Over the past several months the markets have shown extraordinary volatility and we have been witnessing a serious bear market. During that time I have spoken to many traders and investors who have accumulated large losses. More recently, quite a few have said that they have just sold their positions for significant losses. I am regularly asked whether I think we have hit the bottom.

Each of those facts, the accumulation of large losses, the closing of positions after a big drop, and the quest for opinions of whether a bottom has been reached signal underscore some problems common to many unsuccessful traders. Accumulating large losses is generally evidence of a buy and hold philosophy and fails to honor the concept of cutting losses. Instead, it illustrates an all too common issue of letting losses run. As many regular readers know, I have long advocated an exit strategy be in place before a position is entered. It can be a variety of things, but it needs to be there or the large losses will inevitably accumulate.

Selling positions only after losses have become too painful rather than as a consequence of a pre-determined exit strategy is another characteristic of a high number of retail investors. Many traders lose and, sadly, but interestingly it is because they tend to buy near the tops and sell near the bottoms. The fact that so many of the folks to whom I have spoken are now liquidating positions may, indeed, be a signal that we are nearing a bottom. We are getting to the point where there are fewer and fewer sellers left.

Of course, neither I nor anyone else can say whether we have a final bottom or not and I personally believe it is a futile exercise to try to predict that or almost anything else. A big sell-off on high volume is often a tip that we may be seeing a bottom, but like anything else in the markets, it does not tell us with certainty. While we may predict that an index or a sector or a stock is going to move in a certain direction, we must always keep in mind that doesn't necessarily make it so. We must understand and accept that our prediction may be wrong and ready to pull the plug as soon as the error is demonstrated.

I titled this article "Start from the Beginning" and, for me, the beginning of a directional play is the determination of what the market is currently doing. In general, roughly 80% of the stocks in an index are moving in the direction of the market (otherwise, the market probably would not be moving in that direction). Why play against that direction? Would we rather choose something that has an 80% chance of success or only a 20% chance of success. If we see there is a downtrend, it just makes sense to make bearish plays or stand aside. If the market is trending up, the reverse is true. In general, we make profits when we can enter and follow a trend so why not do just that as we start from the beginning?

Merry Christmas to those who celebrate Christmas and to those who don't may whatever your holiday is be filled with joy for you and your family.

Good Trading!
Bill Kraft

December 20, 2008

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