Fundamentals of Trading Methodology
In 1973 Professor Burton Malkiel published his book A Random Walk Down Wall Street. The book has been a key tool for the
proponents of Efficient Markets
Theory, which holds that since all available information is quickly factored into stock prices, all stocks present equal chances for gains. Therefore
trading has no chance of long term success unless you have access to information that is not available to everyone else. The professor theorized that "a blindfolded
monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts."
No monkeys were employed by the professor to test his idea but
rumors quickly spread that the test was actually performed and
the results proved his theory.
In 1998 the Wall Street Journal published the results of 100 consecutive contests to test this theory and the results showed that the professional investors beat
the random picks by a margin of 61 to 39. The performance test was for a period of six months in each contest. The greatest investors of that period did
While the test did show that you could beat average returns, the beat was not as large beat
as it should have been. The problem with such picking is that the longer you hold a
position, the more likely it will be that unknown events will change the outlook
for individual stocks. The more time you allow to pass without
making portfolio changes, the more randomized the returns on the
stock picks. A six month hold period is a long time for circumstances to change. Real
traders need to be more nimble than that.
We have met many traders who have started from humble beginnings in their trading and have made millions. They received the right training and have acquired a
good feel for the market.
Professor Lawrence Harris wrote a paper and later a book that makes the point that the stock market is a zero-sum game. Many people who think that they are smart
have agreed with him. The theory is completely flawed. In the crash of 1929 there were not enough winners to offset the losers. When the market open higher in the
morning than it closed the day before, then there are more winners (longs) then losers(shorts).
The great economist Milton Friedman said it correctly: "Most economic fallacies derive from the tendency to assume that there is a fixed pie, that one party can gain only
at the expense of another."
If you buy a stock for $20 and sell it for $30, and the person you sold it to then sells it himself for $40, then who is the loser? Both of you made $10/share. The stock
may never go down sufficiently for anyone to suffer a loss. Some Mutual Funds still own Cisco Systems with a cost basis of just 8.5 cents
from the first few years after it went public. Conversely, both parties in a transaction may be losers.
Making money in the market is not taught in the halls of universities but it is a mental skill that must be learned from those who have done it successfully, and then fought
on the mean streets of the financial district.
Salomon Brothers was a major Wall Street Investment Bank that ran into a bit of trouble over buying more than their allotment of US Treasury Bonds in 1991. They were fined
and the CEO was fired and banned from the financial industry. The new CEO decided to professionalize the company. Salomon Brothers had a lot of good traders, but many of
them were people with uncouth manners and without a college degree. The CEO fired them and replaced them with graduates of prestigious business and economics schools. Salomon
Brothers quickly collapsed. You can't learn trading from a fancy university. You need to learn it from someone who is successful
at trading (like MarketPirates.net).
Like any other market, the financial markets are governed by the laws of supply and demand. Prices move up when there are more buyers than sellers and move down when there are
more sellers than buyers.
There are two main schools of trading: The Fundamental School and the Technical Analysis School.
In the Fundamental School, you buy a security because it is cheap and sell it when it is expensive. A "value investor" is one who buys cheap securities. This school is the most widely
used and respected school of trading and investing. It relies on markets being inefficient, undervaluing a security for a time and then eventually correcting the mistake. As a value
investor you must wait some unknown period of time for the crowd to figure out the pricing error and buy your security to drive up the price. To do this you must be very skillful at
reading financial statements and understanding the challenges that your target company faces. Wall Street hires the best and the brightest to do this, but the success rate is not as
high as you might think. If the market loses 10% and a stock that you have researched and invested in only loses 6%, then you are a 4% winner on Wall Street and you will get a big bonus.
If the market goes up 5% and you are an oil analyst and your oil picks lose 4%, but the oil sector lost 8%, then you are still a big winner.
The Technical Analysis School holds that reading chart patterns and measuring trading activity in the market will provide important clues as to how the market will behave. Chart patterns and
statistical measurement are the driving force behind each trade. You don't even need to know the name of the company or what it does. The classic swing trade is to buy off of support and sell
at resistance. Support and resistance sometimes form a channel and the price "swings" between upper and lower
boundaries of the channel. Beyond channel trading, Swing Traders look for classic patterns such as double tops/bottoms, head-and-shoulders. triangles, wedges, etc. These patterns are
clearly described in the classic work on this subject Technical Analysis of Stock Trends (Edwards
& MaGee). Bulkowski and Alan Farley are notable recent traders/authors of this method.
We advocate a hybrid of the two systems that focuses on supply and demand. The questions we ask are 1) Is there a current supply/demand mismatch? and 2) Can we anticipate the next wave of
supply/demand mismatch? If short interest is very high is a stock, are they under pressure to cover? Is the company aggressively buying its own stock? Is the company likely to attract
investors by generating good news in the near future that is widely read? Are there trends that favor the company's products? Does the chart confirm the hypothesis?
There are two ways to look at the direction of the overall market: Top Down or Bottom Up. In a Top Down view, which is the most common view you will hear, you look at the big picture and then
design your individual trades to fit that. In Philosophy, this would be called the Inductive Approach: reasoning from the one to the many.
Induction begins with a chart of an Index that represents the broader market, like the S&P 500. Price patterns, indicators, Support/Resistance levels are all looked at to form a Market
Direction Thesis. The thesis may further be analyzed by looking at recent economic data. Then the individual trades are selected that fit this thesis.
In the Bottom Up view, you look at a bunch of stock charts and build your Market Direction Thesis on that. We look at 200 of the S&P 500 each day. If we see a lot of bullish charts then we
have a bullish thesis. If we see too many broken charts then our thesis is bearish. In Philosophy, this would be called the Deductive Approach: reasoning from the many to the one.
Deduction, for us, begins with our 200 charts. Our first pass through the charts is quick, to get an overall impression. This method is definitely qualitative analysis: there is no strict criteria.
The advantage of deduction is that you are faster at responding to market direction changes. We have seen many induction traders take three to five days to respond to a change in market direction.
Our deductive response is much faster.
A good example of deduction: If you can find several examples of stocks successfully breaking out of consolidation, then you should be bullish. If breakouts are uncommon, or often fail, then you
should conclude that the market does not have a strong trend or is bearish. If breakdowns are more successful than breakouts, then you should be bearish. If breakouts are only working about half
the time or less, but they are still worth a try, then that may also be an indication of a sideways market. In a sideways market, you play the trading range: buy at support and sell at resistance.
The secret to success in trading is identifying and maximizing opportunity while controlling risk. Excessive risk is the most common cause of failure in trading.
Maintaining at least a dozen open trades will maximize opportunity and can minimize risk. Spreading your trading cash across multiple assets (stocks, commodities, bond futures, etc.) can reduce
risk IF the beta of the assets are not high.
The maximum opportunity is achieved when you are 100% in the market across several promising assets. The lowest risk is achieved when you are 100% in cash. Balancing the two is done by diversification
across non-correlated securities as you reach for 100% opportunity. Excessive leverage is a recipe for total failure. You should be able to withstand at least 8 trading losses in a row and still be
able to trade normally. Sooner or later, you will have 8 losers in a row. It is not a matter of
"if" but "when".
If a position is not performing as expected after a reasonable amount of time has expired, you should have a new opportunity ready to replace it with. Keep your money where the opportunity is highest
and the risk is mitigated by non-correlated assets. Staying in a trade that is going nowhere is exposing yourself to too much risk and not enough reward.