2011 Lessons

Year 2011 completed my second year of actively trading the US stock market. I have no other choice but to admit that I am disapointed with my performance. After two years I am about 5% negative. And there is only one thing that makes me still keep a positive view of the future. It is the recent realization that trading stocks is not a game. It may be compared to a sport, a business, a professional hazard in a casino ar at a poker table. But it is definitely not a game. Whoever treats it as a hobby, some late afternoon activity to overcome boredom, will only lose money. I've read many stories about highly successful traders that haven't made a single penny for years and blew up several accounts, before they finally started to make something out of their trading. Trading, as any other activity that needs to be mastered, will take its tuition. There is just no other way. One has to invest a lot of time and money before he can realistically expect any minor success. This is the aspect I've been consciously ignoring for quite some time. I thought trading stocks is as easy as reading a book from some trading wizard, applying his strategy and counting profits. But it goes way beyond that.

That's why I thought it might be a good idea to make a list of lessons I learned in 2011. If one cannot critically look on his own mistakes, he cannot correct them. I've made plenty of mistakes. This will probably be one of the most important posts I'll ever write as I'll try to expose all my trading weaknesses I've observed in the past two years and provide possible solutions on how to improve them. These lessons will lay out the foundations of my trading philosophy for at least another year.

Money management is the most important aspect of trading

From the beginning of my trading "career" about two years ago I have applied one painfully simple rule that has prevented me from getting into real trouble. I was always so afraid of seeing a big loss on my account that I almost automatically sold all my losers fairly quickly. Later on as I read several books about successful traders I got a confirmation that cutting losses is absolutely necessary for a long term success. There is an old proverb on Wall Street: "Cut your losses and winners will take care of themselves." And I thought I'll just have to stick to this one simple rule and let winners fly. Well, the truth is a little bit different.

Sound money management goes much further than just cutting losses. Selling small losers before they turn into big loosers is essential but far from enough. You can cut losses but if you get too aggressive when conditions suggest passiveness and not aggressive enough when there is momentum in the market, you simply won't have any significant profits at the end of the year. Period. And this is exactly what happened to me this year. I was nicely up on several occasions, but gave all my profits away soon after conditions changed. On the other hand, when there were opportunities, I was afraid to step in because of my previous failures. I finally figured out that I need to develop some sort of money management rules, that will serve three purposes:

1. Prevent me from making a big loss.
2. Pull me into the market as conditions improve.
3. Take me out of the market as conditions deteriorate.

Most of my analysis in the last quarter of 2011 has been devoted to development of money management strategy. I took my Market Timing System (MTS), which is basically a buy/neutral/sell signal system based on action of leading market indices, developed a Market Stage System (MSS) to determine the overall market trend and applied several new techniques and money management rules to them and got something that I call a Market Risk System (MRS). Fro details about these systemy please see Terminology page. I bet to say that the best thing I did all year was implementing MRS into my trading strategy in the past month or so. If I hadn't I'd probably be in real trouble by now after a series of loosers that I had due to the extreme volatility in markets. Maybe I'll discuss MRS in detail in some other post after I test it in the market.

I need to develop my own system

I think most beginner traders (me included) believe that all they have to do is find some guy that knows how to do it, who provides a free blog or a paid service, follow his recommendations and make money. Sounds logical, right? I'll try to clearly explain why this is not possible or very, very unlikely at least.

Every methodology has it's drawbacks. Every. There are no exceptions. Most extremely seuccessful traders admit that their percentage of winning trades is no higher than 50-60% on average. So, we can conclusivelly presume that the best paid services will have batting average no higher than 50%. Now, with this "fact" in mind the beginner trader's assumption doesn't look so promising any more, does it? But there is more to this than just winning percentage.

First major problem with following someone else's advice is character clash. Every person is different. We all have our own sense of reason. We, humans, the ego-based creatures, cannot do something that doesn't sound reasonable to us. At least not for very long. We like to make it our way. We like to believe our way is the only right way. Maybe this sounds a little bit too philosophical but it's true. The point is that most traders won't be able to follow someone else's advice without soon starting to incorporate their own rules. Which basically means they will come up with a different strategy. This may not be bad, but it should be clear that eventually every trader should develop his own system that makes sense to his personal view of reason.

Second problem with advice based trading logically follows from the first lesson about money management. You can get the best buy and sell signals on the best stock picks in the world, but you won't make it into a consistently profitable trading unless you follow some sound money management rules. And that's the main problem with all paid services. They may provide high quality stock picks, but the money management principles are on your own. And it is the same with money management as with stock picking. Every trader will have his own reason behind it. They go hand in hand. Stock selection strategy must be supported by money management, designed specifically for that strategy. You cannot simply copy it from some other trader. You can take a template from someone else and follow it for some time, but eventually you will start adding your own personal ideas and finally come up with a completely unique method. The need to develop my own system for buying, selling and money management has become crystal clear to me this year.

Profits won't take care of themselves, you have to take them

Human beings are greedy bastards. I'm human being, so I am greedy. When I have nothing, I want something. When I have something, I want more. When I have more, I want even more. You probably know how this progression continues in trading, right? When I have even more, I want even even more, and so on. Right? Well, wrong! In trading the progression goes on like this: when I have more and I want even more, I get back to something. Then I want more back again. As I want more back again, I go back to nothing. As I have nothing, I want at least something back. In the end I have to give away. That's how it goes.

I couldn't get rid of this bug in my head for two years. But after a serious reconsideration of my past trades I finally accepted that I absolutely must turn that "I want more" into "I'll take something off" and "I want even more" into "I have enough". Selling stocks at the right time is ten times more important that buying them at the right time. Selling is one critical aspect of good money management strategy and cannot be left to chance. I could not take profits and watch the stock make another 20% from where I sold it. It was heartbreaking. I was so afraid of leaving money on the table that I just could not sell when I knew I'd had to. And this mentality cost me a lot of money. In short: YOU HAVE TO TAKE PROFITS! Yes, you will always leave some on the table. Always! But this is a simple fact of trading that every trader has to accept otherwise he has no chance of winning this game.

Buying breakouts into new highs is not the only viable strategy

The first book on trading I read was William O'Neil's How To Make Money In Stocks. This is probably one of the top 3 bestselling books on trading of all times. Many traders worship it like a Bible. And there is no question it is of extremely high quality. It's been my personal trading guide for almost two years also. I highly recommend it. What O'Neil essentially promotes is buying breakouts to new highs from at least six week long tight bases. I consider this as a sound strategy and I've tried to trade these kind of setups for quite some time.

However, there are some very obvious limitations to this strategy. Obvious in hindsight, of course. I haven't been able to see them for a long time, due to my firm believe in Mr O'Neil. The first one is that too often the best stocks with the most momentum and thus short term potential simply don't make constructive, buyable, several week long bases. This is is especially true in later stages of a bull market when everything is kind of sloppy and choppy. This has been my observation in the last year. During the whole year of 2011 I've been able to find maybe 15 to 20 stocks that would be potential buy candidates according to O'Neal rules. Most of them failed soon after the breakout as smart money sold into increased deman. Opportunities for long base breakouts just weren't there.

Secondly, as I said, breakouts to new highs tend to become more risky as the bull market comes to later stages. O'Neal promotes capitalizing on stocks mostly when the new bull market develops from the bear market and holding them for several months. This would basically mean sitting on cash through every bear market, until new bull market develops. In case you miss it, well, wait for another correction again. Holding time for this strategy is way too long for me. I like to be a little more active. Besides, buying the wrong stocks can ruin your year as you sit with names going nowhere. All in all, I started to believe this may not be the best approach for me.

The point is that buying breakouts to new highs only works in very specific market environment on very specific kind of stocks. I was a believer in O'Neil for a long time until I finally realised stocks can be traded in other ways also. This realisation forced me to sit down to charts again and make some analysis what else could be traded beside breakouts to new highs. Eventually I've discovered several patterns that looked promising and also uited my character better.

The basic tenet behind all my patterns is their short term potential. I really don't have patience to hold stocks for three months, watching them drift slowly higher day by day. I like to be involved on a daily basis. Momentum is thus critically important. And momentum is in small stocks. I don't enforce any limitations regarding price, but most stocks that pop up on my screen are priced between 3 and 20 dollars. And best of all, the six patterns I've identified are all contextually different, meaning that they develop in different market environments. For a thorough description of patterns that I trade, please see Terminology document under Contextual Patterns.

Other

So, I think these four lessons were the biggest eye openers for me in the past year. But there were many other important lessons, that I will just briefly mention:

• A system for determining market direction - for a long time I tried to approach the general market analysis in discretionary was, meaning I had no mechanical rules to determnie market direction. This year I finally developed a more mechanical system that prevents me from inducing my personal bias into market signals.
• Don't chase - another problem that I could not get rid of. Chasing stocks can be translated into "getting into poor position immediately after breakout". I was often more afraid of missing an excellent opportunity than afraid of taking a loss with a bad stop, which was costly. If you miss the breakout, leave it!
• Don't buy before breakout - anticipating a breakout in fear of missing it or a gap up maybe sounds rational, but from my experience this is a recipe for disaster. Many breakouts simply never happen and many make that final shakeout that kicks you off right before stock really launches. Plain and simple, always wait for a breakout!,
  
• Set stops wide enough - my obsession with taking only very small losses has brought me to extremism in setting stop losses. In most cases I set them way to tight, not aloving highly volatile stocks to breath in their normal rhythm. Yes, stops need to be tight, but not too tight. ,
  
• Take small positions - greed and belief into a great setup can easily make you to take irrationaly big positions. This may work sometimes, but in the long run, it will make more damage than money. Simply, don't do this. Have the upper position size limit.
• Set targets - another mental trick that market plays upon inexpirienced traders. I never wanted to set targets for open trades. My excuse behind this was that I want to let my profits run, so I must not sell to soon. Well, the question here is, when will you sell then? Never? When it turns back down? I realized that setting targets is a virtue that is better be mastered if I want to succeed. This is the area I still have to work on.
  
• Analyse past trades - I'm a pretty lazy guy and I never really felt like analysing all my past trades. I never thought I could learn much from them. Well, I totally switched this view after doing just a couple of such analyses. I learned more from them than from any book I read. That's why I started to make detailed reviews of all my trades, good and bad, on this blog.
• Use buy stops - another weakness of my character. I buy breakouts. What it's very hard for me to do is to buy immediatelly the price trades above my trigger price. I simply wanted to see a "confirmation" first. I wanted it to trade just a little bit higher. I wanted to see some increase in volume, and only then I will place an order. Well, the painful truth is that this is just not the right approach for trading breakouts. By the time I get my confirmation, I'm already late. I'm chasing. I cannot set a safe stop. I will have to get used to placing buy stops. Some of my buys will fail, no question, but I believe buying the right stocks at the right time and setting a safe stop will more than pay-off for those faulty buys.