This FAQ is a collection of information about trading stocks. It is concepts and truisms. These things work some of the time. Hopefully, most of the time... Am leaving white background to make printing easy. I print/save it as a handy reminder of things I learn and forget and have to relearn the hard way.
The following is stolen verbatim from Don Worden who writes commentaries that come with their data feed. If you want prices/charts, there is no better data provider and it comes with free charting software that is very nice. I recommend it highly.
...I do not agree with his rationale for why it works. He uses the VIX as a contrary indicator, which it is, and it works. He believes that the VIX is a sentiment indicator, which I disagree with. In fact, it is not even a volatility indicator. Actually, it is a measure of whether the OEX options are selling above or below their fair values (as generally estimated by the Black-Scholes formula). The formula embodies three elements: 1) prevailing interest rates 2) time to expiration 3) implied volatility as measured by dividing the current price by the 12-month high minus low (along with the price and strike price, of course). This produces a specific answer that we call the estimated fair value. In real life the option may at any time be selling above or below the estimated fair value. These variations are generally blamed on embodying excessively high or low volatility in the formula, although it would be just as easy to say for some reason the formula embodies an exaggerated interest rate level or an incorrect time to expiration. When the time premium goes up, the jargon on the street says the implied volatility is up. Which isn't true. The volatility is what it is. But a different number is put into the formula. When the VIX goes up, it is not a sign that market volatility is up. It is a sign that options are selling at higher premiums. Empirically, we can see that the premiums on OEX options go up when the market goes down. And vice versa. However, it is not obvious to me why this happens. Higher priced options don't tell me anything about fear. Lower priced options don't tell me anything about greed. However, whatever the underlying reasons, the VIX is a contrary indicator...
A reversal day is one of the more reliable patterns you can trade. It has several components and you want to be sure they are proper. It calls a bottom and requires:
- new low for the current cycle
- large spread in the day's prices
- much better volume
- close is close to the day's high
This provides a logical entry point and an easy to figure (1/4 to 1/8 below previous low) stop. Look for a 50% measured move from the cycle as a good possibility. It can be more if the stock is lightly damaged.
These are bear funds. The two mentioned are 2x rated against their index. That means a 5% decline in the index will net you about a 10% profit. This is the only way I short. Shorting is a different science and one that I'm uncomfortable with. Using these funds you never have to worry about getting the stock called back. You also limit your exposure to the downside. You can't lose more than you've invested. As a negative it usually takes a couple of days on both sides to change the trade. So, the timing can hurt a bit when you see it time to move. Other bearish funds are: AMCOX BMNIX DRCVX MNGLX BEARX RYAIX VFINX
My view on trading accounts is different from common views. My trading account is my IRA. Many would want to put this into conservative core holding that are designed for long term appreciation and trade their regular account. This is backwards as I see it. Your IRA is not impacted or taxed on short term gains. It all stays in the account. Your regular account can be set up with long term holding that garner capital gains.
If I were young, I would put every penny I could in a Roth IRA. A good trader can make hay and lots of money with one and end up with a huge gain that is never taxed.
Don't chase a stock that's more than 5%-10% above its base. To do so increases the risk that you'll get shaken out with a loss if it pulls back to the top of its base in normal fashion.
The longest bull market in history has turned us into successful traders. Don't mistake bull market strength for trading prowess. I have traded seriously for over two years. I try to grade my trading activity and my best to date is a C+. That would have taken me out under any circumstances other than the market's performance over that time.
Managing your capital is the number one necessity. Each person has to come up with their own standards--something they are comfortable with that preserves one's capital. We must live to fight another day. Our goal is to make money; money management's standards control our losses.
Protecting Profits
A great rule of thumb is: After you are ten-percent ahead, don't ever give back more than two-thirds of your profit. After you are twenty-percent ahead, don't give back more than half your profit. After you are Fifty-percent ahead, don't give back more than a third of your profit.
When reviewing a stock that has run you notice that the market is weak and support is x% below the current price: The safe action is to reduce your holding by x% times 2. e.g. expect 20% decline; sell 40% of position.
I use very few actual stops. But, I am online throughout most trading days. The stocks I trade tend toward the volatile and interday activity can make tight stops remove me from a trade where I'd have a nice profit continuation at the close. The pros can trade stops at the close. That avoids the daily fluctuations in volatile stocks. We don't currently have such capability.
I don't have a perfect answer here. If you trade a strict program of limiting losses and gains like Gary Smith, you have easy to follow stops. If you are wanting to ride a trend, as I do, you don't want to get taken out on the pullbacks that always happen.
My "mental stops" try to make me admit when I have a sour trade coming on. It hurts emotionally to have to admit you blew it. But, invariably, the first loss is the cheapest loss. That is the mental stop you cannot avoid and still be a successful trader. Those stops are hard to maintain over an extended period. You can't fall in love with a stock and consistently make money. Bull markets let us gloss over and rationalize our bad habits.
If we don't have the right mental or actual stops, we will be severely punish. It isn't a matter of if but when!
Ok, you bought it and it is down big. The question we always seem to ask ourselves is: "Will it come back?" while we should be asking ourselves: "Is there a better place for my money?" You can see such answers don't have anything to do with our history on the stock. There's an old trader's saying to the effect that stock prices have no memory. Because a stock traded at a price is no reason to ever expect it to trade at that price again!
So, review your stocks constantly and don't base it on your current profit or loss. A stock that is up big is in the same category as one that is down big. You can only see today and evaluate based on today's chart.
Bear Markets
A bear market is simply a loss of confidence. A trader can build his own bear market--totally separate from index action. We need to address both types and differentiate.
William O'Neil has a method of finding bottoms that works 80% of the time.
- After at least two days of recovery
- Close up 1% or more for the day
- Close on greater volume than previous day
He refers to this as a "Follow-through Day" where 20% failures he attributes to institutional activity or techs overstating the Nasdaq that then fails on high volume selloffs.
Going Short
Going short for me is simple; I don't. The bulk of my trading is an IRA and those can't be shorted.
Shorting is a professional's play and I'm not one. Every trader needs to recognize his limitations and going short is one that I recognize. Shorting is difficult under the best of circumstances and far more dangerous.
That said, there are circumstances where you want to hedge. I hedge using URPIX and USPIX which are 2x weight shorts against the S&P and N100 respectively. It is an easy hedge to pull off and I use it when I'm very nervous about the market and see the potential for a strong pullback.
Others successfully short sector baskets or limit shorts to the the more popular QQQ and HHH. This is market timing to a degree I am not comfortable with for my personal trading.
The best "short" is to reduce your long positions. It keeps you in with a potential for long profits while giving you the opportunity to protect profits and use the cash raised to buy the pullbacks.
Beige Book
Report that summarizes anecdotal information collected by the District Federal Reserve Banks from key businessmen, economists, market experts and other sources. Used at the meetings of the Federal Open Market Committee (the Fed's monetary policymaking arm).
Source: One of the 12 District Federal Reserve Banks, on a rotating basis.
Frequency: Eight times a year
Two Wednesdays before every FOMC meeting at 2 p.m. Eastern.
Market importance: Some. Used in conjunction with recent economic indicators to gauge the strength of economy. Occasionally moves markets, but the Beige Book is not a commentary on the views of Fed members.
Consumer Price Index
An index (1982-84 = 100) that measures the change in cost of a representative basket of goods and services such as food, energy, housing, clothing, transportation, medical care, entertainment and education.
Source: Labor Department
Frequency: Monthly
Around the 15th of the month at 8:30 Eastern. Data for prior month.
Market importance: High. Timely. All inflation measures routinely move markets.
Other notes: (a) The "core" CPI excludes the often-volatile food and energy sectors and gives a clearer picture of the underlying inflation trend. (b) The CPI for medical care is used to help predict the benefit costs portion of the employment cost index. The CPI for gasoline is used to predict the gasoline stations portion of the retail sales report. The CPI for new vehicles is used to predict the vehicle portions of the retail sales and personal income and consumption reports. (c) The headline number is the percent change from the prior month, but we also graph the year-on-year change. That way you can see the rate at which consumer inflation is increasing or decreasing.
Employment Cost Index
An index (1989 = 100) designed to measure the change in the cost of labor, free from the influence of employment shifts among occupations and industries, based on the changes in two things: Wages and salaries, and employer costs for employee benefits.
Source: Labor Department
Frequency: Quarterly
Last business day of January, April, July and October at 8:30 a.m. Eastern. Data for prior quarter.
Market importance: High. Timely. Almost always moves markets. Generally considered the most important leading inflation indicator available.
Other notes:
The headline number is the percent change from the prior month,
but we also graph the year-on-year change. That way you can see
the rate at which employment costs are ncreasing
or decreasing.
Employment Report
Official name: Employment Situation
A measure of net new jobs created. Also measures the unemployment rate, average hourly earnings and the length of the average workweek.
Source: Labor Department
Frequency: Monthly
First Friday of the month at 8:30 a.m. Eastern. Data for prior month.
Market importance: High. Almost always moves markets. Very timely. Contains information about both job and wage growth and is considered the single best measure of the health of the economy. The tone of the employment report generally sets the tone for the other economic indicators that are released throughout the month.
Other notes:
(a) To key pieces of this report -- the unemployment rate and
average hourly earnings -- appear in many inflation models. And
various pieces of this report are used to help predict a host
of other economic indicators. Average hourly earnings are used
to help predict both personal income and the wages and salariescomponent
of the Employment Cost Index. The index of aggregate manufacturing
hours is used to help predict industrial production. The change
in construction jobs is used to help predict both housing starts
and construction spending. (b) For average hourly earnings, the
headline number is the percent change from the prior month, but
we also graph the year-on-year change. That way you can see the
rate at which earnings are increasing or decreasing.
Gross Domestic Product
A measure in the change in the market value of goods, services and structures produced in the economy.
Source: Commerce Department
Frequency: Quarterly
Released at 8:30 a.m. Eastern. The first-pass estimate of GDP is called the advance report and is released on the last business day of January, April, July, and October (data for prior quarter). The second-pass estimate is called the preliminary report and is released a month later; the third-pass estimate is called the final report and is released yet another month later.
Market importance: High. The actual pace at which the economy is growing or shrinking -- especially as it relates to expectations -- frequently moves markets.
Other notes: (a) The GDP release also includes a key inflation measure called the price index for gross domestic purchases. It measures the prices of everything -- including imports -- that Americans buy. (b) Personal consumption expenditures typically account for roughly 68% of GDP. Investment, government spending and net exports account for the rest.
Productivity and Unit Labor Costs
Official name: Productivity and Costs
A measure of the changes in productivity (output per hour of all persons) and unit labor costs (labor costs per unit of output).
Source: Labor Department
Frequency: Quarterly
Sometime during first two weeks of February, May, August and November at 10 a.m. Eastern (with a revision a month later). Data for prior quarter.
Market importance: Some. Sometimes moves market. Players typically cheer increased productivity and slower unit labor costs (because they have kind inflationary implications) and book the opposite (because they have unkind ones).
Other notes:
The headline numbers are the annualized percent changes from the
prior quarter, but we also graph the year-on-year changes. That
way you can see the rate at which productivity and unit labor
costs are increasing or decreasing.