Friday, March 21, 2014

Understanding Cycles and the Importance of Trading Systems; Plus USDJPY and SPX

Trading can be difficult, and all of us make mistakes at times.  Some mistakes are small, and easy to forget.  Other mistakes are more costly -- and the more costly a mistake, the more difficult it is to live with afterwards.

The irony here is that, quite often, our biggest mistakes are not really "new" mistakes at all; they're mistakes we've made countless times before.  Few big mistakes suddenly materialize out of nowhere (though they often seem to) -- in reality, they are almost always the result of patterns or habits that we've acted out for many years on a smaller scale.  Since the small versions of our mistakes never cost us much in the past (and thus never caused us much pain), we overlooked them, or ignored them, or never even noticed them to begin with.

Big mistakes offer a unique opportunity to learn and grow, because they can usually be traced back to a core error within our thinking that has previously manifested countless times in little ways.

One of the worst things that can happen to a trader, especially a new trader, is to be rewarded for a mistake.  I have to assume this has happened to all of us, in various ways -- some examples of mistakes that can end up as "winners":

1.  We may take a very high-risk entry that ends up paying a profit.
2.  We over-leverage at exactly the right time and win -- when a move the other direction would have wiped us out.
3.  We buy or sell based on "conviction" and not based on the objective evidence of our chosen trading system -- and end up in a winning trade anyway.
4.  We commit a huge percentage of our capital and end up huge winners, when we could just as easily have lost everything.
5.  We exit a trade based on anxiety and not on objective evidence, and it ends up being the best move afterwards.

These are just a few examples of the mistakes every trader has almost certainly made at some point in his or her career.  The "lucky" ones lose right away, and learn from it -- but the unlucky traders are rewarded and profit handsomely.  Having been rewarded for bad trading behavior, these unlucky traders will not recognize their behavior as erroneous.  Eventually, these traders will be wiped out -- probably in a more painful fashion than if they'd simply lost right at the beginning and had the opportunity to learn and correct their behavior.

Just because something worked before doesn't mean it will work again.  How solid is your personal approach?  What are your rules for entering and exiting a trade?  How do you manage risk and position sizes?  What is the minimum risk/reward ratio you'll accept?  What would cause you to exit a trade early -- or late?  What are the rules that govern exit behavior?  What amount of your trading behavior is arbitrary?  These are just a few of the questions with which traders must continually challenge themselves.

Some years ago, I had a trader friend who was a diehard perma-bear, and it just so happened that he got very lucky in the NASDAQ crash of 2000.  When NASDAQ crashed, he had literally just started trading, and he put his entire account (roughly $25,000) into various NASDAQ puts, immediately before the tech bubble burst.  He kept rolling his puts over as the crash continued, and he ultimately emerged from the crash as a multimillionaire.

Unfortunately for him, he got very lucky on his first trades.  His trading "system" (which basically consisted of "buy puts") seemed to be a huge success.  And indeed, that's a great trading system to have during a crash!  But what do you do when the crash ends and you have no other strategies to employ?  At that point, you really have two options:

1.  Take your profits and walk away.
2.  Learn to employ additional systems.

But my friend chose neither of those options (no pun intended) and simply continued with the put-buying system that had made him a millionaire.  After all, why would he change strategies at that point?  He had been handsomely rewarded for his behavior, so what on earth could possibly motivate him to even consider another strategy?  Tragically, by 2004, he had given all his profits back, plus his original capital.  He went from multimillionaire to flat broke.

There's a reason for the saying, "Easy come, easy go."  If we don't "earn" the money in the traditional sense of hard work and discipline, then we rarely have any idea of how to keep it. 

In the end, "strategies" like the one my friend employed are no different than gambling; and true gambling usually generates similar results:  Sudden great fortune almost always ends in catastrophe.  In fact, the National Endowment for Financial Education estimates that 70 percent of people who unexpectedly come into large sums of money end up broke within seven years.

One factor in this is human nature: the more we have, the more we tend to consume.  I'm not going to delve into that aspect here, though; instead we're going to look at how this ties into the nature of the stock market.

Every bit of observable evidence suggests that virtually everything in the universe experiences cycles.  Consider this statement in terms of the seasons; or the life cycles of all living things; or the "life cycle" of an inanimate object (such as a mountain, or a star, or a galaxy).  In fact, I challenge you to find something that does not experience cycles of some kind.  I personally cannot think of anything in the observable universe that does not undergo a build-up toward a zenith of existence, followed by a decline away from that zenith.

For example:  Humans are born weak and defenseless, but build toward physical zenith as they mature.  At some point, humans reach a peak level of health and strength (the "prime of our lives" as they call it) -- and then we start down the other side of that hill, gradually losing strength and ultimately ceasing to exist (yes, the human condition stinks).  Virtually all living things follow a similar arc.  Even stars have a "prime of their lives," but later reach an age where their energy output decreases and they begin to grow colder -- eventually either burning out or exploding (on the plus side, very few humans explode at the end of their life cycles).

Cycles are so prevalent that certain human concepts exist only to quantify the cycles we observe:  Winter, spring, summer, fall; day, night -- not only are these examples of cycles, but those words wouldn't even exist if we lived in a static, cycle-free world.  If not for the cyclical nature of our climate, we'd have just one name for our only season:  "Sprallter."  "Gonna be another lukewarm Sprallter this year!" people would randomly remark to strangers on the street, "Yep!  Always is!"  

Things such as seasons, and day and night, are obvious examples of cycles that experience a build-up, a zenith, and a decline.  A simpler (and more thermodynamic) way to express this might be to say that everything in the universe is either gaining energy or losing energy -- some things faster than others, but virtually nothing in the universe is static.

It appears that, for the most part, we personally cannot control the massive cycles that govern our existence.  How does this apply to trading and investing?

Let's consider a gambling analogy:  If we sit down at a slot machine, put all our money into it, and simply push the "spin" button endlessly, then we do not control our destinies even slightly: the slot machine does.  Our financial fate becomes tied to the "fate" of the slot machine, and we become completely subject to the laws of chance.  Free will essentially vanishes.  Our fortunes will rise and fall purely based on the cycles of that slot machine.

Some investors and traders approach the stock market in a similar fashion, endlessly pushing the "spin" button, as my unfortunate friend did.  That type of approach gives an illusion of control, but ultimately, it has none.  Entering trades largely at random doesn't control the market any more than pressing the spin button controls a slot machine. 

So how do we separate our financial fates as individuals from the fate of the market?  How do we give ourselves a true advantage over blind chance?

We accomplish this by developing trading systems.  Having a trading system is, in essence, an expression of free will:  it allows us to link our fates to the market when we see an advantage, and disconnect when we don't.  Without a system, we might as well just buy an index ETF and ride the market out wherever it goes.  Obviously, very few people who are reading this (type of) column would have an interest in a buy-and-hold approach.  Likely the very reason any of us sought a system in the first place is because we had an instinctive desire to pull away from the herd, and thus to separate ourselves (and our families) from the destiny of the collective.

I don't have space in this article for a comprehensive discussion of trading system specifics -- that's often the topic of entire books.  My goal was more to address why there's a need for such systems.  In closing that thought, it's also critical to remember that after one develops a trading system, then one must further develop the discipline to stick to it.

Moving on to the charts, let's look at usd/jpy first.  On Wednesday, usd/jpy captured my target of 102.600 (from March 17, reiterated March 19) and as promised, once that level was captured, I switched from near-term bullish to "neutral-leaning bearish."  The bear count can still withstand a bit more upside in dollar/yen, but things become ambiguous with sustained trade north of 102.800ish.

This market is a good example of where a trading system can allow one substantial profits.  Unlike SPX, I've felt the wave count recently was pretty clear in dollar/yen, and this market has performed as expected since I outlined the key zones on March 12.  If you've traded the preferred count and key zones in usd/jpy with discipline for the past 9 days, then you're sitting on more than 200 pips of closed profit, and another (roughly) 30 pips in open profit (for those of us bold enough to close longs at the 102.6 target and reverse short in front of the freight train).  For the risk averse, stops on shorts can be moved to roughly break-even with little remorse.  There's always the next trade, and no reason to give back profits if dollar/yen starts entering ambiguous territory.

SPX has shown resiliency since 1839, and on Wednesday, bulls grabbed the ball right at the key trend line outlined earlier that day.  This pattern is starting to look a bit like a triangle, so be cautious of sideways whipsaw action developing.  Thursday's session was an inside day (all trade remained within Wednesday's range), but that can be interpreted in different ways.  On some occasions, an inside day at the end of an uptrend indicates buyer exhaustion; other times, it simply marks a consolidation.  In all cases, it does indicate some level of indecision in the market -- so it's difficult to draw a conclusion from a pattern that suggests the market itself hasn't drawn one.

In conclusion, we've seen a fair amount of volatility recently -- but, in the case of equities, that volatility has simply created a trading range, and trading ranges are notorious devoid of information.  The key levels have become more critical to the next sustained move.  Have a great weekend, and trade safe.

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Reprinted by permission; Copyright 2014 Minyanville Media, Inc.

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