This Week’s Battle Plan

July 21, 2002
Larry Connors

Don’t Bet Against The
Guy With The Knife

When a lamb is
on the way to the slaughter, he may kill the butcher. But we always
bet on the butcher.

-A senior casino executive explaining why his business model is so
successful

This week the lamb won. He slaughtered the butcher. Statistically, it
was a long shot. A very long shot. But it occurred. To put this into
perspective, there have been approximately 1500 two-week periods since
the crash of 1987 (each week is counted twice). These past two weeks
were the worst two weeks of that sample size. I call it the
"bad tail" for those who are on the wrong side of it (like
me). And the "good tail" for those who are on the correct
side of it. The once-in-1500 times when the extreme occurs. The
once-in-1500 times where if you are wrong, you better have proper
money management in place. Or you will be slaughtered by a lamb that
got its hands on a machine gun.

The Drawdown

When I look at my trading, the number-one complaint I have about it is
that I am not a pig. I trade markets that are statistically overbought
and oversold and I take the other side. I have the option of trading
many different styles, but in my opinion this one gives me the very
biggest edge. I know the other reversal traders on the site, like
Kevin and Don, would agree with me. And, I’m usually more right than
I’m wrong. But, my number-one complaint is that my position size is
never big enough. When a bunch of winning trades occur (some very
big), I’m usually bitching and complaining to myself that my position
size was not aggressive enough. But not this week. Not when the
lamb killed the butcher. Then, I’m ecstatic about my position size.
Because the drawdown is not too bad. It’s never fun to live through a
drawdown, to go on a losing streak. But, every trader does. And anyone
who tells you otherwise…well, I’ll be kind and simply call them
delusional.

The Big Three

As I’ve said over and over again, trading is a three-part game. Strategy,
money management and discipline. All three are important. But all
three must be in full synch. Otherwise your returns will never be
maximized. And these past two weeks, when the bad tail reared it’s
head, money management became even more important. Especially until
the markets go back to a more normal state. A state where oversold
eventually goes to overbought and vice versa. A state where the
butcher again, is consistently slaughtering the lamb. Statistically,
that return to a normal state, will likely happen very, very soon.

The House

Now, let’s go back and live in the
world of edges. Let’s live in the world of edges where two of the more
successful industries live in, the insurance companies and the
casinos. Both make a lot of money. The casinos live through the
occasional "whale" coming into town and going on a run. They
factor this into their projections and their business model. So does
the insurance industry. Yes, bad events happen and they too get hit by
the bad tail, but again, it’s usually factored in (that’s one of the
reasons Warren Buffet is so wealthy. Supposedly his companies throw
off about $100 million a week in free cash flow. A chunk of
this $100 million comes from his insurance holdings). And if we are
going to look at the markets this way, we tell ourselves that
400-point down days are not the norm. Another 20 of them gets us to
zero and we can start over…something that is not going to happen!

But we need to be more serious than this. We have to ask ourselves
"What is the historical norm, after a market sell-off as we’ve
seen the past four months, the past six weeks, the past two weeks and
the past one day?" And they all add to one thing. The odds state
we will likely move higher near-term. Likely significantly higher.
This does not mean that the bear market will be over or that the Dow
will rise 1000 points in a week. It means that the odds favor a
significant move to the upside and the risk of being long here is
lower than the risk of being short. The odds are that the world will
start moving back to the norm. That the lamb will again be
slaughtered by the butcher.

So What’s The
Next Step?

Well, if you buy into the above argument, you begin with money
management. You ask yourself what are you willing to risk. How much
money will you put into any one position and what will you do if the
bad tail hits gain. From there you have your framework.

But, if you want to get more aggressive, you would normally go to the
semiconductor HOLDRs
(
SMH |
Quote |
Chart |
News |
PowerRating). What makes them even more interesting
this time is the recent strength they have shown. The semis lead,
not follow. They always have and they likely always will. Incredibly,
they closed higher on Friday than they did eight trading days ago.
During these eight days the Dow has lost over 1000 points. And the
semis have risen. What does that tell us? It tells us that if a rally
occurs, they will again likely lead. And this leadership may be
substantial.

For you futures traders, the e-minis are the obvious place. But let me
give you one not-so-obvious place (and with less risk). Bonds. The
30-year
(
USU2 |
Quote |
Chart |
News |
PowerRating)and the 10-year
(
TYU2 |
Quote |
Chart |
News |
PowerRating). On the short side.
Look at the inverse relationship that has occurred over the past few
weeks. The move in bonds has not been caused by economic factors. It’s
been caused by a flight to safety. And history has proven that a
flight to safety is usually a very poor bet in the long run. If
the market rallies, bond prices will fall quickly and sharply. The
upside risk is far less than the downside reward.

Connors Hedges

If we attack Iraq, all bets are off. The bad tail will again occur,
and maybe worse. This is why position size and stops are essential.
The market has been behaving far worse than it should be based upon
accounting scandals. It very well maybe predicting this attack. The
oil markets are pointing to this is a small way, but the dollar is
not. We’ll see. But, either way, money management is the key here,
should it occur.

Conclusion

The trend is down. Period. It always is
at extreme bottoms. And the market may very well go down further.
Crashes happen and meltdowns do occur. That is why you always use
protective stops. But at these levels the odds favor a very, very good
bounce. The odds again favor the butcher slaughtering the lamb. And
like the casinos, I always try to bet on the butcher.

Have a great week trading (and
remember, none of this matters unless you use protective stops)!

Larry
Connors
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.

This Week’s Battle Plan

BUY THE FEAR, SELL THE GREED

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