There are many stock market sayings that have been passed down from the sages of old; “The trend is your friend., Buy the Rumor, and sell the news, Always buy on strength”, to name just a few. There are hundreds of these sayings. I love them all because, after all, why would anyone not want to receive the benefits of wisdom of the sages of old?

One of my favorites is “Never hold (or carry) a losing position over night.” This advice sounds profound, meaningful and wise, sure enough; until you start thinking about it ;-)

What exactly does it mean to not hold a position over night (winning or losing)? Certainly this must have some valid purpose. If I had bought minutes before the close and the market went lower, should I then panic in the seconds before the close and exit? What if my entry were just plain random (no particular logic behind the buy or sell) and I had a money management method that turned such positions into winners. Should I code my secret money management system to exit just because my random entry was, well, a little more random? I think not.

It is always important to scrutinize words of wisdom coming from any source. A lot of this kind of thinking comes from a day trading mentality. I often marvel how people can even use a word such as “day trading” in a market that trades around the clock like the Emini S&P contracts. This contract gets started on Sunday night and stops only for a short time each day for system maintenance in the afternoons. It then runs until Friday close.

Oh yes, the markets have changed since the days of old when many of these sayings may have had at least some level of validity. So, in this modern era we live in, perhaps the saying would be changed to, “never hold a losing position over the weekend?” I don’t know. It still doesn’t seem to add up to anything making any sense at all to me. This particular saying couldn’t possibly have any validity unless it was followed by the word “if” or “unless.”

For example, don’t hold a losing position over night if you are in a margin call. Now there’s one that makes good sense. Brokers get really mad when you do this to them. In the event your alarm clock is broken; it pretty much guarantees you will get a morning wakeup call from your broker. Hey, who says brokers don’t give full service anymore?

I can think of another good reason to not hold a losing position over night. When you don’t want to be holding the position (for some good reason).

Still looking for sage advice on the stock market? I certainly hope not. Count your blessings! Give thanks we have been given a sound mind of our own. After all, if we didn’t have that, then who’s mind exactly might it be we would delight in having possession of (I am sure this is correct grammar)?

Next time you are thinking of a market asseveration to base your future market earnings upon, be sure to use your noggin. If you are not up for the task, I’d welcome your asking me to write another article on whatever great words of perspicacious market wisdom you might come upon. I’d be absolutely overjoyed to share what sound mind I have remaining ;-)

One of the very worst things that can happen when you begin to trade a new trading system is to start losing right out of the gate. Just about anyone will tell you this occurs to them, “every time” (let me hear a big Amen). This tendency of human behavior is not just limited to trading a system you just found or created either. When I managed hundreds of client accounts, they would all pile in at certain times and leave at others that guaranteed they would lose. They did this with such remarkable accuracy buying my equity highs and selling my equity lows, it would amaze you. Why does this occur and how does one get the best (instead of the worst) of it?

When one is drawn to a trading program, it is because it is doing well. Never the opposite. Ever get an evening call from a broker in some boiler room in New York pitching you with a money manager’s performance that is losing, saying, “Mr. Prospect, this money manager has lost so much money recently, that if you come in with him now, you will surely be a winner?” I didn’t think so. So let’s recognize we are drawn to a new trading system or trading program at any given time because it is doing well. Step one to avoiding the inevitable is to track the trading program for a while to wait for it to not be at a new equity high.

It is simple; buy low and sell high. Maybe nobody ever told you that phrase applied to the equity curve on the money manager or trading system you were looking at, but the principle is solid.

On a trading system that trades the Emini S&P contracts or the SPYders shares etc. I would wait for a drawdown to occur that was average before entering. So you say to the broker, call me back when this money manager is losing, not winning (TIP: that might help to get the broker off the phone).

In the event I am already trading the system, and wish to add contracts for compounding, I use this simple rule of thumb: I wait to increase my equity enough to add a contract while the system is in a new drawdown from an equity high I benefited from. In other words, I will make enough on the system so that after drawing down from the high, I still have enough to add the new contract or shares. What this does, is it increases the probability I will not draw down while doubled up. This is also very important from a psychological stand point as well, because when your equity fluctuations double from having added new contracts or shares, it will likely be a bit unnerving at first; particularly if you are not up. This strategy helps to protect your earnings.

How do I get out of a trading system or money manager I am trading? I get out while I am ahead. If the system is making too much money too fast, it will likely implode, so it is best to get out while the going is really good. Oh yes, you might leave some good gains on the table at some point, but in the long run, this has always proven to be right. Look at any S&P or NASDAQ chart from late in the year 2000 and you will see what I mean. When the curve goes exponential, get out. Buy something that’s low, quiet and poised for growth.

These simple principles will serve you well, but it is hard to do. Grit your teeth and do the opposite of the herd as I have described above. Will it be a money management bonanza? Maybe. If you can stick with it, apply the above principles and manage your risk, I’ll will see you in the winner’s circle next year.

It never ceases to amaze me how people put strange verbal terms to things that would otherwise be extremely painful.  Let’s take the trading term “Drawdown” for example.  What on earth is that supposed to mean?  I can tell you this.  When I lose money, I lost money.  It is just that simple.

You can call it anything you want, but somehow, calling it “drawdown” seems to make it all better again.  Yes, “drawdown” is a forward looking term and those of you who know me, know I approve of future thinking.  It is always the question, what is developing now, that makes the future likely to be as anticipated that makes all the difference in my trading.

If I am trading a trading system I developed, my first thought on parameter selection is what is the market condition likely to be in the near future?  Will it be more volatile?  Will it be choppy?  It is this kind of thinking that helps me to decide which systems I am going to be trading tomorrow and with which parameters.

I will run tests that show me how the parameters shift under various circumstances and I will anticipate this.  It is this kind of thinking that has made a huge difference for me; anticipatory thought.

But the term “drawdown” also carries with it, without regard to your method or its viability, the seemingly all saving idea that you will recover from where you are.  After all, it is just a drawdown.  Well, if it went down, it certainly will in all likelihood go back up, right?  After all, the great master did say, as you believe, so shall it be done.

So is “Drawdown” really a dangerous word to be using?   Yes, I believe it is.  Because it ignores that larger picture of what really is an efficacious approach to trading.  I think it is a conspiracy against newbie traders to keep them from realizing the big picture of money management.

If you really want to get real about it, go read this techno babble that detaches it even more from the experience (http://www.en.wikipedia.org/wiki/Drawdown_(economics)) of losing real money.  After getting your PhD in detached financial verbosity, you might be able to get a job teaching trading to a bunch of unsuspecting students to try to pay back all the money you lost trading in the real world ;-)

Traders have to deal with reality every day. If not winning, then you certainly are losing. It is just that simple!  Trading is the most basic game in the world, but it requires a solid understanding of oneself and the environment around you.  Challenge the terms that are being presented to you and the environment you operate in as a trader and free yourself from biases that can keep you down.

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.

After losing $70k trading new highs (Investor Business Daily style) with 7% stops, I learned my first lesson.  If you have 7% stops, how many times in a row can you be wrong and still be able to trade (financially and/or psychologically)??  The answer is 17 times to get to below $30k.  It seems like a lot, but unfortunately, I was using full leverage on the advice of my greedy broker, so that reduces to 8 consecutive losing trades to get to $30k.

What would it take to recover back to $100k from the $30k level?  333%!  How often does one make 333% on 100% of their portfolio?  Not very often ;-)

Lesson:  Leverage and large stops are killers.

Moral:  The tortoise beats the hare.

Now of course, I did not learn this lesson all at that time because, as I have indicated, I am about the most persistent and stubborn guy you could possibly meet. So it took me a decade.  That didn’t keep me from making good on my losses though.  In fact, I made that loss many many times over.  Another thing that makes it tough to learn.  So there is another lesson.

Lesson:  You cannot correct your behavior as a trader unless you agree you are doing something wrong.

It is impossible to distinguish between luck and skill in most cases.

So, if I can impart any wisdom to you at all that will keep you in the game, the above would be it!

Because, you cannot win, if you are not in the game! Here, I will say it again.  You cannot win if you are not in the game.

Having said that, here is another tidbit of crazy inside knowledge.  Since you cannot distinguish between luck and skill a good portion of the time, the real truth of the matter is you are not responsible for your winning at all.  The market is.  Here, I will prove it (cause I know you are probably shaking your head right now).  Go try to extract a bunch of gains out of the market right now.  So you will say well….. this and well…. that.  Fact is, depending on your method, the market will deliver the conditions you need to make a bunch at the exact time it does it.  Not before, not after.  And, you will have to be there at that exact time in order to benefit.

I said before, you have to manage your risk and then, at some point (and here is the blaspemous statement that will make most traders cringe), a good accident happens.  Accident you say??  Yes.  I use that word, because it is the only one that is strong enough to remind me there is nothing personal about trading. It is all management of risk.  It is a disipline.

How does all this impact your personality as a trader?  You have to bring yourself in line with some sense of truth.  We all like to think we are exempt from the physical forces of the universe.  We like to watch Hollywood movies that confirm our invincibility may be real.  But, nothing shows you quicker that you are wrong than trading.  It is instantaneous feedback.  So, try to be humble and the way will open your way to success.

Past my initial starting days (of losing) as a trader I shared earlier, I began to study the market and develop computer models using my background in statistics and experimental design.  In Part III, I will try to cover a bit about how I became a systems developer.

My mother passed in January of 1991 and left me about $100k.  She had
done well through the 80s investing in blue chip stocks and I knew of
her success.  Actually, noboby  in the family imagined she had amassed
a hidden fortune of about $650k even though we all knew she invested
in stocks while working at the phone company job she couldn’t stand to
be in.

When my grandfather passed in the mid 70s, he left me 500 bucks, which
my mother helped me to invest.  A number of shares of AT&T that began
to grow on her advice. I thought she had taught me something over the
years, so I could not begin to imagine that, when I told her, on her
deathbed, that I would do well with my inheritance, I did not have a
clue what I was talking about ;-).

I proudly opened a brokerage account with my new found fortune and
prepared to make it big!  Trading on full margin, using the infallible
principles of William O’Neil and his recommended 7% stops, I quickly
took that $100k down to around $30k.  Needless to say, I was
demoralized and also felt I had betrayed my own mother in my failure
(all this happened over only a few months time).  I felt bamboozeled!

I had two choices. One, I could fold and go back to my miserable life
licking my wounds, or, I could grab my own bootstraps and figure out
what on earth had just happened to me.  I grabbed my bootstraps, yes,
but I could not have ever imagined the incredible road it would take
me on.  An unforgettable journey of unconventional living…..

The first step in realizing you need to fix something, is in the
realization that you are the problem….

In my next post I will cover some of my background and how different
trading approaches have different statistics that impact your
personality and your ability to trade.

Serious traders have rules they ‘follow”. I too have a set of rules… somewhere. Once you’ve made a few hundred mistakes and a few dollars you start to follow rules automaticaly. A good rule to have for trading rules is not to have too many rules because then it is hard to break them if you only have a few and you don’t beat yourself up (as bad).

Here is a list of my favorite rules-

- Don’t lose money

- Trade only in the direction of G-Lines

- Use stops (with discretion)

- Set weekly goal (10 points for me)

- Be patient (but dont miss a move!)

- Accept a loss and move on

What is your favorite set of rules? Leave us a comment below