" I was answering that I saw no signs of reversal. This post above though described a trigger for market reversal. Let's have a look at the chart where you will see a horizontal line showing the trigger:

Looking at the top of the few bars forming the mini-range just above the breakdown line, you can see also where the resistance $121 came from. So, what we have here is: high at $122.12 made on 04/26, sharp retreat next day bottoming out at $118.25, a few days of consolidation forming a range between $118.20 and $121. That's the range that presented the setup mentioned in the call.

From here we had two scenarios. First is hypothetical now: SPY breaks $121 thus invalidating the breakdown. From there would would be watching for possible double top or abandon short idea if new high were made. Second is what took place: support was broken, and the rest is history.

Blog summary

Trading Philosophy – General Understanding of the Markets.

Ø Market and Logic

Ø The Dual Reality

Ø A Trader’s View of the Market

Ø Information vs. Price

Ø Trends and Reversals

Ø Changes and Consistency in the Markets

Ø Manipulation in the Markets

Building Trading System

Ø Role of Technical Analysis

Ø How to Start

Ø Paper Trading

Ø Type of Movement

Ø Structure of the Setup

Ø If-Then Scenarios

Ø Types of Entries

Risk Control

Ø Role and Necessity of Stops

Ø Stop Loss vs. Sitting It Out

Ø Averaging Down

Ø Basics of Stop Loss

Ø Deeper Look into Stop Loss

Trading Psychology

Ø Basics of Trading Psychology

Ø Novice

Ø Intermediate

Ø Experienced

Ø Sophisticated

Ø Psychology of a Stop Loss

Ø Psychology of Relapse

Ø A Trader’s Mental State

Day Trading, Scalping and Tape Reading

Ø What Is Scalping

Ø What Is Scalping II

Ø What Is Tape Reading

Ø Basics of Tape Reading

Paper Trading: Waste of Time or Valid Learning Method?

Numerous discussions of paper trading, and its value as a learning tool, usually see participants divided into two camps. One claims total uselessness of paper trading, another vows never to start without it. The scoffing camp points out the obvious limitations of paper trading:

• It doesn’t allow you to estimate slippage during your execution.
• It leaves unanswered the question of whether your order has a chance to be executed at all.
• It keeps you in a relatively relaxed state of mind as there is no pressure of endangering real money.
• It also doesn’t allow you to master your order routing tools in full.
• Finally, it’s very easy to cheat oneself, changing one’s decision after the fact and booking corrected results.

Is this all true? Why, of course it is. Does it render paper trading useless? By no means. Paper trading can be extremely helpful if two conditions are met. The first is applying this learning tool at the right time and with the right purpose. The second condition is doing your paper trading right.

Let’s try and build the rules of paper trading that will allow us to turn it into powerful learning tool. We can identify three cases where paper trading instead of live trading is in order:

• A beginner getting his feet wet.
• A trader testing a new trading system.
• A trader hitting a losing streak.

The first case is the most common. Let’s analyze the right way to structure paper trading for this situation.

Paper trading allows you to ease into real trading and see if your theoretical approach works. It is a stage where you start measuring your method against market movements. You are going to have enough time to deal with the psychological pressure and execution side later on, adding them gradually as you start trading with a small size. However, before real money is used, theory should be checked against the reality, and this first experiment should be as painless for your trading account as possible. Obviously paper trading does not pursue any meaningful target unless your trading system is structured so you can test it; thus, start with constructing your trading approach, then proceed with testing it in real time.

Paper trading is done in a fairly simple way. It is an imitation of your actions without actually sending your orders to the marketplace. You define your setup with all of its components: trigger for entry, stop level, signs of exit, possibly with partial exit and stop trailing. Then when observing the market action you are imitating your responses and writing them down. This is going to be your first encounter with the market so take it seriously. Paper trading will teach you plenty about market action without risking your money if you are watching carefully and acting responsibly.

Observe whether your setups are working. Watch the market action and define if your response is reasonable. If you lose money on paper day-by-day, something is not right with your approach. Try to make corrections, find out what factors have not been considered. This is your troubleshooting stage – look for problems to solve. If you get negative results, do not get frustrated – take them as a blessing in disguise. It’s much better to find out about a problem before committing actual money to a flawed method.

Watch if your risk control is working. Do you lose within your defined limits on any given trade and on any given day? Maintain strict discipline at this stage – your future trading results are going to suffer if disciplined behavior doesn’t become your second nature.

The crucially important purpose of paper trading is to find out the maximum drawdown that you can run into. This element might require a somewhat prolonged paper trading stage. The point here is, losses and wins are not necessarily distributed evenly along the timeline of your trading. You can run into cluster of losses. While the average loss might be affordable in terms of your trading capital, such a cluster may not. It is very important to make sure that a losing streak is not taking you out of the game.

Here are the rules of paper trading that allow it to be as realistic as possible and make paper trading an effective learning tool:

• Make your decisions real time only, not after the fact. Looking at the chart and deciding where you would have entered and exited won’t do you any good. Everything is easy in hindsight and looks very different when you are up against what Alan Farley called The Hard Right Edge – end of the real-time chart leading you into unknown. Write down your entry when your setup is triggered; write down your exit when the chart hits your profit target or stop.
• Keep you trading rules exactly as if you were trading real money. Any decision of “I’ll do this although with real money I would do that” kind renders your paper trading worthless. If your stop level is hit, your paper trade is stopped and should be written down as such, even if a stock immediately bounced back up. If your profit target is not hit, do not write it down as less profit but still profit – it negates the very purpose of paper trading, which is to see if your targets are realistic and your stops are placed correctly.
• Take trades with the same degree of risk as if you were trading real money. A decision to paper trade a risky stock that you do not intend to trade when doing live trading makes no sense. You paper trade to test your strategy, not to play around.
• Use the same set of tools as you intend for live trading. If your trading strategy requires Level II, for instance, paper trading without it with idea that with it your trading will be even better makes no sense. It won’t be better, it will be different.
• Consider your entry and exit executed only if there are actual prints at the price you target. Just seeing bid or offer where you want them is not a guarantee that you could get your order filled at that price.
• Consider the amount of shares available at your price. If you intend to trade 1,000 shares but there are only 100 shares offered, chances are in real trading you wouldn’t get your order filled in full. Watch actual prints to determine how many shares there really are.
• Do not use paper trading to project what kind of money you are going to make. This is not the purpose of this stage. It can only make you unnecessarily impatient and eager to start trading live before you are ready. Simply write down the results to see if your planned strategy is working.

One more purpose of this stage is to get comfortable with your tools. Configure everything as you need it for live trading. Move windows around your screens to have them placed as conveniently as possible. Start with your charting software. Play with the fonts to have all the information that you need on the screen while text is still easy to read. Play with the colors so that different windows are easy to distinguish. Learn to quickly manipulate your charting software. Change symbols, link windows, change time frames – do everything that you will need to do in the course of trading. Draw necessary lines on the charts, add and delete studies and indicators that you are going to use. Do it long enough to make the process automatic.

Learn your order routing software. Manipulate the controls, changing quantity of shares, price of your order, type of order and route. Switch from limit order to market order and back, practice changing the price quickly. Play with controls long enough to make the process automatic. See how to set advanced orders. If necessary, print out excerpts from order routing instructions and place it within easy reach.

Finally, start routing orders in a way that keeps your money safe. Do it in the following way.

Set small amount of shares – from ten to fifty. Set the price far enough from the market price to not get filled. If a stock is trading at $20, prepare your buy order at $10 and short order at $30. Send the order. Observe how a confirmation appears. Now cancel the order and observe the confirmation. Make sure that all the messages you receive become familiar so you do not spend much time reading them later. Make sure that confirmation pop-ups do not get in the way of observing the action. Observe the reliability of your quote feed, especially in the most active periods – market opening produces fast conditions when the quotes are most likely to lag. Make sure that you have trading desk phone number on a speed dial to be able to reach help as fast as possible if something happens to your internet connection or quote feed – no technology is perfect.

It’s often asked how long this stage should be. There is no fit-for-all answer. There are traders that breathe through it in a week, and I know a trader that paper traded for a full year. It doesn’t mean he was a slow learner. He just was perfecting his trading system until he was totally satisfied with it. Although a year is probably a bit on an extreme side, a week or two is not really what suits most people. This is usually not a matter of exact time that would be the same for everyone. Paper trading serves certain purposes, and you should move ahead when those purposes are achieved. Keeping all the rules of paper trading, do you show consistent profit? Have you observed how your setups work and gotten comfortable with them? Have you made sure that you know the drawdown your system can produce and that you can sustain it? Have you become comfortable with your charting and order entering software? If you can answer Yes to all these questions, then paper trade just for a couple weeks more. If not for any other reason, do it to practice one of crucial elements of your psychological makeover – patience. The skill to sit on a sideline will serve you well. It will also allow you to get into your first trading day with more feeling of self-control.

We mentioned two more cases when paper trading is appropriate.

Testing a new system or to tweak an existing one is obviously calling for going back to paper. You are changing something – why risk real money before you make sure it works well? Usually when a trader is doing that he already has enough experience under his belt to know how to paper trade effectively. Just make sure that you give it enough time so your results are statistically significant. I know a trader who does this kind of new tweak testing not even stopping his live entries and exits. While making real trades he simultaneously writes down optimized ones, comparing the results and making conclusions about the quality of optimization.

Going through a losing streak, a trader wants to find out the cause of under-performance. Is it market conditions that change in a way that ruins his system? Is it a trader himself acting in an undisciplined manner? If it’s the market, does something get changed fundamentally or is it a short-lived fluke? Does a major trend change? Is it just a temporary range contraction with no volume? What is likely to come next? These kinds of questions are not easy to answer in the heat of the battle. Thus stepping aside to re-evaluate things, to regroup and to regain your confidence or to re-tune your approach is a good decision.

For whatever reason you go to paper trading, your major step to assure the success of it is to define the purpose and to work out the steps to achieve it.

Stupidity, hypocrisy or both?

When I have the same conversation many times in a row, I know it's time to do a blog post on the topic. This time it's a discussion (somewhat outside of usual scope of my posts but relevant anyway) of the causes of financial crisis, framed as "who is to blame" question. This thing is, I refuse to join the "darn banksters and their greed got us where we are" chorus. Not because I have some particular reason to love banks and bank people, mind you. I simply can't see how you blame something or someone acting according its nature and doing so within the framework you yourself created.

Any explanation, any description, any user manual is by definition simplification of things. Let's simplify this.

If you put a carrot in rabbit's cage - carrot will be eaten.

If you put a rabbit in wolf's cage - rabbit will be eaten.

Putting carrot in rabbit's cage or rabbit in wolf's without understanding what fate awaits for both is stupidity.

Bemoaning carrot's and rabbit's fate, blaming rabbit in carrot's "death" and wolf - in rabbit's is hypocrisy.

Pushing lenders to lend to barely or un-qualified borrowers; Lowering lending standards; Repealing laws and rules that kept such unsafe practices at bay; Guaranteeing those unsafe loans via GSEs; Keeping super low rates for too long - all this created a framework where profits could be had while risk was mitigated or masked by those guarantees. Creating a situation where a profit-oriented by its very nature organization can make a profit while relegating risk to someone else's shoulders and not foreseeing the inevitable failure is stupidity. Creating such situation, observing that organization doing just that and blaming it for following its very nature is hypocrisy.

Should banks be excluded fully as entities having their hand in everything that happened? Lord no. But the idea that the bank by itself is some kind of evil organization or that people working in or for the banks are necessary bad is ummm... how do I say it softly... stupid? Yet it's just the mindset that is being propagated. Let's all hate banks and solve our problems by materializing this hatred in this or that form - while real culprits are all too happy to channel the anger away from themselves.

Manipulation: myth and reality

Always hot and contradictionary topic, causing emotional flare-ups all over various boards and forums. Since the conclusion some make is that manipulated markets are untradeable, it becomes a matter of practical interest for us. As traders though, we are interested in reality, so let's try and analyze the matter at hand. Also, as traders we want to do it not for the brain exercise but in pursuit of a practical pragmatic purpose - and that's what we are going to arrive at.

Little qualifier before we begin: everything said below is said about normal liquid markets. I am not discussing extremely thin markets where the smallest order can move the market - those are disaster in the making for anyone who wants to play them, manipulation or not. I am talking about those real markets, you know - hundreds of millions of shares available, thousands of players involved.

Second qualifier: everything said below is said as a TRADER - someone who reads the markets and strives to profit from his read. If you prefer to discuss social aspects of this topic - that's for some other blog.

First things first: we need to agree on a definition - so we discuss the same thing. Let's go over some versions and see which ones are realistic and which are not. So, what do we mean when we say "manipulation"?

1. Assigning the price arbitrarily.

Here are couple phrases that you will find familiar; I have no doubt you heard them many times.

"They keep the price down so they and their friends could load up on the cheap".

"They run the price up so they and their friends could unload".

Sounds familiar? Thought so. The premise here is, there is certain entity (THEY) that is capable of making the price whatever they want. Practically assigning a price. Woke up this morning, got yourself a price... How nice for THEM. I have couple questions though.

First: HOW? Really, what is the mechanics of artifically keeping the price low or running it high? Can you just say "stay low" or "run up" and so it will? Or you have to actually SELL in order to keep it artifically low and BUY to run it artificially high? Because if you have to sell, really sell real shares, then what is the point in doing that? If you want to take advantage of the low price you kept low by selling, you will need to buy, right? And that's when you are going to play right in hands of those who bought from you earlier - lifting the lid and switching to buy side, you are going to run the price up now, to the benefit of those who bought from you earlier. If you are lucky, you may break even by buying back your shares at about the same avereage price you sold at earlier. Most likely you won't. Same scenario plays out if our brave manipulator runs the price up by his own buying. He does that for... whose benefit? His own or his friends, right? And just what will he/they have to do in order to take advantage of that inflated price? Why, sell of course. But he is not supporting the price anymore since he turned into a seller. If he run the price up all by himself, it's going to collapse as soon as he withdraws his bid, let alone starts selling. (If you are tempted to say at this point "wait, but his actions could have attracted others so he kind or provoked them and then they did his bidding for him" - good thinking but hold your horses, we will get to it).

So, actual selling or buying in order to get price where manipulator wants it is not really the way to achieve anything but get steamrolled. And, I still have second question. Here it is:

Listen, if government/Fed (entities most often accused of manipulating the markets) really have the ability to just make up any prices - why do we experience these gut-wrenching crashes at all? Those wild fluctuations cost elected officials and public servants their jobs, influence one's historic reputation - why wouldn't THEY just keep markets going up forever and ever? Everyone's happy, everyone's wealthy, some are rich, no mass revolt, no complications, THEY are cheered - what possible reason would THEY have to let it all go down in flames making THEIR life immensely difficult?

There is only one conclusion I can come to here answering "true or false" to this one: FALSE!

If we agree that no entity can simply assign a certain price, let's move to the next possible definition.

2. Manipulating information flow.

THEY present reports and numbers and analysis in a distorted way in order to provoke certain reaction - that's the gist of this accusation. True or false? I don't think anyone in their right mind would deny it's possible and it does take place. The only question I have about this one: what else is new? Name me any society, any civilization, any period in human history where and when it wouldn't be done. Let's be real here: no one should endorse or condone or justify this practice - but there is no reason to consider the markets being untradeable for this reason. How exactly you trade the markets where information is being distorted is another matter, and we did dicuss it earlier, for instance here. As far as traders' point of view goes: there always was, is and, I'll venture to suggest, will be a divergence between what available information says and how the market reacts. You will find confirmations of this phenomena in the books written 100 years ago. Whatever you think about the practice, whatever causes it - by no means it prevents anyone from correct reading the market and profiting from its moves. It happened always and at all levels - Bre-X, anyone? UAUA false news last fall?

Interesting thing about this aspect is, many of those who express their outrage at this kind of practices by government, Fed etc. also claim they they see through the lies and know how things look in reality. I certainly don't claim anything even close to this kind of understanding of these complicated economic issues, but... if what THEY do is so transparent, then it must be possible to exploit, no? I mean if you understand what manipulator is doing, then as a trader thank him and use his manipulation to your benefit. And if you can't - well, either his manipulation is not as transparent as you think (in which case what's with accusations) or your trading skills are not as great (in which case, maybe best to focus on honing those) ?

My conclusion would be: TRUE, but old as the world itself.

3. Government's and Fed's own buying or selling of certain assets.

Sure. Why would anyone try to deny this if they themselves claim they are doing it. The question though is, so what? They pursue certain goals, thei intentions can be analyzed, so how is it different from any other market force? Read the tape and trade accordingly. And, while we are on a subject of definitions, let's call it for what it is: intervention. Because, if you want to call any entry into the market with certain purpose in mind a manipulation, then any single buy or sell, yours included, will be manipulations. Government intrusion, considering that the government is not, or should not be, exactly market moving force can safely be called intervention then.

Conclusion: TRUE, but from a trader's point of view, how is it different from any other market moving forces?

4. Faking intentions so other traders get duped into wrong reactions.

Ahha! Now we are talking my language (those of you who read our trading logs know it as Threeiish). This is where we are going back to that suggestion that manipulation can be done by provoking trading mases to act in a certain way.

There are two aspects to this kind of manipulation. One is what is known as "painting the tape". The term refers to illegal activity in which manipulators buy and sell the stock between themselves. While they remain net neutral, their actions create a false impression of a certain activity. This is clearly and undeniably illegal; if you know for the fact it's taking place on a certain security and have an evidence - simply report it.

Another aspect is actual trades placed by manipulator in the market in attempt to create certain reactions. Our manipulator may try to buy very quietly in order to mask the fact that he is building position - and that's what in fact skillful player will do at the early stages of accumulation. When his accumulation is mostly done, he will try to make his buying more noticeable to attract new crop of buyers by increasing volume and new highs in price. When and if he is successful, other players will come and take the price higher - and he will start distributing his shares to late buyers. And that's how The Game is played. This is readable. This is basics of the method known as Tape Reading. If our manipulator is successful in doing it - more power to him, AS LONG AS IT'S DONE BY HONEST RISK TAKING. Yes, that's my criteria - because what I described means he takes the risk, fair and square. If he is unsuccessful, he will lose money. Can it be that the company goes bankrupt on him while he accumulates shares? Sure, if he didn't do his homework well. Can it be overtaken by another company at the price lower than his average accumulated price? Can the sector turn down before he gets a chance to distribute his shares? Can some new technology come around and benefit a competitor while making the company whose share he accumulated obsolete? See where I am going with this? Unless our hypotetical manipulator acts on illegaly obtained inside knowledge, he takes honest risk - and, most importantly for us trades, in a process of doing so he creates readable opportunity for us. At least for those of us who have the skill to read it - but isn't it the whole point?

Let's make out last conclusion: TRUE, and thank you trading gods for that.

Got other scenarios? Throw them in, let's discuss.