Portfolio/Risk management when volatility increases

A comment/question was asked last night about how I how I adjust my trading to changes in volatility. It's a rather thought provoking question and it really reaches to the broader question of how do you manage risk. Portfolio risk has been the subject of much thought over the years and was brought to the limelight with a brilliant paper by Harry Markowitz with his paper "Portfolio Selection," which appeared in the 1952 Journal of Finance. This paper launched the whole concept of modern portfolio theory.

Essentially, Markowitz proposed that investors should assess the overall risks of their portfolios, not simply the risk of an individual security. He introduced the idea of diversification where a portfolio is invested in multiple instruments whose returns are uncorrelated which, by its very construction, results in reduced market risk.

I do not take this approach primarily because I seek returns that are greater than what such a portfolio would likely offer. Since I always talk about active portfolio management, my thought is to reduce risk by actively trimming losses when they occur; never allowing one position to hurt the overall portfolio by a significant percentage.

Added to this idea, I engage in a different kind of diversification commonly called hedging which is basically offsetting your risk in one area with a negatively correlated offsetting position. These negatively correlated positions change over time in my mind; i.e., they are not always the same. For example, I have been looking to short oil as an offsetting position to my long gold shares. Oil and gold tend to move in the same direction although not a perfect correlation by any means. In fact, at this juncture gold is much strong than oil and oil appears that it could retrace after its first bounce. Since gold has just had a big move and longer term swing points are directly ahead and since I don't care to close out these long gold shares, a short in oils could serve as a counter play to the metal stocks cushioning any weakness there with weakness in oil.

Another way to circumvent volatility is to play smaller and to work trades on differing time frames. The example above is a desire to hold gold shares longer term and to cushion them with shorter term hedge trades.

Using Sectors as a Guide to Trading

One of the ways I try to generate ideas for where to concentrate my efforts is by using sector rankings to determine where to look. When the market begins to confirm a thesis you have that represents a change in the intermediate term direction, you can often do some scans to decide what spots are ripe for either going long or short. Currently my thesis is that the market will trade lower intermediate term changing from the sideways affair. If true, then I would like to generate ideas for some short side trades.

Tonight I have taken and pulled two ordered lists for sector returns. On one list are the longs and the other the short potentials. Within the two lists I've chosen to break them down by how they have performed for the past month and the past 5 trading days. I chose these time frames because the past 5 days we have seen a change in direction short term and the past month we have been going sideways.

Next I look to see what is common in the two lists. If the past five days has seen pressure on stocks that have also been under pressure for the past 30 days, then those sectors are probably good places to look for potential short positional setups. Here's that data.






Vice versa, if you are still long or wanting to be long, a common sector on the two would be a could choice. Again, here's a look at that data.






I've been looking for any good short term short setups and have identified a number of sectors to look through. Now this is just one way of looking at the data. I'm sure there are others. The point of the exercise is to consider the combination of sectors across time frames at critical junctions to identify possible trades.

Volume ... more thoughts on weak stocks

When I last wrote on these pages I was attempting to develop thought and charts to explain how I see volume. We started with stocks that were declining and the initial set were stocks that saw huge (price wise) declines in short periods of time. These charts exhibited large volume spikes on large downside prices declines. I had tried to distinguish between distribution versus stops being hit and naturaly (though hurried) profit taking occuring.

In this iteration on volume tells, I'm looking at weak stocks where volume and price declines are not sudden as before. These types of declines, when they persist, are almost always a sign of consistent distribution occuring. That distribution is from both large and small players and I suspect, is the consistent cashing out by larger holders at prices that still make them fortunes. The ones holding the bag in these cases, are all the little folks who bought the story associated with the stock and whoose approach to stock investing/trading is to buy and hold. K has shown a consistent uptrending pattern for a good two years now until the past three month where it has began to trend lower. This lower trend is concerning if you are long because it is reaching that critical point where it is either going to begin to exhibit a perpetual crawl towards lower prices or it will find support and begin to trend higher once more.

The typical pattern that I'm looking at in this and the next chart is that you have some sponsor or sponsors of the stock during the price rise. The story is good and everyone wants to buy it. It's likely that the larger holders of the stock have gotten a special deal and are sitting on huge profits after the two year run. As the stock begins to weaken (either because the story was false/fake and/or because the fundamentals have changed) the larger holders start to distribute into the late comers, folks who are unaware that the trend is changing. The story is still told and the blind buy, but those who are in the know are slowly getting rid of their stock. Note, they are holders of hundreds of thousands of shares. It takes them a while to distribute their stock. That distribution usually takes place towards the top; at the topping phase; and all the way back down.

Take this next stock which has made the complete trip already, WLV. This stock was given a story and that story was sold to the public (look back at the press clippings if you don't believe me). It was the best thing since sliced bread. As it neared a topping point, the insiders we likely selling as fast as they could without crumbling the price too much. They did that all the way across that long topping pattern for a year in late 2004 through late 2005. When the price broke though, they distributed what they had left all the way down and finally the late comers were washed out at new lifetime lows just recently on a nice volume spike. Now the bottom feeders will likely come in again.

This article along with the previous one exhibits the two common patterns associated with declining stock prices and it attempts to distinguish between distribution and profit taking/stop losses as that's the key to staying out of trouble. The golden rule is that if you can't distinguish between the two on a given chart, then simply stay away. There's other places to spend your money rather than flipping the coin. The other golden rule is that you usually need not be in a hurry to buy a weak stock. Even if it's distribution, there is almost always a retest of the lows before a sustainable rally can occur. This gives you and entry and exit point you can live with. That's the safe way to play long entries on such chart patterns.

Volume; a continuing analysis ...

In the last post, we left off with the idea that we have limited information on volume; namely an overall count, a correlation of volume with price and the direction of those prices. Given this limited data, and after looking at literally hundreds of thousands of charts over the years, I would suggest that the following statements are true and useful when analyzing volume:

1. If we have daily volume, we can construct a moving average of volume
2. If volume on a given day is much higher or much lower than the average volume, then that probably has some significance
3. For definitions sake, we can assume that an up volume is a day where the closing price today is higher than the closing price yesterday. A down volume day would be the opposite
4. We can also assume that the interpretation of volume will likely be impacted by the underlying trend of the stock being examined
5. Volume needs to be interpeted as part of the overall picture. Volume and price go hand in hand and although volume will precede price in some cases, interpreting volume without the help/context of price data is like panning for gold in your bathtub
6. Not only do you need to interpret volume in the context of price action in the stock you are examining, but you also need to consider price action in that stock's sector and the general market as well

All of these things I both believe in and use in my interpretation of volume. When I look at a chart, I look at both price movements and the volume that accompanies those price movements. For me, the key tell in a chart is whether or not volume gives us more information about why price is doing what it's doing. In some cases, it gives us no additional but in those cases where it does, it strengthens our belief in what the future price action should be based on our intrepretation of what that volume and price tell us.

The simplest way to consider what volume tells us is to look at some charts. Rather than picking charts in the past and saying, here's what it should have told us, instead I'll pick current charts and tell you what I believe it is telling us now.

Distribution Versus Correction
The difference between these two words is critical. Distribution is a continual pattern of selling into strength to distribute your shares to others. When large holders of a stock distribute, that stock cannot be owned until they have finished. A correction is usually reasonably short in duration and the stock can be bought when the correction has ran it's course. Stocks that are distributed take a long time to get back to their previous highs. Stocks that correct can do so relatively easy. When you are looking at a chart that is undergoing either distribution or a correction, this is what you are attempting to decide; which is it?

Chart Ambushed

Let's start with a chart showing a very bullish stock that has suddenly been ambushed. I've chosen the chart of MIND which has just suffered a huge spill moving from a high of $26 to $20 in about 8 days. Now I wouldn't want to buy this stock right here, right now, but I would suggest that the volume spikes signify scared longs taking profits rather than large holders of the stock liquidating and never wanting back in. How can I draw such a conclusion?

The first observation is that we had a huge run up in price without a consolidation from $19 to $26 and that was after only a brief consolidation that followed a run from $12 to $19. So essentially, prices more than doubled without much of a break and in all of this transpired in about a 3 month time frame. This stock needed to be ambushed.

A second observation is that the price correction has occurred during a total of 3 days. Unless some fund which had a large position in this stock either went belly up or decided that they had to get out at any price, then this is instead liquidation by longs that were either overextended or ready to bail out at any price. If you consider this objectively, it was likely the latter case, not the former.

Thirdly, the price depreciation accompanies a sell off in the general market. This also suggests profit taking.

Lastly, the down volume bars are not as large as the up volume bars of the recent past. When this occurs, more weight is added to the idea that we are correcting, not distributing.

Given the above, this is likely a stock that is NOT undergoing distribution but instead a correction. That doesn't mean you should buy it here, but it does mean that it can be bought again and relatively soon probably.

Here's another chart that looks about the same as MIND. In this chart, ISRG, the correction is even deeper. That's another item you have to consider. I like to consider the 50 and 200 day moving averages as key to understanding stocks. If a stock closes under the 50 day moving average, it has an increased probability of falling further towards the 200 day moving average; not guaranteed, but increasing likely. Although ISRG has the same type of volume pattern reads as MIND, it appears likely that it wants to correct as far back as $80 or so which is where we find the 200 day moving average and a large gap up area. Note that the down volume bars are larger than the recent up volume bars. That's a warning sign that the correction is likely deeper and adds a bit more weight to the idea that it could be distribution versus correction. Given that the majority of the signals suggest correction, not distribution, that's my read here as well.

Here's another chart. This is ITMN and it appears to be undergoing distribution versus a correction. Can you see why? In this chart we see some differences from the prior two. Here we see a stock that traveled fast, like the others towards higher highs but in this case, the highs happen to coincide with previous highs. After a poke higher, a small retrace and a second attempt to reach higher highs, failure set in and then a collapse on gap down move.

Look at the recent volume bars. The three largest volume bars over the past 6 months were down volume days and that's despite a stock that has climbed tremendously in price. Note that the higher high came on lighter volume as well.

My guess is that this stock is likely being distributed, rather than just correcting. It's stocks like these that should be considered as potential short candidates or, if you want to trade long only, avoided. Here's one more. Distribution or Correction? My take is distribution. Again a double top and then a big gap down on earnings. It's likely those with larger positions will sell any rally attempts in the coming days and weeks leaving this stock under pressure for a reasonably long time.

Down Trends and Volume Tells

Although not foolproof, if you pay attention to price and volume you can read a chart when it is falling in price. You can many times ascertain the important answer as to distribution versus correction. Distribution you can short into or avoid while corrections can provide great opportunities to get long again and again.

In the next issue, we'll look at stocks that are weak, but volume isn't spiking to see what that tells us.

Volume - what does it Mean?

I've remarked many times that there are three factors that, if understood well, will go a long way to improving your technical analysis of the market. Like everything else, they are not foolproof yet they do consistently produce results which is why we trade the market. These three factors are time, price and volume. I propose to do a series on the three factors here starting with volume.

Volume
What is volume? In the most simplistic terms, volume is a statement of intent. There's up volume and down volume. For individual stocks, you will not find such a listing though although for the indexes you get an aggreate of this across all stocks in that index. That doesn't mean that the data doesn't exist, it's just not available. You can get a sense of up versus down volume from the charts however by assuming that a day where prices increase you count that as an up volume day and vice versa when a stock declines, that's counted as a down volume day.

But what does it matter whether the majority of the volume is occuring on an up day versus a down one? Why should one care?

Why Volume Matters?
Volume is the essence of supply and demand and in the end, the supply and demand is what moves prices. Since we trade in order to make money, it's important to understand if there are more buyers or sellers of a stock at a given point in time. Volume can help to tell you that.

The other thing volume does is that in many situations, volume precedes price. By that I mean that volume signals occur before price signals. When larger buyers are either accumulating a stock or distributing it, they typically leave their footprints in the volume bars. Sure it will be reflected in the price as well, but its in the volume bars that we can make sense of what price is doing and many times volume signals will clue us into what price is about to do.

So if volume can tell us so much ... how can we make sense of it?

Interpreting Volume
The most significant problem with interpreting volume is the scant information we have to work with. First of all, as mentioned above, we don't have a day-to-day accounting of how much volume was a buyer hitting the bid versus a seller hitting the bid ... in other words, who was initiating the action. That would be the cleanest data if it were available. Instead, what we have are the following:

1. Over all volume on a intraday, daily, weekly, and longer time frame
2. Price that correlates with the above volume time frames
3. Direction of prices - the short, intermediate and long term trends for the time frames being studied

... more to come ...

Discerning the difference between short covering and real buying

When a market has been bullish for a while, there is a tendency to see sharp short covering spikes occur. They are driven by nervous shorts who run for cover thinking that maybe they are wrong again as well as over anxious bulls who want to call the bottom. The difficulty is determining whether a snapback against the trend really has staying power or is simply a short covering rally that is destined to fail.

There's no hard and fast way to determine which is which, but the proof of the pudding is usually found in the volume. A short covering rally will look just like a lasting move in that volume on the way up will gather strength and crescendo with a nice increase over recent volume. That part looks the same. What is typically not the same is how things look on the way back down and the subsequent attempt to push higher. If you high volume on the way back down or less volume on the secondary attempt to push higher, you are likely witnessing a short covering rally and nothing more.

Although there are other sign posts to look for like, the quality of the rally (is it broad or narrow), whether it is driven primarily by futures buying, whether it is centered in speculative stocks mostly, etc., paying attention to the volume story is the most critical factor to observe.

Avoiding the pain at the edges

There are three trends to a market based on time frames; short term, intermediate term, long term. Unless you are a buy and hold or maybe short and hold type of person, the long term doesn't offer a lot. The short and intermediate term, however, hold promise.

When a market is moving in a given direction, the majority is right, except at the edges. Think about it for a minute. If the market is moving higher, then the only reason it is moving higher is because the majority of the money is on the buy side and thus the demand for stocks is greater than the supply. When the demand outstrips supply, prices move higher. If there is more demand than there is supply, the majority of the money is necessarily on the buy side. Taken further, when a market is heading higher, the majority is not just true of dollar terms but also true of players since the majority of the players are smaller and the smaller players are typically buyers of stock, not shorting stock. When stocks head lower, eventually the majority of the players also becomes sellers (although they are selling previously purchased stock, not shorting). Thus, the majority is right again ... until the next turn/edge arrives.

It's only at the edges where the majority is wrong because the where a change in direction truly occurs, the majority will necessarily become the minority. The rest of the time, the majority is right.

Now how can a trader take advantage of such knowledge? The obvious answer is that if you are an early adapter to the change in trend, then you are less likely to feel the pain that a turn causes. You don't necessarily need to take the other side of the trade but you do have to do some selling when the majority are forcing stocks higher just as you have to do some buying when the majority are selling.

In the next conversation, I'll talk more about how to avoid the pain of a turn in more detail. It's probably one of the most crucial points in how to outperform the markets.

Scanning - Managing your lists

So you figure out that you need to scan in order to generate ideas and you get really ambitious creating 5 or 6 scans that find setups that interest you. You run the scans and start building watch lists for those patterns that are interesting. You may make 2 or 3 trades based on your scans but for every trade you make, there's probably 10 or 20 still on the watch lists that you are observing. After a month of doing this your watch lists grow to a size that they basically become unusable. You have too much data now rather than too little! You still don't have a workable solution. You need to find a way to manage the lists. I know, I've been there and constantly am working to keep my lists fresh.

Just as there's no one scan that will give you that magical entry and only that entry, there's no magical way to manage your watch lists; at least not that I have found. The trade off is how much time you spend versus missing how many potential entries you miss because you were not on top of the situation.

Since I spend way to much time on trading already, I have tried to find a system that keeps my managing of lists to a reasonable amount. The way I've tried to do this is by managing my lists based on time frames. I've kind of formed a routine that, although not religiously followed each and every day, I try to go through the same steps daily to keep my lists fresh and ideas generating. Below is an accounting of the steps and a pointer to the lists that I have recently began publishing so that you may see them.

Background

I keep a lot of lists around but there is a method to the madness. Basically I have two sets of lists; lists that make up the basic market sectors where I store charts that are of interest to me and lists that I used to manage new ideas and possible trading setups. This discussion is about the latter group of watch lists.

List Management for New Ideas

The basic structure of how I maintain them is based on time frames. There are a total of six lists that I'm constantly working. They all start with the word Action and then their function. For example, one is called Action-Long and another Action-Short which are my two primary repositories of stocks that I've been following recently and still look to provide a tradeable setup in the near future. The are my longer term lists with respect to time frame.

Moving into the shorter time frame, each day I create a list of potential trades based on scans or other sources of information. That list is called Action-Daily and I maintain it and all the other lists talked about in this article as shared watch lists on Prophet Net. The page that you open by clicking on this link is a list of all shared watch lists on Prophet Net. You can find my personal lists by searching either in the Name column or the Owner column of the table that is presented. The name is the name is the name of the list (ex. Action-Daily). The owner is my moniker on Prophet Net, tradechatter. Since I already maintain my lists on that site, the simplest way currently to share them with you is to simply publish them and show where they are.

Daily Activity

Most every day, I go through the following process:

1. The first action is to review all stocks in the Action-Daily watch list. If they still look promising as an entry in the next day or two, I leave them there. If not, I look to move them to the Action-Weekly watch list if I believe they may offer a move in the coming week. If they appear as if they are still promising but will not move relatively soon, I move them to the Action-Short or Action-Long watch lists. If they no longer look promising I throw them away (remove them from the lists). This leaves me a relatively clean Action-Daily watch list
2. Next, I execute my nightly scans. If the stocks I uncover during scanning look to be immediate plays, then they go into the Action-Daily list. If they look like they may offer an opportunity within the next week, I'll drop them in the Action-Weekly watch list. Again, if interesting but not likely to produce an entry point within the coming week, I'll drop them into the Action-Short or Action-Long lists
3. During the trading day I often glance at the stocks in all my lists looking for action (up or down). I typically have the lists sorted by percentage change in price, so it's easy to spot those that are moving. If I see some unusual activity in a given stock, I'll look to monitor it more closely and may move it to Action-Daily or Action-Weekly watch lists

In case it isn't obvious at this point, the Action-Daily list gets the most attention each trading day. It is where I make new purchases or sells. The Action-Weekly list also receives attention because stocks there could begin to move at any time but nothing was urgent when I last reviewed them.

Weekly Activity

Once or twice a week I try to work through every stock in the Action-Weekly watch list to see how they are progressing. Just as with the daily routine, I either upgrade stocks to the Action-Daily watch list or downgrade them to the Action-Short or Action-Long lists or get rid of them altogether.

Earnings Activity

When earnings season rolls around, I keep an Action-Earnings watch list were I work through all the charts of those companies that have recently reported earnings and if there is an interesting setup I'll add them to this list. I only do this for the first 4 to 5 weeks of each earnings season as 80% of the companies report during that period. I do not look at every chart but a lot of them and I try to be reasonably selective on charts that are of interest. I typically do this each weekend. As with the other watch lists, when I'm ready to work this watch list, I first quickly look at the charts already in the list and cull them from the list quite liberally unless they are still of interest. Again, I move them appropriately to Action-Daily, Action-Weekly or Action-Short or Action-Long.

Recent Trades

The only other short term watch list I maintain the Action-RecentTrades watch list. Many times I will re-enter recent trades once they set back up again either from the long or short side. Since they tend to offer good continuing trades, I don't want to lose track of them and keep them in there own list. I periodically review them when I have time during the trading week and move them to an appropriate list as described above.

Summary

It's not a perfect list management scheme by any means but if you depend on a fresh set of ideas for trade setups, having some sort of list management scheme is necessary. The system I've outlined is what I use. You can find these lists on Prophet Net.

Scanning - it's a process

One of the common misperceptions that people have is that you need the perfect scan; that scan that gives you back 3 winners from the universe of stocks that exist. I don't believe that is reality. The reality is that you must look through 50 charts for every 3 that might make sense at right now. Of those 50, maybe 10 are worth watching, 2 or 3 may be worth an immediate trade and the rest are throwaways. Scanning is a process. I'm sure there are many ways to structure the process but, for your covenience, I've listed my mine below.

With Prophet Net (which I use almost exclusively) you can easily set up scans and watchlists to track potential trading candidates over time. I'm sure there are other services and I only mention them as an example because it's a product I use and have a subscription service to. One of the items I like best about about there service is that you can arrange your scan results to show the time periods you are interested in and you can place a number of charts on the same screen enabling you to flip through them really fast. I can flip through a 100 charts in 5 or 10 minutes and save the ones that need further analysis with a single key stroke. Once I have flipped through all the potentials, I review those that showed promise.

It is at this point that I divide them into two groups; immediate and future. The future ones I don't do much more on them until later. The immediate ones I'll look more at there longer term charts (I look at 6 month charts with only moving averages at first) and any recent news and how the stock reacted to it. During earnings season, I'm especially careful to try and avoid large positions in a stock that will report. I might carry a small position but a lot of times, I'll just stand aside and then re-enter later if it still makes sense.

A common misnomer is that you have to catch all of a move in order to be profitable as a trader. I could not disagree more. I don't care if I miss one dollar of a move at the beginning and then end and even a dollar in the middle if I catch a couple dollars of the overall move. If I'm constantly looking for setups, what does it matter whether I make all I can make in a given stock? What matters is not getting hit with a huge loss in any given stock. You can't always avoid this but if you work with a lot of charts that show promise, the odds are you will do ok. Of course now we are crossing into the land of money management and that's a subject for another piece.

Scanning for Set Ups ... continued

In the last couple posts I have shared some of the setup scans that I run nightly looking for fresh ideas of stocks to trade. One thing that I always keep in mind is what the general market trends are therefore where I wish to concentrate my time as I look for trading ideas. In other words, do I look for bearish setups or bullish setups. Are we transitioning from one to the other?

In the current environment I would argue that we are likely transitioning from bullish to bearish on an intermediate term trend basis. If that is indeed true (and that is my current thesis), then I should look for stocks that are likely doing the same thing. Here's a scan I use for just that purpose. Its target is to uncover stocks that have previously been bullish but now are potentially changing to bearish. The criteria is

• Exchanges: NYSE AMEX NASDAQ(NM)
• Average Volume is at least 50,000 shares
• Last Price crossed below 50-Day MA
• Last Price is below 20-Day MA
• Last Price is below 200-Day MA
• Virtual Volume is at least 50% greater than Average Volume
• Last Price is at least $2

I have another one that is essentially the same but it looks for stocks that are above the 200-Day MA but have just crossed under the 50-Day MA. The stocks in that scan are generally more positive but they have further to fall if in fact they are turning bearish so I always take a look to see.

Scanning for Set Ups ... continued

In the last post we talked about a general scan that I use in an intemediate term bull market. If you consider that the market (and individualy stocks as well) do not go straight up but instead advance, pull back, then advance further; then it makes sense to try and identify stock purchases when stocks are pulling back. The reasoning for this lies in the desire to buy stocks at a point where you can reduce your risk of error; that is if you are wrong and the stock really is done moving higher, then you want to be able to exit without it taking a large part of your capital. Note, that a retrace works the same if the direction is down. In that case, the trend is down, stocks retrace higher, then resume their decline.

So here's a scan I run when an identifiable bullish trend is in place. It attempts to identify stocks that have been strong but are currently coming back in some and may offer an opportunity to purchase them.

Criteria: • Exchanges: NYSE AMEX NASDAQ(NM)
• Average Volume is at least 50,000 shares
• Virtual Volume is at least 50% less than Average Volume (30 day MA)
• Last Price is greater than 2
• Last Price is below 20-Day MA
• Last Price is above 50-Day MA
• Last Price is within 10% of 52-Week High
• Last Price is above 200-Day MA
• Last Price is within 10% of Lifetime High

A somewhat opposite scan looks for bearish retraces although I'm still exploring a better set of criteria for it.

Criteria: • Exchanges: NYSE AMEX NASDAQ(NM)
• Average Volume is at least 50,000 shares
• Last Price is below 50-Day MA
• Virtual Volume is at least 50% greater than Average Volume (30 day MA)
• Last Price is at least 2
• Last Price is below 20-Day MA
• Last Price is below 200-Day MA

Scanning for Set Ups

There are many ways to approach trading. Over the years I have moved more and more towards managing a large number of positions rather than concentrating my money in just a few. I have purposefully done this to reduce risk as the size of a particular position is necessarily lower and the number of stocks I carry in a given sector tends to be more dispersed.

In order to do this though, you need a steady source of ideas. In today's world, the easiest way to generate these stock entry ideas is via stock scanning. There are many tools available to search for trade setups. I've chosen tools and data sets that are easily accessible and executable anywhere I might happen to be both domestically and around the world; thus the tools and data sets I keep need to be available remotely via the Internet. I do not care to have a heavy client but instead a thin client that is simply a browser which is enabled from the remote server. This has some limiting factors but it allows me the independence of not having to have a particular application on a particular hard drive of some computer that I have to have with me in order to work. With my setup (www.prophet.net) I can do my work where ever I may be as long as I can access the internet.

Independent of which tool set you might use, there are applications that allow you to scan for technical setups that may produce possible trades. The key is to find some set of criteria which yields potential trade setups. Since I believe that the market rewards some trades at a given time while punishing others, I have built scans (that I continue to refine) that attempt to identify the technical patterns that you see me trade with on this site like wedges, retraces, breakouts, etc. When the general market seems to be support a retrace pattern, like today and tomorrow, then I will concentrate on looking for bullish retrace patterns.

Here's a simple scan that I use anytime general market appears to be in an intermediate term bullish advance.

Criteria:

• Exchanges: NYSE AMEX NASDAQ(NM)
• Average Volume is at least 50,000 shares
• Last Price is above 50-Day MA
• Virtual Volume is at least 200% greater than Average Volume
• Last Price is at least $2

In this scan, I'm just looking at any stock that traded on above average volume today, is liquid and not a penny stock and is likely bullish (trading above the 50 day moving average).

In the next post, I'll review some other scans that I use as I continually look for trading ideas.

Mining your Data (Final Thoughts)

We left off asking the question about what was the bulk of the trades that made up the sweet spot of trading in our data analysis. The analysis showed that 70% of the trades were spread across four patterns

1. Breakout
2. Trend Line Break
3. Short/Intermediate Trade
4. Retrace

and in that order (in terms of success). The failures were across all trade setups (as well as the four above) but these four were the patterns that were best identified with winning trade setups that occurred in the >15 yet less than 30 day duration.

This got me to thinking of why these trades. My first thought is that most intermediate term moves play out in 5 to 7 weeks on average. The sweet spot trades lasted between 3 to 6 weeks. That tells me that the sweet spot trades most likely happened to catch the bulk of the move on an intermediate term leg up or down. I have not confirmed that, but it is my suspicion.

The second thought is that if a stock doesn't fail during the first 2 weeks or so, it's probably a keeper. Since I have a tendency to trim winning stocks, I usually don't let them play out much longer than this time period. Over the past couple years this has become even more true than previously as I had no losers greater than 30 days on the books.

Lastly, I've become more adverse to holding stock into earnings. Earnings occur every 3 months. That forces me to reduce size usually if not to outright close positions.

Further Work Needed

An area that I've began to collect data but don't have enough to make any general conclusions is the general trend of the makret (short, intermediate, long term) and it's impact on my trades. By next year I will be able to say more about this as I continue to consider what data I want to collect in order to make my trading more profitable.

Mining Your Data

I once was asked why I expend the effort to collect so much data about my trading. My answer then, as it is now, is that without data, there's nothing to analyze in order to improve. Anybody can collect data although few do. The trick is to make good decisions about what to collect, to collecte it, and then to do something with it.

There was a great comment over on The Chart Of the Day where the question was asked about time frames; whether the length of my trades has increased or decreased over the years and whether there was any correlation between that and my success or failure rate. The follow up question was whether risk was reduce/increased as a result as well. They were very thoughtful questions and reminded me that I indeed needed to revisit my data looking for answers.

Trading is Personal

Before we begin data mining the data that I have collected over the years, you first have to understand that trading is personal; it's a reflection of you. Although many people trade in a similar fashion, I suspect that no two people trade exactly alike. We are all individuals whoose make up is unique. The decisions we make about what to buy, to hold, to sell is very individual. There is no holy grail to trading successfully. It's about trial and error, analysis and improvement.

Data Mining

Before we begin to mine the collected data, we have to ask what we are looking for. The specific questions asked over on The Chart Of the Day was about length of trades and perceived risks. I would broaden that a bit to ask about ??


Time Frames - Winning and Losing

Over the past four plus years I have executed almost 7000 trades with the bulk of those trades coming in the past two years when I have been able to dedicate more of my time to the markets. As a result of the previous analysis I had done, I remember that the most important conclusion that came out of that reflection was the desire to not hold losers but instead to cut my losses sooner and to move on.

Towards the end of 2004, I had much more time to devote to trading and by 2005, I found myself trading in very short time frames; partly because I was experimenting with the idea of whether I trade successfully on a daily basis, partly because the markets dictated a shorter term focus (in a previous article I've talked about the affect of the general market on particular stocks).

Getting back to the data though. The tables you see here is a summary of that data examining:

• The percentage of trades that fall into day, 2 to 5 days, 6 to 10 days, 11 to 15 days, 16 to 30 days, and more than 30 days (for the 4 years of data points)
• The win percentage for each of these time frames
• The average return for each of these time frames
• The drawdowns for the three time frames where significant changes have ocurred over the 4 year period, namely the day trade, 3 weeks to a month, and greater than a month

From the data points collected over the past 4 years now, I clearly met the objective of cutting losses more quickly, having dramatically reduced the average loss on a stock from 38+% in 2002 to 0% in 2004 for trades that lasted more than 30 days. The improvement is clearly seen as well in trades between 16 to 30 days where I cut losses quicker moving from 27% to the low teens on a percentage basis.

At the same time, with my expermentation with very short term trades, I've seen my loss percentages rise on day trades reaching 23% but I improved the winning percentage of those trades once I began to concentrate on them from a toss up the first 3 years to almost 7 out of 10 in 2005. The devil is in the details though. If you dig deeper, the dollar figures show that the reason I increased the day trade win percentage is because I took profits early and allowed losers to run longer during the day. That's reflected in the percentage returns where you see 23.58% loss on a day trade basis compared to a 19.84% gain on the same time duration. Unless I can improve my absolute dollar gains on a day trading basis, it's a losing proposition.

Where Is the Sweet Spot?

The real gains in 2004 came from the trades that were > 15 days in duration but less than a month. Those trades accounted for 80% of the returns. When I look back at 2004, it was exactly the same story, accounting for some 90% of the gains for the year. This has been consistently true for me since the beginning. The bulk of my gains come in the 2 weeks to a month time frame. More analysis is needed to understand why this is so. In the next series, I'll take a look at what types of trades are the ones that make up the bulk of the sweet spot. Are they retrace trades, breakouts, etc. Is there a pattern that's repeated that we can look to exploit?

... to be continued ...