Market has plummeted as was forecasted. Today - Tuesday market lapsed down as much as it was supposed to go down today. So the market performed what I call a “snap-back” to the G-Line. This happens often and you can see that in our past forecasts

Here is what I mean -

Depending on what the forecast looks like for the rest of the week a trader can either cover his shorts at the open or move his stop to lock in the profits.

This is a great example of why our forecasts should be used primeraly for weekly swings and not intraday noise.

Here is another example of the snap-back on the entire week -

One of the most important things about trading is the management of the risk on your trade positions.  Let’s face it, if the market just doesn’t go anywhere while you are in a position, you just cannot gain from it.  So, depending on market volatility, you really cannot control to any degree what your gains will be.   You can, however manage what your losses can be to some degree with good risk management techniques.

The principle is simple but it is really hard to do (all these examples will be based on a long trade, use the opposite for shorts).  When entering a trade, I simply do the opposite of what I feel.  That’s right, buy when the market is falling and sell, when it is rising.  If trading on a daily time frame, to buy for example, I might like to see the market at a 3-5 day low, or below a moving average of some reasonable length.  Then, I like the particular interval I am in to also be down.  For example, I will buy on a down day.

I have attended money manager conferences and listened to industry professionals talk about how they will buy into strength.  This is great in a bull market, but in today’s uncertain markets, in my opinion, it is a recipe for disaster.

Let’s look at the logic of it.  That stock market spends a good portion of its time alternating up and down without making any ground.  This is true on just about any time frame.  Research suggests this is true around 66% of the time.  That means you have a significant edge over random entry using this concept for trade entry alone.  Further, it tells us that as the market moves higher (on a buy) there is that much less to go before it turns around and continues back down again.  As a result,  it can be much lower risk to actually enter a buy when the market is declining (to some measure of its alternating range) because the amount I stand to lose is lessened.

So, even though it is very uncomfortable to buy while the market is declining, I know it is reducing the amount of risk I will take on the trade at the same time.

Let’s consider the psychological factors as well.  If I am feeling really scared that the market is falling when I am putting on a long trade, I know most other market participants are feeling the same thing.  This assures me that my fear to buy is really an indicator that measures current market sentiment.  If sentiment is really that low, then I reason we must be running out of sellers to drive the market lower.

Let’s look at it from a numerical standpoint on where I might place a stop loss order.  If the recent previous low on the S&P is at 1280 and the market is declining into that area,  I am thinking the market will likely react and go back up at that level.  If I buy near that level, I can place a stop beneath it by a reasonable margin, say 1275 and have that be a reasonable measure, if it gets hit, as to  whether I was really wrong or not.  So as the market declines to that level, my mind is oscillating between the greed of buying the absolute low and the fear of it continuing to fall.  But, for every point it falls, it is one more point reduced from my risk.  At some point in this equation and mental oscillation, I pull the trigger and buy (preferably at 1280 or so, if I can get it).

Using this mental exercise to enter a trade has taught me much.  I have done this for years and have been very successful with it.  Now, having trained myself in this way, I experience fear if these conditions are not true.  This is true because I want to get a good deal, and this translates into small stop sizes and smaller losses when I have them.

What does this mean in the big picture?   By keeping my losses reasonably small and going against the majority, I do not get demoralized by trading.  That keeps me in good spirits while the market is beating people up (which is just about the time it will take off for a really good move).  So the famous wisdom of Rudyard Kipling stands;  it is important to keep your head about you when all about you are losing theirs….

You can’t win if you don’t play the game.  The market has a way of demoralizing its participants just before the very best moves.  By keeping your risk managed, and your spirits high while trading, you will always be there when the market decides to deliver you a really big trade (the one thing you cannot control).  Make sure you are there to benefit from the spoils of the trading battle.

It always amazes me how people do not understand the financial implications of their trading activities. It is hard enough to be profitable, let alone having to deal with the IRS and trading expenses.  Knowing the various issues involved can help you to make significant differences in your bottom line.

Many people trade in and out of the market, not realizing the implications of trading expenses.  One such expense is commission. Commissions are quite different on stocks and futures ( Yes, many people say futures are risky, but that is not because of futures, it is because of the people who trade them and how they do it).

An Emini S&P contract, which is traded on the Chicago Mercantile Exchange out of Chicago, represents $50 times the index in value of the S&P 500 index.  If the index is trading at 1300 then, it is $65,000 worth of stock.  A small account can trade in and out of this market for only about $2.40 per side all expenses included (”all in”).

On the flip side, you can trade the Spyders, symbol SPY.  SPY is an Exchange Traded Fund or “ETF.”  ETFs are a fast growing market place and are attracting huge amounts of capital, as are the Emini S&Ps.  SPY would trade at or about $130 per share when the S&Ps were trading at 1300, so an equivalent purchase would be 500 shares ($500 * $130 = $65,000).  At a decent broker, you could trade that at around a penny a share, or $5.00 per side, almost twice as much as the Emini contracts.

Then there is the topic of slippage because you always pay the ask to buy and the bid to sell.  This is another hidden expense that, if you are trading frequently, will add up to a lot in time.  On the SPY this “spread” is typically a penny. At $130, this is another $5.00 per side, making a total of $10 per side on the SPY to get in.

For lower priced stocks, such as the Nasdaq ETF (QQQQ) the expense is substantially more on a percentage basis, because it trades at a much lower price (therefore you are trading more shares).  Most ETFs are lower priced that the SPY, making the SPY an excellent choice as a stock market based trading vehicle.

On the Emini S&Ps the minimum tick and expected slippage for a small account is $12.50.  Add the commission to that of $2.40 and you are at around $15.00 each side.  Substantially more than the SPY, but less than many other ETFs on the stock market side.

Then comes the taxation portion of the equation.  Of course you will want to check with your accountant on this, but stocks, or ETFs are taxed as short term capital gains. Futures are taxed a partially long term capital gains (60%) and partially short term (40%). As a result, the tax benefits of using futures as an investment vehicle for actively traded taxable accounts can be substantial.

One other factor influences my personal decision to trade futures over ETFs on my stock index trading and that is the nightmare of dealing with stock brokerage statements and my accountant.  If you trade actively, you will pay your accountant a lot to sort through all crazy ways your stock brokerage puts together statements making it difficult to reconstruct what happened for accounting.  To make it worse,  when you call the brokerage for assistance, they can’t seem to tell you what the statements mean either (I speak from experience- try it for yourself).

Deciding which vehicles to trade when you are an active trader can be a very important decision, hopefully this will help you as a guide to structure your trading activities to best benefit.  My choice stands with futures.

The market gapped up around 3% this morning on news of a US government mortgage bailout.  The way they release these things from behind closed doors on a Sunday night assures me the democratic process of our government is all and well (just as it was with Bear Sterns).

Personally, I do not believe the taxpayers should have to pay for the failed conduct of a few very rich guys (who will probably walk away that way too).  All that aside, how do we trade gargantuan gaps and how do we trade our cycle when we are already at an anticipated key level high for the week? There is one answer; very cautiously.

As I write this (Monday 9/9/2008 shortly after the open) I see that NYSE advancers beat decliners by a staggering 19:1.  This is the strongest breadth reading I believe I have ever seen.  This typically suggests a dramatic change in the mood of the markets.  Of course it will need to settle down a bit first, before continuing.  With that in mind, it is important to watch your risk exposure.  Wild swings are likely to occur as those with short term profits, take it, those who are short run scared, those trading on the bigger time frame jump in on the opportunity.

What typically happens in these cases, is the magnitude of the change is so large and occurred so fast, the majority will be afraid to short into it and longer term buyers will be reluctant to sell.

With that in mind, we do still expect the market to (continue to) follow our forecast this week, but, if you are not already in, take your time and find an area to enter that meets your risk reward needs.

The truth is out. The traditional argument as to whether technical analysis has any legitimacy as compared with traditional buy and hold stock market investing techniques lives on and the few of us as money managers who seem to have survived, smile knowing much of the argument is amiss in what it is really asking.

I have managed to survive and do well as a money manager. I have watched market advisory services come and go over the years with new ones coming forward with new claims and new participants entering the market ready to eat it all up (or be eaten).

But, what is it that has enabled me to survive as an active manager? Is it my phenomenal skills? Is it this magic thing called “Technical Analysis.”? Or is it just simply being in the right place at the right time?

Certainly two of three of those choices could be random. But one thing is not, and that is Technical Analysis. In the traditional sense, as one might read in books, I have never ever found any technical analysis tool to be of any benefit to me in the development of a trading strategy (barring moving averages which I use to introduce intentional delays or to create zones to trade from).

So if I could never use them, then what exactly is it that perpetuates the myth (at least as I see it)? The best guess I can come up with is failure to do a simple test of the obvious. The survivorship bias of most people not staying in the game for any length of time results in new participants going back over the same nonsensical stuff again and again.

So, I decided to conduct a test (actually, I did this 15 years ago but will duplicate it here for you). Real science (as I have done for years) and resolve, once and for all (or at least in portion) this debate.

I conducted a test on the efficacy of stochastics (oscillators in general) as stand alone trading devices. The text book method for the use of these tools in trading is that a condition below 20 means the market is “over-sold” and should be bought.  If the oscillator goes over 80, it is then called “overbought”, and should be sold.

This all seems very scientific. And, if you look at a chart, your human eye will gladly pick out all the highs and lows the oscillator picked (to the exclusion of all else). Convincing! But as I said, this is science, so we won’t rely on the human eye.

Oh yes, you might argue. Stochastics (oscillators in general) can be used in other ways than for overbought or oversold conditions. I full heatedly agree. But the principle in the following tests will still stand. So, bear with me…

Let’s look at a scatter plot of a stochastic oscillator for various levels five units of time into the future. This picture will tell us everything we need to know about stochastics (on the given time frame) without any messing around (this is what scientists do) -

Stochastics Scatter Plot

The graph is made up of over 3000 data points on a 5 minute chart, looking 25 minutes into the future. Now before your brain shuts off, don’t worry. It is not that scary. Simply, it shows us that on this particular test, for values of the stochastic oscillator above 80 (that is supposed to be a sell signal) the returns vary from -10 to +10 points overall. In fact, the returns vary from about -10 points to +10 points overall. Over on the left, it does show there were about 5 events (grey dots) where there were declines of as much as 20 points, but over all, the graph is random (evenly distributed). On the bottom of the graph, we can see, below 20 (that is supposed to be a buy signal), the returns are also distributed from about -10 to +10 points. The middle ranges are also similar.  This tells us that the distribution of prices 25 minutes into the future on a stochastic oscillator are… (oh no Rob, don’t say it) RANDOM!

There, I said it. Random!

If you had traded using the 80/20 rule over the period of this test, holding 25 minutes on each trade, you would have lost over $3000 not including commissions. Next time you think about using an oscillator in the textbook traditional sense, remember this.

The fact is, this test result will hold true for just about any time frame on oscillators and just about any other technical analysis indicator. As the time frame increases, it may become more reliable (at least on stock indexes). In many other cases and markets will actually be the opposite (ie. Buy 80 and sell 20).

Maybe the age old debate will linger on? Maybe I have put it to rest? I think not. Though I am sure I will get some responses to this (and I hope I do) so you can send me your technical indicator. I will gladly test it for you and send you the scatter plot with an interpretation (subject to my own scheduling). Fact is, I have never seen a technical analysis indicator hold up to this type of scrutiny and this is one of my “nice” tests ;-)

This article is not to discourage the use of oscillators or other technical analysis tools. Quite the contrary. Tools do have their places depending on the intent and design. I always encourage trading based on a solid premise. Getting at the testing of the premise is key, and scatter plots is one great way to cut through a lot of garbage and find truth quickly and save you from a lot of heartache. It only took a couple minutes to set up this test. I encourage you to do the same, or, send your indicator or trading system to me and I will test it for you and help you with logic and improvements if I am able…

When you find a solid premise to work on that holds up to stringent testing, you can start making some good money trading with it. Knowing where you are through testing makes the psychological component of trading easier, lending to the mental success cycle required to succeed financially. Asking the right questions can put debates to rest and lead you to greener pastures.

1. Get caught up on your unanswered email
2. Update your To-Do list, goals
3. Call people you haven’t spoken in a while
4. Visit gym for god’s sake!
5. Write a trading plan for Tuesday and the following week
6. Finish reading that book that’s been laying by your bedside
7. Go outside, get some fresh air
8. Analyze your account equity and find ways to improve your trading
9. Get social - traders tend to be isolated/antisocial. Join online social networks like twitter, myspace, youtube, facebook, trade2win.
10. Spend time with your family members!

From EminiForecaster.com we wish you a happy Labor Day!