The 22 Rules of Trading

A set of trading rules

Today, the market was heading lower as it has done for the balance of the week. Then, at 13:00, everything started to move up. I checked the news sources and could find nothing that explained it. I emailed a friend and got this answer:

Technician would say, buyers appeared at the previous low below 8000. Successful test. Didn't fall apart so they bought it.

I guess I should watch the DOW (or ETF DIA). I've just watched SPY and QQQQ. It didn't occur to me that the entire market could move off resistance to a DOW level. And look at how sweet it is that it hit RSI 30 at the low. Just perfect for an oversold rally to start.

I came across the book Quantitative Trading: How to Build Your Own Algorithmic Trading Business on quantitative trading at Barnes and Noble tonight. It looks interesting but I have enough of a backlog that I would not get around to it soon. However, he also has an interesting weblog that covers some of the same interesting material as in his book. I'll add that to my list of blogs to follow.

The business of algorithmic trading was an activity once reserved for only traders at hedge funds or the proprietary trading operations of financial institutions. Not so anymore says author Ernie Chan, a proprietary trader and blogger who runs a quantitative trading blog site. In Quantitative Trading, Chan shows investors how to use Excel and MATLAB(r) to build their own algorithmic trading tools using a budget even a home day trader can afford. He then reveals how to conduct quantitative research and analysis, and discusses what it takes to turn quantitative trading strategies into profits using stocks, ETFs, and other financial instruments. Chan also provides downloadable spreadsheets and MATLAB programs that tie into material covered throughout this book.

Wow. All you had to do with GM for the past couple of months was to short at the open and cover at the close. You'd have made 30% in September, 208% in October, and 33% so far in November. And GM is down from $5.00 at the open to $4.22 today. That's an extra 15%. If you didn't wait for the close, you'd be up 53% this month. On one trade per day.

Of course, you'd have to have really believed in this trade to have carried it out for all of September. There was a 25% drawdown until the 19th of September followed by +69% until the end of the month.

[Excel: Short GM]

[GM short equity line]

Support and Resistance: The Greatest Trading Tool

A good article on trading in general and on support and resistance specifically.

Despite all the hype from the internet marketers who try to sell you the latest trading 'secrets', the fact is there are NO secrets.

• Identify setups which provide the potential for lower risk and/or higher probability trades.
• Enter and manage those trades in a consistent and disciplined manner.
• Minimize risk.
• Manage your money.
• Manage your emotions.
• Journal your results, and review them to identify what's working and what's not working.
• Keep doing what is working, and
• Improve what is not working.

If you're not trading successfully, it's because you're not doing one (or perhaps all) of these things.

ShortStories

A website dedicated to short selling.

Here is Jim Cramer, pumping a bunch of tech stocks on 2000-02-29, just weeks before the NASDAQ topped. Here is a quote to take you back to those days:

It is no secret that the Dow, made up principally of companies that can't raise the bar, is down 12% while the Nasdaq, which is made up of companies that can raise the bar, is up 12%. And in the self-fulfilling jungle that is Wall Street, only growth can maintain growth!

So where are they now? Three still trade on the NASDAQ, two are on the pink sheets, and five don't trade with these symbols -- probably out of business. ARBA trades for about 1% of its bubble-high of $1500, INSP is at 0.5% of its high of over $1500, and VRSN trades for about 10% of its high of $300.

What about the Old Economy stocks he singles out to diss? Freeport-McMoRan acquired Phelps Dodge in 2007 for $25.9 billion in cash and stock, so I'm just going to guess that that's a positive return. Just by eyeballing the other charts, I'd say that these are the returns over the same period:

• MRK -50%
• PFE -75%
• X +150%
• UNP +200%

On balance, I think you'd have to be ahead with the Old Economy picks that Cramer sneered at.

So I thought, "Wow, the Nasdaq 100 traded a huge range today." I looked at the stats for the past two years and realized that every day in October, the trading range (high to low as a percentage of the low) has been one of the top 25 values in that period. In fact, every value is in the top 20. If you look at the trading volume for that time, 8 of the 12 trading days in October rank in the top 25. It's amazing how volatile the market is compared to its historical averages.

Excel spreadsheet of QQQQ range and volume

Update 2008-11-01: I updated the spreadsheet to include all of the data in October. Of the 25 days in the past two years with the widest trading range, 19 were in October. The first of October was ranked 117th and the thirtieth of October was ranked 47th, but no other day in October was outside the top 30 days in the past 516 trading days.

Better Than Buy-And-Hold

Buy-and-hold is not only the riskiest possible strategy, it doesn't even qualify to be called a strategy. Buy-and-hold is actually the absence of any intelligent exit strategy and is mostly adopted by default. Buy-and-hold is only recommended by unknowing pundits who are out of touch with the modern marketplace and are willing to advise their followers that taking unlimited risk and being in the market 100% of the time is a good idea. Obviously, that mistaken advice has proved to be very costly.

[...]

Here are three suggestions on how to implement an effective trailing exit strategy:

• Identify the direction of the current trend. If the trend is up you will want to set the trailing exit a safe distance away from prices so that you do not exit while the stock is trending up. You want to let profits run. If the trend is down, set the exit closer to prices to cut losses and preserve capital.
• Keep an eye on volatility and adjust the exits farther away if volatility increases and then move them closer if volatility decreases. The exits need to be kept outside of normal up-and-down price action that changes with volatility. Volatility is presently at record levels so give the upward trending stocks plenty of room.
• Before you exit, make sure you have a plan to re-enter the stock if the uptrend resumes. The trailing exit provides a very valuable yet inexpensive form of loss insurance. The price of that insurance is that your exit may occasionally get you out at a point where the stock stops going down and turns up. Rather than miss the uptrend and blame the protective exit for the lost opportunity, simply buy the shares back. Worst case, you will have paid a small price for protection from a possibly catastrophic loss. Your exit did its job.

One of the technical indicators I track is the percentage of NYSE stocks trading above their 50-day moving average. Usually, when this indicator hits 10-15%, it's the bottom of the bear rally, and usually the top is at 75-80%. Currently, this indicator has been holding steady at 1% for the past two days, the lowest number I've ever seen. And yet, I don't see a reason to believe we've seen the bottom yet.