By Jeff Miller :
Each week, the Stock Exchange highlights the results from different technical trading methods. We also provide contrast, and often dissent, from a fundamental analyst. Usually we get to celebrate winners and consider new picks. This week a couple of our participants need to face the music, discussing a losing choice.
Our last Stock Exchange highlighted healthcare and biotech. The sector was OK after a mid-week dip. Some of the specific names did not fare well. Even worse, two weeks ago, Road Runner picked [[RH]]. As I write this, the stock is down over 20% after hours. Earnings and revenues were fine, but the announced outlook was terrible.
It is time for a frank discussion.
This Week - What About Losing Trades?
The two examples of losses are both interesting, but our team's approach differs. For the key lesson, we turn to trading expert (and trading coach) Dr. Brett Steenbarger.
Brett has a great discussion in this post from 2014, The Psychology of Stop Loss Levels . He explains the value of a well-chosen stop. He notes that a trade involves both a direction and a path.
Being stopped out means that you were wrong about the anticipated price path. It doesn't necessarily mean that your underlying idea was wrong. The loss can be a prod to help you better manage price paths, and it can also be a prod to take a fresh look at your idea. In both cases, the loss can help make you better.
This is a first-rate article, with both pluses and minuses about stops. Too many traders view stops as some magical method that generates only winners. They set stops too tightly, and instead miss out on winners.
It is crucial to right-size positions, knowing how much risk to take. Brett writes :
It's not uncommon for small traders to have big dreams and take positions that are unusually large for the amounts of capital they're trading. Any trader can experience strings of losing trades merely by chance. When position sizes are too large, those strings of losers incur a risk of ruin. Once you're down 50%, it takes a doubling of remaining capital just to return to break even.
There is no answer that fits all situations. Many years ago, I offered some help, with discussion of the Kelly Criterion and some practical examples.
I'll comment further on this in the conclusion. Meanwhile, let's see what the team members have to say for themselves:
J : Oscar, what about the weakness in biotech?
O : This kind of fluctuation is completely normal. No one should be surprised.
J : What action did you take?
O : Just like I do at the track. I don't want my money on a loser, so I move on. Sometimes my pick is OK, but something else is more attractive.
J : How many sectors do you hold at a given time?
O : Three.
J : So the risk control comes from a limited amount of sector diversification as well as trading stops. It is like the first of Dr. Brett's methods.
O : I guess so. That is what I do.
J : Road Runner, what about that pick of RH?
RR : You said there was news after hours? I will evaluate the price tomorrow.
J : It appears that the company guidance was so bad, it will completely break your lower channel. How do you deal with such losses?
RR : It is a percentage game. I right-size each position. I know that most picks will win, and the wins will be larger than the losses. I trade about 5% on each pick.
J : So you are careful about "over betting your bankroll."
RR : I'm not sure what that means. A single loss - even a big one - hurts my performance, but I do not take excessive risk. There is some expression about "betting the farm" that strikes close to home. Even a loss like RH will not make me jump off a cliff or something.
J : The loss puts you behind Holmes in the yearly standings. You were leading before this (I can hear some enthusiastic barks in the background).
RR : I'll get back on top.
J : What do we have for this week?
Road Runner: I have once again discovered my favorite chart pattern NetEase ( NTES ). Here is the rising channel and the current position at the bottom:
RR : I suppose you will once again invoke Chuck Carnevale and F.A.S.T. Graphs .
J : Naturally. This time you have some support from the master instead of that silly coyote. It could be a good entry point for long-term investors, as well as a potential trade.
RR : I am delighted that Mr. Carnevale finally agrees with one of my excellent picks. Beep Beep!
Oscar: I have a new sector favorite: Utilities. You can readily see that the market has resumed the love affair with this sector.
J : Aren't you distracted by any sports streaks? How about the Cubs?
O : A short losing streak is not always meaningful.
J : Exactly. Neither is a winning streak. Let's take a look at NextEra Energy ( NEE ). It is the largest component of [[XLU]] at 10%.
J : Right. We do this because of erratic trading in the ETFs. There are plenty of choices. With a little work, you can find a collection of choices that has a near-perfect correlation. That said, our own choices have a F.A.S.T. graph that is very like that of NEE.
J : It might be affected by a Fed rate hike decision later this month.
O : What's a Fed? Do you mean the Nationals?
J : Get your mind out of the dugout. How about your updates on reader requests?
O : OK. Here is the current list.
J : Why no XLU?
O : I respond to reader requests. Our readers are not on that bandwagon.
Holmes: I love dips, followed by a period of basing. My most recent purchase, Credit Suisse ( CS ), is a good example. Let's review:
For this stock, it is helpful to look at a longer time period - beyond my normal holding period. Here you can see the rebound a few weeks ago from this same level. There are also prior examples.
J : Are you encouraged by the French election? Worried about the British vote?
H : I do not worry about elections or which humans are conducting one. The chart shows the dip and the potential. That is really all that you need to know.
Felix : I have nothing new this week.
J : I am not surprised. When we have a sideways market, you have few chances to spot momentum.
F : That is exactly right. You and Vince always tell us not to reach. We are just following orders.
J : We? I suppose you mean that Athena has nothing fresh either?
F : Right. She said to tell you that you will see her again when something is happening.
J : This is the longest vacation in company history. How about your weekly stock rankings? Still buy, hold, or sell, depending on the color?
F : Yes, and I welcome new questions. That is how the list is built.
Whatever trading method you use, you must analyze risk and anticipate losses. A record with no volatility is a sign of faked data.
Many traders err because they choose position sizes based upon what they want to gain rather than what they can afford to lose. Most of the failed traders in my experience - including many good ones - did so by getting too big.
There was a test of this idea where a group of subjects with PhDs were given a bankroll and invited to play blackjack. They were accurately informed that the game was rigged to give them a 5% edge. A few hours later, they were all broke. Even smart people underestimate the chance of a losing streak, even when the odds favor them.
Here is a summary of the cast of characters. Find your own favorite!
Stock Exchange Character Guide
Average Holding Period
Macro and stops
Dip-buying Mean reversion
Macro and stops
Stocks at bottom of rising range
One month or long term
Recession risk, financial stress, Macro
Background on the Stock Exchange
Each week, Felix and Oscar host a poker game for some of their friends. Since they are all traders, they love to discuss their best current ideas before the game starts. They like to call this their "Stock Exchange" ( Check it out for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am usually the only human present, and the only one using any fundamental analysis.
The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.
We have a (free) service for subscribers of our Felix/Oscar update list. You can suggest three favorite stocks and sectors. Sign up with email to "etf at newarc dot com." We keep a running list of all securities our readers recommend. The "favorite fifteen" are top ranking positions according to each respective model. Within that list, green is a "buy," yellow a "hold," and red a "sell." Suggestions and comments are welcome. Please remember that these are responses to reader requests, not necessarily stocks and sectors that we own. Sign up now to vote your favorite stock or sector onto the list!
See also FBI: Gun Stocks Set To Fly on seekingalpha.com