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
Ø Trading is Not War

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.

Thus, 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.