A Discounted View

Nicolas Darvas was a professional dancer turned stock market speculator. He happened to stumble upon investing when one of his employers opted to pay him in stock instead of cash. As it turns out, Darvas could not make this particular show but in a gesture of professionalism offered to buy the shares from the venue owners. This decision ultimately changed the course of his life and led him to write his well-known book “How I Made $2 Million in the Stock Market.” Despite the trite title, the experiences shared by Darvas are invaluable to an aspiring trader . Moreover, William O’Neill of Investor’s Business Daily and Market Wizards fame built his proprietary CANSLIM process mirroring most of the Darvas principles. While still effective and useful today, the principles conveyed in this book are well-known and shared openly online. Instead of touching on those aspects of the book, it will be valuable to examine the emotions experienced  by Darvas in his trading journey. In par...

During a market downturn the VIX is a commonly referenced indicator. The value of the VIX is derived from the price of out-of-the-money S&P 500 (SPX) put options and will increase as SPX declines. Given this behavior in the VIX, it can be used as a valuable trading tool  on its own and in combination with other indexes or indicators . For example, one of the most common strategies  is buying put options on the SPX when prices begin to top or decline. In other words, the VIX can be used for a simple equity market hedging strategy . This buying of SPX put options will cause the implied volatility to rise, resulting in higher premiums for the options. Since the VIX measures implied volatility of SPX index options, it will move inversely with the SPX. That is, as prices fall there is more put option buying which results in higher VIX levels. Not only does VIX increase as SPX declines, but it also has a tendency to increase more quickly the faster and farther the S...

Bubbles are a naturally occurring phenomenon in financial markets. However, while academics and subscribers to the Efficient Market Hypothesis will argue that a market inefficiency, such as a bubble, could not exist, practitioners  see differently. After all, anyone with money at risk  in their own account or for clients will say that the market did not behave rationally during the recent credit bubble in 2007-2008 or the Dot-com bubble in 1999-2000. Bubbles have existed for centuries with the most infamous dating back to Tulipmania in the 1600’s in Holland. Human nature and our inherent behavioral biases  fuel the rapid rise in asset prices that accompanies a bubble’s expansion phase. This unsustainable growth in investment leads to an eventual dramatic decline that happens nearly as fast the popping of a balloon. While the peak and end of a bubble are easily identifiable in hindsight, the stages of a bubble can be further classified into five chronologi...

No matter how hard you try to fight it, trading will test your emotional stability. It simply cannot be avoided. We as human beings are wired with an emotional, reptilian brain that will over-rule our rational and probabilistic thinking especially when dealing with money. Moreover, Alexander Elder  states “Thinking about money interferes with decision making” (The New Trading for a Living). New traders look at open profits and think about the ways they can spend the money they just made in the market. Elder continues by saying “ Professionals focus on managing trades ; they count money only after trades are closed.” In other words, professionals focus on process not outcome .  Additionally, when a novice trader is experiencing a large drawdown or a series of losses he or she is more inclined to hold losing positions below initial stops with the hope that the prices will recover. The inability to sell a losing position stems from our emotional brain. For example, emoti...

In his book, Trading Systems and Methods, Perry Kaufman provides some simple, non-mathematical rules that all traders should employ when running a trading program. While there is a purpose and time for using statistics and more advanced mathematical concepts to manage risk, these guidelines will help keep your trading on the path to profitability.   Only risk a small amount of total capital on any one trade . This suggestion echoes the teaching of Dr. Alexander Elder who popularized the 2% Rule . Simply put, when trading you should never exceed a particular amount of risk in any one position that could compromise your performance. In the futures industry, risk-based position sizing algorithms  are commonly used to determine the ideal position size or Optimal f. Know your exit conditions in advance . Kaufman states that “There should be a clear exit criterion for every trade, even if the exact loss cannot be known in advance.” I...

In The New Trading for a Living , Dr. Alexander Elder suggests two methods for controlling risk. Previously I wrote about how the 2% Rule  will mitigate risk when building a position. Elder’s other risk guideline, the 6% Rule, can be used to minimize risk at the portfolio level. Just as the 2% Rule puts solid risk management in place at the position level, the 6% Rule provides a useful risk constraint for the entire portfolio. Specifically, the 6% Rule restricts traders from allowing total outstanding risk of all positions to exceed 6% of the portfolio value as of prior month-end. The 6% Rule protects your account from incurring a series of small losses that amount to one large, meaningful loss. For example, a 1% loss may seem innocuous however once a series of five or more of these accumulate in your account in one month the losses will begin to be felt both financially and psychologically. To an extent, the 6% Rule works against human nature. That is, as traders begin to...

Executing sound risk management principles in your trading is essential to having any chance of investment survival. If one position is sized too large and generates an enormous loss, this can be catastrophic to your account as well as your psychology as a trader. Fortunately, there are methods you can learn that will protect your account. In The New Trading for a Living , Dr. Alexander Elder proposes a method for controlling risk at the position level which he calls the 2% Rule. This guideline states that the total risk in any position cannot exceed 2% of the current month-end account value. For example, if you have $100,000 in your account at the end of the previous month, the 2% Rule limits your maximum risk on any trade to $2,000. That is, risk is defined as the dollar value of the difference between your purchase price and stop loss and cannot exceed 2% of the account value under this rule. Be sure to not confuse 2% with the total position size. While 2% may seem sm...

Despite the title of this post, the curious development of animal anatomy will not be the topic of discussion. Instead, readers will have an opportunity to observe a potential reversal move underway in equity markets and crude oil delineated by this distinctive price action. No trend can last indefinitely and being able to spot signs of a reversal will help a trader better manage a position. One such method is identification of price action through what Dr. Alexander Elder describes as Kangaroo Tails. This sort of price behavior has a unique pattern. Elder states, “A Kangaroo Tail consists of a single, very tall bar, flanked by two regular bars, that protrudes from a tight weave of prices” (How to Trade for a Living, 65). Kangaroo tails that close down indicate a potential market top whereas when it closes up a possible reversal higher is developing. As with most patterns, price action on a long term basis usually carries more weight as it represents a general shift in the market ...