Money management and an exit strategy

Investors serious about succeeding on their own need to learn an important lesson about trading first: stock picking is not the most crucial aspect of being a successful trader. Money management and a trading plan will determine investment returns over extended periods. Knowing how much to invest and how to take a loss, more than always picking winning stocks, are the skills that mark most professional traders. Of course, every trader wants to imagine they are going to be right most of the time, that they have a special gift for picking stocks. In truth, that expectation is unrealistic. In fact, novice investors learn quickly that being wrong – and taking losses – comes a lot easier than they imagined. For the unprepared, this awakening is brutal.

If taking losses is such a big part of trading, how does anyone walk away from the market ahead of the game? A surprising revelation to the uninformed is that some of the best traders in the world are making a handsome living by picking losing stocks most of the time. They perform this magic by limiting their losses and maximizing their gains. In other words, their trading plan allows them to manage a string of relatively small losses before irregular big winning trades make up for the pain of an unforgiving market. When a trader’s account takes a dip – called a drawdown – he or she stays committed to their plan, largely because it forces the trader to respond quickly to a trade gone bad. This demands an almost inhuman capacity to set aside one’s emotions – our ego, our fears – and to pull the sell trigger. No insisting that the market is wrong, that it will get things right and see things your way soon. Instead, a good trading plan insists on a prescribed exit strategy before the trade is entered.

Stock Trends provides a good example of how a trading plan can help turn the reality of a miserly market into appreciable investment returns. Recall that Stock Trends is a system of categorizing stocks based on a moving average system of analysis. It is a rigid system, simple in its definitions, but consistent in its comprehensive application to the North American Stock market. For over 16-years the Stock Trends indicators have been published for stocks listed on the Toronto Stock Exchange. This has been an interesting testing ground for applying a mechanical trading system – a model portfolio derived from a trading plan with prescribed buying and selling triggers based on Stock Trends indicators and technical triggers. The Stock Trends TSX Portfolio has been filtering the weekly market activity and applying the same trading strategy since 1993 with positive results – a 39% annualized return on average investment.

The trading record for this strategy provides important insight applicable to every investor’s approach to the market. Over the almost 16-years of trading 440 stock positions have been taken. Each position is limited to a fixed investment of $10,000, with the buy criteria specified by Stock Trends’ Bullish Crossover trend indicator as well as minimum price and volume requirements. The important aspect of the buy strategy is the limited exposure – one assumes trading equity of at least $50,000. The second part of this attempt to limit exposure to losses is found in the exit strategy. One of the sell triggers is a stop loss provision (8% trailing stop on the highest closing price). Although the exit strategy is based on weekly trading, and has some implied exposure to abrupt daily stock movements, it has been relatively successful in managing trading losses.

In line with expected results, the Stock Trends TSX Portfolio trading record shows that only 40% of positions taken were winning trades. It turns this middling success rate into positive returns by keeping losing positions relatively contained. The average loss of losing positions is 10% (all results include trade commissions). The average gain of winning trades approaches 30%. Most revealing is the distribution of returns on these trades. The vast majority of returns are clustered between -10% and 10%, with the accompanying graph showing the skewness of the distribution curve. This should be the typical expectation of a trader: relatively few big winners compensate for the more numerous in-field hits.

Obviously, a big factor in every trading system is the order of the trades. Excessively long strings of trading losses challenge every investor, and can wipe out many unprepared investors. Stock Trends Portfolio loss runs have reached a high of 12 consecutive trading losses, however most losing strings end at four. The maximum drawdown on trading equity was 35% (in a period between late 1998 to mid-1999), not particularly great, but still better than the 45% drawdown that the TSX delivered after the 2000 peak – a crushing collapse that buy-and-hold investors did not recover from until five years later. The recent bear market hurt, too – another 49% drawdown!

Investors, big and small, should have a trading plan in place that helps remove some of the self-defeating aspects of our personal profile which handicap success. Dealing with trading losses is difficult, but learning how to act systematically with them will protect an investor from developing costly emotional attachments to individual trades. Keeping a detailed trading record is an important part of understanding how to make your trading plan work for you. As the Stock Trends model  portfolio illustrates, you do not have to be a perfect stock picker to  succeed in the market.

The market is not a level playing field, nor should it be

There has been growing debate about institutional trading practices, with politicians and the public again demonizing moneyed players on Wall Street. These practices are facilitated by technology that has made speed of execution an advantageous and profitable backroom for dealing securities microseconds before they become available to the broader trading public. A recent article by MSN’s Michael Brush explains this high speed trading, flash trading, and black pools. Coming to the defence of these practices are investment professionals like Donald Luskin and Chris Hynes, co-authors of a Wall Street Journal op-ed piece that fuelled expected wrath from investors who smell rats on Wall Street again.

However, the anger of the public on these technologies and alternate markets is simply another form of populism. The notion of equality and a level playing field in the markets is misguided. Markets operate at many levels, from small investors with sleepy mutual funds held for years at their bank to highly capitalized banks with multi-million dollar trades executed many times a day. Markets now operate 24-hours a day in a broad range of securities and assets. The key growth for these tremendously important  capital markets is liquidity – the ability of the industry to bring in capital to individual markets and spur trading. Without liquidity the world’s markets would collapse into the dark ages.

How could there be a level playing field in the high stakes game of investing? Without expanding institutional liquidity the markets would become extremely volatile. Without technology driving the growth of institutional liquidity the capital stock does not grow.

Too often critics of the market – markets where the best rise to the top based on human and capital resources – cry foul because their utopian desire for equality is transgressed. But the beauty of a free market is that it expands the pie, and gives every player a chance at growing assets. However, not every player is entitled to the same resources. Risk and reward are the underlying determinants of the playing field. The more you put at risk, the more resources – human and capital – demanded. Wall Street represents the the best, the brightest players in the market. It is capitalized accordingly. This has always been the case.

It is important that ordinary investors recognize the benefits of free markets and the way resources are allocated by pricing mechanisms. Yes, it would be great if everyone had access to the same computers, the same capital, the same acumen. But that vision is a corruption of the human condition, it is the disabling framework of socialism.

Every day trader knows that the propensity of making profits does not improve with the frequency of trading. High speed trading and back room dealing does not improve the prospect of success any more for the players, either. Every buyer must find a seller. Every winner meets a loser. That is the market.

The market should not be viewed as some egalitarian model. It is not. Instead, it is a mechanism for growth where every player has a role and an opportunity to build their assets commensurate with their human and capital resources. Fairness is not a single level playing field.  If we try to make it so, we will handicap growth and violate our liberty.

Washington Stock Exchange

The stock market is supposed to be the bastion of the free market – ownership of private enterprise swaying to the demand and supply of private capital. However, judging by recent trading activity that model seems strangely defunct. As last week’s trading record shows, quasi-government enterprises are the stocks most attracting investors. Fannie Mae (NYSE:FNM), Freddie Mac (NYSE:FRE), American International Group (NYSE:AIG), as well as government-beholden Citigroup (NYSE:C), and Bank of America (NYSE:BAC) are notably at the top of the market’s most actively traded stocks. The market seems intent on speculating that this public-private contract has a positive outcome. Whatever the result, this is where the trading action is.

Duh! … another zero level thinker

The following is an excerpt from a speech by James Montier of Société Générale in London on the problems with the Efficient Market Hypothesis (EMH). (thanks to John Mauldin).

Montier shares again his 2004 replication of Keynes’ beauty contest, and shows us just how difficult it is to outsmart a market. A humorous example of the Nash equilibrium at work in an imperfect world.

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The undue focus upon benchmark and relative performance also leads Homo Ovinus to engage in Keynes' beauty contest. As Keynes wrote:

"Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the price being awarded to the competitor whose choice most nearly corresponds to the average preference of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees"

This game can be easily replicated by asking people to pick a number between 0 and 100, and telling them the winner will be the person who picks the number closest to two-thirds the average number picked. The chart below shows the results from the largest incidence of the game that I have played - in fact the third largest game ever played, and the only one played purely among professional investors.

The highest possible correct answer is 67. To go for 67 you have to believe that every other muppet in the known universe has just gone for 100. The fact we got a whole raft of responses above 67 is more than slightly alarming.

You can see spikes which represent various levels of thinking. The spike at fifty reflects what we (somewhat rudely) call level zero thinkers. They are the investment equivalent of Homer Simpson, 0, 100, duh 50! Not a vast amount of cognitive effort expended here!

There is a spike at 33 - of those who expect everyone else in the world to be Homer. There's a spike at 22, again those who obviously think everyone else is at 33. As you can see there is also a spike at zero. Here we find all the economists, game theorists and mathematicians of the world. They are the only people trained to solve these problems backwards. And indeed the only stable Nash equilibrium is zero (two-thirds of zero is still zero). However, it is only the 'correct' answer when everyone chooses zero.

The final noticeable spike is at one. These are economists who have (mistakenly...) been invited to one dinner party (economists only ever get invited to one dinner party). They have gone out into the world and realised the rest of the world doesn't think like them. So they try to estimate the scale of irrationality. However, they end up suffering the curse of knowledge (once you know the true answer, you tend to anchor to it). In this game, which is fairly typical, the average number picked was 26, giving a two-thirds average of 17. Just three people out of more than 1000 picked the number 17.

I play this game to try to illustrate just how hard it is to be just one step ahead of everyone else - to get in before everyone else, and get out before everyone else. Yet despite this fact, it seems to be that this is exactly what a large number of investors spend their time doing.

by James Montier of Société Générale

Position sizing

Most of us enter the stock market burdened with faulty biases and misguided conceptions about how to succeed in our trading program. We think that we can beat the market by being smarter than the market. We think that we will establish a winning method of stock selection by way of superior information, that the road to profits will be paved by our consistent ability to pick winners. In short, we enter the market with an emotional commitment to our own judgement. Unfortunately, it is this highly individualized bias that is our ultimate nemesis. Experienced traders know that the key to market success has less to do with a uniquely developed style and method of picking stocks, and more to do with a disciplined execution of sensible and rigid money management principles.

These “judgement biases” are described meaningfully by Van K. Tharp, in his significant contribution to the business of trading, Trade your Way to Financial Freedom (McGraw-Hill,1999). Our trading systems are handicapped by the fact that we typically trade our beliefs about the market, we accept conventional representations of information, and adopt trading practices that undermine trading success by inadequately protecting against actual risk. Further, we consistently and foolishly bet against the odds and succumb to undisciplined approaches to trading.

What precisely are we talking about here? Let us assume that a trader has developed a trading system that generates a positive expectancy – a profitable trading strategy that either has a superior winning percentage (% of winning trades) or a superior profit factor (where the profits of winning trades far exceeds the losses of losing trades). There remains a variable that will, in fact, determine the actual long-term profitability and risk factor that results: the position size.

An often-cited experiment by Ralph Vince, who has been an seminal author of important trading analysis treatises (Portfolio Management Formulas and The Mathematics of Money Management), tested the gambling performance of 40 Ph.D’s on a simple computer game with a 60% chance of winning. Each were given $1,000 in play money and instructed to bet however much money they wished (or could) over 100 trials. The end result was that only two made money.

The undoing of this group of individuals, in fact, is the undoing of many traders: we tend to bet more when we think we are going to be right (or need to be right), and bet less when we are less certain of the outcome. In other words, our emotions have dictated our risk. If the 40 Ph.D’s had religiously accepted the mathematical probability that a constant bet of $10 over 100 turns would have resulted in a 20% gain. Yet, these individuals were inclined to vary their bets (risk) in hopes of achieving better results.

There are varying methods of determining what is an optimal position size. Some are related to drawdown. Some are related to other statistical variables that a given trading system produces. But for general purposes we can simply recognize some basic common sense principles. First, in order to trade properly one must remove emotional attachment to a position. The only way this can be done is if there is enough available trading capital to allow for actual risk. You cannot trade effectively with inadequate capital. Second, traders must limit risk in a quantifiable fashion. For the purposes of retail traders like the majority of Stock Trends followers, a benchmark of 1-2% of available trading equity should be at risk in each trading position (Where the risk is defined by a quantifiable measure. For example, the average loss per trade plus one standard deviation.)
Obviously, position size will be determined by available capital, so the money management guidelines will be predicated by sufficient funds available. Finally, constant position sizing will enable a trading system to minimize the hazardous effects of our inherent, emotionally charged biases.

The best analysis tools I’ve seen that provides position size guidance is the m3 Money Management Modeler, designed by trader Brian Ault of Fulcrum Shift Trading. Brian’s platform looks at trading as a probability assignment, taking essential input variables to determine HOW MUCH to trade on given positions – either stocks or options. Traders, advanced and novice, should learn how to incorporate this kind of risk analysis in their trading strategies. A good trading plan should factor  in probability analysis.

[Most of this is post is a reprint of a Stock Trends Weekly Reporter editorial from 2003]

Golden time to take out some insurance

If investors had a crystal ball that could map the market course ahead, they would want to know the answer to one critical question: whither the greenback? Although monetary excess and fiscal strains appear aligned for a humbling slide in the value of the U.S. dollar, an uncertain economic recovery and the timing of a dollar downdraft has the market conflicted. A picture of this angst is found in the gold sector, where dollar bears typically find a comforting lair. Gold stocks have been trending flat for months, lost in a trading range amid the broad market’s rally off its March low. The strength of emerging markets – many up over 30% in the last three months - may reflect some of the money flows that would have gravitated toward precious metals instead of dollar assets. However, as the global stock market rally becomes vulnerable to a pullback, investors should anticipate an approaching watershed moment for bullion and prepare for bullish price momentum in gold stocks.

After rallying from an October low of 150 to a February peak of 350, the S&P/TSX Global Gold Index  has since bounced between its 2009 high and long-term 40-week moving average trend line. The 13-week average price level, at 315, seems to be the magnetic center for the gold index while base metal mining stocks rocket ahead at an impressive clip. A continued consolidation at this level suggests that a rally back to 350 could be ahead for the gold stock index – especially if bullion prices gain traction during this summer stock market rally.

The price of gold hit a two-month high early this week, dabbling with the $970 level. Investors should be keying on the metal over the coming weeks - advances in bullion prices that stretch toward the $1,000 high water mark will bring appreciable upside opportunity for investors weighted in gold stocks. A rally to this psychological barrier will be an important technical signal for the investment landscape, surely providing investors with enticing odds for doubling down on inflationary pressures built into the U.S. monetary structure. Tremendous liquidity has been pumped into the banking system and few market participants have full confidence that the Federal Reserve has the political will to deliver a winning exit strategy if the U.S. employment picture remains sour. Investors enjoying the market ride this summer would do well to hedge their bet on a prolonged bullish trend for equities with increased exposure to the gold sector.

The iShares S&P/TSX Global Gold Fund (TSX:XGD) is currently categorized as Stock Trends Weak Bullish – the exchange traded fund has been dancing along its trend line support for a month. Trading activity has been stable but uninspired through the last quarter, but now would be a good entry point for investors. The fund’s price pattern formed over the past four months is the technical framework for a trade. The triangular continuation pattern – share price has gradually converged toward its current mean at $19.60 - suggests that a breakout move toward the $21 level would be bullish. Sharing this chart pattern are big cap gold stocks Agnico-Eagle Mines (TSX:AEM) and Goldcorp (TSX:G), both showing leadership for the group.

Some specific gold plays are already showing strong bullish trends and tipping toward better things ahead for the rest of the group. Leading small cap gold stocks include Golden Star Resources (TSX:GSC), West Timmins Mining (TSX:WTM), Queenston Mining (TSX:QMI), and Lake Shore Gold (TSX:LSG) – all shining performers. If investors get spooked by a sharp correction when the summer stock market rally reaches exhaustion, these and other precious metal stocks will be fruitful insurance policies.

Good news from Media stocks

A sign of an improving economy is the bullish turn of media stocks. The Stock Trends Picks of the Week report includes a number of them this week, including McClatchy Co (NYSE:MNI), and the Journal Communications (NYSE:JRN) – both breakout stocks advancing on high volume.  Media General (NYSE:MEG) and the New York Times (NYSE:NYT) also have made surprising moves and appear in the report. Google Inc. (NASDAQ:GOOG) is in a Stock Trends Bullish trend and is poised to rally off trend line support. Expect continued advances from Liberty Media (NASDAQ:LMDIA), as well.

Investors can play the sector with the Powershares Dynamic Media ETF (NYSE:PBS).