Stocks -- Defending the Bottom Teaches Important Principles

Stock traders over the past few days have successfully defended the prior lows for the major indexes. In this chart, the left chart shows today's 15 minute chart, showing a steady rise following this morning's open. The right chart shows the daily chart, with the November stock market lows near the left edge of the daily chart. Today's chart isn't complete yet, but today's candle shows what may be either a hammer bottom or a dragonfly doji forming. Until the day is done, the candle could certainly change, but it is worth watching and paying close attention to.

Some Lessons to Be Learned

On the one hand, the more often we test the previous November lows, the more likely we are to see a breakout to the downside. We are, after all, close to the lows, and with good reason for being there. On the other hand, the more often we test those lows and hold them, the more likely we are to see a rally, as investors decide that "the worst is over" and want to buy at what they perceive to be "cheap" prices. This line of thinking exposes an investor/trader to a serious flaw in thinking. I call this flaw the "falling knife" syndrome. Just because a financial instrument has fallen precipitously, doesn't mean that it can't fall even more! And when traders are caught in the trap of thinking, "It has fallen so far, it just has to go higher now," they are likely to lose money. This is flawed thinking. In fact, from a purely statistical standpoint, when a breakout occurs, it is far more likely to continue in the original direction, rather than reverse direction. What has gone down, can go down more! Trying to catch the proverbial falling knife only results in bloodied finances!

Lows Are There For a Reason that is Neither Bullish Nor Bearish
These battleground levels are neither bullish, nor bearish. That's why they are battlegrounds! Prices consolidate at these levels because there is conflicting data, both bullish and bearish, at these price levels. It is a standoff! A breakout can occur in either direction at any time. I'll wait to take a position until I know who won that battle! I have found no consistent pattern that gives me confidence in either buying or selling at these consolidation/battleground levels for a longer-term trade. (To me, a long-term trade lasts days or a few weeks, not months or years.) If I am already in a profitable trade, as in this case (I hold some bearish ETFs right now), I will tighten my stops, often each day, so that if a breakout occurs against me, I will exit with as much profit as possible.

Money is Only Happy When Put to Work!
My money must be working for me all the time -- every day! I only trade, and I only hold a trade, as long as it is doing what I bought (or sold) it to do -- go up (or in the case of a sell, go down)! If it goes sideways or the wrong direction, I exit the trade "rapido"! Time is money, and wasted time is wasted money!

Emotional Peace Counts for Something

This strategy of holding a position only when profitable doesn't just save me money. It also permits me to sleep better at night. I saves me emotional angst! Peace of mind is worth its weight in gold!

Opportunity Cost -- Wrong Trade at the Wrong Time -- The One that Got Away
Lastly, and this is almost universally ignored among investors, it also prevents me from experiencing "opportunity loss". The cost of a lost opportunity because my money was tied up in a bad trade or unprofitable trade is a true cost, but it is a hidden cost. More accurately, it is an ignored cost. I'm not just in this business to make money! I'm in it to make money as quickly as possible. If I miss an opportunity while I'm waiting with white knuckles and praying for a trade to make money, or (heaven forbid) to turn from a loss to a gain, then I'm leaving money on the table. I lose the money I could have had if I had used my money on a different trade! That is a costly error -- literally!

Don't Give Control to the Market

I'm also giving control of my profitability and my money to the market. The market is not here to make money for me. Only I should be in control of that. Holding onto a bad or unprofitable trade transfers power and control of my money to market forces. Bad idea! This concept is taught powerfully by Phantom of the Pits in his book, "Phantom's Gift".

Laws and Principles
All of these principles are important. When I violate these principles, I lose money. Here is another way of stating the importance of abiding by principles:

"And unto every kingdom is given a law; and unto every law there are certain bounds also and conditions." D&C 88:38

In the "kingdom" of the world of finance and trading, my job is to learn and abide by those laws, bounds, and conditions. When I fail to do that, I pay a dear price. When I learn and live by those laws, I prosper!

Some of the Immutable Laws of Trading

Today I posted a comment to help a fellow investor/trader on Marketwatch.com.
Here is an excerpt of my comment:

"One of the cardinal rules I use in trading is called Rule #1 from a book by a very successful trader (who, by the way, gives it away FREE):
"Rule #1: Assume it is a bad trade until proven correct! Positions established must be reduced and removed until or unless the market proves the position correct. (from Phantom's Gift -- see my blog site for more info on the book -- absolutely at no cost whatsoever.)
"This rule has saved me a lot of pain, and has ironically also made me a lot of money! Not only is maintaining a losing position bad for my pocketbook. It is bad for my emotional state and it gives control of my money to the market instead of me keeping control of it in my hands."

If you'd like to read my entire comment, including some other laws of trading, you can read it here:
Treasuries Rise Again

The essence of Rule #1 is that you only stay in a trade if it is a profitable trade within a reasonably short period of time. All other trades are exited quickly! You don't put on a trade and then sit around praying that it will make money, all the while waiting with white knuckles and baited breath. By doing this, I save not only my money, but my sanity! I also guarantee that I will have money to trade another day!

Waves of Buying

Today's stock market indexes provide an excellent case study in observing waves of buying activity. These tiny waves are referred to as "bubbles" by Cahen in his book. Each time prices close below my moving average (in this case, the dotted white line is a Weighted Moving Average), then I will buy at the top of the next green candle that passes back above the moving average. I will then sell the odd-numbered contract as close to the apex of this wave as I can best estimate. I use the Bollinger Bands to assist me in this. My sole objective on the even-numbered contracts is to not lose money, since I'm holding them throught the downturn of the wave. Of course, when these waves of activity occur as in this example, I make just as much from the even-numbered contracts as I do from the odd-numbered ones. In this way, I am using the patterns that Cahen describes in this book, combined with Rules 1 & 2 described in Phantom's Gift, to accelerate my earnings. On a higher time frame, these waves create a pattern that Philippe Cahen refers to as a pattern of "parallels". This chart shows a photo-perfect example of this phenomenon of . Wow!

Risk Aversion Trumps Potential Profits!

I frequently hear asset management people tell people to hold onto stocks that are falling with the justification that eventually, they just have to turn around, or that they have fallen so far, they must have hit bottom. They reason that prices must move higher, and investors should therefore remain in them so that they don't lose out on the opportunity when stocks eventually move higher. I disagree with this philosophy for various reasons:

1. Opportunity Loss -- Every dollar that is invested in a losing stock/trade is a dollar that can't be used in a winning stock or trade. If that money is locked up in a bad trade, there are a myriad of opportunities missed that might have made money instead! One opportunity that is lost on a falling stock is the opportunity to short it instead. Even if -- like me -- you don't short stocks, you could profit from buying an ETF that does short that market sector! You could be making money from the ill sentiment toward that stock, instead of losing it. Or you could at least stop the loss by hedging with an inverse ETF in the same sector. Perhaps the greatest opportunity missed with this philosophy is the opportunity to have purchased that same stock or ETF at a much lower price. Taking a small, early loss is the only way to avoid this opportunity loss.
   
2. Clear Head -- When you exit a bad trade, your analytical skills improve immediately because you have cleared your head and can see the markets with a more objective perspective. It is amazing how releasing our minds from the emotion of a bad trade can help us to more clearly recognize the good ones.
   
3. Irrational Markets -- There is a saying (don't know who to attribute it to) that the financial markets can remain irrational longer than you have money to wait out that irrationality. This is true! You'll go bankrupt waiting for that "inevitable" turnaround that you just knew would eventually come. Even if that turnaround does come one day, there is a good chance you'll never see it because you'll lose your money waiting for it. It also seems to come just when we have been pushed out of the market after we just couldn't stand any more loss.
   One of my favorite thoughts from Phantom of the Pits is that we must recognize the blessing of a small loss. He also says that the trader who loses least, wins most.
   
4. The "Falling Knife" -- This idea comes from the very potent image that if you try to catch (or in this case, hold onto) a falling knife, you will get very bloody and experience severe physical trauma. The same concept is also true of our finances. Trying to catch a falling stock also bloodies the financial waters of our lives just as surely as catching a physical knife blade does. These financial "gurus" who suggest "holding on" to losing investments always reason that because prices have fallen substantially, they must therefore begin to rise now. No, they don't! Prices that are down can go even lower. Much lower! Momentum is to the downside! Stocks can go to zero! Don't try to catch a falling knife! Take your losses early, and you'll not only sleep better at night, but you'll also be able to keep a clear head (#2 above) to select other investments and get back into the market to make money instead.
5. Fox in the Hen-House -- Many of these supposed investment advisers and experts are in a losing market position themselves. It is true that "misery loves company". Many of these people (or their clients) are losing money on the same stocks they are recommending to others, and therefore they are hoping that by suggesting that other people buy them also, their own (or their clients') loses will stop and the stocks they recommend will start to move higher again, thus rescuing them from their own misery and losses. Corporate executives are notorious for recommending their stocks even while they are selling those same stocks themselves. These people have a gross conflict of interest, so all their comments should be taken with a grain of salt -- better yet, a pound or two of salt. This is also true for many investment advisers.
   

I would rather exit a bad trade quickly (Phantom's Rule #1), and buy that stock back again later at a much better price when the bottom has truly formed and when my thinking is clear. Thus, my purchase price is better and my return on investment is also improved versus someone that buys and holds regardless of market turmoil.

Miss First 20% and Last 20% of Trend
One investment tip that I have heard attributed to the Rothschilds (although I don't know if this is true) is that they don't try to catch the first 20% or the last 20% of a stock's rise. If someone holds onto a bad trade, they stand to risk all or most of the rise, not just miss the first or last 20%. I have found that my trading methodology allows me to accomplish this -- getting in at the early stages of a new trend, and getting out just as the momentum is starting to wane. Sometimes I'm wrong, but more often than not, I'm successful, and my successful trades are far more profitable than my bad ones. Learning strong technical analysis skills helps tremendously to reduce the risk and raise profits.

Best Book on Risk Vs. Profits
My philosophy on focusing on reducing risk instead of on profits was influenced heavily by Phantom of the Pits in his book, "Phantom's Gift". It's the best book on trading that I've read, and what makes it even better is that it is available free. That's not just a bargain. From the perspective of return on investment (ROI), it's value is therefore literally infinite! My only real investment is the time to read it and the effort to change my behavior. I can't make a better investment than that!

China Announces Rise in Gas Prices, Crude Collapses

Crude oil prices have collapsed due to a major fundamentals-related announcement out of China. The government of China has announced that they will substantially reduce gasoline subsidies that have artificially inflated use of petroleum in the world's most populace nation. China's petroleum consumption has been artificially propped up by the government's subsidizing of gas prices at the pump. Since China's population wasn't paying a market-based price for gasoline, consumption was higher than would have been expected with crude oil at such elevated levels. If China's drivers must now pay a price for gasoline that is closer to the market price, demand destruction should result, reducing global demand for oil.

This has caused the market to react because this will very likely cause rapid demand decay as China's emerging middle class must grapple with much higher gasoline prices. This is an example of the law in futures trading that "anything can happen". We must always be prepared for news that can change the direction of the markets at any time. Phantom refers to these in his book, Phantom's Gift, as shocks to the system. They occur frequently, and we must be ready for them at any time.

Three Waves of Market Reaction

In this chart, we see clearly the three waves of market reaction to surprise shocks in the world of finance. I am referring to three waves of orders flowing through the futures exchanges, not Elliott Waves. I have marked each wave near its end above.

Elliott Wave Theory

There are also larger waves on higher time frames. While I am not an adherent to Elliott Wave Theory, I acknowledge that it may have some validity. It certainly has many devotees. I have a an excellent book on the subject that was graciously gifted to me by the author. However, it is so incredibly complex (waves within waves, etc.), and so subject to interpretation, that it tends to be more art than science, in my opinion. It also takes very practiced practitioner to be good at it. The waves I am referring to in this chart are not Elliott Waves.

Three Waves of Orders

Phantom of the Pits refers to three waves in his book, Phantom's Gift. This chart shows three waves of selling today as different market participants reacted to the various data.

1. Wave #1 occurred today when the data was released and traders responded immediately to the data. This wave often occurs as professionals, and especially floor traders, react immediately to breaking news.
   
2. Wave #2 in this chart occurred when the stock market opened and investors were able to respond to the data. This wave also often occurs as orders flow into the pits from those who have belatedly heard about the recent news.
   
3. Wave #3 occurred in this chart when retail investors (the general public) began to catch wind of market sentiment and began to react. Often, this will occur when brokers call their clients and make recommendations. These retail investors will then respond to market sentiment based upon their agreement or disagreement with brokers. This wave often occurs when the public hears of the recent news, and is often the strongest wave.
   

Note that often, wave #3 occurs just at or near the market apex or, in this case, the nadir of the market's reaction to news. Sadly for most retail investors, it is often the turning point of the market.

Phantom of the Pits refers to the three waves in his book, Phantom's Gift, but doesn't explain in great detail. He does say that the safest and most reliable place to enter the market is at the earliest stages of wave #2. He also implies taking profits on wave #3 and positioning against the public by fading the market in wave #3, which is when volume is the strongest but will soon lose steam. This may seem like a contradiction, but it's not. The third wave, while strong and often causing new highs or lows, is also the thinnest. This is the best time to prepare for a counter-trend move or reversal. I'm not familiar with any books on the subject of this phenomenon of the three waves of orders, except Phantom's Gift. If you do, please contact me by writing a comment attached to one of my posts in my other blog. Thanks!

Shorted Dow

My last post mentioned conditions under which I would short the Dow, which have now manifested themselves. However, prices are close to the 15 minute EMA (left chart), so I am anticipating that prices will find support near here, at least temporarily. If prices move through that EMA and remain below the previous highs, I will plan to go short again. This conflict will probably result in consolidation in this range until this conflict is resolved by either the bulls or the bears. This is hinted at on the tick chart (right) as well as potential dynamic support by the Bollinger Bands on the 3 minute chart (middle). This would be a likely place for prices to rebound higher to resume today's uptrend, or to merely consolidate.

From my experience, however, one never knows which side will win out. With all the worry troubling the stock markets these last few days, there has been a somewhat bearish sentiment lately, as manifested on the daily charts (not shown). However, with Bernanke's statements yesterday and bullish economic data today, the bulls might very well win out. I must be prepared for anything!

I have noticed that stock index traders tend to have very short memories. Morose sentiment one day often gives way to ecstatic sentiment the next day, resulting in manic-depressive movements in the stock indexes. And that's fine with me, because it provides the momentum, liquidity, and volatility needed for profits in the futures markets.

I will continue to buy and sell based upon Phantom's Rule #1 and Rule #2, using my entry, add-on, and exit points, as long as these charts continue to trade with smooth, clean trading conditions. I suppose that only a trader could view this apparent chaos as a thing of artistic beauty! But to me, that's what they are!

Factals: Finding Order in Chaos!

What is chaos theory? What is a fractal?

Fractals As Entry and Add-On Points

I use fractals as entry points for new orders and to add to existing positions. Fractals are the safest points to do this with the least amount of risk because they occur precisely at turning and inflection points or at points where a dominant trend reasserts and/or reinforces itself. This reassertion phenomenon occurs repeatedly in the above graphic at the green arrows then the upward trend begins anew. Each of these fractal points offered an opportunity to add new positions.

Fractals Entries Minimize Risk
This involves less risk because if the reversal of direction fails at these points, it is immediately evident and a trader can exit quickly with only a small loss. One prominent trading book suggests adding only at the point where the previous high was surpassed (the red-arrow fractals in this chart), but I don't agree. By taking a new trade only as the most recent high is surpassed, a trader must accept that the trade very likely will go negative for at least a short time in the future. If, on the other hand, a trader buys at the green arrows just as prices confirm above the Exponential Moving Average, most likely the trade will be in the profit within a minute or two (and usually less), and will never go negative at any point. To me, this minimizes risk and maximizes profits.

Fractals and Phantom's Rules
This concept of using fractals at these inflection points is also harmonious with Phantom's Rules because it disciplines a trader to react quickly to remove or reduce a position unless it proves correct almost immediately under Rule #1. Fractals also provide a very clear point to add onto an existing position under Phantom's Rule #2, providing that all conditions are met for the add-on.

Definitions of "Fractal"
fractal (frac tl)
n. A geometric pattern that is repeated at ever smaller scales to produce irregular shapes and surfaces that cannot be represented by classical geometry. Fractals are used especially in computer modeling of irregular patterns and structures in nature.
n. Mathematics, Physics. a geometrical or physical structure having an irregular or fragmented shape at all scales of measurement between a greatest and smallest scale such that certain mathematical or physical properties of the structure, as the perimeter of a curve or the flow rate in a porous medium, behave as if the dimensions of the structure (fractal dimensions) are greater than the spatial dimensions.

Chaos Theory Explained

cha·os (kā'ŏs')
(Mathematics ) A dynamical system that has a sensitive dependence on its initial conditions.
(Physics) a dynamical system that is extremely sensitive to its initial conditions.
(definitions from Dictionary.com)

Chaos: Stochastic behavior occurring in a deterministic system...
Stochastic behavior is probabilistic behavior. (Stewart, Does God Play Dice?)
By placing both stochastic and deterministic in the same definition, the mathematicians have formed a bridge between the two sciences - two sciences that were regarded as mutually exclusive until then. Chaos is the study of deterministic systems that are so sensitive to measurement that their output appears random.
(excerpts from Introduction to Chaos Theory, by Mike Andrews)

Chaos Theory can be generally defined as the study of forever-changing complex systems. Discovered by a meteorologist in 1960, chaos theory contends that complex and unpredictable results will occur in systems that are sensitive to small changes in their initial conditions...

Although chaotic systems appear to be random, they are not. Beneath the random behavior patterns emerge, suggesting, if not always revealing, order. Recognizing that the stock market is a non-linear, dynamic, chaotic system /one stock market mathematician/ applies the principles of Chaos Theory in order to determine the pattern behind apparent random nature of market prices.
(from a website called, "Pi, The Movie")

Following are some images of fractal patterns as they occur in nature. They are often beautiful to behold. Fractals are the beauty and order of nature's chaos!

Fern fractals

Leaf fractals
Fractals in the meanderings of a river

Fractals in brassicas

Other

Wheat Trading Contracted, Difficult

The tick chart on the right showed volatility, but the 3 minute chart on the left suggests a contraction of the Bollinger Bands and poor volatility. When the Bollinger Bands are so contracted and tight on the 3 minute chart, trading activity on the tick chart tends to become erratic and difficult to trade. With corn and soybeans limit up, I am using the time today to read trading books. My favorite is Phantom's Gift. It always charges my trading batteries.

Another short trade

These trades are only good for $100-$200 per contract, but add up when they are summed up at the end of the day. They key is to watch both prices breaking through the Exponential Moving Average and the Klinger+ATR indicator, which usually gives a prescient hint at changing sentiment, as it did in this case. If the Klinger indicator changes color against my position before I have more than 5 ticks of profit, I immediately tighten my stop to the last high or low of the previous candle. I will exit if prices reverse through that high or low of the previous candle. Usually, I can break even. The other key to making consistent profits is Phantom's Rule %1:

Assume it is a bad trade until proven correct. Positions established must be reduced and removed until or unless the market proves the position correct!

In essence, this rule is saying that he who loses least, wins best!

Phantom's Gift - one of the best trading books -- and it's FREE!

Here is a link to a document that I downloaded (it is free) from the Futures Magazine website:

http://phantomsgift.4shared.com/

This document is my Bible of trading. It doesn't teach technical analysis or trading methodology, but is more about the immutable laws of trading success and trading philosophy. It is written (it is done interview style) by Phantom, a veteran futures trader who has made great sums of money in the futures markets.

I believe that in every realm, there are laws that control success in that realm. Phantom's Gift teaches many of those laws. I will, from time to time, refer to the "Rules" taught by Phantom in his book, as well as other laws that I have learned.

I met Phantom years ago in a forum for Forex traders. He became what I considered to be a mentor, but I eventually lost track of him and haven't had any contact with him for about 3 years or so. I would very much like to renew acquaintance, if anyone knows him and can help me renew our friendship.

By the way: this shared folder is hosted by 4shared.com, a wonderful website for sharing files. You can open an account with them yourself by clicking on the link below my profile at the right side of this page.