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Lessons from a difficult year of trading

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This correspondence details lessons I have learned about myself, my trading and the markets as a result of a difficult year of trading.

Perhaps these lessons can benefit you, especially if you are a discretionary trader who uses chart patterns for trading.

I am not shy about hyping my good trades. I am also not hesitant to point out my unprofitable trades as well. In fact, traders who know me best would say that I am much more inclined to discuss my struggles than my victories in trading.

Touting only profitable trades is a violation of full disclosure because profitable trades are not representative of overall trading performance. On the other hand, an analysis and discussion of the trials and tribulations of trading can produce trading insight. In fact, I believe that the best thinking by traders occur during periods of adversity. It is during these periods that traders think most deeply about their trading and risk management protocols and practices, about market behavior and about the human dimension of market speculation.

I am presently experiencing a quite unpleasant 12-month period in the markets. It has been Chinese water torture. I have been forced to go back to the drawing board to re-examine every aspect of my trading.

Background

First, some perspective is in order.

Coming into 2010, I had three pretty good years of trading. In 2007, my trading account gained 95 percent (due mostly to Gold). I was up 59 percent in 2008 (EURUSD and GBPUSD). Then, 2009 was an okay year with a 24-percent gain (due almost exclusively to a mid-year Sugar move). I had a fair first four months in 2009, up about 7 percent, but trading has been a struggle since then. I am in a 12-month drawdown of around 13 percent. The peak-to-valley magnitude of this drawdown (marked by red box) has been mild by historical standards, but the duration has been a 30-year record. The scatter graph below displays all my drawdowns in excess of 10 percent.

 

I have had some excellent trades in the past 12 months, but they have been too few and far between. As I stated earlier in this correspondence, this past year has been like Chinese water torture…drip…drip…drip! Of all the drawdowns I have encountered over the years, this one has without a doubt been the emotionally toughest to endure.

Since 1981 I have experienced more drawdowns than I can remember – at least two in excess of 5 percent every year I have traded. I have survived every drawdown. I have no doubt I will survive this drawdown – and that I will emerge as a better trader.

As has always been the case with drawdown periods, I attempt to ask (and hopefully answer) three questions.

1. Has my trading plan/guidelines/rules been out of synch with the markets?

  • If so, in what ways? Has the drawdown uncovered some basic flaws of the plan? [Note: Basic flaws in trading plan are masked during profitable periods – they show their hand during drawdown periods.]
  • What modifications could I make to address foundational flaws of the trading plan, not to optimize the plan against the recent time period, but to improve upon the plan. [By the way, I am not a believer in the optimization of indicators.]

2. Has the basic behavior of the markets changed?

  • If so, might the change in market behavior be permanent?
  • If permanent, what might be the reasons?
  • If permanent, what are the implications for the trading plan?

3. Has my trading execution been out of synch with the plan? (Note: this applies more to discretionary traders than to systematic traders.)

  • If so, in what ways has my execution been out of synch with my trading plan?
  • Have there been any particular patterns in the breach of the trading plan?
  • What changes are needed to bring execution back into line with the plan?

As I analyzed the past year, the answers to the three questions are YES, YES, and YES. My analysis attributes a percentage contribution to trading results by each item. Perhaps in a future post I will address the attribution analysis.

Over short periods of time nothing can really be done to address #1. All trading plans are cyclical in terms of their alignment with market action. Addressing foundational flaws of a trading plan is an ongoing effort for all traders. This is a healthy and needed process.

But a “Yes” answer to item #2 is a more complicated matter. I believe the basic behavior of markets has changed permanently. See my blog post here for my thinking on this matter. Yet, I also believe that my solutions for items #1 and #3 will address the changing nature of the markets.

Action plan

The bottom line issue for me is simple – What changes do I need to make to my trading plan (and the execution of the same) and to my risk management protocols to return my trading plan to consistent profitability? Without going into depth on each item, the following represents my action plan. Some of these items represent modifications, some new twists and some a rededication to basic principles.

Focus on charts from an elevation of 40,000 foot

Daily chart patterns have become increasingly unreliable. In fact, the changing nature of the markets (especially in forex and futures) has almost made shorter-term patterns things to be faded. This means that I will not look at an intraday chart and only look at a daily chart if the weekly or monthly charts have given me a reason to do so. Fortunately, the weekly and monthly charts have not been compromised by changes in shorter-term market behavior.

Decrease risk per trading event

My historical maximum risk per trade has been 100 basis points, with the entire position entered at once. I have readjusted this maximum risk to 60 basis points, with positions being established in halves or thirds.

Avoid range-bound markets

The past year has greatly reinforced the concept of “markets at rest remain at rest and markets on the move remain on the move.” I have lost a significant amount of capital in the past year anticipating breakouts that did not occur.

Be much more aware of the underlying trend

Defining “trend” can be a difficult challenge, but I have begun monitoring some moving averages – not in the sense of developing or using a moving-average trading system, but as a proxy for trend. A majority of the chart pattern trades that have cost me money in the past year have been countertrend (as measured by the moving average proxy).

Transition away from high/low/close bar charts to closing price charts

“Noise” has increased in my primary markets (futures and forex). I have had way too many orders executed at intraday price extremes, only to have the markets close at prices favorable to my trades. The most important price of the day is the closing price. The most important price of the week is Friday’s close.

Modify my protective stop protocol to reflect increased intraday noise

I have always believed in having protective stop orders in place at all times. I am no longer a strong advocate for this practice. I have been stopped out of too many positions only to see better exit spots within hours or days. Rather, I am now an advocate of the following protective stop protocol.

  1. No stops in overnight markets, including forex
  2. Mental stops based on closing price charts – the use of mental stops requires disciple to follow through with intentions
  3. Very wide actual stops (daytime session) to protect against a “worst case scenario”

Actively trade a portion of a position

Historically, I have held onto my entire position until the target was reached or until the initial protective stop was hit. This strategy has not treated me well during the past year, and, in fact, has negatively impacted my bottom line for the past two years. Rather, I have adopted a strategy to hold half of a position while trading half of a position, selling only on strength and buying only on weakness.

Avoiding ambiguous market situations

As a discretionary trader (as opposed to a systematic trader), there are always market situations that fall into a grey zone – “is there a set-up or isn’t there a set up?” I have historically erred on the side of giving a set-up the benefit of doubt, believing that I would benefit if just one in four questionable set-ups worked. My theory has been that making money is more important than being right. I have reappraised this trading strategy in favor of demanding more clarity from chart patterns. I still believe that making money is far more important than being right — but with less reliable chart patterns, erring on the side of caution is now part of this belief system.

Limit my decision-making time window

I have long had a rule to determine and enter my orders each afternoon and then avoid exposure to the markets during the trading session. At the same time, I love the markets and, like so many other traders, get caught up in the price-making process. The degree to which real-time decision making has negatively impacted my bottom line really hit home in the past year. I am NOT a good intraday trader – never have been, never will be. Paying attention to the markets during the trading session is detrimental to my financial (and emotional) health.

Another aspect of intraday decision making is worthy of note. There was a time in the markets when the trend of the first several hours would continue through the day. This is no longer the case. Directional price momentum during one time slot seems to have no correlation to momentum in subsequent time slots. Markets now routinely make new highs and lows frequently throughout the day.

Let me close this post with one other thought. I am in a drawdown. Yet, I am in no hurry for a new NAV peak. I have seen too many traders blow-up by “doubling up to catch up.” I can only control what I can control – but profitability during any given time period is not a controllable variable.

That’s it for now, folks.

It’s as easy as “ABC” – classic H&S failure in Corn

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Often a pattern failure tells a better story than does a pattern completion.

This is just what we have in the case of new crop December Corn. As of last week it appeared that Dec. Corn was forming a H&S top pattern. On Wednesday, May 11, the market completed the top pattern (the “A” in the story). On May 12, the market had a minor upside reversal, but remained below the neckline. On May 13, the market poked back above the neckline intraday, but closed below the neckline. Then on May 16 the market spent the entire day above the neckline, followed by a strong gain on May 17. This is the “B” in the story and confirmation that a bear trap had been sprung.

I consider H&S failure patterns to be very tradable chart developments. The advance today, May 18, penetrated the May 10 right shoulder high and officially completed the failure pattern. This is the “C” in the story. Support should be solid at 664.

The target of 733 is based on projecting the distance between the April 26 high and the May 12 low (which is 69 cents) upward from the right shoulder high of 664. The market should probably not take out Wednesday’s low (652-3/4).

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Great blog post on charting by MercenaryTrader.com

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Flags flying at half-mast – a sign of death!

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 Risk On – Numerous charts show signs of a pending decline 

In the markets, as in real life, flags flying at half mast symbolize death. A number of half-mast flags and pennants in the raw material markets indicate that the steep decline in early May was just Act 1 in a two-act play. The flags are symbolic of the intermission between the Act 1 (the first decline) and Act 2 (the next phase of the bear trend). 

Bear flags or pennants are present in the following markets: 

  • Crude Oil
  • Heating Oil
  • Gold
  • Sugar
  • Soybean Oil 

Crude Oil and Heating Oil display classic pennants. Rallies toward the May 11 high (while not necessary) would be an excellent shorting opportunity. The target of the pennant is Crude Oil is 84.80.  

The target in Heating Oil is 2.5060.

The Gold displays chart construction similar to the energy products with two exceptions. First, there is potentially enormous support under the Gold market in the form of a previously completed 4-month continuation inverted H&S pattern. However, old support sometimes has a way of disappearing. Second, the huge volume on May 5 could indicate accumulation buying by strong hands. However, if the energy pennants lead to a strong decline it will be difficult for Gold to hold up in a Risk On/Risk Off market environment. 

Sugar also displays a classic bear pennant. This market is in a well-established bear trend and has been since early February. Notice that the pennant in the October contract is forming just below the neckline of a 5-month H&S top. The target in October Sugar is 17.83. 

If my analysis is correct in Soybean Oil, the current pause in the form of a flag should be the last support before a sustained markdown in price. Once this flag gives way, prices should trend to 45.60. (Caveat: The pattern in Bean Oil could prove to be an extremely bullish continuation H&S pattern. Traders need to be flexible on this one.) 

Additionally, a number of other markets present technically bearish potential. These markets include:

  • Russell 2000
  • S&P 500
  • Silver
  • Corn
  • Soybean Meal

The Russell 2000 is hovering right at the major 8+ month trendline. A violation of this trendline would indicate that the bull trend since March 2009 is seriously aging. The initial target would be 770 as part of the transition from bull market to bear market. 

 

A confluence of technical developments can add to the legitimacy of a breakout. There are four factors that could trigger a sell signal in the S&Ps simultaneously by a decline below the May 6 low. First, the 2-month cup and handle bottom would fail; second, the 2-month trendline would be violated; third, the May 2 Ben Laden blow-off would be confirmed;

and, finally, the hourly chart symmetrical triangle would be completed. 

I touched the third rail in late April when I announced that Silver was in the bubble phase. I was tarred and feathered on May 1 when I pronounced the previous week’s volume (7.5 years of global supply) was a strong sign that Silver had topped. The market has found support in the low 30s and a bounce into the low 40s is possible as Silver develops its own half-mast bear pattern.

New crop December Corn has traced out a H&S top. It would not be unusual for Corn to top now.

The seasonal chart shown indicates a strong tendency for new crop Corn to top in May or June.

Finally, the daily chart of August Soybean Meal displays a very clear possible descending triangle. A close below the recent lows would complete this pattern and establish a target of 300.

Adding all things up, the period just ahead could be a tough life for raw materials (and stocks).

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It’s 1…2…3 strikes you’re out!

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The S&Ps have a possible top

When it comes to classical charting, it is always best when a multiplicity of developments occur. Such is the case in the S&P right now. There are three (if not four) chart developments that could support an important change in trend.

FIrst, the late April breakout from the 9-week cup and handle pattern has not resulted in follow through. The top of this pattern was tested hard on May 5. A move below the May 5 low would be a failure of this pattern. Possible strike 1.

Second, the daily chart displays a trendline from the March low. While I am not a big fan of trendlines, when a trendline violation occurs simultaneously with other developments it grabs my attention. Possible strike 2.

Third, the intraday chart displays a clearly defined 5-point symmetrical triangle top. Possible strike 3.

Importantly, a decline below the May 5 low would complete all three developments. There is one other important technical factor worthy of note. The Ben Laden top now appears to be a clear blow-off. The market has been unable to trend back into the range of this reversal day.

I will short this market if the May 5 low is penetrated. The target would be 1243. I remain long the Nasdaq from April 20– and am very close to being stopped out of that trade.

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What Now, Silver Cow?

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Just for fun, yesterday I did a snarky post on a very short-term “pie-in-the-sky” forecast for Silver. I called for the bounce to stop between 39 and 42 (actual high was 39.47) followed by a decline to below 33, then a rally to 42. The lines on the chart below were drawn yesterday morning.

So far so good. Pure luck…if I am right it will be pure luck. A wild guess! A hail-mary pass! I admit it. Of course, I am far from right yet. Alot can happen. The Silver market (and any other market) can do anything it wants to do whenever it wants to do it and it would not surprise me. The Silver market is NOT accountable to my whims or wishes or wild guesses.

I had a number of folks challenge my forecast, wanting to know on what technical or chart basis I would come to such conclusions.

I have no idea if I will be right — like I stated above, I was taking a wild swing in the dark — but I will share with you my reasoning (right or wrong).

My price scenario was based purely and soley on what I thought the market had (has) to do to most severely punish Silver bulls, more specifically, Silver bulls that are long above 40 per oz. My secret is out! I have told it all. My market call had NO basis in technical analysis. Period! My career as a classical chartist is over. I have sinned against my craft. I created a scenario that was based on what I thought the Silver market could do to most demoralize the johnny-come-lately Silver bulls.

I could have also created a price scenario of what I think the Silver market could do to most severely punish the Silver bears. Perhaps I will share this in the days to come. Perhaps a “punish-the-bears” scenario is the real agenda of the Silver market.

The truth be told, I could care less which scenario comes to pass. I have no vested interest in Silver. I am a trader. I trade price, not market biases, not fundamental scenarios, not Fed doomsday events, not the future value of the US$. And by the way, the last time I checked the U.S. Dollar is not traded in the Silver pit. Never has been. Never will be. There is an actual contract for trading the Dollar.

That’s all for now, folks.

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Silver – What’s next short term?

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Most chart patterns fail and then morph into larger patterns in a process I call “redefinition.” This is especially true of intraday charts. They are extremely unreliable.

With this in mind, here is my best guess on the short-term chart structure of Silver.

On the daily chart, a major top is in place. I keep hearing people talk about waiting for a decent break to buy  — about catching the next upleg in the market. Unbelievably, many “investors” are still bullish on Silver. To me this is a gigantic red flag. Conventional wisdom (i.e., the prevailing view of the marketplace) holds that Silver is in a significant correction within a much larger bull trend. The bias of investors (those not wiped out by the first decline) is to be long.

What we know for certain is that a parabolic move ended in massive record volume in Silver trading (futures and ETFs). This is a sign of a top. The burden of proof is on the bulls. In fact, should the market rally and make a new high it would be one of history’s great shorting opportunities. People have attempted to convince me that Silver was not in a parabolic move. WHATEVER!!!!!

Make no doubt about it, Silver has topped. If it has not topped, it will be many, many months before a legitimate bull trend can re-emerge.

Short term, the hourly chart displays an advancing channel. I believe that a bear market correction to the $39 to $44 zone is possible, but not on this leg up.

More than likely the market will have a further downward correction, perhaps even making a new low for the decline, before a more serious rally into the low 40’s can occur. From a market psychology standpoint, a decline to the low 30’s followed by a rally into the low 40’s would get the bulls all excited again — just in time to be slammed once more.

Then the market should drop into the mid 20’s.

Full disclosure: I have no position. I have no bias to defend. I don’t really care where Silver goes. I am perfectly ok if Silver goes to 5 or to 100. I don’t care if my next trade is short or long. I only care that sometime in the next 12 months the Silver market will give two or three low risk/high reward chart setups.

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Silver — history repeating itself

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Three reasons why Silver might be close to a temporary bottom (within a larger bear market).

  1. There will be support at the trendline from August and January lows. Today could end up as a reversal day.
  2. Small investor may be washed out — this is needed for a rally to occur. SLV had record volume Thursday at 294 million shares. More volume than SPY. This volume represented small investors liquidating, not accumulating. The buyers were people who took profits last week. Sorry, small investors, this is the way the raw material markets work.
  3. The top in 1980 would indicate a rally from here. The rally should not exceed $39 to $42. Do not be confused — Silver is now in a bear market.

Soybean Meal — building a 2011 top

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“Cops raid the brothel” — part 2

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I left out an important part of history in yesterday’s post on Silver…that is, the origination of the phrase: “When the cops raid the brothel, everyone is arrested, including the piano player.”

I first heard this phrase at the CBOT in early 1980 in direct reference to the Silver market collapse. On the chart below you will note that Silver topped at 5056, dropped quickly to 3025, recovered to 3970, then was destroyed to 1080 and eventually 4 (that is $4 per oz.) for a total decline exceeding 90 percent.

The reported reason for the decline was the failed attempt to corner the physical market by the Hunt brothers of Texas. Today’s equivilant would be a combination of JP Morgan and the small speculators through the ETFs. The CFTC stepped in January 1980 and hiked the margin requirements. The rest was history.

The real reason for the decline was that Silver had no business being at $50, that Silver is a COMMODITY, and that commodities have boom and bust cycles.

Many, many investors got wiped out by the drop. During a meeting at the CBOT, a member made the statement, “Isn’t it too bad that not only the Hunts got wiped out, but little investors who had nothing to do with the manipulation also lost the family farm.”

To this comment, and old-time trader made the statement…”Well, you must remember, when the cops raid the brothel, everyone gets arrested, even the piano player.” I will never forget the phrase or the meaning of the phrase.

By the way, the conventional wisdom during the advance of 1979 (extending far into the 1980s) was not much different than it is today. Inflation concerns, worries about fiat currencies, fed policy, etc. These were the reasons the small investor bought Silver then and the reason they bought Silver in this cycle. Margin call after margin call later, the small investor always plays the role of the piano player.

By the way, a good way to play Silver in stocks is to short the ultra long, AGQ. Of course, pick your spots and use stops. Even if Silver develops into a broad trading range, AGQ will decline.

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