Averaging down - Yea Or Nay

"Averaging down" as a trading approach regularly causes controversy. While difference of opinions is always good, let's have a deeper look into it to make sure that opinions are informed and that we are talking about the same thing.

There is averaging down and averaging down. Not all of them are created equal. I'd break them down by two kinds.

1. A trader buys, position goes against him, he fails to cut his losses, sees them growing and getting out of hand. Eventually at some point he adds to his position following the logic "If I liked it at $20, it should be even better at $10" and/or "it can't go any lower". Both are false: anything can and often will go lower (no lack of examples of that over last year, eh?); and who is to say it was any good at $20 to begin with? And is $10 a better price or simply a proof that $20 was a mistake? This kind of averaging down is a "bad" one; it's done out of frustration, and it adds to a mistake. More often than not it increases eventual loss. In most cases what follows is: your position does recover some, by some magic stalling right under new breakeven level ($15 in our example). This gives you a chance to exit with a small loss but you don't take it - after all, recovery has started, you are looking at possibility of nice profits now (and on double size, no less). Sure enough, stock reverses and drops under $10 where you either exit with even bigger loss or put it in your long term portfolio, a.k.a. Grave of Short Term Trades Gone Bad. Another frequent scenario is, stock dives briefly under your second entry level, you sell your second position for a small loss, and that's where stock reverses and goes back to that 15... you curse your decision to cut losses on second part and don't sell first part - after all it's cutting the loss that killed your chance to get out even, right? Sure enough, it reverses down and you are looking at ever-increasing loss again.

Those rare instances when this strategy works only reinforce the idea of it being a viable approach, eventually provoking you to employ it again and again, until it leads you into a loss exceeding anything you saw in your worst nightmares.

2. Averaging down is a part of planned strategy. When a stock comes into your target zone but there is a lot of uncertainty in the markets, you don't feel confident enough to fully commit and don't want to stay on a sideline. You break your purchase in parts and plan a strategy for those parts. This strategy includes various scenarios of building up to full position in a case of further drop, in case of reversal, in case of stall. It also includes an "uncle point" - event or scenario which proves that the whole idea of entry was an error, so whatever is accumulated up to that point is being dumped. There is nothing's wrong with this kind of averaging down - it's done by a design, to minimize exposure at the uncertain time and increase it as events develop in a favorable way. I wouldn't even call averaging down but that's a matter of semantics.

As we see with many other things, there are no absolutes in trading. There is, however, need in clarity, in straigforward well-designed and thought through plan. Such plan, among other things, wil include definitions - as we mentioned earlier in this blog, "as you name the boat, so wil it float".

Securities Tax Proposal

I've got quite a few e-mails asking about my take on this proposal, enough to warrant a blog post. For a someone making his living by trading the market my answer may be somewhat unexpected: I don't worry about it too much.

 

Here is why: I don't believe it has any realistic chance to materialize; And if it does, we will have much bigger problem on our hands than the end of active trading as our way to provide for ourselves and our families.

 

Let me explain. Most of my correspondents are coming from the (absolutely correct) assumption that such tax will end day trading. Imposing a prohibitve cost on the transaction, it no doubt would do just that. Notice that it's not just an additional burden, additional cost on the essential need that would help replenish government coffers as for instance gas tax would - it's prohibitive cost that renders the activity unprofitable and eliminates it altogether. There goes the idea of "let the Wall Street pay for bailout" - there won't be financial benefit to the government. Instead, there will be the destruction of the whole profession, sending more people to an unemployment lines. And I am not talking about day traders only - what about whole brokerage industry, discount brokers who suddenly lose their whole client base? More uneployed, more unhappy, less taxes collected - who could benefit from that?

 

Now, is the impact going to be limited to day traders and brokers that serve them? If it were so, some political expediency in search for a scapegoat could still warrant such proposal going through. After all, imposing $25K rule on day traders was no less idiotic (although less damaging), yet it did pass. In this case, however, it's about much more than just those pesky day traders. You don't really think it's just a day traders who trade every minute and every second and whose prints fill the tape with this endless flow, do you? Think of how many day traders there are and what kind of volume they could provide - and compare it with every day's volume on NASDAQ, NYSE and AMEX. What do those numerous trading desks of the banks, brokerages, all kinds of funds are doing day in day out, all day long? Who provides liquidity for longer term traders when they want in or out? Who makes the market bidding and offering on each and every stock at each and every point in time? Whom pension funds buy from and sell to when they reposition themselves? All these people, all these organisations will suddenly be put out of business by such tax. Now, imagine them all being out of the action. What happens to volume, liquidity and bid/ask spreads? Can you apply any word to the US capital market other than desert if that happens?

 

Let's talk about foreign investors - what are they going to do when they find themselves in the market with no lliquidity? Does the government want mass exodus of those?

 

Let's talk about companies listed on US markets. What are they going to do when the markets all but cease to exist? This is their financing source and pricing mechanism. Does the government want mass exodus of those?

Let's talk about the public. Does average member of the society benefit from the cost of transaction being passed to him/her when their 401K etc are being positioned and repositioned? Or from their self-directed transactions being burdened with this cost? I mean, no one seriously thinks brokerages are going to eat this cost, do they?  Does the government want to load our, dwindling as it is, investments with this additional expense?

 

Internet and globalization era, the markets all over the world are accessible with unprecedented ease... do you impose such prohibitive measures on your market and push people into the  welcoming hands of competitors?

 

All above leads us to one question: who would benefit from that proposal? After all, for any legislation to go through, there must be benefitting party influential enough to push it through. I fail to see any single entity within the USA that would benefit from it. We have Wall Street, Main Street, public and government as the suspects to look at. Who of them benefits from this? Not the government, not the banks and brokerages, not the public, not the companies. I just can't see it happening.

 

Now, as a last argument: not all things happening are being governed by the logic and that dying creature called Common Sense; sometimes raw emotions, populism, pandering to the lowest emotional reactions of the crowd takes over. That could lead to such proposal still being seriously considered and passed. Well, I still prefer to think that with no one particularly interested in the outcome, it won't - and if it will, we, as I said at the beginning, would have much bigger problem on our hands. We would have Powers That Be deliberately destroying the very fabric of the society, contributing to the job losses, capital outflow and desrtuction of the business - all for no good reason. If that happens, we better make sure we turn our houses in fortresses and have means to protect them, because in the chaos and insanity that will come, clicking Buy and Sell buttons will no longer be of any concern.

Turning Points: how trends are born and how they die

There are a lot of lessons to be derived from the recent market events. In this post I want to focus on two that have to do with identifying turning points. At the risk of making post too long, I'll put them together since they are very interconnected.

Turning points are in effect change of the trend. Thus, it's important to look into what maintains trends and what causes them to end.

Lesson 1. What causes trends to end, or pendulum effect.
System when pushed hard and far enough, pushes back. The harder and farther has it been pushed, the harder and farther does it push back.
This concept is well described and explained in a brilliant book The Fifth Discipline: The Art & Practice of The Learning Organization .
We all witnessed how, during oil stunning rally, all kinds of higher and higher targets were assigned - 150, 200, 300. Part of those predictions that is related to what we discuss is this: there were explanations to those targets and to continuing rise of the price, that cited all kinds of equations, how much oil is out there and can be extracted per day, and how much oil per day is consumpted and needed. Projection of the growth in both parts of equation led to a conclusion that supply and demand ratio will inevitably cause further price rise. Were those equations correct? Sure - if you accept the fact that system will not push back. But it will (and it did) - in a form of slowed down consumption (caused in no small part by the very cause of imbalance in the system, fast and hard oil price rise), in a form of developing other energy sources (yet to materialize to really meaningful degree). Similar predictions put food prices above the clouds, and failed in a similar fashion. Similarly, rapid increase of predators in a certain area eliminates their very food base and leads to banace restoration when predators start dying of starvation. Similarly, explosive expansion of a particular company often undermines its growth perspectives and requires contraction to regroup and find the way to evolve in a more mature fashion. Similarly, overheating of a certain area covered with water leads to increased evaporation and forming of clouds that cool the area off. Finally, to return to the markets, similarly excess of buying leads to exhaustion of buyers and eventual trend reversal. Similiarly, abundance of short positions leads to short squeezes. This phenomenon is known as "becoming a victim of own success". It's also known as reversion to the mean. Nothing exists in vacuum - everything is a part of the bigger system, and when a certain element of the system gets out of balance, there will be parts of the system that push for balance restoration. Thus trends are being born when a certain element upsets the system, and trends reverse when system pushes back.

Lesson 2. What maintains trends, or inertia effect.
Markets tend to overshoot any reasonable targets on both sides.
This phenomenon is well known as well, but somehow rarely taken into account at the time. When oil started showing signs of cooling off and reversal, very few people called for such seemingly far away (at the time) targets as 80 and below. When NASDAQ started running in 1998, no one could even think of such heights as 5000 - and similarly, when it reversed in the spring of 2000, no one could imagine that it could drop as low as it did. "Market can stay irrational longer than you can stay solvent" - sounds familiar in light of recent events even to those who never heard this sentence, doesn't it? If you want to see the most recent example of this, look no futher than at intraday chart of UAUA for two days, Oct 16 and 17. It would reach all reasonable targets, and still continued to go to unreasonable, and then some more, and then a lot more. This phenomenon takes care (which in market terms means deprives of profits or causes losses - cynical, I know) of those who trade on "obvious" as they see the obvious - which is usually how the majority sees it. "Deprives of profits" part is materialized when profits are being taken where reasonable targets are reached - and market advances well beyond reasonable, leaving those who took their profits in the dust. "Causes losses" part is materialized when countertrend position is being initiated at reasonable targets (shorting oil on the way up at 80? 90? 110? Going long on thwe way down at 120? 100?), and market overshoots those targets and stays "insane" long enough to cause desperation or margin calls.

Failure to take into account and to balance against each other both of these principles leads to severe misreading of the market. Try to analyse what caused billion-sized losses in Pickens energy fund, and you will see how this works. Having made immense amounts of money in oil, where such mis-calculations came from? From misreading the system as a whole first, thus believing in endless price rise? From underestimating the inertia on the downside move, thus multiple calls (and according actions or luck of such) of "oil will never lose $100" kind? You will see numerous examples of miscalculations of this kind in analysis and trades of many around you, and possibly in your own. Hopefully, this overview will help you recognize the fallacies in thinking and balance these counteracting principles in the future.

Information - Price Divergence

This is one of the most reliable indicators helping you discern the market's intentions. Some theory first, not too much, I promise... rather like a brief refresher. Market is a discounting machine, meaning tomorrow's development is being factored in by today's price action. That's why one who acts on known information is always late - when information is known to everyone, it's being already acted on, and late arrivals will be taken advantage of. As an example, think of upgrades and downgrades issued AFTER a major price movements or earnings announcements. Price action is an ultimate truth in the market - and it means that if there is a divergence between what a price is supposed to do based on available information, and what price does in reality - it's a price action that you need to go with. More than that, such divergence serves as a very powerful indicator for you, because it shows you that at this junction Smart Money clashes with Crowd. Crowd goes with obvious - with what information says. Smart Money meanwhile takes contrarian position. This is an ultimate case of "Trade what you see, not what you think".

Now, let's use fresh example as practical illustration of the principle. Yesterday, while the markets were preparing to a 700B rescue bill vote (you can read a whole transcript of our trading session in trading logs, Oct 3), I was asked:

[11:48] {member} so..whats your thoughts after passage on mkt for the day?

Here is the answer:
[11:49] {Threei} seems like selloff in cards... with or without initial short-lived spike

... and follow-up comment:
[12:10] bill passage is now all but sure, yet market doesn't really running
[12:10] makes you think...
[12:11] that dump may be an outcome in any case

Indeed, this is exactly what happened: immediately after bull passage market dropped fast and hard. Let's see how I arrived to that conclusion (which naturally kept us out of long trades at the moment of House vote). When a project of this bill was first announced, market rallied for two days. When a bill was brought for a vote first time and rejected, market dropped 700 points. Natural conclusion is, market likes the bill and will go up when it passes the House. So, day of the vote comes, comments clearly show that the bill is going to pass, yet we see failry lackadaisical, if I may say so, movement. Market is positive but there is no serious upward pressure, no boiling, no bruning desire to buy everything in sight. That's your Information - Price divergence. Information says: bill will pass, market likes the bill, it's a long. Price says: beg to differ. You saw what happened next. Price always wins, and a trader makes money by being right on price, not on information.

Non-stop Discussion of... Stops

No matter how much I write about stops, this topic doesn't seem to go away. Like Phoenix from ashes, time and again it arises. Recent discussion with a long-term trader returned me to this endless source of questions, doubts, hopes and frustrations.

Warning for overly sensitive types. The text below may seem harsh. Consider it tough love. My counterpart in this discussion took it this way and, I am sure, stands to benefit from it.

The story is probably all too familiar. A good trader in all other regards, knowledgeable about both fundamental and technical sides of trading, capable of picking right sectors and stocks, determining the direction and timing his entries. Beautiful performance on winning trades. Overall performance, ummm... leaves to desire. Threading water at best, losing money is more like it. Why? You probably guessed it. Some of misses are so disastrously big that they manage to negate all the wins and add some red on top.

I think I'll never understand why traders so stubbornly refuse to take stops. No, I was not born with this skill ingrained or inherited. I had my share of blown stops in early years, and they cost me dearly. But but but... how many times the same lesson needs to be taught before we finally heed it?

Here is why I don't understand it. Are you, a trader who doesn't want to take stops, compete for the title of Da Best Trader of All Times and Nations? Because if you manage never ever to lose, you sure are going to be one. No trader in history avoided losses. Not one, period. Whoever your trading idol is, be it Jesse Livermore or the guy who taught you how to click Buy button (hint: GENTLY), did he win all of his trades? No matter how skillful you are, you will lose on some of them simply because of market's nature. Uncertainty Thy Name O Market. It works in odds, not in certainties - meaning, even the best of setups and flawless trades executed according to those setups will fail sometimes. Now, if you acknowledge this (and if you don't, you have no business to be trading), why not limit your losses? This is exactly what stop loss does - according to its very name it STOPS YOUR LOSSES.

Let me say this... the question above is rhetoric one. I know why you refuse to do it. I already wrote about it in the past at
here (and discussed how to place them in two articles before that). One aspect of this, however, I want to return to. This aspect is RANDOM REINFORCEMENT. It means that not every time a market is going to reward you for doing the right thing or punish you for doing wrong one. Sometimes a stock you just took a stop on will rebound right away. Sometimes a stock you held against all rules will reward you for breaking the rules. Each such case will lead you into temptation to abandon your discipline. "Just this time, please, and I promise to be good again" Nope. Won't happen. You will be bad again, because being bad was rewarded. This great temptation by the market is like siren song - never what it seems to be yet who of us can resist.

Cure is simple. Run the stats. Calculate the total of all losses that got out of hand. Calculate the total of all the losses taken according to the rules - when the stop was hit that is. See what those stocks did after you got out - rebounded? Died on the vine? calculate where your portfolio total would have been should you take all the stops in disciplined manner. Calculate the same fior the case where you would have refused to take any stops. You got your answer.

Me - I take any stop whenever it's hit and consider it my salvation. Foe stop to me is not.

Lost and Found, or Does Common Sense Work in Trading?

There are things in trading that run contrary to common sense as we know it. Recent conversation with a trader who asked for advice is a good example of such occurence and illustrates often-made mistake.

First, a joke showing what common sense leads us to do. Fair warning: joke is silly and decisively not funny. A drunk crawls under the street light looking for something on the ground. Asked what he is looking for he says "Lost my watch on that corner". Asked why he is looking here when a watch is dropped 15 yards from the spot, he explains "It's dark over there, little chance to find anything, so I am looking here where there is a street light".

... OK, I warned it was lacking in laughter department. Nonetheless, it indicates that looking for a lost thing in a well-lit spot instead of where the loss has occured is silly. Now, let's get back to our trader and his question.

- I have this pattern of suffering a string losses... it starts usually when I get onto some very volatile stock or a stock making unusually big movement, looking so lucrative because of a great potential. So I jump in, it moves against me, I take quite a loss. Next thing I know, I make trade after trade on this same stock. It's like I got addicted to it and just can't move onto something else. Loss after loss, the day turns into total disaster. Got something to hit me with to cure this disease?

- Got a question for you. Why continue trading that same stock after couple tries proved unsuccessful? Why not leave it be and move to something ou have firmer grip on?

- Well... it makes big movements, I have better chance to get back all those unusually big losses...

- But you don't have reliable read on this particular one. Isn't it more likely that you will suffer more "unusually big losses"?

- Ummmm. I don't know. I just feel it's natural to stay with it until I get my money back. Hasn't happened yet, even once.

That's when I remembered that joke. It's a common sense and natural thing to do in every day's life to look for a lost something at the spot where you lost it. In trading, not so much. Go to well-lit spot and look to get your money back there. Lost money is not tied to a particular spot (stock), it's lost in the market. The market is a big space; go where there is a streetlight that helps you read things well. A stock that you have no read on is to be left alone. You have no personal relationship with it, you don't need to get revenge; it has no idea about you and it's not after you. Free yourself from things that don't work. Focus on what does.

Scan for Your Battles

At the beginnning of March I opined that under certain conditions we were going to see market rally to 13000 DOW and 2000 NQ. Now that those targets and I suggested liquidating long positions, are hit a few e-mails asked whether I see this moment as a short opportunity. My negative response caused feedback along the lines "If no long anymore, then why not short?"

Here is how I approach this. There is no such thing as continuous read on the market or particular stock for me. In other words, I don't have a clear idea what to do all the time. Sometimes there is a recognizable situation, and that's where I take action by initiating a new trade. Sometimes there is nothing recognizable, and I sit on a sideline or liquidate existing position - not because I see the tide turning but simple because I have no read anymore. Thus, the reason for exit can be "I read the move as exhausted" or "I can't read this move anymore". In a former case, yes, I may start hunting for an entry on the opposite side. In a latter case - no, I exit original position but do not look for an opposite direction trade yet.

All above has a broader implication for my trading approach. My process of hunting for a trade is entirely based on an idea of having my favorite setups and waiting until such setup shapes up and triggers an alert for me. I don't watch particular stock and hunt for an entry - rather I wait for whatever matches my entry criteria. View it as casting the net with certain mesh size and reviewing whatever got caught in there. Such net for me is a scanner which I have configured accordingly to my criteria and which scans the market constantly looking for what I asked it to. Covering NYSE, NASDAQ, AMEX, TSX, TSX Venture, OTCBB, Pink Sheets and indices and being easily customizable for any thinkable trading approach, it's all the search tool I need. There are three things though it doesn't have: no dartboard, no tea leaves and no "scan for winning trades only" setting.

Such approach can be construed as one of cases of "let the market come to you". Usually it's applied in a sense of waiting for certain price treshold where you render entry most favorable. This is just another way to apply this idea.