Risk Aversion: The Trader's HandicapMarket & Sector Review
This Week's Economic Reports
Risk Aversion: The Trader's Handicap
You have often heard the sage advice, "Cut your losses early, but let your winners run." Do you have trouble following it? Based on experience, you may think letting your winners run is easier said than done. While it's not a good idea to let a losing trade mount losses to the point that the entire position is wiped out, but it's often not easy to hit upon a winning trade, and then, just sit back and let it ride. There's a strong temptation to take profits. You also are aware of the old cliché, "Who ever got hurt taking a profit?" Why you can't you let this winning trade just run a little longer. An analysis of your trade diary entries shows that if you could have held out a little longer, you would have made substantially more profits. Many traders hate to lose, and when they see a winning trade materialize, they want to lock in the profits and insure a win. Whatever you call it, it is still risk aversion. For some strange reason we are quite willing to gamble with losses, but when it comes to wins, we will take a sure thing over a gamble any day. Risk aversion is surely a weakness of many traders. If it can be beaten, traders can make significantly greater profits.
Why is risk aversion a problem? Why not just take small profits across a series of trades? It all depends on how successful your methods are. If you have methods that work 90% of the time, then you can take small profits and come out profitably overall. Unfortunately, most traders have a track record that is much lower than 90%. Obviously then, it is vital for your economic survival to make larger profits on your winning trades. If you take only small profits on your winning trades, however, your wins won't balance out your losses. Therefore, it is essential to avoid selling a winning trade prematurely.
The sting of several losing trades can impact your pride and your ego. Losing even greater amounts of money by letting a winning trade turn into a losing trade is even harder to accept. Your conscience often tells you, "Sell now before it is too late." There isn't a simple solution to this problem. Profits can be hard to come by in the trading world; it's hard for many to risk losing a profit once they see they can lock it in by selling early. It may be hard to swallow, but winning traders tend to be those kinds of people who actually enjoy risk. They are happy to see they have hit upon a winning set of circumstances and they can't wait to see what happens. They want to push the limits and see if they can squeeze out as much profit as possible. If you aren't a natural born risk taker, it may be difficult for you to hold out and avoid selling early. If you are the kind of person who feels uneasy while a position is in motion, you may have to make an extra effort to let your profits run. One strategy is to sell off increments of the position as it rises in value so that you can ease some of the psychological pressure gradually. By taking a little bit of profits at a time, you can feel an ever-increasing sense of safety.
It is essential that you trade with money you can afford to lose. The reason most traders are risk averse is that they are trading with money they need for basic living expenses. Thus, they are risking their safety and security, and this puts added pressure on them to perform. It isn't surprising that under these circumstances, one has trouble taking risks once a position starts to increase in value. You can come up with all the rationalizations you want, but if you trade with money you deeply care about, you'll have trouble risking it, and "to make money, you must risk money." You must manage risk, and that's hard to do if you don't have a large trading account. An large trading account allows the trader to risk as little as 1, 2, or3% on a single trade and still make a substantial profit. Risk aversion is a handicap. It's hard to beat it, but many do. If you are one of the few lucky ones, you'll realize substantial profits and trade consistently and profitably.
Market & Sector Review
Before we go into this week's longer-term look, let's take a quick look at the shorter term. I find it simply amazing that we are but 2% or 3% (depending on the average) off of 4-year highs and the sentiment out there seems to be ready for a 1987 type of crash. The AAII survey this week found 29% bulls the lowest since May and 40% bears, the highest since May on a 2% decline. Put buyers are outnumbering call buyers, the Rydex fund ratios are showing large shifting of funds from bull to bear funds. If this was indeed a top you would expect to see just the opposite, everyone buying this small dip. Buying calls and not puts, switching money to bull funds and out of bear funds. I am beginning to think this market may have a real good upside surprise in store for us. That being said, let's take a look at the intermediate to longer term picture which is not so pretty.
Sometimes it's strange how certain things come together at times. This subject was originally intended and partially written for last weeks letter only to be put aside in order to discuss the New Elder's Triple Screen Market Scan. That in and of itself isn't strange of course but what is, was this past Wednesday I listened to an interview with Larry Katz of Market Summary and Forecast and Larry discussed his increasing bearishness on the markets and covered some of the same things I will be covering today, a link to Larry's site and that interview appears at the bottom of this section should you care to listen. There is also a link to something I found on the net this past week that I believe all should bookmark and read at their leisure. It's called "The Secret to Emotion Free Trading" by Larry Levin of Futures Educaton.com. The free E-Book is in .pdf format so you will need the free Adobe Acrobat Reader.
It is no secret to long term subscribers that I am looking for a major top sometime this year, the conclusion of the 4-year cycle and the resumption of what I believe to be the secular bear market that began in 2000. Let me point out that whenever you look at or perform any analysis put that analysis and your indicators into context, perspective. For instance when you are in a bull market pay attention to oversold levels and ignore overbought levels, in a bull market stocks can remain in overbought levels for quite some time and still advance quite a bit. The reverse of course is true for bear markets. This analysis today is in two contexts; first it is my belief that in 2000 we entered a secular, meaning many, many years bear market that will be interrupted periodically by cyclical and tradable bull markets; and secondly the conclusion of the 4-year cycle. Also it is worthy to note that bear markets can take on two longer term shapes: one is the obvious, prices sliding to much lower levels; but secondly just like in the 1970s the bear can take the shape of a rather large sideways movement as the market awaits the economy to catch up with equity prices. Unlike market bottoms market tops often take quite a long time to form, usually many months and sometime a few years. So let's take a look at the longer term bearish case:
Note the following:
RSI continues to negatively diverge with each new high in the S&P.
If we measure the initial rally from October through December 2002 and plot some Fibonacci levels we currently are bumping against an area which is 261.8% of that rally.
If we look at March of 2003 as the real beginning of the bull market (subject to interpretation of course) we can look at 3 distinct legs if you will as outlined in yellow boxes. The March through beginning of June rally advanced 277 point or 35% and lasted approximately 13 weeks.
The next box outlining leg 2 advanced from approximately 985 (August low) to 1163 in March 2004 or 18% about half the first leg in about 29 weeks or 2 ½ times longer than the first leg.
Now we look at the 3rd box or leg 3 which may not be completed as yet. We advanced from and August 2004 low of 1062 to the current high of 1246. An advance of 184 points or 17%, about the same so far as the last leg, however this leg has lasted so far over a year (55 weeks) which is over 4 times the first leg and almost twice as long as the second leg.
It is taking longer and longer to progress less and less.
Next let's take a fresh look at time and duration of bull markets. For newer subscribers here is a bell curve, courtesy of Victor Sperandeo (Trader Vic) of 125 Primary Bull Markets from 1896 through 1991 as to both extent and duration of bull markets.
Note where we are:
S&P 500 has advanced 62% and the Dow Jones 52% from their respective bear market lows, note where that lies on this bell curve.
Duration above is expressed in Calendar Days not trading days, as of yesterday this bull is 1,043 days old.
Notes:
At the early 2004 high’s we had almost 95% of all stocks trading above their 200-day moving average.
In March 2005 the S&P had advanced roughly 7% from those 2004 highs yet now about 83% of stocks are above their 200-day moving average.
At the 1245 (S&P) recent highs, new 4-year highs, only about 64% of stocks are trading above their 200-day moving average.
Fewer and fewer stocks are participating in each new advance, each new index high.
In Larry's interview he pointed to an old Jesse Livermore statement something to the affect of: "If you can't make money in the market leaders then watch out." One of the leadership sectors from the 2002 bottom of this market has been the banking or financial sector so let's look at what is going on their.
Notes:
The banking index (BKX) made its bull market highs at the end of 2004 and while the S&P and other indices have recently made new 4 year highs the banking index is still about 5% below its 2004 highs.
In April of this year while the S&P held well above its October lows the Bank Index however briefly broke it’s October low.
In early March when the S&P made new highs the banking index not only failed to make new highs it made its second lower peak of the year.
On the subsequent rally to new 4-year high on the S&P, the banking index not only failed to do so but so far has failed to even break its February or even its March high.
I believe the above is telling a good story for the bear case, there is more but enough for this letter. If you break down the indices a bit you will note that oil and the energy sector is playing a large part in the advance. This sector is considered a defensive sector and if you look back at past market highs you will note this sector coming into play late in the advance. When we will top and turn is hard, if not just about impossible to say but I believe we are getting close. Again this analysis is of the averages alone and not any individual stocks. You may own some of the 20% that will perform well. We are attempting to merely put the overall odds in our favor, this bull market is getting very old, be aware of it and play it accordingly.
Now the two links I promised above: Larry Katz Interview - Link on right side of page."The Secret to Emotion Free Trading"This Week's Economic Reports
Have A Great Week!BillDisclaimer: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.
Note the following:
Notes:
Now the two links I promised above: