I want to invite you to discuss your personal experience with the importance of being patient in your trading. Whenever I look back on my past trades, first of all I can modestly admit that the vast majority of them is directionally correct (otherwise I’d be better out of this endeavor), but secondly I observe that again the vast majority of them is timed quite badly, and from the bad timing mistakes being too early is overwhelming. So here I would like to concentrate on the issue of patience.
I recall some time in the late 2006 one poster at the “The Big Picture” blog accused Barry Ritholtz that the blog made him substantial losses as he was shorting the heck out of the market. Barry answered that the guy “must grow his own balls” and do not treat blogs as financial advisers.
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That was a perfect example of bad timing in the 4-year cycle, quite a costly mistake if you make it.
Now, looking back to that turning point we see that corporate profits (the only thing that really counts at the stock market) were quite healthy up to the late Summer of 2007, despite the serious weakness in the real estate market that indeed started in early 2006. Besides, looking back I have a strong opinion that we had a mid-cycle slowdown (Goldilocks scenario) in first half of 2006, which finally manifested itself in the serious market weakness during the Summer.
Before getting into details let me propose a hard-learned general principle:
If you are waiting for a major (or medium-term) market top you should wait for a clear and bold signal. If you think that the market already topped but you can’t find any bold, obvious signal of that, then you are likely to be wrong. The signal always exists and you must develop skills to determine it. And you must keep waiting until it comes
Now I want to illustrate my point with examples. So what should we do with macro (4 year) cycles that are most likely related to the recession or recovery? Every recession (or mid-cycle slowdown) has its own raison d’etre.
- In 1980 Volcker killed the inflation (and the stock market) with almost 20% interest rates. Add S&L crisis on top of that
- In 1991 the consumer was killed by real estate downturn
- In 2001 economy suffered from Nasdaq bubble pop and over-investment into year-2k problem
- This time we have another real estate bubble pop
The bullet-points above are the “Achilles’ heel”. When you know it you know what to look at. Going back to 2006-2007 the real art was to understand that the stock market will nor react to the real estate problem but will crack when the loose lending practices will affect the banking sector. Here’s the chart:
As you can see the ratio of banking index to S&P gave an advance warning that the market will top about a year in advance. The junk bond market gave a good advance warning as well:
Or you can watch how the yield curve became inverted in second half of 2006 and then rolled over:
The relative weakness of transportation stocks is an another classic warning:
So the patience gets rewarded - if you had waited for any of those signals.
What about the level of confidence about a medium-term top? I think it works the same. At May 13 I was able to come with correct signal that the market is expected to top, but I was not that confident in my finding and yes, I was wrong. But then at May 17 I was much more confident. And today rollover of stock market confirmed what I’ve expected - the intermediate top is behind us and the bear market is back.
This is the latest chart of financial stocks divergence:
The game is clearly over this time
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11 Comments
Your discussion of patience and timing is interesting, and important. I’d like to share a few recent trading experiences to expand on what you’re saying and to make the additional point that position size is also important. That is, while waiting patiently to be proven right over time, keeping a small position is much better than no position or a full position.
GM and FNM had been favorite shorts of mine for a long time, I had been selling call spreads and naked calls and shorting the stocks repeatedly with fairly decent success in and out with small positions. Then when GM spiked to the mid-40’s during the union negotiations, which I felt would soon be reversed (eventually it was) I got burned on a few naked 40 calls and went back to no position in GM. Should have kept a small short position and added to it on the way down. Instead I stayed on the sidelines and watched it go all the way down from above 40 to below 20 without me. Similar situation in FNM. So in both cases although I made some decent money picking at them before the big move started, I missed out on the big move in both cases. On the other hand, at least I didn’t make the mistake of putting on full short positions early and getting hurt badly because of it.
On the long side I had been buying and selling ENER for a point or so at a time, and selling covered calls….last time it got called away at 35 I didn’t re-enter with another small position, instead I waited for a correction that never came, so it rocketed to 60 without me except for a small buy-and-hold position in an IRA. In my stock trading account I had no position. Should have at least sold naked puts after the stock was called away to maintain a little long exposure, that would have been better than nothing. I guess what I’m trying to reiterate here is what Jesse Livermore said in his Reminiscences book about keeping a small test position in play and then putting the full position on the line after you’ve been proven right. I think that is the best way to implement patience and timing.
On a related note, one thing I’ve found very helpful psychologically AFTER riding a big position for awhile, then being faced with the stressful situation of should I take the profit or keep riding it and risk giving it all back, is to simply close half the position and let the rest ride.
I trade almost exclusively in options, and one lesson that I’ve painfully learned is to ALWAYS buy expiration dates well beyond the timeframe that I consider to be reasonable.
For instance, if I think that something must occur within 90 days, I’ll buy a six-month option. Having extra time has saved my bacon many times.
This is an interesting topic — thanks Mr T. Because while this blog is not meant to be a trading blog, it’s no doubt true that people use the info they get here and at other blogs (and in the comments) to make trading decisions.
Regarding ‘Patience and Trading’, and the sub-theme of rarely timing a trade optimally (and so e.g. having to decide whether to be patient when it goes against you initially), what comes to my mind immediately is how difficult it can be to decide when to get out of a trade in order to limit a loss, and/or whether to use stops in a disciplined way for that purpose. I still have real difficulties here. You must be ready to act to limit a loss, and putting in a GTC stop/limit order can enforce that. But I have also experienced where in the end a stop order has stopped me from making money by getting me out of a trade that I then had not enough inclination to re-enter when it finally went my way later. Use of indicators could be a way to decide if/when to re-enter (although maybe some other indicator led you to wrongly enter the trade too early previously).
Now, looking back to that turning point we see that corporate profits (the only thing that really counts at the stock market)…
At one stage, yes. But at another stage it may be e.g. book value that holds a stock up.
Solar Lad’s comment is a good one.
For my own anecdote, one of my friends on the floor had a surpisingly effective strategy. If he had an equities trade idea, he would study it, do his due diligence, get all excited, and then “execute” by putting a note in his calendar to actually execute the trade exactly one month in the future.
Almost inevitably, the trade was correct in the long-term, and almost inevitably, he would have gotten thrashed in the first month.
Eah, an interesting idea about indicators. I certainly heavily use indicators and oscillators to find out what’s going on.
But I never thought about consciously using indicators for the purpose of trading discipline. I think I will adopt that.
The idea is, I use certain blended level of indicators as a stop loss or take profit signal, even if my emotions tell me to stay. Same for entering the position.
#2
I trade almost exclusively in options, and one lesson that I’ve painfully learned is to ALWAYS buy expiration dates well beyond the timeframe that I consider to be reasonable.
This is the ‘pig’ thing (from ‘bulls make money, bears make money, pigs get slaughtered’): people often buy nearer term options because they are cheaper.
#6 Agree, I think you need at least $30k or more to build an option portfolio. Every option at least $1k, cheaper ones are too dangerous. You need at least 20 different contracts in different directions and maturities to be well diversified and stable. And you need $10k cash just in case “the great opportunity” strikes
I’ve seen a lot of smart people fail in the stock market simply because of a lack of patience. If I had more money at stake when I first started, I might have flamed out also. Everyone knows in advance that a stock like CROX will eventually become a textbook case of a typical popular fad that fades away, but if you tried to short it too soon you got creamed. On a macro scale, if you know your Austrian school, you know how things will probably end, but try to call it too soon (say in the 70’s after Nixon closed the gold window) and you will be set for even bigger disappointments.
For simply shorting stocks I like “How to Make Money Selling Stocks Short” by William J O’Neil, if only because of the reassuarance it gives you with the knowledge that you are better off waiting for confirmation.
As I tell my clients, there will always be another train pulling into the station at the stock market. If the one you are waiting on isn’t there yet, take one that is. And if you missed one, don’t chase it, just WAIT for the next.
I’ve just made a simple calculation of the speed with the stock market declined in the intial stage of 2000 bear market and now.
Back then stock market (S&P) gave up 13.7% in 262 days from Sept 1st 2000 to May 21st 2001. That is 0.0522% per day
Now it declined 8.88% in 223 days Oct 9th 2007 to May 19th 2008. That is 0.0398% per day
Conclusion: this bear market will be slow and boring. You will need a LOT of patience
Satyajit Das is the author of “Traders, Guns, and Money” and one of the world’s foremost experts on derivatives. I would recommend this book to anyone. The most important thing he said is stock markets “first overreact, and then underreact.” I’ve seen this pattern over and over again. Take Countrywide last year. The all-time high was about $44 in Janruary of 2007. Then came the subprime lender implosion with New Century plunging 50% one day in late February. Countrywide sank to $33. Time to short? No way. This is the initial overreaction. In May, I got my opportunity. Someone floated a rumor that Merrill Lynch was going to buy them out, and they hit $41.
I won’t mention the trade that lost me more than that last year, but it was a rash and not a patient move.
I’d also recommend taking a smaller short position - or hedge with calls - that would allow one to ride out potentially vicious short squeezes and bear market rallies. Not following this rule, I shorted ABK at 22, and BSC at 58. When ABK got squeezed to 33 and BSC to 68, both right before their collapses, my positions were too large to allow me to ride out those moves. I covered and didn’t reshort before the big declines. It kills me that when I’ll look at my EOY P&L, I’ll see I managed to lose money shorting ABK and BSC.
DSL almost did that to me as well. Shorted at 28 and it squeezed to 37. I was pretty sure it was going to go where it is currently, but when one’s account gets creamed due to an overly large position, it becomes very easy to lose faith (”What don’t I know?” “Will this squeeze even higher?”) and cover.
I’d say the opposite of “patience” is “greed”. One may be certain that a company is going to the single digits but one needs to plan for the contingency that the journey there may include 40%+ bumps to the upside. Smaller positions give you much more latitude for timing, allow one to be early, and ride the squeezes with the ability to add to positions.
Another recommendation for “Traders, Guns, and Money” - a very entertaining and informative book.
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