A Look At a Few Charts: Revisited

As a follow-up to the charts I posted before my annual August hiatus, here’s what happened for each of those names. The yellow line in each of these charts is July 17, when I posted the charts before.

SPY:

The broad market ended up having a big drop as August started, but mostly recovered since then. If you tried to trade breakouts you got chopped to pieces. If you tried to fade breakouts you had to take a lot of heat during the chop for not a lot of benefit. This chart is textbook for how I used to give away a lot of my gains for the year by forcing trades during this time. I’m happy I sat this out. Things seem bleak for the markets going forward with global slowdowns and recession indicators flashing. I’m leaning toward taking more defensive long term positions here.

AAPL:

Earnings were good, AAPL spiked and then sold off all the gains. Then it dropped, and shorts got burned in that chop. In the end, it’s at the same level today as it was when I posted the chart before. Nothing but pain in August.

ROKU:

ROKU was the exception to my August rules. After some contraction before earnings, it popped and didn’t look back. If I weren’t sidelined by rule, I would have gone long on the Swing VWAP breakout at about $135. I have liked ROKU all year and in this case, breaking my rule would have paid off. Missing things like this and accepting it are important to having the right trading mindset. There have been so many good setups in ROKU this year, and I’ve been able to catch a few of them. It’s ok if I don’t get every one. Greed is a killer, as is fear of missing out, and begrudging any moves you may have missed.

TSLA:

TSLA ended up being pretty volatile with the earnings report and different news stories during August. Any of my typical setups would have lit me on fire. Lots of chop, lots of heat whether you traded breakouts or faded them. The only edge was in knowing the news and earnings beforehand, which is basically impossible unless you are cheating with inside info. Another good chart to watch rather than trade.

Going into the fall, I’ll keep an eye on any setups that may occur. I’m biased toward the bearish side, but we’ll see how things pan out.

SwingVWAP trade: $BYND

Here’s another trade I just closed out as I’m unwinding for my August shutdown. I went long $BYND on a close above the upper SwingVWAP on July 16 at the yellow line. My stop was the low of that breakout candle at the red long-dashed line. Two days of sideways and then it took off. On July 23 (the date this chart was made), the breakout to new highs followed by a big collapse that went back below the open got me to cash out. Good trade, right?

On the next day, $BYND held there, and then, of course, today happened:

As I keep preaching, things like this ruined me in the past, and ruin newer traders. Yes, I missed a big chunk of the move. If I were blinded by greed, I’d be upset that I didn’t get all of the move. If I were driven by fear, I’d be afraid of missing out on more if it keeps running. I’d chase here, and probably get blown up. Going into August, I’d give back all I made on this trade and then some I imagine as I would press and chase and look for things that aren’t there as revenge for missing out on all of a good move.

There’s so much opportunity in the markets when things are moving. Taking parts out of moves in spots that make sense is the way to consistent profits over time. Manage your risk and take some off the table. Go ahead and leave some, and be content with that.

Market “Physics”

Hey, long time, no blog.

As I have watched the broad market continue to float higher, and as I watch debacles like $AAPL gapping 50 points down back in January, I of course try to make sense of it all. WHY is it happening? For a trader, the answer is “I don’t know, I can’t know, I don’t care”. A trader just goes with what is happening. This has always been a difficult mindset for me. Still, I am always trying to improve my understanding of how the market really works so I can better take advantage of it.

Take the $AAPL case. One day the company is worth $500+, according to market prices. The next, it gets slashed by more than 10%. Did the company REALLY change value that much, intrinsically? No. It was the same company yesterday as it is today. Does the new post-dump share price represent a fair valuation of the entire company? Possibly. But what has really happened? A small subset of owners of the company with a small subset of the total outstanding shares decided (or were forced by margin calls) that they needed to sell at this price for any number of reasons. Did every share outstanding get truly revalued in a market transaction? I would say NO. Every share outstanding got marked-to-market based on these few transactions. If you try to think of stock price as a proxy for what people think a company is worth (i.e. market cap) then none of the day in, day out price changes you see in stocks really make any sense at all. In the past this has caused me to stand by in a stupor in the face of strong uptrends without joining in. It just doesn’t make sense from a market cap and company valuation perspective. As I was thinking it through, I realized something. Basically, money is created and destroyed in the stock market each and every day. There is no law of conservation of money, nor is there any such thing as “price work”, meaning trading energy applied to the stock to revalue it. Thinking of the markets in terms of physical processes (like momentum, work, energy, force) is inherently flawed. Let me explain.

In physics, things have intrinsic properties. A tank full of jet fuel contains a certain mass. It has internal energy defined as temperature. Each and every particle in the tank has these attributes in basically an equal distribution. If you wanted to heat that tank of fuel from 50F to 200F you would need to apply heat energy to the entire system. You would have to apply enough heat to each individual particle to raise its temperature from 50F to 200F. We then sum up all the heat needed for all the particles and that is the total energy required to heat the whole tank. (This is not necessarily how you would do the math, but physically it’s an accurate description of what happens in reality.) If you wanted to heat half that amount of fuel from 50F to 200F, it would take half the amount of total energy to do it.

Now, if you think of stocks in this way, your brain will turn into greek yogurt quicker than you can say “austerity”.

Say that we start with a “tank” full of stocks, such as every single share of AAPL outstanding. If the market price is $400, then we determine that all the shares in the tank are “worth” $400 each. The tank as a whole (the entire company) has an ‘energy state’ called market cap. Total number of shares * $400 = the “value” of the entire company. Now you would think that to raise the market cap by 25%, you would need to apply monetary buying pressure to each little share until they are all up by 25%, so that the whole is equal to the sum of its parts, just like in physics. NOPE.

All it takes is for a few traders to take a tiny fraction of those shares out and revalue them through transactional work in the market outside of the $AAPL tank to a new level of say $500 per share. Then the magic happens: all the rest of the shares in the tank are instantly revalued, without ANY action performed on them at all!! This may be obvious to most people, but it’s an immensely important realization. It’s like taking 1 gallon of JP-8 from a 10,000 gallon tank at 50F, heating that 1 gallon from 50F to 200F, and then dumping it back in the tank. In physical reality, the 1 gallon cools a lot and the rest of the fuel heats a tiny bit as the extra energy is diffused to all of the fuel. That is intuitive. However in the stocks case, as soon as the 1 share goes from $400 to $500 and is thrown back in the tank, suddenly by simple declaration the entire rest of the tank is at $500 as well. A miracle: wealth has been created. If this was physics, then it would mean that heat energy had been created. This is one reason why I say my science background is a disadvantage on trading. I have a fundamental worldview that is not applicable to the trading world. In the markets, wealth can be and is created and destroyed all the time through this multiplicative effect of mark-to-market. (As an aside, it’s also easy to see why they suspended mark-to-market pricing during the housing meltdown. Valuing the whole of the banking system at the depressed price that a portion of the garbage loans were trading at would have destroyed all the wealth in the world, at least monetarily, and for no real physical reason. It couldn’t be allowed to happen, so they bent the rules. At the time this made a lot of the idealistic “Blue Blazer” types very angry, including myself, but was absolutely the right call for them to make in hindsight.)

So when you see a stock chart, and you wonder “How can everyone think AAPL is worth $700 per share!?! Are they crazy?!” make sure you stop yourself and think again. In reality, a relatively few people think that a small fraction of those shares are worth that $700 right at the moment of the transaction. All the rest of the shares outstanding are marked-to-market based on this tiny sample. That is why company valuations can be so whacked out for so long.

The key is to predict how traders may react en masse when this financial alchemy happens. Besides just the revaluation of all of the stock, I think that this effect is also highly magnified by the derivatives market. Increasing the value of a million shares by $1 can result in a huge magnification of hundreds of millions in the options contracts. The tail wags the dog.

These thoughts help me to align my market paradigm closer with auction theory and away from physical analogies. The difficulty for me is turning this knowledge into actionable trade ideas.

Are You REALLY Accepting the Risk of Your Trades?

In listening to the “Trading in the Zone” audiobook, I came to a section about truly thinking in probabilities and what it means to accept the risk of your trades. This got me thinking about a few things.

The basic facts are that we cannot know what will happen before we take any individual trade. There are too many unknowns and unknowables to have any certainty. We can have an edge that plays out over time, but in each individual trade literally anything can happen as any other traders enter or exit trades while we are in the market. It’s one thing to know that not every trade is a winner. It’s another thing to fully accept that before you put on a trade.

It occurred to me that the way I think about stop losses is wrong. Before I trade, I pick a stop point, usually by technicals, and how much money I’m “willing” to lose at most. This is not truly accepting that risk!! If the trade goes bad, I feel awful that I lost, that I was wrong, that my net wins/losses keep sinking. I feel like the market faded my decision and took away my money. Of course I don’t think the market is consciously trying to get me. I attribute it more to my own “bad” judgement. This also means that if a trade goes in my favor, I’m afraid of the market reversing and taking that little bit of profit and some capital away. I cut the winner. I also will bail out at break even if a trade fades a little, then goes back to my entry point. I feel lucky to “save” the money that was at risk. I cut myself off from the possibility that the trade might work out. I basically guarantee that I will either lose 1R, scratch or win much less than my usual 1R. Add in commissions and it’s a recipie for being a net loser.

Now sometimes, like in my last GSVC trade, I’ll manage the winner well. I did so because I had so much cushion from my entry point that I was no longer afraid of taking a loss. I hadn’t accepted the risk, I was just ignoring it because I had so much breathing room. If the trade had languished near my buy point, I’d probably have been looking for excuses to bail out near 16, if not for a small loss if it “looked” ominous.

It hit me that to really accept the risk of a trade, I need to think of the stop loss as the ante I need to pay to find out if the trade will work or not. Instead of defining it as a “worst case scenario that probably (in my head) won’t happen”, I need to think of it like the cost to buy a lotto ticket, or the chips required to pay the blinds in poker. Your stop loss and position size should represent the amount of money you are going to pay to see if this particular trade happens in the way that your edge predicts. As soon as you put on the trade, that money is spent. It’s gone. It’s not yours anymore. You don’t need to fear losing it any more than you fear losing the dollar you pay at a carnival to throw darts at balloons trying to win a prize. If you do fear that, you are trading too large. If you had to pay $1000 to throw that dart, you’d think twice. You’d measure the cost against what you might win. As a loser trader, you just put on any old trade and then hope it works out. That’s like paying the $1000 and then hoping you hit a balloon so you get the $1000 back to pay your rent, plus whatever extra winnings you get. You are going to make poor decisions, overpay for the chance to find out if you are right, and lose in the end.

I’m going to work on my personal thoughts about stop losses. I’m going to try to think of them not as a “worst case” possibility, but a certain cost. If I’m not willing to outright pay that certain cost for my potential trade, then I have no business taking that trade. A trader’s job is to judge opportunities, and unless you accurately judge the costs of testing your judgement, you’re sunk.

Ante up or fold!

Humbled

Since I wrote the “Facing Reality and My Dilemma” post, I have received a lot of feedback. Everything from “You can be a successful trader” to “Your tools help me–don’t stop!” I was surprised and humbled by the outreach. I also received a gift of “Trading in the Zone”. This put me over the edge. I’m blown away. It placed a bid under me. I thank all of you. All this time I had hoped that my stuff would help someone to be successful. I didn’t think it would come back to me in this way. Traders consistently surprise me by the depths of their generosity and camaraderie.

I’m going to make another try at trading. It will probably be another few months of preparation, but I will be back sometime in 2012. In the meantime, I will also work new tools and scripts for you readers. I had my moment of existential crisis, and now I’m back on solid footing, thanks to you.

Thank you, sincerely, to all of my friends out there.