It´s getting exciting…

Do you know this moment when you finally realize that something that you can achieve something? The moment you become aware of the fact that what you learned seems actually to be applicable to reality? This moment of being excited, energetic and nervous? The moment when you are certain that what you do actually can have an impact on your life? The moment you think that it is much easier than it actually will be and the moment you become overconfident?

Well, this moment occurred to me a few days ago and still I don´t understand the significance of what I found out.

What happened?

Having learnt the very basics of moving averages I thought that I could start analyzing the usefulness of these tools. So I did some back testing at http://www.stockbacktest.com. Since I could not test my beloved Netflix (Why???) I had a look at Apple…

Since no one reads this blog anyway and there are some serious flaws in my analysis lets reflect on what I found and tell you the SECRET (just kidding).

The awesome 10-50 Crossover system

So first of all I had a look at the chart with different moving averages. Below you see the 200 days SMA, 50 days SMA and 10 days SMA

sc (1)

So, we see that Apple currently trades below the 200 days SMA – apprently A RED FLAG. Based on what I read about moving averages the 200 days SMA seems to be one of the distinguishing factors – the line you want to be on the ride side of. So there should be no buying on the wrong side of this indicator. Since I am ignorant (I know, I know) and curious about different crossovers, I checked the applicability of the 10 days SMA in conjunction with the 50 days SMA anyway.

sc (2)

This looks like a promising crossover system. In the limited time frame depicted a crossover of the 10 days SMA over the 50 days SMA seems to be a clear buying signal. So, lets back test this. What would have been the performance using this crossover system between January 1 1991 and December 31 2015? Given an initial equity stake of $5000 and transaction costs of $7 per trade the return achieved would have been…

backtestingapple

What the hell is going on? A total return of 7400% and thus and annualized return of 39.8% – that´s incredible! Lets be honest, the numbers do change a little bit based on the choice if you use trailing stops, profit targets etc. But the strong performance of this system is consistent. Even in the horrible 2007-2008 crash this crossover system applied to this stock would have been profitable.

Yes, probably I am guilty of back fitting my data. Yes, it is very likely that I omit very important factors and yes, it is very probable too that I misinterpret what I see.

But still, WOAAAAAAAH!

I do not think that this strategy will make me money but this discovery increases my curiosity and passion to learn as much as possible about this by so much.

I now have the feeling I talked about in the beginning of this post – it is possible to learn this and the markets are definitely not random.

I will go back and check some more primitive cross over systems now and probably be too ignorant about many facts. But there is so much to learn and I am as committed as never before to do it.

Best,

Nils

Averaging Yourself To Profitability

The last post established the characteristics a successful trader should embody. But just being in control of emotions without any actual technical knowledge will not make you profitable in the markets. So let´s get started with some technical lessons (again, YEAAAAAH). Just as the last time the source of my newly acquired knowledge is a book by Steve and Holy Burns. “Moving Averages: Incredible Signals That Will Make You Money In the Markets” introduces the basics of moving averages and I only can recommend reading it. The knowledge is pure gold (especially given the fact that it does not even cost three bucks).But lets get started.

Many of the most successful technical traders dedicate a lot of their success in trading to moving averages. Why and more importantly what are moving averages? Moving averages are prices averaged over a specific time frame, for example the average of price of the last 10 days. These indicators help to judge where the price of a stock currently is trading compared to the average price. Thus they constitute technical tools for the identification of trends. Moving averages can be calculated for different time spans and the longer the period the calculation is based on the easier it gets to observe trends in the chart since the short term noise is filtered out. However during high volatility moving averages tend to be less useful since emotions take over in these kinds of markets. The undeniable benefit of these technical tools is that moving averages depict quantifiable facts. No guesswork has to be done in order to express the past trend up the the actual moment. The below chart depicts both the German DAX index and two moving averages (50 and 200 days) allowing to judge the momentary price development compared to the historical average.

Dax

There are three kinds of moving averages: simple, weighted and exponential moving averages. A simple moving average (SMA) is a normal average calculation of the prices of the asset. A Weighted moving average (WMA) gives more weight to recent than past prices in the calculation of the average. Similarly does an exponential moving average (EMA). However the difference in weights between prices of different time frames in this case is exponential and does not remain the same. Now let´s have a look at a few different moving averages and their possible use.

5 Days Exponential Moving Average

The 5 days EMA captures the momentum of the market. It only should be used in low volatility markets with strong momentum and can indicate possible trends on a daily basis. A breakthrough of this level might be a possible indications of a trend. In conjunction with the RSI (see beneath) this indicator can mark entry and exit points. Additionally it might be of use as a trailing stop after a breakthrough of a longer time frame moving average as well as a end of day trailing stop. The time frame trading  this moving average is only up to two weeks and profits should not run too far above this chart because prices usually will return to it.

10 Days Exponential Moving Average

Similar to the 5 day EMA this moving average gives indication about the short term trend and should not be used in volatile markets that daily break through the line. It can be used in daytrading and is supposed to keep you on the right side of the trend. This line usually is the first to be lost before a stock gets into trouble. Additionally it can be used in conjunction with other moving averages such as the 200 days SMA in order to obtain long and short signals.

21 Days Exponential Moving Average

The 21 days EMA usually is the last line of support in volatile uptrend. The time frame is intermediate it can keep you on right side of volatile stocks. It might be used in conjunction with the RSI to cover long and short positions. The Netflix chart below (yeah, I still am very attached to this stock) shows how the 21 days EMA could be applied together with the 50 days SMA. At the same time we see that the indicator alone might be misleading. When the shorter term 21 days EMA crosses over the longer term 50 days SMA this seems to be a long indicator while the opposite seems to hold when the longer term crosses over the shorter term moving average.

netflix.png

50 Days Simple Moving Average

The 50 days SMA might keep you on the winning side of a trade for many months. In uptrends it often functions as support level and as resistance in downtrends. As we just saw in the previous example it can be used profitability together with the 21 days EMA.

100 Days Simple Moving Average

As an intermediate between 50 and 200 days SMA´s if this indicator is not hold often the next stop is the 200 days SMA. In bull markets this line often yields a great risk reward ratio.

200 Days Simple Moving Average 

This probably is the strongest signal telling you which side to be on. If prices trend above this line a bull is likely whereas prices below indicate a bearish development. First of all this makes you strengthen defense by  being on the right side of a market. After a bear market a break through the 200 days SMA gives you a good risk reward ratio. Additionally, this moving average can provide a strong support level for growth stocks.

Crossover systems

Moving averages may be very useful but often alone trigger false signals. Crossover systems use two moving averages that give signals when the shorter term moving average crosses over longer term moving average. This enhances the quality of signals compared to a simple moving average. Above we already saw the possible combination of the 21 days EMA and the 50 days SMA. In order to catch large price swings a use of the 10 and 30 days EMA might be applicable. Long term trend followers look for a signal called the “golden cross” which is triggered by a crossing of  the 50 over 200 days SMA.

Besides crossovers of two moving averages some other indicators can aid the trader in making entry and exit decisions. One of them is the Relative Strength Indicator (RSI). The RSI is an index measuring relative strength in the market. It compares the magnitude of recent gains to recent losses and thus is supposed to indicate whether the market is oversold or overbought. The index yields a value between 0 and 100 where a values of 70 and 30 indicate overbought and oversold markets respectively. The next chart shows how the RSI (on the top of the chart) may be useful in deciding whether to exit or enter. At the very bottom of the market the RSI indicates that the stock is severely overbold and thus might give an entry signal even prior to the crossover of the moving averages.

tesla

Wow, there are many different moving averages and it is not that easy to interpret them.But who expected trading to be an easy thing. Personally, I took a lot of useful knowledge out of this book. When reading it and detecting patterns in the charts my interest for investing was further strengthened and I look forward to test the systems and then finally apply them (hopefully successful).

Best,

Nils

 

Emotional Control

A determining factor of trading success is emotional control! That´s what I learned in “The Market Wizards” and that´s what Steve and Holly Burns emphasize on in “New Trader 101: The Fastest Way to Grow Wealth in the Stock Market”.

Of course everybody knows that character traits such as a big ego, greed or fear might be detrimental to our lives in general. But especially in our trading activities these characteristics should be eliminated.  An ego leads to overconfidence. As a consequence the trader enters the market being unprepared. However, doing the necessary homework before starting the own trading activities is inevitable. Hours upon hours have to be invested into studying chart patterns and historical price data. This allows the trader to achieve an edge in the market which is the statistical advantage of your trading system over time. Furthermore an ego leads to stubbornness. The inability to admit mistakes in the financial markets might very well be lethal for the beginning trader.His desire to be right weights stronger than his desire for profitability. Unable to admit a mistake he does not cut losses when small but will eventually take losses when large (this is what happened to me and Netflix – Do you remember?). The novice trader however should not be afraid of these small losses. Even for successful traders 40-60% of trades tend to be losers. However they lose small and win big.

There are some simple rules that might help the new trader (me) to overcome the challenges human nature poses us:

  • Watch Your Position Size: If you experience an emotional roller coaster with every price move of your position then you probably should overthink your position size. But in any case never risk more than 1% of your trading capital on any one trade. Your first goal is capital preservation. The math is simple. If you lose 50% of your equity you have to gain 100% back just to come out even. So trade small! Risking not more than 1% of equity on any one trade enables you to survive losing streaks (which will occur) and lowers the stress level. If your trading capital is 10000$ this rule allows you to risk no more than 100$ on any trade. Lets say you decide to buy stock XY trading at 100$ a share and decide to stop at a 5% decline down to 95$. This allows you to buy 20 stocks and thus invest 2000$ of your capital in this company. In case of the 5% decline your stop is activated and you end up losing only 1% of your capital. If stock XY is a more volatile growth stock you might decide trade a smaller position size in order to allow for a temporary decline of up to 8%.
  • Don´t Ignore Risk: As just mentioned even successful traders lose on many of their trades. So it is important to be aware of the fact that every trade is a possible loser. There are three possible payouts for you – large wins, small wins and small losses. You should not allow yourself to have large losses on any of your trades. Before entering the trade you should already know which price movement indicates that you might have been wrong and thus leave the position. When this happens proof to yourself that you actually will take the small loss instead of the possible devastating large losses. Additionally, a tool to mitigate risk is holding uncorrelated assets such as currencies, oil, stocks and other commodities. This will make sure that you do not lose all in a general bear market. Hold not more than three positions at any time in order to not bet more that 3% of total trading capital.
  • Risk/Reward: You should not risk capital on a trade that only offers a limited upside. If you risk 1% of your trading capital then given the technical indicators there should be at least a reasonable likelihood of a 3% gain. This will allow you to be profitable, even with most of your trades being losers.
  • Have A Trading Plan: Just like the other points this is crucial for every trader. A trading plan contains what your entry signals are (should be based on thorough study of historical patterns an markets), what risk reward ratio you are looking for (best 3/1), where you will stop loss, how to lock in profits (for example with trailing stops) and what your edge in the market is. Furthermore, unalterable rules such as the 1% position size or taking small loses are included and should be regarded as if constituting a personal constitution. Additionally, rules that make you trade less during losing streaks might be feasible. For example you could only trade half a percent of trading equity after four consecutive loosing trades. Don´t ever leave your trading plan  – this is gambling and gamblers lose always in the end. Following your trading plan will give you faith in yourself because you know that it only allows for big wins, small wins and small losses. You save your capital from large losses and since you have an edge in the market you will be profitable eventually.

These simple rules are often mentioned by the very top traders in “The Market Wizards” as well and constitute easy measures allowing for potential huge performance improvements. Let´s all dedicate to stick to these rules.

Best,

Nils

 

 

 

The Turkey Fallacy

Once there was a man whose labor it was to catch turkeys in order to sell them on the local market. He used to do this with a special trap. With pieces of bread turkeys would be lured to the trap that could be triggered by pulling a string. Once enough turkeys were gathered beneath the trap the man would pull the string and catching them. This would make all other turkeys aware of the trap though. One day, as every day, the man was doing his labor. Finally, there were 12 turkeys gathered beneath the trap. The man, unsure whether to wait longer, told himself “I´ll wait for one more turkey and then pull the string”. Just as he said this to himself two of the twelve turkeys walked away. “Well, 12 turkeys is a good amount for the day as well. I´ll just wait until the two turkeys return and then pull the string!”. But another turkey walked away just when the man completed his thought. Upset about the fact that he had not pulled the string earlier he decided to finally pull the string when there would be 10 turkeys.However, no turkeys returned but rather more would walk away until at the end of the day the man would be left with no turkey to catch at all.

O´Neil tells this story in order to teach us a lesson about cutting losses. The exact stupid behavior the man in the story is guilty of is the general behavior of people investing in the stock market. Once a stock decreases we regret not to have sold the stock before and decide to sell when the price has recovered. Often the price never recovers and finally huge losses mount up. The tendency not to sell is because people feel they realize a loss when selling the stock. But you have to be aware that the loss already has occurred and your goal has to be to protect yourself from further losses and to get some time to think. And it is in any case easier to think with cash in the bank than with struggling stocks in your portfolio. So what can you do to fight the tendency to keep losses running? You do need a rule determining when to cut losses. In general stocks should be sold if below 7-8% of purchase price. This is the absolute limit you should allow a stock to lose before selling it. If stocks did advance after your purchase you should let prices fluctuate more than just within this margin. The positive effect about a rule like this is that action becomes automatic. There is no tendency to keep the stock anymore. If a threshold is reached the sell button automatically is activated. “But what if the stock stabilizes and then finally advances many hundred percent in price after I have sold it?” might be a justified question to ask yourself. And let me tell you that this is going to happen and it will happen many times. But if this happens remind yourself that you did safe yourself from bigger losses by selling early. O´Neil compares the possibility of selling a stock prior to a big price advance to an insurance premium you have to pay in order to save yourself from catastrophic consequences. You are just happy that your house did not burned down and do not care about the premium that you could have saved.

This simple lesson teaches us how important it is to have clear rules since the human mind does not fit successful investment activities well. To me how to cut losses early seems to be the most valuable thing I learned reading “How to Make Money in Stocks” – even more valuable than the general CANSLIM framework. I hope to be able to properly use it in the future.

Best,

Nils