Another way to look at stock selection and market direction

In this post I talked about my recent performance, and the erosion of profits made earlier in the year. To recap, it wasn't necessarily the trades that I took that were the problem, it was the trades that I DIDN'T take. And this was a result of paying too close attention to the general market. But first, some background.

There is a 'top down' theory that has been successfully used by traders for decades - Jesse Livermore was one such exponent. You initially look at what the general market is doing, which may determine whether will look for long or short trades, before identifying individual stocks that you may want to trade.

This also formed part of William O'Neill's CANSLIM theory, his basic assertion is that 3 out of 4 stocks tend to follow the major market averages.

However, there is another way.

My current trading performance - update

As anyone who has seen my trades list will know, the last few months have been pretty poor for me. Small loss after small loss. Keeping losses small is an integral part of a trend following strategy, but the near complete absence of any winning trades in that period led to an erosion of profits built up in the earlier part of the year. To put into context, it can be clearly seen here:

Mind the gap!

One of the dangers of trading equities is the potential for price gaps when unexpected news is released. A good example of this week was UK stock Thomas Cook Group.

This had been a turnaround story where I know of a few trend followers who profited massively from the uptrend which started at the end of 2012 and carried on through the first half of 2013. 

As we can see, the stock had started trending in an upwards in recent weeks before a huge price gap occurred on on yesterday's open when it was announced the company's CEO was to leave.

Oil has sprung a leak

And the trend goes on...

There's been some very good profitable trends in other non-equity markets recently, such as the major forex pairs involving the Yen, Silver, and this one in Crude Oil.

No need to check out fundamentals. Just follow the price, and have the patience and discipline to let price tell you when the trend is over.

Trend following principles

A short video of timeless wisdom. Enjoy!

You are always a student in this game

I got an email the other day from another trader who was talking about his preferred setups that he looks to trade, as well as touching upon previous correspondence we had about psychology and risk. Then he said something which deserved further comment:

"Just to be clear......I realize very clearly that I am the apprentice in these musings of mine and you are the master. My performance is a reflection of my lack of credibility."

While flattering, that statement is also completely wrong! All that can be said is that I happen be a bit further along the same journey.

As far as I am concerned, EVERY successful market participant remains a student of the market and its participants. They also are students of themselves. No one ever masters trading - all you can do is strive to make continual improvement. The Japanese have a term for this:

New testimonial

Stephen is a keen trader who freely admits he has struggled in the past with the risk and psychology aspect of trading, especially when it comes to letting profits run. Part of the reason for this was not having a clearly defined trading plan that he could follow.

Stephen closely follows the underlying fundamentals of the stocks he trades, and has filters he uses to narrow down the potential candidates. The trend following part of his overall plan will act as a timing device to get in and out of those stocks, helping him particularly in getting out of a profitable trade at the appropriate time.

He kindly sent through the following testimonial today:

Letting your profits run

Last night I had the pleasure of a conversation with a trader about his performance and where he needed to improve. His trading story to date mirrored my own early days - starting off on day trading on very short timeframes before moving to the daily timeframe, along with trying to adhere to the principle of following trends - cutting profits and letting profits run.

He doesn't have a problem in taking small losses. He also only risks a very small percentage of equity on each trade. He has never blown up an account. In those respects he is ahead of 90% of traders out there. He has been trading for a few years now, yet he is only about breakeven in his overall performance.

This trader is very close to making the breakthrough to overall profitability, but there is one element missing - the inability to let his profitable trades run.

Sticking to what works - for you

I've had the recent pleasure of re-reading How I Made $2 million in the Stock Market, by Nicolas Darvas. The book gives a great portrayal of how someone worked to formulate his own method, which talked to him and allowed him to profit significantly in a relatively short period of time.

For those who don't know the story, Darvas was a dancer who travelled the world, and basically created his own 'Box' method of interpreting price action, allied to finding some fundamentally strong stocks. He relied solely on telegrams from his brokers giving him close, high and low prices for the day so he could construct the Darvas 'boxes'.

Therefore, he had found a method where, once he was in a trade, the price action would tell him all he needed to know.

Concentrating on what's important

"At the end of the day, your main goal should be to make money, not to get an A in How to Read a Balance Sheet" - Richard Donchian

When you are trading, you need to focus your mind on what is important information and what isn't. Spending time looking at information that isn't critical to what you are trying to achieve is a waste of time and effort, and won't add to your bottom line.

So, what is important to you? To a degree, that will depend upon you basic ideas about trading, your timeframe, preferred holding period etc.

As a trend follower who uses hard and fast rules about when to enter and exit, what is critical to me?

A story of two price gaps

Here are two charts of major UK stocks which have suffered well publicised gaps down recently.

The first is Tesco. Their gap down has been caused by a massive overstatement of their profits. As a trader, you would either have been out of this stock or short - the line of least resistance has been clearly to the downside before that news came out. As Paul Tudor Jones said "I always believe that prices move first and fundamentals come second".

Some kind words

I was flattered to receive the following comment yesterday on this post from a reader:

"Top notch posts! :-) I've just recently started looking at your blog and some of your previous postings are most insightful indeed. Its very easy to find analyses and opinions online, but very difficult to find "trader psychology" advice that is actionable here and now. Kudos to you Sir."

The majority of what I write about here is loosely based on correspondence I have had with other traders, or from discussions with traders I am mentoring. These tend to act as a trigger for a topic to talk about. After all, those same issues may be affecting or impeding your performance too. Either way, hopefully they are thought provoking. 

Trading in the moment of now

Trend following is an exercise in observing and responding to the ever-present moment of now - See more at: http://www.tischendorf.com/2009/08/03/ed-seykota-quotes-trend-following-trading-wisdom/#sthash.8Kfj5iOx.dpuf

Trend following is an exercise in observing and responding to the ever-present moment of now - See more at: http://www.tischendorf.com/2009/08/03/ed-seykota-quotes-trend-following-trading-wisdom/#sthash.8Kfj5iOx.dpuf

Trend following is an exercise in observing and responding to the ever-present moment of now - See more at: http://www.tischendorf.com/2009/08/03/ed-seykota-quotes-trend-following-trading-wisdom/#sthash.8Kfj5iOx.dpuf

"Trend following is an exercise in observing and responding to the ever-present moment of now." - Ed Seykota

Psychologically, what happened an hour ago, yesterday or last week, both in the markets and with your own trading should be an irrelevance. It's in the past. What's done is done. You cannot undo your actions - good or bad.

At the same time, what might happen in an hour, tomorrow or next week is unknown - what you think may happen might not happen. As Seykota says, you need to focus on what is happening now.

A plan on how to get over a major drawdown or price shock

It is an unfortunate part of trading that people can suffer the traumatic experience of losing a significant part of their equity in one go. In extreme examples, some traders may even blow up their account. This may be as a result of some major unexpected news coming out. It may be as a result of your broker putting most of your money in a downtrending stock. It may be because you took a big position just before earnings were released which then gapped against you.

When something like this happens, your mindset will take a battering, and before you commit any fresh funds to the markets, you need to step away for a while and regroup. As hard as it may seem, how you deal emotionally with what has happened is of paramount importance, and may even determine whether you can make money in the future.