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One of the readers asked me why I do not trade leveraged ETFs any more.  Did I fail at trading the ETFs?   The answer is Yes and No.   If you judge it by gains/losses, I did not since I made some money trading the EFTs.  If you judge it by my equity curve, I failed since I had so many draw-downs and spikes in the previous months when I focused exclusively on FAZ and SRS.

Draw downs and spikes mean that I am intrinsically taking too much risk.  Take a look at my trading in March, I had one big winner(FAZ) and that was all.  Without that trade, It would be a losing month.  if you have been following my blog, you know how lucky I was with that trade.   That big gain does not have much to do with my skills.

Keeping draw-downs to minimum is one of key characteristics of good money management.   Big draw downs mean poor risk management.   Let’s say if I was down 20% in March and up 30% in April, on the surface it seems Ok since I am still up 10%.   But if you look deep into it, it is horrible.  I let my risk control slip so that I ended up down a whooping total of 20%.  Yes, I was up 30% the next month.  Nevertheless If you examine it closely, it is still horrible. Here is perhaps what I did after losing 20% in March.  In order to get my money back, I increased my position size and took trades that probably did not have optimal set-ups.  And I was lucky and  pulled it off.  However, if I keep doing this, I am sure I would have two -20% months in a row sometime in the future.   Trust me.  It is very hard to come back when you are down 40%.  I would be just much better off with two consecutive positive months, 5% each.

If you can keep your draw-downs low, it does not matter what kind of vehicles you trade.  Some traders can be very good at trading boring bonds or T-Bills and bad with stocks.  Some traders can be good at trading E-mini and bad with Forex. It is all normal. For me, I really suck at trading penny stocks.  Yet some people are just good at it such as Tim Sykes.  It all comes down to choosing the right vehicles.

The primary goal to invest/trade in the stock markets is to make money.  However, we will never achieve this goal if we do not know why and how to manage risk.

Why risk management has top priority

In trading, risk management is far more important than anything else.  To make money, we need a trading stake.  How could we make  money if our trading accounts are wiped out or our capital is tied in some rotting positions?  It is absolutely  OK to have losers. But it is NOT OK to hold onto them once Mr. Market has warned us to get out.  Here is a post about how to treat losers and another about how to set stop loss orders.  

How to control your risk

So the first thing is to cut the losers.  Nevertheless. It is not enough to just cut the losers. If we have many losers to cut in a very short period of time, they can add up quickly.  We will have to set our overall loss cap and adjust our position size accordingly.  For day trading, our loss per trade should not exceed 0.5% of our total capital and our daily loss cap should be no more than 1.5% of our trading capital.  In other words, we stop trading after 3 losers in a row. A daily loss cap is not enough; we need to set a weekly cap too. My weekly cap is 5%.  If I have lost 5% by Wednesday, I will stop trading for the rest of the week.  And my monthly cap is 10%.

We will also have to pay attention to our position size. Position size should be reduced to a level where we can feel comfortable without looking at it or thinking about it constantly. If we are constantly worried about our positions, then they are too big and our judgment will be impaired.

In order to control position size, we will have to pay attention to what sectors our positions are in. If we have MOS and POT at the same time, then they are considered one position since they move together most of the time. We should only have one of them or at least split our capital between them.  For example, after careful studies, you feel comfortable with 10k per trade.  You normally choose whatever is the strongest in a sector. Let’s say MOS. You put 10k into MOS and have nothing in POT. If you really like POT, then do a 50/50 or 60/40 split between MOS and POT.  You just can not have 10k in each since that would be equivalent to 20k on a fertilizer stock.

Another advantage about reducing the size of our positions is that we can use a wider stop loss and still stay within our risk threshold. If our risk for each trade is 200, then our stop loss would be 2% of a 10K position or 4% of a 5k position.  With the same amount of risk, a wider stop loss works better than a narrow one.  Of course, our profits will drop due to the reduced size.  But once again, I will put risk control before anything else in trading.

Here is the recap

1. Cut losers
2. Set a daily/weekly/monthly loss cap
3. Control position size
4. Pay attention to sectors

In trading, shorting stocks is referring to try to profit from falling stocks. From day one in school, you were taught all kind of wonderful investment strategies such as buy low and sell high or buy higher and sell higher (my strategy).   It sounds very unnatural to profit from falling stocks.   Nevertheless, Shorting is a genius idea.   If you ask me, nothing in the financial world comes close to allowing short selling.   It simply is a splendid idea for speculators like you and me. 

This will never happen in any places other than trading. When you buy a piece of real estate and hold onto it for a few years, you sell it for a profit if it has appreciated over the years.   It is all sound and good.   What if you go tell a housing developer to lend you a piece of real estate and sell it in 2007, buy it back in 2009, give him back the real estate and you keep the difference?     He would think you are just out of your mind.  He also must think you are one crook because you profit from his pains.   So in real life, you can not ask someone to lend you something and short sell it for a profit even if it is a technically sound idea.

However, you can enjoy shorting here in the stock market.  In order to short stocks, you will have to borrow stocks from your broker.  Your broker normally keeps a constant ratio between the number of shares shorted and the total number of shares in his inventory.   Let’s say that number is 40%.   Then it will be hard to borrow the stock to short once the number reaches that level.  That is why you can not short some stocks sometimes.  And you can short them again after a little while.  If a broker loans you any shares to short without any inventory, it is called “naked shorting”, which is illegal.

Here are a few unique characteristics about shorting

1. When a stock drops, it tends to move much faster than when it goes up. Here is why. In reality, the bulls far outnumber the bears since people are taught that shorts are unethical and you should be investing instead of speculating, blah, blah…  Therefore, when a stock goes down, there are a lot of panicked bulls that trample each other, thus cause a stock to drop very fast.
2. Stocks can drop on their own weight.  Have you seen stocks that drop a little bit every day without any volume for a long time?   Sellers (shorts and panicked bulls) just gradually pile on each other every day.   However, stocks seldom go up without any significant buying power and volume. Only cornered stocks would move withou any volume.
3. If you short a penny stock, it might gap up 500% tomorrow morning, which is very rare.  In addition, you should be fine if you keep your positions small   However, the most you can lose in a long position is 100%, which is also very rare.

Shorting is not for everyone.  As I said many times, you do not have to know how to short stocks to be a great trader.  You can be a great net long trader as long as you know when to stay out of the market when it is getting ugly.

Which one is suitable for you?  let’s first take a look at each style.  The following is based on the assumption that you follow the idiom “cut losers and ride winners”

Day Trading

Pros: 

• very little risk due to not holding postions overnight
• easy and quick entries and exits
• no need to worry about long term general trends
           

Cons: 

• much smaller profits than swing trading
• A very accurate system is required
• not good for people who have a day job.
            

Pros 1 and 2 are very easy to understand.   For pro 3, I believe we do not need to worry about the long term trend of a position that you are day trading because we try to capture small moves for a day position.  If a stock is in a long term up-trend, the probability that it will retrace at a certain point it is over 99%  since all stocks zig and zag. When it shows any signs of zagging, you can fade it intra-day. It is the same when a stock is in a downtrend.
 
 
 

Swing  Trading

Pros: 

1. bigger profits
2. no need for a very accurate system
3. suitable for everyone,  lawyers, doctors, policemen, you, me and Dupree
              

Cons: 

1. More risk due to holding positions overnight
2. A lot of your positions might die since they require much bigger moves     
              

Pro 1 is true since I always believe that your risk and reward is mathmatically proportional.  If you take a bigger risk, you MIGHT have  a bigger reward.
 
Pro 2. I explained in this post (Probability and Risk/Reward Ratio) that you will still make money even if the accuracy of your system is below 50%.

Let’s first take a look at each style. Investing means that you pore over a company’s financial statements, management, product lines, operational costs, barriers of entry, profit margin etc.. In other words, you look at a company’s fundamentals. If you think the market value of a company’s stock is below its intrinsic value, you buy it. Trading is on the other end of the spectrum.. Entry and exit of a position is made based on thorough technical analysis of a stock. Which one is better?

Most of financial articles and college econ. classes teach people how to be an investor at an early age. They will throw tons of econ. theories at you and cite Warren Buffet or Peter Lynch as living examples that investing is better than trading. What they do not tell you is that most of the investors lose money, let alone achieving anything remotely like 1/millionth of what Warren Buffet or Peter Lynch has achieved so far. I still remember that Benjamin Graham, teacher of Warren Buffet, said in his famous book Security Analysis “You are better off to buy a well diversified mutual fund in the long run than pick individual stocks on your own. If you are determined to do it yourself, read on.”

From my experience, trading is more suited than investing for average people like you and me. All the people I know, relatives, friends and next door neighbors who are/were investors suffered huge losses in 2008. The problem is that they did not have huge gains during the bull run from 2003 to early 2007 to offset those big losses. Cut the losers and let the winners run. You might have heard of this phrase from time to time. It sounds simple. Nevertheless, very few people can follow that idiom. Most investors do exactly the opposite thing, which is cut the winners and let the losers run. When he has a winner after a number of losses, he would ask himself 500 times a day if that winner would reverse. The more he asks himself, the more worried he is. He ends up prematurely exiting his otherwise a very profitable position. However, when he has a loser, every time that loser bounces back a little bit(sucker rally caused by shorts covering), he sees a light at the end of the tunnel. Yet the position edges even lower. He keeps asking himself “How is it possible? How is it possible since this stock has such a low PE ? Why? Why? ” The position continues to edge lower while he is still pondering why his investments are rotting. I have seen people hold onto gigantic losers that are over 50% under the water. 50% is an understatement in 2008. Before an average Joe like you and me know what went wrong with the company, the stock has been already crushed unrecognizable.

One reason that an investor can not cut losers is that he has a very strong conviction when he decides to buy a stock after spending so much time trying to understate the fundamentals of a company. In other words, he is very biased by the time he finishes studying the fundamentals of a company. If that stock goes against him, he will always fool him into something like “I am a long term investor and this company’s fundamentals are sound.” Before he realizes it, he has a pet. Here are a few classic losers in 2008. They all have sound fundamentals. But…

Click on the thumbnails to have a better view of these losers

MGM(MGM MIRAGE)

Drys(DryShips)

RIMM (Research In Motion Limited)

SIGM( Sigma Designs, Inc)

A stock moves because of the underlying psychology of many participating traders/investors. It reflects the mental states of all these participants. Technical analysis works like a heart rate monitor that you can use to see what others are thinking and then you make a trading decision based on what you can deduce from the readings. If you are a pure technician, you spend no time reading anything about the fundamentals of that stock. The stock is just an electronic symbol that may show you x,y,z symptoms of going lower/higher. You calculate/guesstimate/deduce the probability of the stock moving in your predicated direction. If your answer is 51%, you open a position.

 As we can see, one of the biggest mistakes an investor makes is keeping a pet. With a seasoned technician, it can not possibly happen since he might not even know what this company does. It is just a symbol to him. He can long a stock as easily as short the same stock. He uses solid risk management to avoid big losses, which is cutting the losers. There are good, bad and ugly technicians.

• Good technicians follow the idiom, cut the losers and let the winners run.

• Ugly technicians cut the winners as fast as the losers. These traders will always be around though. But they are not able to make consistent profits.

• Bad technicians slip into the investor mode, whom Mr. Market will send them packing as quickly as they entered the market.

When Dick Fuld, the CEO of now bankrupted investment bank, Lehman Brothers , testified on Capital Hill, he said “We acted like investors. We did not cut our losers quickly enough to avoid the steep losses.”  If you would like to invest in the stock market, buy a mutual fund or an index fund.  Most people simply can not beat those professional fund managers.  Most fund managers have a bunch of highly educated people working for them and they spend more than 8 hours a day researching stocks.  A lot people who I met actually believe they can beat those fund managers consistently even if they only spend 1 or 2 hours a day at most on researching stocks.

Of course, this is a perennial debate between investors and technicans. Choose one suitable for yourself. Happy Trading/Investing.