Tuesday, December 8, 2009

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.

Sunday, November 15, 2009

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.

Sunday, August 30, 2009

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.

Saturday, August 29, 2009

Trading climate: new or same old?

Reading a lot of "market is not a place for a reasonable investing/trading anymore" comments, I thought I'd chime in and offer my point of view.

To see where I am coming from, consider that I:
- have been trading every day (aside of vacations) for the last 13 years (2 months shy as of this moment),
- made every trading mistake known to humanity and couple I invented all on my own,
- recovered from them after 2 years of learning curve and trade for a living ever since,
- conversed with hundreds if not thousands of traders of all thinkable backgrounds, time frames and approaches.

Here are some of things I see similar in any market, I'll list them and you see if they sound familiar.

1998 - 2000, tech boom, things go higher and higher and higher. Some are happy, making tons of money and talking about "new paradigm"... and some are not, losing their shirt on attempts to short the market, talking about how insane and irrational the run-up is, predicting demise day after day, talking about manipulation and how impossible it's become to trade. There are stocks here and there that turn into cult names, and groups of fanboys cheering them up. XYBR is louded as next MSFT, WAVX is predicted to go over 100, analysts say QCOM should go over 1000 when it trades at 700. KTEL goes from 5 to 20 and 30, and "realists" (your faithful was one of them and paid dearly for that) short it, and it proceeds to 80. Some make money trading what's right in front of them; the rest is discussing how the market should not be this way, trading their beliefs and losing money.

2001 - 2003, tech crash and consequent bear market. Trend reverses, yet permabulls continue buying every new low thinking it's just a pullback (new paradigm, remember?). Market proceeds lower and lower and lower, and seeing the magnitude of drops, a lot of people start talking about selling being overdone. Now it's a move down that is considered insanely big. Each new leg down is being blamed on, guess what... manipulation of course. "Market became impossible to trade" is being heard from every corner. Optimists average down and lose their shirt. Yesterday's darlings start disappearing altogether - simply go bankrupt, delisted etc. Some lucky names get bought out before the final crash, and its the suitors that get killed now. Quality companies lose their value at unthinkable rate - QCOM is nowhere near 700 anymore, and soon loses even 100; a lot of former highfliers go to lows some call insane (NT, JDSU anyone?). Now.... one thing seems to be the same: During all this some traders make money trading what's right in front of them; the rest is discussing how the market should not be this way, trading their beliefs and losing money.

Bull market starts in the spring of 2003. No internet crazies anymore, but hey, there is always a place for "new new paradigm". Market goes higher and higher and higher, and a lot of people say it's insane, housing is a bubble, financials are overblown... and lose their shirt trying to short them... Now, one thing seems to be the same: Some are making money... my reader, be a doll, save me some typing and insert the end of the first two paragraphs.

Housing finally bursts, crash ensues, some of yesterday's darlings go bankrupt (spectacularly I must say), bear market starts. Market proceeds lower and lower, and attempts to buy each new low become common and lead to new bursts of frustration and refrain of "insane, manipulation, impossible to trade". Some are making money... etc, I know, get's annoying.

Market puts a low in March of 2009, and starts making new highs - insane new highs, of course... you can finish this part now without me typing it all.

See some things repeating themselves over and over again? Patterns in who makes money and who doesn't? Patterns in language, in assigning the blame, in finding another scapegoat (day traders in tech boom, "frequent traders" now), in invoking all-encompassing word "manipulation" that makes some feel better but still doesn't help them make money? Patterns in going against the trend, effectively fighting the market instead of being in tune with it? Patterns in trading ones own beliefs instead of market's reality given us in prints on the tape? Patterns in thinking "if something doesn't go according to my belief, it's the market that is wrong but never I"?

See where my favorite motto of many years TRADE WHAT YOU SEE, NOT WHAT YOU THINK is coming from?

Monday, August 24, 2009

One question test

As it often happens during the most uncertain times - at what potentially is a trend reversal point - I get a lot of questions about signs of such reversal, in this case top. As it often happens, a lot of those questions are asked in order to confirm author's belief - and if no such confirmation is obtained, back and forth arguments ensue. Over the last week or two, I expressed my point of view that we were not ready for full blown reversal yet, and more upward action was likely to come.

One theme that constantly popped up in such exchanges (not a first time mind you, it's rather typical way of thinking) was this: "but there is no job creation, commercial real estate is imploding, A is weak, B is wrong (long list of what is wrong with economy)... this market must drop, I am shorting it!"

Notice one thing that all those reasons have in common? Well, aside of them being probably right. They all have no ties with market timing. Here is what I mean by this: if you employ some idea for trading related decision-making, you have two major questions to answer. One is the direction of your planned trade. Another is timing of the trade initiation. All the ideas listed above have to do with direction... do they have anything to do with timing? How do we distinguish which ones help us pick the right entry moment and which do not, leaving us to seek more indications to time our trade right?

Easy. There is a one question test that does just that. As you evaluate your trading idea, ask yourself: IS IT A NEW TURN OF EVENTS OR WAS IT SO A DAY, A WEEK OR A MONTH AGO?
Because if jobs creation wasn't there a month ago either yet market went up during this month, how does this fact enable you to enter short now? It does not. Any economy related, company related, sector related idea can be verified by this question in order to find out whether it should be used in timing your trade or you need to keep it as purely directional idea and look for something else to help you with timing.

You would think this is something that concerns mostly position or swing traders... but I get this from day traders too. 'I am shorting RIMM, I just analyzed their this and that, and it's very weak". RIMM is up 2 and half points for the day, so I ask: Why here? Is there any short setup, sign of reversal? What is it that makes you think short right here and right now? The answer is: Well, I just finished reading that report... Pause, then we both laugh as my counterpart realizes that his timing of finishing the report is fairly dubious as a market timing event. OK, I start laughing just a tad sooner as I am not polite enough...

Anyway, once again. Your one question test concept is, could this have been said a week or a month ago just as well and did not impact market during this time? If so, what makes me think it will do so now?

Thursday, July 9, 2009

Interesting lifestyle concept for a trader

The World visited our city

Interesting concept eh? Unless you are are prone to seasickness... but navigating choppy market should have taken care of that I assume.

Main problem would probably be constant confusion with time zones and their relation to New York time... when do I get up tomorrow for NYSE opening if we are in New Zealand?... Sydney?... Bahamas?... (OK, this last one was easy).

For those who are too lazy to click on a link: this is floating condominium constantly circumventing the globe. Buy your condo (not very cheap, mind you) and live in permanent cruise-state.

Can't help it but show one more version of the shot:

Tuesday, June 23, 2009

Averaging down - Yea Or Nay

"Averaging down" as a trading approach regularly causes controversy. While difference of opinions is always good, let's have a deeper look into it to make sure that opinions are informed and that we are talking about the same thing.

There is averaging down and averaging down. Not all of them are created equal. I'd break them down by two kinds.

1. A trader buys, position goes against him, he fails to cut his losses, sees them growing and getting out of hand. Eventually at some point he adds to his position following the logic "If I liked it at $20, it should be even better at $10" and/or "it can't go any lower". Both are false: anything can and often will go lower (no lack of examples of that over last year, eh?); and who is to say it was any good at $20 to begin with? And is $10 a better price or simply a proof that $20 was a mistake? This kind of averaging down is a "bad" one; it's done out of frustration, and it adds to a mistake. More often than not it increases eventual loss. In most cases what follows is: your position does recover some, by some magic stalling right under new breakeven level ($15 in our example). This gives you a chance to exit with a small loss but you don't take it - after all, recovery has started, you are looking at possibility of nice profits now (and on double size, no less). Sure enough, stock reverses and drops under $10 where you either exit with even bigger loss or put it in your long term portfolio, a.k.a. Grave of Short Term Trades Gone Bad. Another frequent scenario is, stock dives briefly under your second entry level, you sell your second position for a small loss, and that's where stock reverses and goes back to that 15... you curse your decision to cut losses on second part and don't sell first part - after all it's cutting the loss that killed your chance to get out even, right? Sure enough, it reverses down and you are looking at ever-increasing loss again.

Those rare instances when this strategy works only reinforce the idea of it being a viable approach, eventually provoking you to employ it again and again, until it leads you into a loss exceeding anything you saw in your worst nightmares.

2. Averaging down is a part of planned strategy. When a stock comes into your target zone but there is a lot of uncertainty in the markets, you don't feel confident enough to fully commit and don't want to stay on a sideline. You break your purchase in parts and plan a strategy for those parts. This strategy includes various scenarios of building up to full position in a case of further drop, in case of reversal, in case of stall. It also includes an "uncle point" - event or scenario which proves that the whole idea of entry was an error, so whatever is accumulated up to that point is being dumped. There is nothing's wrong with this kind of averaging down - it's done by a design, to minimize exposure at the uncertain time and increase it as events develop in a favorable way. I wouldn't even call averaging down but that's a matter of semantics.

As we see with many other things, there are no absolutes in trading. There is, however, need in clarity, in straigforward well-designed and thought through plan. Such plan, among other things, wil include definitions - as we mentioned earlier in this blog, "as you name the boat, so wil it float".

Sunday, February 22, 2009

Securities Tax Proposal

I've got quite a few e-mails asking about my take on this proposal, enough to warrant a blog post. For a someone making his living by trading the market my answer may be somewhat unexpected: I don't worry about it too much.
Here is why: I don't believe it has any realistic chance to materialize; And if it does, we will have much bigger problem on our hands than the end of active trading as our way to provide for ourselves and our families.
Let me explain. Most of my correspondents are coming from the (absolutely correct) assumption that such tax will end day trading. Imposing a prohibitve cost on the transaction, it no doubt would do just that. Notice that it's not just an additional burden, additional cost on the essential need that would help replenish government coffers as for instance gas tax would - it's prohibitive cost that renders the activity unprofitable and eliminates it altogether. There goes the idea of "let the Wall Street pay for bailout" - there won't be financial benefit to the government. Instead, there will be the destruction of the whole profession, sending more people to an unemployment lines. And I am not talking about day traders only - what about whole brokerage industry, discount brokers who suddenly lose their whole client base? More uneployed, more unhappy, less taxes collected - who could benefit from that?
Now, is the impact going to be limited to day traders and brokers that serve them? If it were so, some political expediency in search for a scapegoat could still warrant such proposal going through. After all, imposing $25K rule on day traders was no less idiotic (although less damaging), yet it did pass. In this case, however, it's about much more than just those pesky day traders. You don't really think it's just a day traders who trade every minute and every second and whose prints fill the tape with this endless flow, do you? Think of how many day traders there are and what kind of volume they could provide - and compare it with every day's volume on NASDAQ, NYSE and AMEX. What do those numerous trading desks of the banks, brokerages, all kinds of funds are doing day in day out, all day long? Who provides liquidity for longer term traders when they want in or out? Who makes the market bidding and offering on each and every stock at each and every point in time? Whom pension funds buy from and sell to when they reposition themselves? All these people, all these organisations will suddenly be put out of business by such tax. Now, imagine them all being out of the action. What happens to volume, liquidity and bid/ask spreads? Can you apply any word to the US capital market other than desert if that happens?
Let's talk about foreign investors - what are they going to do when they find themselves in the market with no lliquidity? Does the government want mass exodus of those?
Let's talk about companies listed on US markets. What are they going to do when the markets all but cease to exist? This is their financing source and pricing mechanism. Does the government want mass exodus of those?

Let's talk about the public. Does average member of the society benefit from the cost of transaction being passed to him/her when their 401K etc are being positioned and repositioned? Or from their self-directed transactions being burdened with this cost? I mean, no one seriously thinks brokerages are going to eat this cost, do they?  Does the government want to load our, dwindling as it is, investments with this additional expense?
Internet and globalization era, the markets all over the world are accessible with unprecedented ease... do you impose such prohibitive measures on your market and push people into the  welcoming hands of competitors?
All above leads us to one question: who would benefit from that proposal? After all, for any legislation to go through, there must be benefitting party influential enough to push it through. I fail to see any single entity within the USA that would benefit from it. We have Wall Street, Main Street, public and government as the suspects to look at. Who of them benefits from this? Not the government, not the banks and brokerages, not the public, not the companies. I just can't see it happening.
Now, as a last argument: not all things happening are being governed by the logic and that dying creature called Common Sense; sometimes raw emotions, populism, pandering to the lowest emotional reactions of the crowd takes over. That could lead to such proposal still being seriously considered and passed. Well, I still prefer to think that with no one particularly interested in the outcome, it won't - and if it will, we, as I said at the beginning, would have much bigger problem on our hands. We would have Powers That Be deliberately destroying the very fabric of the society, contributing to the job losses, capital outflow and desrtuction of the business - all for no good reason. If that happens, we better make sure we turn our houses in fortresses and have means to protect them, because in the chaos and insanity that will come, clicking Buy and Sell buttons will no longer be of any concern.