Times of the Year

As we reach Labor Day and the end of the summer vacation season, it occurred to me that it might be an appropriate time to examine some of the influences of the calendar on stock and option trading. While it may be surprising to some, time of year can actually have an influence on market behavior. I don't mean to suggest that the season should control our trading; I only mean that it doesn't hurt to pay attention to the calendar as we trade. For example, many investors are aware of the phenomenon of tax selling in early December, for example. That often is a good time to unload dogs and gain the benefit of a tax loss for the year. Often, following the tax loss selling there is what has become known as the "Santa Claus" rally leading into Christmas and the beginning of the New Year.

Another calendar related circumstance is the practice of "window dressing" in which many mutual funds and portfolio managers have engaged over the years. Funds generally report performance quarterly to their shareholders and, in order to make themselves look good, may sell the losers before the report is compiled and add some winners so that it looks like the fund is in great shape. Sometimes, stocks that are not readily recognized may be dropped and more well known names added to the portfolio so the investor can see what fine companies are held by the fund. This window dressing can lead to relatively heavy trading in some issues and is completed before the quarterly reports go to press.

Since many of the large players vacation at the Hampton's or in the south of France or some other wonderful place during the summer, that season can be marked by some low volume and, therefore, high volatility trading. It seems to me that the few weeks leading up to Labor Day are particularly prone to that type of activity.

Certain months of the year also seem to have a general tendency (though definitely not always) to experience dips or reduced volatility. Those are the months following earnings reports. Most U.S. companies report earnings on a quarterly basis and those reports are frequently released in the months following the end of a quarter. As the release of earnings reports approaches, excitement can build and many trades may be made in anticipation of the report. Depending upon market conditions and investor anticipation, we may see price begin to run up as the earnings date approaches. Once the earnings are announced, there is no longer anything to anticipate so there may be a fall off in investor interest and in prices in general. Since the quarters end in March, June, September, and December, many earnings are announced in April, July, October, and January. The months that follow those reports are months when the excitement has passed so we want to be aware of the possibility of reduced interest and market excitement in May, August, November, and February.

As with most things in the markets, there are no hard and fast rules as to what to do in those months. It is simply a factor about which an investor should have some awareness.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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Searching for the Key

Over the course of my trading career I have met a lot of people who were trading or trying to trade. I met them at seminars I took, in trading groups, at seminars I gave, and at events where I have spoken. If we are to believe the statistics, most of them were doomed to fail. From the perspective of an outsider watching it is pretty easy to identify the ones who probably just won't succeed. I have seen the same mistakes made over and over by the same individual and by many different people. Instead of giving themselves an edge to succeed, they set themselves up for failure. I was reminded of some of the mistakes by someone who is doing it right. An old friend and partner called me today to tell me he was retired, had read my book, and wanted to trade. He asked for other study suggestions and said he was "chomping at the bit" after reading my book and another. At this point, my friend already has parted company with many who will fail as traders. He said he really wanted to start right away but knew he had just enough knowledge to be a danger to himself. How right he is. He sees the potential, but, even more importantly understands the risk.

Impatience is definitely an enemy of the successful trader. I can't tell you how many times I have witnessed people who were exposed to a strategy new to them begin trading it right away with real money. Most often they only understand the bare bones of the strategy, if that, and have no idea how to adjust a trade or when adjustments might be necessary. In many instances if asked what do they have at risk in a position they are unable to answer. They are just charging forward seeing only the "up" side until the down side jumps up and bites them.

Another common problem is the hunt for the secret strategy or for the automatic software that guarantees success. One fellow told me you couldn't earn big profits with the strategies in "Trade Your Way to Wealth" and complained that I didn't give away any secrets. Absolute nonsense. Of the many strategies discussed were things like buying stock and shorting stock along with many option strategies including buying LEAPS calls. Of course one can earn big profits with those strategies and many undoubtedly have. And, yes, there is no hidden secret. The secret is in the open. Know the strategy, know the risk, formulate a plan including an exit strategy and follow the plan, exercise sound money management, trade with discipline-- that's about it.

Most trading strategies are relatively well-known, and will lead to success if used properly by a knowledgeable, disciplined trader. Almost none will work for the trader who is not intimately familiar with the strategy or who permits his emotions to make his trading decisions.

Another common characteristic is the search for the perfect system or the perfect software. No one, absolutely no one, can know the future. How can anyone say that any system of trading the markets is going to be infallible? What will be the state of the world in 3 years? or in 5 years? Won't what happens in the world affect the markets? Will the U.S. be at war? If so, with whom? What will the capital gains tax structure be? What will have happened with inflation? We can speculate on those things all day long, but we can't know until we get there. No software or system can predict the unpredictable. Those who create and sell systems and software know that they cannot predict with certainty. That's why they can never and will never guarantee your success using the software. When the well-funded software developer is willing to guarantee your capital when using his system, it might be time to buy. Meanwhile, examine them with a careful eye. I don't mean that many systems and a great deal of software aren't helpful. Some definitely are; they are just not the panacea the eager trader seeks.

Though many of us understand that the future is unpredictable, we still try to trade by prediction. Some will advocate buying a stock because it has great fundamentals and, therefore, it "must go up." Over time they may be right (maybe not?). The question is when. Simply because a company is great doesn't mean that it's stock price will go up. GE is a great company in my estimation. In 2000 it traded at a split adjusted price around $60. Today it is trading at less than half that. Any prediction that GE will hit $70 may have to wait. Several months ago, a subscriber suggested that the only way to go was to buy and hold. He used his family's holdings in Citigroup (C) as an example. In 2000 Citigroup stock was trading in the low $50's. In mid-2007 it was trading in the low $50's. Today (August 20, 2008) it closed at $17.49. Well, some say, of course it dropped, that is because of the credit crisis. That is the fundamental reason, but as of about the middle of 2007 it was at least unpredicted if not unpredictable. I am unwilling to sit through the drops from $50 to $18 if I can avoid it so rather than trying to predict, I try to let the market movement take me out and put me in.

One last problem for this article that I have seen with unsuccessful traders is that they see a trade but don't make it because they are waiting for confirmation. I'm not against confirmation, but I have seen situations where the delay in entry causes the trader to miss the trade or much of it, or, even worse, puts the entry far from an exit in the event the play goes the wrong way thereby increasing risk rather than reducing it by awaiting more confirmation.

Down the road, we'll look at some other issues and, hopefully, some ways traders can make themselves aware that they are setting themselves up for the fall.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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The Insidious Nature of Greed

Most of us are probably aware that emotions can be the downfall of traders. The markets undoubtedly react to fear and greed. All we need do is recall the tech bubble of the late 1990's when traders were paying exorbitant prices for stocks of companies that had no earnings, and in some cases, barely a business plan. Greed fueled the fire and people bought positions with no thought that things might turn south. Instead, the drive for profit controlled their actions. Risk awareness and risk aversion went out the window and, for many, so did large portions of their portfolios when the markets turned over and headed south.

As I considered writing an article about the dangers of greed, I was reminded of a man I casually knew and whom I watched at a gambling casino in San Juan many years ago. The fellow was a fairly well known and pretty well-heeled lawyer back east. He was playing roulette at a high stakes table and was apparently using the Martingale approach where he doubled his bet whenever he lost. The strategy often may work since the gambler starts with a bet of one unit and doubles it after each loss so that when he finally does win, he wins his original unit. As those familiar with the strategy are probably aware, it may often yield success, but it definitely can produce catastrophe if the gambler has enough losses, he will come up against the table limit and no longer be able or permitted to double his bet. As I came upon the table, I noticed that the lawyer was flushed and sweating profusely. What I learned was that he had gambled and lost thousands and he was reaching the table limit. I heard him ask the pit boss to increase the limit and saw his face drop even farther when the request was denied. The wheel spun and he lost.

What motivated this fellow? Certainly greed or he probably would not have thought of high stakes gambling in the first place and probably also a belief in infallibility of his system. The two often go hand in hand and often result in disaster. I recall another trader who once called me and told me he had just bought 200 short-term call contracts (that controls 20,000 shares of stock) on a company whose earnings were to be announced the next morning. I asked him why he did that and he told me it was because he knew the earnings were going to be good and he knew the stock would go up. I said: "How do you know that? Do you have insider information?" He didn't have insider information, he just "knew" it. When I suggested that the price of a stock often dips when earnings are announced even if they are relatively good, he ignored the possibility and told me to just watch the next day. I did. The stock price fell and the phone rang asking how he could fix what had become an awful trade. This guy had made his trade purely on the basis of greed and his belief that he could predict the future. He was mistaken and the greed turned to fear and anguish in a nano second.

Both those examples are somewhat extreme, but they should be a warning to all of us. No matter what we think, we can't know the future and no matter how infallible we believe a system to be, it isn't.

Something I have observed many times over the years of teaching seminars, coaching, and just communicating with traders is that there are an awful lot of people trying to use strategies that they haven't learned. I've seen people in trading groups go to a talk about some strategy that is new to them and immediately put real money at risk using the strategy without any idea of the risks or whether or how the strategy might need to be adjusted in the event things didn't go the way they "hoped."

In my individual coaching sessions and in my book, "Trade Your Way to Wealth", I try to make it a point to invite traders' attention to risk and how it might be managed. In trading as in life, it isn't all going to be good. We need to be aware that almost all of us have a streak of greed and that it can suck us into some pretty bad situations if we don't take measures to discipline our trades and control our losses.

And as a last note, if you don’t yet have plans for October 26, why not come and hear me speak at the Traders' Library 2008 Traders' Forum in Chicago. In my session, I will use current examples to show you how to make limited risk and even no risk trades to protect capital while putting yourself in a position to enjoy significant profits. Featuring some of the top minds in the investment world, this 2-day event will be a great place to learn more tricks of the trade and to meet and mingle with smart active traders. I would be pleased to meet you there—visit www.tlforum.com for more information and to register today.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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Standing Aside is a Strategy

Over the past several months, I have received a number of emails and heard from many traders how hard they consider the markets have been to trade. In talking to others, I have heard many sad tales about significant losses. In a sense, these complaints echo those I heard when the markets turned south in 2000. I always try to ask these folks what they are doing in the markets and the answer most often is that they are buying stock or taking bullish positions. The problem, of course, is that the markets have been decidedly bearish in general and unless a trader was focusing on oil and energy, the chances for success weren't very good. Markets are going down because most of the stocks in that market are going down so why be surprised that we lose if we are playing against the market?

I am convinced that most people are bullish by nature or training. The consensus, wrong though it may be, seems to be that we need to buy stock or directional options to make money in the markets. I once knew a man who literally made millions in a few short years trading the markets only to lose it all when the tech bubble burst. Of course, there were many reasons why he went broke including failure to manage money and failure to discipline his trading, but most importantly, he refused to do anything but continue to make bullish plays as the market turned more and more bearish.

It is fine to be bullish, but my suggestion is that if you are bullish by nature and only like to make bullish plays, then stand aside when the market turns bearish. Going to cash and just watching when a market is bearish is a lot better than watching our assets melt away as we try to pick the bottom.

There are many ways to make money in bearish and sideways markets. I discuss several of those ways in my book, "Trade Your Way to Wealth". In Appendix D to that book, for example, I specifically set out bearish and neutral strategies along with the bullish and describe things like their relative risk, capital required, time likely to be in the position, potential rewards, etc. However, just because those strategies are available doesn't mean everyone knows them or knows how to use them. If you are among those whose bent is bullish and who neither knows nor cares to use bearish strategies, the best strategy is probably to stand aside until the bull returns.

Awaiting the return of the bull requires patience and many would-be traders are very impatient to say the least. Patience, though, is a great asset for a trader. Rather than rushing in to catch the falling knife as so many do, how about waiting until a bullish move is confirmed and then invest. That certainly seems better to me than watching the portfolio race toward zero.

As the paid subscribers are aware, I have been addressing the bearishness for months now, and, in the bullish services have sent out many fewer alerts than when the markets were moving up. My efforts for the bullish services have been to try to find the occasional position that looks like it has reversed up and get in with a reasonably tight stop in case I am wrong on the direction. In general, though, I have spent much more time "standing aside" than I normally would in a bullish market. During the same period, the Option Trader service has had more trades simply because of the ability to make bearish and neutral trades.

The markets or a stock can only go one of three ways -- up, down, or sideways -- and there are strategies for each, but we have one other option available when we are unconvinced about direction or just uncomfortable with a market; we can stand aside and wait until we find the conditions we like. It may take time and require patience, but it is better than the alternative.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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Play the Market at Hand

In recent weeks, I have received a number of emails from traders who have been suffering a high percentage of losses in their accounts and who wonder what they are doing wrong. In many cases the answer is that they are playing a market that does not exist right now. They have been buying stock only to see it fall in price. While some stocks will inevitably move up in bearish markets, most are going to fall. If we think about it, the markets would not be falling if most of the stocks in the market weren't also falling; that is why the indexes drop -- most of their components are dropping. When we buy stocks in a falling market, we are making a bet on an upturn rather than taking what the markets are willing to give.

I am writing this article on Monday, July 28th and, at the moment, 68% of the S&P 500 stocks are showing losses. If that is the case, why would I want to buy an S&P 500 stock? Isn't that the way to give the other guy the edge? In trading, as in life, there is no foolproof way to predict what will happen tomorrow. We can try to predict the future, and sometimes we will be right, but, truth be told, we have no control over the future. A rising market can turn on a dime as the result of some unexpected, unpredictable event or geo-political event. If we can't predict the future, how can we possibly succeed at trading?

The answer, I believe is to play the hand we are dealt rather than trying to play the hand we hope we may be dealt. In playing the hand we are dealt, we can try to get an edge by observing what the market is actually doing rather than what we think it might do. If, as has been the case, the markets are falling, why not make bearish plays instead of trying to force a play in the opposite direction? I once knew a successful trader who said: "Play it until it breaks." Pretty good advice in my opinion. If the markets are generally bearish, emphasize bearish plays until it turns. If 70% of stocks are going down, consider playing the downside by selling short, buying puts, entering bear call credit spreads, or any other bearish strategy to give yourself the edge by favoring the current direction. Will the market turn? Of course it will, but no one and no system can tell us when. Meanwhile, let's try to take what it is willing to give.

If I am looking for a directional play, I look to see the market direction and then I look at sectors that are moving the same way as the markets and then I look at individual stocks moving in the same direction as the sector. Once some candidates are identified, the next step, for me, is to see where my exit will be in the event I am wrong on the direction so that I can try to exit with as small a loss as possible. If I enter a directional play and it moves my way -- great. I'll just follow my exit strategy for the play and let it run. If it goes the wrong way, my initial exit should get me out with a relatively small loss so I can try again.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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