Pesky swans

How a loss this month has led to a credible improvement.

In the first part of this month, I dropped the fund several percentage points before I picked up my game. We currently stand slightly below where we started at the months beginning— now moving forward again diligently. Why did this happen?

One poor aspect of my management, I came to realise, was my protective stop flexibility.

A stop, as I’m sure you’re all aware by now, is a get out of dodge level. It is a level that says, if the price goes beyond this point, then I’ve got it wrong. It is an automatic cancellation of the trade.

There is a little more in it than that as a stop can be a regular variety or guaranteed. But let’s leave that discussion for another day.

The 1% rule

By flexible, I mean that I had the habit of altering my stop to prevent small but accumulative losses. That rather defeats the point of a well-placed stop.

Why would I have done that? It’s an incorrect mindset thing. As I’ve said several times, I tend to risk 1% of the fund with each trade. My strategy is that we may lose that single per cent but with the proviso that our wins are, on average, bigger.

The 4% rule

That’s super, but unfortunately, I had another rule which was not to be committed overall by more than 4% of the fund at any one time. Meaning I could trade four single percentage loaded trades on the same or different currency pairings.

Where this comes unstuck is when we are trading overall at less than four percentage points.

Bad habit and ‘black swans’

My bad habit was that instead of taking a small loss, I could move a stop as long as I didn’t have an overall loss of more than four percentage points—a critical flaw.

A loophole to my thinking. It was also a loophole that paid very well towards the fund, as I had few small losses. But it left me vulnerable to ‘black swan’ occasions where the unexpected happened, and 4% could occasionally become many times greater.

Those rare events could occupy most of our trading margin for extended periods—not a satisfactory situation.

I rewrote my trading rules to close the subconscious loophole. And the reason for losing several trades early this month was, I think, a consequence of this much-needed change.

Somethings had to improve

Without the flexibility of moving a stop from its single percentage loss level, I had to get appreciably better at trade selection and the placement of that (unmoveable) stop.

In turn, I think that has led to our improved real-time coordination between analyst and trader—[As you know, James has been on paternity but is now back almost fulltime]. We have developed our Skype screen share of James’ charts and with real-time trade audio.

The responsibilities of the analyst and the trader are clear. Still, the ability to define individual trades in real-time and in terms of probability and improved definition of an entry, stop and objective have gone stratospheric.

In other words, as you can probably tell, I’m pleased with the change and where it can lead us. And without those pesky swans!

So why is the stock market rallying if 20% of the country is unemployed?

Our thing is day trading—holding as necessary out to a couple of days. We trade currency pairings both long and short. We read the markets price action—the value, setup and signal. We do this technically, which means we read a chart and without the undue concern about fundamentals.

However, you also have money in medium-term funds. Al Brooks is an exceptional short term trader and teacher. Those abilities have technical relevance in all timeframes. Here is what Al says about the medium term. It relates to the S&P 500, but as we have noted before, all markets in some way or other will follow the S&P—often much slower if it’s good news, but much quicker if it’s terrible.

With interest rates at or approaching zero, you may be thinking that the medium-term share/stock market is the only option. Maybe, but I’m content taking the short term technical view. Below explains why.

How far will the stock market fall?

The pandemic will lead to unemployment comparable to the Great Depression that started in 1929. The stock market fell almost 90% from its peak in the 1930s. Why is the market rallying so strongly when the unemployment and GDP now are the worst since the Great Depression?

One reason is that we now have a Fed; brilliant, bold people who have learned from the past. The Fed Governors have said that they will effectively create infinite dollars to prevent the destruction of the economy. Investors see that as the Fed placing a floor under the market. 

I think investors and traders are getting this wrong. The market is down only 10 – 20%. The Fed’s floor would be around 50-60% down from the high. There have been many selloffs in that range since the Depression, and we completely recovered each time. I, therefore, think that the Fed’s real floor will be about 50 – 60% down from the high. The market is up in part, simply because investors believe there is a floor somewhere. 

We live in a country (US) with a relatively free market. The Fed wants it to stay that way. They, therefore, will not intervene as quickly as many investors hope.

Investors and traders who are buying at the current price think they are buying just above the Fed’s floor. They are not. The base is far below, and these traders will discover that the support that they expected is not where they assumed it would be.

The rally is technical.

So why is the market rallying so strongly? The pandemic (we assume) is not going to be as bad as the bubonic plague in Europe in the 1300s. Also, institutions love what the Fed is doing. 

These are both necessary for the rally, but the sine qua non is the technical or chart pattern.

The market is merely repeating a behaviour that it has done thousands of times on all time-frames. It is no more complicated than that. Experienced chart readers know that, and they are trading with that expectation. 

The stock market probably would not be able to do it as strongly as it has without the (good) news about the pandemic and the Fed. However, that technical pattern merely is unfolding as it usually does. 

Traders and investors should soon expect a test back down, and then a trading range. That range will be a continuation of the last 30-month trading range, and it will probably last all year.

The stock market and the pandemic

Al Brooks is a trader and previously a physician with some virology expertise. These are his (re-written) thoughts on the pandemic and its effect on the stock market.

Impact of the pandemic

When the pandemic struck in February, traders were confident of one thing. They knew it would drastically change the behaviour of consumers. 

Since consumer spending is responsible for 70% of the GDP, companies would make less money or even lose money. Earnings determine the value of companies. If the total revenues of America’s companies were going to be less, the price of stocks had to fall. 

No one knew how bad the unemployment and the reduced spending would be. But everyone knew the economy would be wrong. It took a while for America to conclude that life will not get back to normal until there is a vaccine next year.

The stock market leads the economy

The stock market is a futures market. People buy a stock based on what they think the price will be in the future. Therefore, the market typically goes down before there is a recession and up before a recession ends. 

The market has rallied sharply over the past four weeks. Traders concluded that a 34% reduction in the stock market’s price was more than what was needed. 

The market is now in search of a price that is appropriate. Traders concluded that the February high is too high and the March low is too low. Somewhere in the middle is just about right. 

It will take many months to find the theoretically fair price. As traders become more confident of what the reasonable price is, the legs up and down will get smaller. 

After many months of equilibrium, traders will become confident that there is no more significant risk of a 2nd or 3rd wave of infections and economic damage. Traders will begin to ignore the pandemic and then life will start to get back to normal, or at least a new normal. Once that happens, the bulls would try to create a rally to a new high.

The vaccine will probably work

Traders want to know that a vaccine will work. Vaccines work for most viruses, but not all. HIV is an obvious example. It took decades to create a reasonably good treatment for people infected with HIV. A satisfactory treatment is one that helps the patient and dramatically reduces the chance of spreading the virus to others. 

For COVID-19, it would probably also take many years to develop a comparably effective treatment. Treatment without a vaccine would have the world living with the virus indefinitely and possibly forever. That dismal prospect would be a chronic weight on the economy. 

Remdesivir might help

There was a report this week from the University of Chicago, concerning Gilead’s Remdesivir. They used it to treat 113 patients with severe disease—most discharged within a week. 

While it is good that the drug appears to reduce the death rate, it is not enough to make American life healthy again. Being on one’s death bed and then surviving is better than not surviving. But whoever wants to be so sick that he is on a deathbed? That is not our regular life.

It is important to note that there are politics in everything, including medical research. Also, there are statistical abnormalities that result in what appears to be a good result but is just a coincidence. Doctors know this and therefore want to see similar results from several medical centres before being confident that a drug is beneficial.

What traders want from a vaccine

Traders want a vaccine that will prevent infection in a large percentage of the population. For example, the flu vaccine only works in about 70% of people who get vaccinated. People want a more reliable vaccine than that because COVID-19 is a more severe illness. Traders also want the protection to be permanent or last at least several years. 

Viruses mutate. If they mutate enough, the old vaccine is ineffective.

Finally, traders want to be sure that a vaccine will not have horrible side effects. If it does, many will refuse to get vaccinated. The result will be lots of people choosing to risk getting sick and passing the infection to others. That would prolong the damage to the economy. 

These uncertainties will be here for another year. That will probably keep the market sideways into 2021.

But what if the pandemic is not the main problem?

The stock market was the most overbought in its 100-year history. It will probably take a decade for the fundamentals to catch up to the high price. 

That is what happened after the buy climaxes in the 1960s and the 1990s. Each led to about a decade of sideways trading. There were 50% selloffs and 100% rallies, but the market was in a trading range. The market sometimes made new highs, but they led to a reversal back down instead of a bull trend.

The stock market has been in a trading range for over two years and will probably continue so for the rest of the decade. However, there will be at least one more new high. It might even come next year. But the market will likely have a difficult time getting far above this year’s top for a long time. 

Don’t lose money

Don’t lose money, is a Warren Buffett motto.

The sentiment applies to all investments, but as a financial trader, I need to be clear in my mind what this message means.

My goals are: (1) protect the account, (2) make some money, (3) make a lot of money.

As with any business, and unlike investing, to trade necessitates taking losses. It’s part and parcel of doing business.

Protect the account

Protect the account (or don’t lose money) means to follow the rules. Such rules have to be agreed, understood and written down. Determining trade guidance at the point of or during a trade’s activation is unacceptable.

If you glance at my trading plan, you will notice that the rules are not complicated or excessive—however, they are necessary.

For instance, before taking a trade and as part of my strategy I need to be sure that a potential reward is at least equal to my initial risk; and I need to trade at a size that if lost will not break my 5% weekly rule. The list goes on.

As an intraday trader (which means I mostly day trade but now and again trades will be held overnight) trading is relaxed, but at the moment of a trades activation, it can all happen in moments.

If I break a rule, it is classified as a mistake and needs to be brought out in debrief and corrected—irrespective of whether the outcome was positive.

Protect the account does not mean to be tentative with a trade or take profits too early. It means don’t make mistakes—don’t break the rules.

Make some money

If my rules work, and I don’t break them, and my methodology is sound, after one hundred trades (about 30 days) I am sure that I will make some money.

And that is the bedrock of it all—doing the same thing well over and over without mistakes. If I do that (we) will profit.

Make a lot of money

Albert Einstein famously said that compound interest is the most (potent) force in the universe.

How to make a lot of money is compound the trade amount. I do this at the start of each week. I adjust my risk/reward percentage to reflect the account size. (Note: if not an expert then a monthly adjustment is more appropriate).

If I follow my first and second goal, then the third (the real purpose of it all) will happen.

How to split your investments

Recent weeks show why it is a good idea that we balance any investment fund correctly with equities, commodities, bonds and cash.

Easy to say so after the event. (Check-out an earlier blog post ‘how to invest‘).

I realise that to have some investment in UK government bonds (treasury bonds if the USA), rather than all equity, when ‘bonds’ are making a slow decline and shares are soaring is hard to do. But that is precisely the time to do it.

Bonds act as a type of hedge against a portfolio of shares. But getting the split correct (equities/commodities/bonds/cash) is also advantageous.

Also, put 10% to 15% of your stash into a short-term trading fund. (The Slow Trader fund is only open to current investors).

What do I mean by short-term? Anything from high-frequency trading (HFT) to a daily chart fund. The HFT are computer algorithms trading in/out at as low as a part of a second and ‘daily’ chart funds are more sedate.

Our trading (Slow Trader) is somewhere in the middle as we currently favour the one-hour chart as our anchor timeframe.

If it’s HFT for you, then be careful which HFT you chose. They can be expensive, and I was surprised to learn that historically expect over 50% of such enterprises in operation at the moment to go bust.

But what is the advantage of having a short-term trading deal in your range of investments?

Take a look below at the weekly chart of the Euro vs US dollar with its massive reversals over the last couple of months. (Equities and commodities paint a similar if not worse medium-term picture).

In all likelihood, this would have eliminated a medium-term investor but provided opportunities for a capable short-term trader.

A short term trader needs to be consistent

As the stay-at-home brings challenges to many, to us traders, it has made the routine more stable and more rewarding.

Few investment vehicles are profitable right now. Even the longer-term trader will struggle with market volatility.

For the savvy intraday trader, it is steady as she goes.

What, if anything, has changed for the short-term trader?

Other than market size, nothing. What is so very important is not to risk any more on any one trade that a trader would do otherwise.

The average price movement in the forex market is several times larger today to what it was a few months ago.

A time of great opportunity one might think. But actually, it’s not. For us, it is business as usual. The same number of trades (as the market cycle is more significant, but its structure never changes) and the same reward as profit potential balances with risk and probability.

Our edge is being able to read the market context with a high degree of directional probability, ascertain the market value and find reasonable market setups.

After that, it is a matter of an appropriate entry (we can enter both ways in the market—long or short), and we manage that trade until the market value goes to the opposite end of the reason for why we entered in the first place.

And do that consistently day after day.

Big ups and big downs

Many markets, the currency pairings being no exception, have had significant surprise price moves recently—and will probably continue to do so for some time to come.

Have we changed our trading style to deal with these rare times? No, we are driven by the market structure as reflected on a chart.

Over the last week or so many of the currency markets are price changing within what we refer to as trading ranges. Big ups and big downs. How do we deal with that?

We take our trades based on context, value, setup, and price action. In a trading range, we look to sell high, buy low, use an appropriate stop, scale in, trade small and take small profits. (Small being relative to account size).

We’ve added a page showing the chart analysis by James. These are a synopsis of a cycle or a particular trading period. In the charts posted, most of the bars represent one hour within a structure that takes us over several days.

Unless you are familiar with the price action terms, it is unlikely that the detail will make any sense. But for those who can read the terminology, you will gleam the significant edge that we feel we have.

As I have mentioned previously, most competent price action analysts can accurately annotate a chart after the event. Only an exceptional analyst can do so ahead of a live market with a high degree of probability.

Good time for traders—investors not so much.

To an investor having enjoyed one of the best bull markets over the recent years, the markets current vulnerability must be disconcerting.

To a trader, the market is providing excellent opportunities.

But a trader has to be vigilant. The oil price disruption as we viewed the markets early Monday morning of this week necessitated a change.

That change was not a conscious decision, but rather one that followed the market structure.

With unusual price movement (big ups, followed immediately by big downs) we were pleased that we had decided not to be in the market over a weekend. During which time gap bars (where the market opens at a significant difference in price to where it closed) would be prevalent.

The oil price movement and the effect it had on our currency pairings meant we could not find a structure on the hourly charts and above. But the 15 minutes (day trading chart) did.

We provided a 1.3% increase in the fund since Monday. Not bad for a four-day week!

What I mean by structure can be seen below. Although this is a one-hour chart to provide context and include the oil spike, we conducted our actual analysis and trade management on the lower time-frame picture.

It is easy for an analyst to put structure annotations on a chart after the event. My analyst (James) provided these calls and more as, and often slightly before, the market developed. Through technical analysis, James is exceptional at accurately telling the market story ahead of time.

You might think that all the trader then needs to do is trade. I wish it were that easy.

Even with an excellent market analysis, the job of trader (entry, stop and target position, amount to risk and assessment of probability) takes a long time to perfect. Not to mention a perfect understanding of what the analyst is providing topped with an ability to make quick, rational decisions.

How does a day trader get started? Price action and context traders’ course that we recommend has over 100 hours of instructional videos.

Then a fledgeling trader is ready to backtest the lessons for a similar amount of time. After which paper trade in real-time and then trade lightly for as long as it takes to be consistently profitable. Only then does a trader’s account increase.

To graduate as an analyst, however, a more magnificent natural adaptation to the world of price action is needed.