Thursday, November 24, 2011

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; 


- 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.

Tuesday, November 8, 2011

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?