By Larry Connors
Having been involved professionally with the financial markets since 1981, I've gotten the opportunity to see some great advances in the industry. The Dow was near 800 when I came out of Syracuse University in 1981, and shortly thereafter I joined Merrill Lynch in Boston. The daily volume on the NYSE was under 30 million shares at the time (hard to believe now), and the many futures and options vehicles that we trade today were years away from being developed.
The one constant that I've seen over the years, not only in my own trading, but in observing professionals in the industry, are the three following principles which are the backbone of all successful traders. These elements have not changed in more than two decades, and my strong belief is that they will not change for decades to come. Master these three key principles, and continue to improve upon them, and your chance of success will grow exponentially.
I'll refer to these principles as the Three Keys. The Three Keys are the backbone of all successful traders. What are the Three Keys? They are Edges, Protection, and Psychology. The more you improve upon the Three Keys, the greater your chances of success will be.
Over the coming weeks, I'm going to expand upon each of these Three Keys by releasing a free 12-part course, commencing the week of November 12. Each part of the course will include a sampling of our latest research, and teach you how it can be applied to your trading. As you progress through the course, your trading knowledge will be greatly enhanced.
Everyone is looking for an edge in the market place. In my opinion they exist, especially over the short-term. When prices get extended too far to the downside, they tend to snap back (this is known as reversion to the mean). The further they pullback, the larger they snap back. Is this true for every single pullback? No! But when we look at tens of thousands of pullbacks going back decades, you see a decided edge over the short-term. Meaning, these stocks tend to do better than an entire universe of stocks does over the same period of time. The more efficient you are at finding and quantifying these pullbacks, the better your chances of trading success are.
Many people believe that all they need to do is properly identify a time that an edge exists, and the money will flow from there. This scenario goes on all day long -everyone who goes on television or is quoted online or is in print believes the stock they are discussing has an edge. Maybe it does (though we strongly believe those edges should be quantified ahead of time -- otherwise in our opinion, it's "guessing," something we don't want to be doing when money is at stake). But as important as identifying when to enter with an edge is, you need to know when to exit. Edges usually exist for only short periods of time. Get out too soon, and you've diminished the edge. Hold the position too long, and the edge begins to disappear.
What is the key time to exit a position that has a "quantified edge?" We've found it's ideally 3-7 trading days. But, you can do better than this. Time exits are static, and we want to be dynamic (meaning we'll let price get us out, not time). So, what are some of the better ways to use price to exit trading positions? There are a few, but our favorites (which have been quantified) are crosses above the 5-day simple moving average (meaning once the stock closes above the 5-day SMA, you exit the next day). Another favorite that we developed a few years ago and still use is waiting for a stock's 2-period RSI to close above 70 (65-75 is a good range with 70 being in the middle). For each of these exits to occur, it means that the stock has rallied off its lows, and buying pressure has pushed prices higher. Depending on the entry edge, you can trade set-ups which have been profitable over 70% of the time going back more than a decade.
To summarize, the first key piece to successful trading is buying on pullbacks, which have shown a historical edge, and then exiting when prices rally to above their 5-day SMA or when the RSI closes above 70. The better you can do this, and the more often you can do this, the more likely you'll be successful.
Whenever anyone takes a position in a stock (and this includes any buyer of a stock), they are immediately faced with three types of risk. These risks are:
Market Risk
Sector Risk
Corporate Risk
Let's look at each individually, and learn what we can do to protect ourselves from these risks.
Market Risk
Market Risk is the risk that the overall stock market brings on a daily basis. Whatever causes the stock market to decline is a risk that is many times felt by the stocks we own. How many times have you seen your positions rise and fall in line with the market? This is especially true with such things as political risk, as we saw with 9/11, or economic risk, as we saw with the credit debacle in the summer of 2007. Whenever we buy a stock, we're at some type of risk to what the market does. And as happens quite often, as well as a company is doing, it means little if the overall market is plunging.
So, how do you protect from market risk? There are many ways but the simplest is to be short an equal amount of an index ETF. This means that if you are long $50,000 of stocks, you can lessen the market risk of that position by being short $50,000 of an index fund. If the market drops, the index fund will also drop making your short position profitable. The key with the hedge is to make sure you have stocks which have greater edges than the market! This means in the perfect world that your stocks will drop less than your index short does when the market declines, and your stocks will rise more than your hedge does when the market rises (this leads to the quest of creating the perfect hedge fund for yourself). In reality, you are buying insurance with the hedge. The goal is to get the most amount of protection for the least amount of money. If you can do this, you've gone a long way towards the goal of successfully trading your money year after year.
Sector Risk
Look at the top performing mutual funds each year. You will likely see they are concentrated in one sector (the money managers of those funds are considered brilliant by the press during these times). At the same time, look at the worst performing mutual funds for the year. You will again likely see they are concentrated in one sector (those money managers are considered dumb by the press during these same times). In reality, these managers are not brilliant, nor are they dumb. They are simply tied to the movement of the sector. If the sector rises, they make money and look smart. If the sector declines, they lose money and look not so smart. As the sector goes, they usually go.
The same holds true for trading. You are at sector risk (both good and bad depending on which side you're on) when you concentrate too much of your portfolio into any one sector. This fact became very apparent to me in the fall of 2006 when I saw one evening that we had approximately 60% of our holdings in oil and oil related stocks. We were over-concentrated in the stocks of one sector because the sector had pulled back, and a number of stocks pulled back within the sector, triggering numerous buy signals over a few days period of time.
How do you avoid that same scenario happening to you? The easiest way is to implement a sector rule. That rule can state that you will not put more than X% of your money in any one sector no matter how many buy signals are triggering. X% can mean 15% or 20% or 25%. You decide the comfort level. The goal is to protect yourself in case the entire sector goes down. By limiting your exposure to the sector, you have lessened your risk to the sector.
One more thing on this? Many sectors are related. For example, gold stocks and silver stocks may be considered different industries, but they are still metals and they are related. Know your sectors and understand the correlation between sectors. Again, the goal is to protect yourself from sector risk, and in order to lessen your risk, you want to limit your exposure to that sector.
Corporate Risk
What is corporate risk? It's the risk associated with owning a company. If a company does poorly, misses earnings, has accounting irregularities, etc., it all adds up to corporate risk. How do you protect yourself from corporate risk? Well, the bad news is that if you own a stock, you cannot eliminate corporate risk. And most people think that stops will help them, but that's not true when it comes to a company announcing negative news after the close, and then it gaps down 25% the next morning.
The best way to lessen corporate risk is through position sizing. This means that you limit the percentage of your portfolio to any one stock. I do not have the perfect answer as to what's too much or what's too little. But 50% in one stock is certainly too much. Getting down to 20% is more manageable, but it's still very aggressive. Depending upon your risk profile, 2-10% may be the correct answer. And, if you're unsure, stay with the lower percentages. Just know that you need to find more edges in order to make larger returns with smaller position size. This means that you will likely need many strategies with edges in order to get a large portion of money to work. But again, the goal is to lessen the risks, and position sizing is one of the better ways to lessen corporate risk.
Now that we've discussed Edges and Protection, let's now discuss the third key to successful trading, this is Psychology.
As many of us have learned, trading is a great game, but it's also a game that can take a lifetime to master. Not only do we need to be able to find edges and protect form the risks involved with those edges, we also must be able to execute day after day. Like athletes, our scorecard is available to see after each day. This scorecard not only reflects your profits and losses, but it also must reflect the amount of risk you had to take in order to achieve those returns. I'd rather do 15% in a year taking minimal risks than 100% in a year knowing that I could have blown up at any time (a lot of so called smart hedge funds painfully learned this lesson with their money and other people's money in the summer of 2007).
The biggest edges we've been able to identify and quantify occur when fear is at the greatest. Fear creates the unknown, and the unknown many times creates mis-pricing in securities. Usually this mis-pricing lasts for a very short period of time and then the prices revert back to the mean. Our job as traders is to systematically take advantage of these mis-pricings as they occur.
As easy as this may sound, it's more difficult to do in the real world. Many times the edges are not isolated, meaning that they don't happen for one day and then snap back. Markets will become oversold, we'll start scaling into positions and then the market will become even more oversold (that's the DNA of the market place). It's during these extreme times that the best edges exist. But unless you are fully protected or hedged, you'll likely have losses in the positions you bought earlier. With this in mind, the pain becomes even greater each day the market moves lower. In fact, many times, the pain becomes greater than the knowledge that this has historically been the best time to be buying.
In the summer of 2007, the media created a mass hysteria over the credit crisis. In fact, the building I worked from that summer faced the Goldman Sachs building. I was expecting to see them throwing traders out the windows as rumors were flying around that their main hedge fund was getting crushed (it was). But as bad as things were, it created incredible opportunities to be buying stocks which were grossly oversold and had statistical edges that we had never seen before. Had one had the strategies to take advantage of these opportunities, the only thing that stood in the way was to pull the trigger.
I'm fortunate to know many good traders who run funds, trading firms, and those who trade professionally for themselves. Many trade as we do, using reversion to the mean to identify short term edges and many then hedge these edges one way or another. A number of these traders had their biggest month in years in August 2007. The opportunities were there, and these guys executed. They felt the same fear as everyone else -- but they executed, and they won.
I also know of funds that did not execute. They too had the same edges as everyone else. But they didn't pull the trigger. For 26 years I've heard the same term used --they puked it up at the bottom. And as ugly of a term as that is, it's been a reality I've seen played over and over again. Smart, rational, highly educated individuals, allowing their emotions to overtake rational thinking, and allowing substantial losses to occur at the time that their biggest profits should have occurred. Trading is about putting together a plan, quantifying the edges, diversifying the edges (through multiple strategies) protecting those edges from market, sector and corporate risk and then executing. Everyone spends a lot of time looking for the edges. They spend less time on protecting the edges. And they spend the least amount of time on preparing themselves to execute those edges. Time spent on executing is usually the difference between the many that play this game as an expensive hobby and the few who play this game at the highest levels year after year.
In order to trade successfully every piece mentioned above has to come into play. As I said earlier, this is a lifelong process, with the goal being to achieve mastery. Achieve mastery, and the money will likely follow.
Philosophy
1. Goals of the course. Trading with "quantified edges", reversion to the mean, hedging, trading systematically, etc.
Edges
2. Shallow Pullbacks
3. Mid-level Pullbacks
4. Large Pullbacks
5. Combining the three levels of pullbacks to maximize edges. Buying on limit orders below the previous days low.
6. Exits
Protection
7. Stock market hedges (IWM, SPY, QQQQ & options)
8. Sector hedges/protection
9. Corporate protection
10. Different levels of hedging (1x1, 2x1, scaling down the hedge as the market becomes more oversold)
Psychology
11. Not taking trades, trading without quantified edges, over leverage, daily execution and the urge to lift the hedge.
Putting it all Together
12. Applying the Knowledge Everyday
The Three Essential Keys to Successful Trading
