This Week’s Battle Plan
Your Money Manager At
Work
From the front page of last Sunday’s New York Times:
                          Â
Portfolios Depressed, Traders Seek Therapy
“….I had a client who grew anxious every time he had to sell
a holding. He kept saying ‘I can’t let go,'” said Richard
Geist, president of the Institute of Psychology and Investing. Dr
Geist also teaches at the Harvard Medical School and is both a
psychotherapist and a financial advisor. “I asked him what
that reminded him of,” Dr. Geist said. “He told me he
remembered as a child that he had trouble letting go of his mother
when it was time to go to school.”
John Ruskin-The Crown
of Wild Olive
The great justification of this game is that it is truly when well
played, determines who is the best man; who is the highest bred, the
most fearless, the coolest of nerve, the swiftest of eye and hand. You
cannot test these qualities wholly, unless there is a clear
possibility of the struggle ending in death. It is only in the
fronting of that condition that the full trial of the man, soul and
body, comes out. Whatever is rotten and evil in him will weaken his
hand.
John Ruskin wrote these words more than 120 years ago. He was talking
about war. But he might as well have been talking about Wall Street.
For all that is evil and rotten has been exposed. Bear markets do
that…just as war does. Bear markets expose weaknesses in all
businesses and in all investment styles. Buy and hold…exposed.
Not using stops…exposed. Investing on analyst’s
recommendations… exposed. Cheating through
accounting…exposed. One-way momentum investing…exposed. I can
go on and on. But, if you are still in the game today, and especially
if you are as successful today as you were a few years back, you have
survived. In Ruskin’s terms, you are “the best man” (woman).
You are the most fearless, the coolest of nerve, the swiftest of eye
and hand. Whereas the rest of the world has been stripped bare by this
sell-off, you are still successfully playing this game. You may not
have a trading methodology that trades perfectly (no one does), but
you do have something that is superior to 99.99% of the people out
there who are in this game. And that includes thousands upon thousands
of money managers. Especially the ones who have have the honor of
being in the 50-50 Club. You ask what that is? That’s a money
manager who is down 50% from July 2000-June 2001 and another 50% from
July 2001-June 2002 (incredibly, there is an abundance of these
clowns). You have survived and possibly prospered during what is, in
my opinion, one of the worst markets since World War II. (And by the
way, it probably doesn’t get any tougher than this). Congratulate
yourself. For Ruskin would.
Now let’s move on to our continuing series of lessons.
This Week’s Lesson: Adjusting To Volatilty
One of the reasons so many individuals become unnerved during market
declines is that market declines are usually accompanied by increased
volatility. Let’s discuss what this means:
If, for example, a stock you trade normally trades within a two-point
daily range, a doubling of volatility will mean that its daily range
will increase to four points. That is what we have seen over the past
two weeks. The average stock in the S&P 500 has nearly doubled in
volatility over the past few weeks. This means a lot. This means that
if you are trading using a fixed-point stop (lets say 75 cents/trade),
you are getting stopped out at a far higher rate than you were a
few weeks ago (sound familiar?) If you are placing your stops at
the high or low of some bar, your stops (risk) are far bigger today
than they were a few weeks ago. The same goes if you are looking at
intraday swing lows and highs. Again, your stops are far bigger than
they were a few weeks ago, meaning your risk (and losses) are greater.
What does this further mean? A few things. First, psychologically it’s
far more stressful. You are either getting stopped out more, or you
are taking larger-than-normal losses (unless you’ve halved your
position size). It also means that your thought process is likely
being affected. It has to be. Increased volatility means increased
anxiety. If you doubt this, go day-trade a REIT for a few days and
then trade KLAC (anyone who tells you it’s the same is on a steady
diet of Prozac or whatever they give people to deaden reality).
So, how do you deal with this until things go back to normal? (and
they will, likely very soon). The easiest way is to reduce position
size until you see volatility dropping. This means that if you
normally trade 1000 shares, you lower your size to 500 shares. This
halves your risk and gets you back to where you were earlier in the
year. And how can you tell when volatility is back to normal? There’s
a couple of ways. First, look at the VIX reading. Even though this is
not perfect, you can still gauge the expected volatility for the near
future. It’s now near 40. Normal for the time being is 20-25. The
other way to gauge volatility is with a short-term historical
volatility filter (most charting packages have this). Look at the
10-day reading. A reading of between 18-23% is somewhat normal for
this time. In the future, look at the 100-day reading as what is
normal and when the 10-day shoots well above it, it’s likely time to
lessen your position size (if you need help on this, please e-mail
me).
Again, it’s easy to feel a bit un-glued from these past few weeks.
But, this is what a sharp decline brings, and future sharp declines
will bring the same. The key is to adapt your position size and
understand how and when to adjust. We earlier talked about weaknesses
being exposed in bear markets, and increased volatility during these
times exposes weaknesses in stop placement, position size and trade
management. It’s easy to adjust and correct with the correct tools.
Again, e-mail me if you need further clarification on this.
This Week
You don’t need me to tell you we are oversold. But, this is a
condition that has been going on for a few months and getting more
oversold. What is interesting is that there have been some good
opportunities to make money on the long side. They’ve come via 1-2 day
outsized rallies (see May 8, June 14 and July 5, for example). But,
there has been no follow-through from these rallies. We are again very
oversold and it would not surprise me to see another sharp rally,
especially early- to mid-week.
On a bigger scale, this past week was the ninth worst week since
World War II. I looked at the week and month following the eight
worst weeks and found that the market rallied on six of the eight
occasions (the two losing times for the monthly moves were in 1987
after the meltdown) and a few times the rallies were large. Also, my
fear meter (the VIX) has only had two periods of higher weekly closes
since 1993. The first happened a few times in the fall of 1998. The
market rallied, retested and then rose nearly 20% over the next month.
The same holds for September of last year. The market then rallied
about 20% over the next month. None of this means we have to go
higher. Only that the likelihood of a larger-than-normal rally exists
sometime soon.
I’ll Be On TraderTalk This
Thursday
…to discuss all this, and more. I’ll be on from 4:30 PM EDT until
the last question is asked. If you can make it, you will find me here.
Summary
The past two years have been the great equalizer. Turn ’98-’99 upside
down and you have today. And if you’ve profited from both markets, you
are one hell of a trader. Whatever you’re doing, you’re doing
it very correctly. I suspect you are shorting as well as buying,
using stops on all your trades, not bouncing from one strategy to the
next, adjusting your position size to volatility, and essentially
doing the same thing over and over again. This is the key to your
success, and I congratulate you.
If you feel you need help on any of this, please e-mail me, or come to
this week’s TraderTalk.
Also, Dave Landry, and many of the other people on this site are here
to help you. If you need their e-mail address, they can be found at
the bottom of their columns.
Have a great week trading (and hope your 401(k) plan is not invested
with the guy who had trouble letting go of his mother when it was time
for him to go to school)!
font-family:Arial;color:blue”> and Brice Wightman
Larry Connors is
CEO and co-founder of TradingMarkets. He is also the author of four
books on trading, including “Street
Smarts,” co-written with Linda Raschke, “Connors
on Advanced Trading Strategies“, and “Trading
Connors VIX Reversals.” Larry also recently
released the video course ”Buy
The Fear, Sell The Greed: Timing The Market Every Day For The Rest Of
Your Life.â€
Brice
Wightman is a Market Analyst at TradingMarkets.com.