Newsletter

June 10, 2006

Getting Over A Loss - It's not Easy

Market & Sector Review
Accumulation/Distribution Days

Largest Changes This Week

This Week's Economic Reports

Getting Over A Loss - It's not Easy

After considering current market conditions and the condition of your stocks; you've decided to take a $1,000 loss. When this happens most of us experience anger, our ego suffers, and we wish it just didn't happen. You rationalize: It's the nature of the game; it's my tuition in trading school. You can't stop thinking, however, about bills that are due shortly or that planned vacation in a month. Thinking, $1,000 is a lot of money, I can't consider it a minor setback and move on. That however is exactly what you have to do. The dynamics of risk aversion and loss taking run deep in most of us. As a trader you must step back: look at the big picture, understand that if I work hard enough and under the right market conditions I'll come out way ahead.

Trading the markets whether on a full time or a part time basis is a business, not unlike any other business. Yes, this business involves risk, but so to do all other businesses. Corporations, large and small alike, also have trouble taking losses. Behavioral economists have shown that companies often go bankrupt rather than admit that their business pan needs reworking. Bankers will often refuse to write off bad loans because they don't want to admit that they mistakenly lent it to people, or companies, that were a bad risk. Institutional money managers leave losses on paper because they are afraid to own up. Many investors will not even open their brokerage statements during bad times; "out of sight, out of mind."

Feeling guilty taking a loss isn't irrational, it's human nature. There is a strong biological urge in all of us to protect ourselves and our loved ones. In today's world that means having enough money to pay for food, clothes, and housing. Therefore when we lose money as a trader it hurts, especially when you think of what that money could purchase. As children we were taught by our parents and teachers to protect ourselves and to do what you need to make money and save it. Losing money on a trade therefore will make us feel guilty, and depending upon the size a little panicky. As an active trader you must change your thinking. You must fight against your natural inclinations and learn to take losses.

Perhaps the first step is to admit to yourself that you feel guilty. Realize the guilt is the result of you're taking a risk that could inadvertently harm you and your family. The loss is particularly hard to accept if you really need the money to pay basic living expenses as opposed to money set aside for trading purposes. You should never use money set aside for basic living expenses to trade. If you know that you've done everything to minimize risk and you truly know that you can survive a worst-case scenario, you'll be able to take a loss more easily.

Mentally put your trading capital in a different compartment from the monies set aside for your personal life. Learn about risk management Risk Management - An Introduction and build up enough capital for trading.

Next identify, then refute, assumptions about risk and loss. Make a list of justifications that you can read after you have lost: "Losses are a business expense"... "It's like a personal investment in my trading business"... "It's like paying tuition in order to learn important trading lessons." These sayings may not work at first. It's hard to change your expectations over night. It takes practice. Losses are a fact of trading life; they still can be difficult to accept. Remember you're fighting your own natural biological forces!
Market & Sector Review
Accumulation/Distribution Days

In this newsletter two weeks ago I spoke of sectors that may go opposite any bear market and explored 3 sectors that actually advanced during the last bear market. I ended that letter with an old market cliché; "There is always a bull market somewhere". And also posed a challenge; "Can you find it". This week I will explore a very effective tool that will help you spot that bull market wherever it may lie.

All the charts posted in the Members' Section of the Prudent Trader (eleven major indices and thirty-one market sectors) contain an indicator named Accumulation/Distribution Days. While there is some subjectivity involved in the interpretation, this indicator should help a great deal in determining, whether a particular index or sector is under accumulation or distribution. The calculations are based upon William O'Neal's (Investors Business Daily) definitions obtained from his book "The Successful Investor". The following definitions are quoted directly from "The Successful Investor"; Editor's notes denote the chart colors and any subjectivity that may be involved. On your next trip to your favorite bookstore check out this as well as other books by Bill O'Neal, your money will be well spent.

"In any uptrend, there will come a point when selling activity overtakes buying. This we call distribution, and it's important that you recognize it as its happening. The first day of distribution is when the index (or sector) closes down from the day before and the volume is higher than the day before"... "No up-trending market, however, is turned down by just one day of increased volume selling. What we have found, by studying every market top going back 50 years, is that three to five days (in recent years it's been five days) of volume distribution over a span of two to four weeks is sufficient to turn the market's uptrend into a downtrend." Editor's note: Potential Distribution Days are displayed with red volume bars. The subjectivity comes into play in this way; if the index or sector is down just a little bit and the volume increase was just a little bit you may wish to ignore that day. Regardless of any subjectivity if the index or sector is down on an increase in volume a red bar for volume is displayed.

"By counting three to five days of distribution, then, most of the days will actually be down and only one or maybe two might show little upside change…The key is that you recognize and correctly count the volume distribution days in whatever form they take… At such points, you must be backing away and not making any purchases. You also want to be selling to raise some cash and definitely getting off margin. You want to stay in phase with what the market is actually doing, not with what you hope it will do or what other people think it should do. That's how 99 percent of the investing public operates. They're guided by personal opinions and their own and other people's guesses or hopes."

"You never know how far a down-trending market will go. All you know is that it's under heavy distribution and it's going down…Even though you don't know how far down the general market will go, you watch day by day as it's declining. At some point, it will rally and recover for a few days. Pay no attention to the first and second days of the rally. There will always be upward blips in any general decline, but the major trend will still be down… The only time in an attempted rally that you can conclude with greater reliability that the trend has changed from down to up is typically from the fourth day on. If the volume suddenly picks up from the day before with one or more of the major indices posting a significant increase, you have what we call a confirmation of the rally that began with the first day up." Editor's Note: The reverse of a distribution day is an accumulation day, this is where the index or sector closes higher than the previous day and the volume increased. You will often on the initial rally attempts see an accumulation day or two, the volume bar will be blue on the charts, but should not be acted upon by themselves.

"The confirmation, or follow-through, usually comes on the fourth through seventh days of an attempted rally. Sometimes it can come the tenth day or even later and still be constructive, but rallies that follow through that late may not be as powerful. On the confirmation day, one key market index must be up a powerful and decisive amount, usually about 1.7 percent or more on trading volume that's higher than the day before and typically better than its daily average. The important thing, however, is not to get faked out on the first or second day up and sucked into a premature rally, because you don't really know for sure whether the market has turned until you get the confirmation." Editor's Note: In recent years IBD has adjusted the 1.7 percent as low as 1 percent depending upon market volatility for a rally confirmation day. The Prudent Trader Accumulation/Distribution bar splits the difference using 1.4 percent and the volume bar is green. Keep in mind the difference in calculation to determine a valid rally confirmation day; subjectivity again. With the increased volatility we have just witnessed, check any green bar that appears and look at the percent advance, you may want to use the 1.7 percent at this time. All other volume bars are blanked out making it very easy to read the charts.

"The tremendous added value of this system is not just that it will help you retreat from a topping general market and get in on the next bull market off the bottom. It can also keep you in cash during many of the false rallies that never follow through properly. This practical concept has several huge advantages. There have been two or three bear markets (or declines of 18 to 20 percent or more in one or more key averages) where the market, from the time it topped until it hit rock bottom, never experienced a valid follow-though day during its many attempted rallies until the actual bottom was made… What's important to understand is that no new bull market has ever started without a follow-through day, and most follow-throughs have come on the fourth through seventh days of rally attempts."

Let's revisit the Health Services Chart from two weeks ago with the S&P-500 overlaid on the chart in blue, indicators displayed are calculated on the Health Services sector alone:

Notice that in the beginning of March 2000 both this sector and the S&P attempted a brief rally. Shortly after that brief rally a rally confirmation day occurred in this sector and the green bar was above the moving average as well (black line is the 55-day simple moving average of volume). Notice that again in late April; late May; and late June three more rally confirmation days on excellent volume. Notice also that many of the red bars shown (distribution days) occurred on relatively small moves and although the volume was greater than the previous day it was still under its moving average. Also take notice of the movement of the McClellan Summation Index for this sector and the movement of the six month relative strength figures. This sector was just following the S&P you say; well let's take a closer look. In July the S&P-500 was merely testing its recent rally highs (an advance from March of about 11%) the Health Services sector had advanced approximately 26 percent from its March levels. Just following?

Now let's look at the S&P-500 vs. Health Services for the remainder of the year 2000.

The S&P-500 declined from its March peak of about 1520 to a December low of about 1275 or about 16 percent. At the same time the Health Services sector advanced to 710 or about 61 percent above its March lows and a 20 percent advance in the second half of the year while the S&P was declining 16 percent. Just to reiterate this is a look back at one sectors action during a bear market, it is not a recommendation to buy or sell any security in this sector at this time.

I believe this to be an outstanding indicator once you understand it and learn to deal with the subjectivity involved. Current charts (updated on Wednesday and Friday) appear in the members section for eleven indices and thirty-one sectors. This is only one, but one very important indicator displayed on each chart, calculated on each of the index or sector components alone; helping you determine exactly where bull and bear markets may be. Personally I know of no other site on the internet that provides you with this detailed and most relevant data; use it and you'll make more profitable investments/trades.
Largest Changes This Week

This Week's Economic Reports

Have A Great Week!

Bill

Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.