Credit (and vol) continue to lead the way as smart deriskers as ES (the e-mini S&P 500 futures contract) ends down only 0.5% - which sadly is the biggest drop since 12/28. The late day surge in ES, which was not supported by IG or HY credit (and very clearly not HYG - the HY bond ETF - which closed at its lows and saw its biggest single-day loss since Thanksgiving), saw heavier volumes and large average trade size which suggest professionals willing to cover longs or add shorts above in order to get filled. Materials stocks underperformed but the major financials had a tough day as their CDS deteriorated to one-week wides. VIX (and its many derivative ETFs) had a very bumpy ride today. VXX (the vol ETF) rose over 14% (most in 3 months) at one point before it pulled back (coming back to settle perfectly at its VWAP so not too worrisome). After the European close, FX markets largely went sideways with the USD inching higher (EUR weaker) as JPY strength reflected on FX carry pair weakness and held stocks down. Treasuries extended their gains from yesterday's peak of the week yields as 7s to 30s rallied around 6bps leaving the 30Y best performer on the week at around unchanged. Commodities generally tracked lower on USD strength with Oil the exception as WTI pushed back up to $99 into the close (ending the week +1.1% and Copper -1.1%). Gold and Silver ended the week down almost in line with USD's gains at around 0.25-0.5%. Broadly speaking risk has been off since around the European close yesterday and ES and CONTEXT have reconverged on a medium-term basis this afternoon (to around NFP-spike levels) as traders await the potential for event risk emerging from Europe.(more)
Saturday, February 11, 2012
Per Marketwatch's Mark Hulbert, corporate insiders are dumping shares at a pace last seen in July 2011. While not a perfect timing mechanism it's certainly worth noting.
- Corporate insiders are now selling their companies’ stock at a rate not seen since late last July. That’s a scary parallel indeed, since that late-July spike in selling came just days before one of the more painful two-week periods in the stock market in years. In early August, as you may recall, the U.S. government lost its triple-A credit rating, and the bottom dropped out of the stock market. Between the last week of July and the second week of August, the Dow Jones Industrial Average dropped 2,000 points.
- To be sure, heavy insider selling doesn’t always lead to this much market weakness, or this immediately. And there were a lot of other things going on last summer that aren’t present today.
- Still, on the theory that corporate insiders — officers, directors and largest shareholders — know more about their firms’ prospects than do the rest of us, it can’t be good news that they are selling at such a heavy pace.
- Consider a ratio calculated by Argus Research of the number of shares insiders have sold in the open market to the number that they have bought. Last week, according to the latest issue of Argus’ service, the Vickers Weekly Insider Report, this sell-to-buy ratio stood at 5.77-to-1. And among insiders at companies listed on the New York Stock Exchange, this ratio was even more lopsided at 8.2-to-1.
- Making these recent readings even more worrisome, according to Argus Research, is that they came on markedly stepped-up activity among corporate insiders. This increases our confidence that the ratio accurately reflects prevailing sentiment among a broad cross-section of the insiders.
- To put recent insider behavior into context, consider what they were doing in the latter part of November, the last time I focused a column on the insider data. In the last full week of that month, for example, the sell-to-buy ratio stood at 0.81-to-1 — a far cry from the 5.77-to-1 registered in the first week of February.
The VIX tracks the implied volatility on S&P 500 options. When investors are nervous, they’re more likely to purchase put protection, driving up the cost of options and implied volatility in the process. When markets are calm, or investors are too complacent depending on your point of view, the VIX tends to sink back into the teens.
At its current levels around 17 and 18, the VIX is modestly below its long-term average of 20 and is well below its 2011 peak of nearly 50. It’s also below the mid 30s it hit in October, when I argued that the VIX was too high and would likely moderate towards the high 20s or low 30s.
But while the VIX should certainly be lower now than it was six months ago, I believe its current levels seem too low. While market conditions have certainly improved since the fall, it looks like investors may have become a bit too at ease. With the risks to Europe lingering and most of the world still stuck in a lackluster recovery, a bit more caution — or fear — may be warranted.
Historically, economic activity, credit conditions and market momentum are three key drivers of implied volatility. All three have improved in recent months. Leading indicators have risen, market momentum has improved and credit spreads – measured by the spread between the 10-year note and an index of high yield bonds – have contracted by around 1%. Thanks to the improved general market environment, the VIX should certainly be lower than my October forecasts. However, in my opinion, a fair current value for the VIX would be around the low to mid 20s, higher than today’s levels. And unless we see a further acceleration in the economy and more spread tightening, I would expect volatility to post a modest rise in the coming months.
So assuming that volatility is set to rise, how should investors adjust their portfolios? First, remember that it’s the change in, not the level of, volatility that tends to impact asset prices. In an environment of rising volatility, investors would want to modestly lower their weight to market segments that are very sensitive to changes in volatility and raise their weight to less sensitive or lower beta instruments.
Practically, this could mean a modest reallocation out of high-yield fixed income towards investment-grade bonds, an asset class that currently appears to be a better relative value (potential iShares solution: LQD). While the spread between high yield and Treasuries has contracted by roughly 200 basis points since September, the spread between Baa bonds and Treasuries has been stuck at approximately 325 bps. Investors may also want to consider modestly increasing their weight to mega-cap equities. This segment of the market still trades at a significant discount to the broader market and is less sensitive than other segments to changes in volatility (potential iShares solutions: OEF, IOO, IDV, HDV).
Capital structure refers to share structure, market cap and the financial position of the company. First, we want to see a share structure that is low in shares outstanding but also low in its fully diluted count. This means there aren't tons of options and warrants that can weigh down the stock after it begins a good run. The overall share structure can also be used to grade management. Remember, most of these companies do not make money and there way to raise money is to sell more shares. Compare the achievements of the company with its current share structure. Has the company been productive or has it been ineffective and carries a bloated share structure?
Second and most important, the more cash a company has the better. In looking at non-producers, it is obvious that the companies with significant capital have an advantage over those who have less than $2-3 Million in the bank and may have to finance within the year. For producers, we want to see enough cash flow and capital in the bank that the company can grow its production with minimal dilution.
In analyzing explorers and developers, we want to find the companies with projects that are likely to become a mine and are likely to be coveted by a large or major company. Consider the location. Is it in a friendly mining jurisdiction like Mexico, Nevada or Quebec? Is the location near an operation of a larger producer or major company? If the answer to both is yes than it is far more likely to become a mine. Also, we want to see projects that not only can be mined but mined profitably. How did the market respond to a preliminary economic assessment? Would the project payback cap-ex in a few years or five? A past producing property is another good sign.
Let me provide an example. We added Trade Winds Ventures to our model portfolio last summer. The stock experienced a deep pullback but had stabilized for a few months. Trade Winds had a deposit literally right next to Detour Gold's multi-million ounce deposit at Detour Lake. It was a no brainer. This wasn't a grand slam but it was a very nice return in about five months. The key, which is our next point, is we bought it when it was cheap and not while it was zooming higher in 2010.
Buy Takeover Candidates on the Cheap
This is especially true of the explorers and developers. You are an investor and so are potential acquirers. You both want something that has growth potential at a reasonable price. Like a major company, you will not chase something that has already moved and has little upside from its present market value. Thus, buy these targets cheap. The market is coming out of a major bottom so there should be plenty of candidates. On the first day of the year we added a US-listed development company that we thought was cheap. Technically, it had very little downside. It's up 25% since then. Had we bought it 12 months ago we'd be down 25%.
Favor Junior Producers with Development Projects
Juniors who make it to production will do well but it it those juniors that can go from zero or one mine to three or four that will be the biggest winners. We prefer producers but we are looking for those that are likely to have multiple operations. Producers that have strong development projects in the pipeline have advantages over pure development companies and those producers lacking the assets to grow production. For example, our favorite gold stock for the past two years and largest position in the model portfolio is set to put its second mine in production in the coming months and then its third mine into production by the end of 2013.
Find Management Teams with a Track Record
This is especially important if the company wants to be a producer. Mining is an extremely difficult business and therefore your odds of success will be much higher with those who have done it before. Two of our biggest winners, Gold Resource Corp and First Majestic Silver, were led by people who had a great track record. At the same time, the absolute biggest names will command a premium in the market, so be judicious. Management is always important but in building and operating a mine, it is paramount.
Again, for the more speculative non-producing juniors, one should always buy on the cheap or at least buy something that hasn't made a new high in a year or two. When the market turns favorable, juniors can rebound quickly as we've seen. For small producers and development plays we look for a technical catalyst. If the stock is near very strong support then we know the downside is limited and the risk to reward is favorable. If the stock is close to breakout out of a multi-year base then we know it has room to move significantly higher sooner rather than later.
In recent commentaries we've told you why you should be buying. This time we tell you what to buy, without actually giving names. Hopefully you can extract a few nuggets from this piece that will serve as a springboard for your research. We are excited because this bull market is going to quietly ramp higher over the next several years. The present is probably your last chance for at least a year or so to buy many companies on the cheap. You can go at it alone or you can consult a professional.
Last week, the Baltic Dry Index (BDI), a measure of shipping costs across four vessel sizes, fell to 662 points, the lowest since August 1986. Since the start of the year, the BDI has fallen by 61%. (The index measures the demand for shipping capacity versus the supply of dry bulk carriers.) As the BDI shows the cost of transporting the major raw materials by sea, it is often seen as a good gauge of the global trade volume.
However, experts are now cautioning against a misinterpretation of the BDI’s recent precipitous drop. In fact, the index’s fall does not portend a global trade contraction, but rather a fall in shipping costs. As for the latter, there are several reasons. Firstly, the supply of carriers is fast outstripping that of demand. According to London-based Clarkson Plc, the world’s biggest shipbroker, the fleet of dry-bulk commodity carriers will expand by 14% this year, compared with only a 3% increase in seaborne volumes of minerals and grains. Sverre Svenning, director of research at Fearnley Consultants, a unit of Oslo-based shipbroker Astrup Fearnley, said, “The biggest problem is that the fleet is continuing to expand like there’s no tomorrow. We’ve seen that the imbalance between demand and supply has just kept increasing.” Secondly, new carriers are being built at a faster pace because of higher efficiency. Thirdly, most of the less efficient carriers are being sold off, instead of being scrapped. The latter two trends only exacerbate the current over-supply of carriers.
Shipping analysts also noted that the BDI only measures the shipping costs, and not the volume being shipped. Hence, the recent drop in the BDI is more of a reflection of an over-supply situation. Because of this, many ship owners are now choosing to idle their ships, instead of accepting the current rates, as the returns are often too low to even cover the operating costs. In addition, ships are also slowing down their speeds and dropping anchor to better manage the over-supply situation.
Jeffrey Landsberg of dry-bulk analytics firm Commodore Research & Consultancy in New York summed up the current situation, "It's a common mistake to use the BDI as an economic indicator. It should not be used because it has little to do with demand."
Dennis Gartman at a 2007 investing summit in New York.
Those are his words, folks. I’m not clever enough to make stuff like that up.
The noted trader, editor and publisher of “The Gartman Letter,” and contributor to the business-news channel CNBC was wary about the market until recently. Hulbert Interactive: Tools for tracking and comparing the perfomance of hundreds of investment newsletters .
Now he’s thrown caution to the wind, declaring that stocks can go much, much higher in what he described as a “multiyear secular bull market.”
He’s also bullish on gold again after selling last year and likes “non-U.S.-dollar English-speaking currencies” and markets, particularly Australia and Canada.
His wild-eyed optimism puts him in the company of other raging bulls this column has profiled, like James Paulsen of Wells Capital Management and Laszlo Birinyi. Read Howard Gold column on why Laszlo Birinyi saw a big run for stocks ahead at MoneyShow.com .
Was autumn nadir a once-in-a-blue-moon buying opportunity?
If Gartman’s right, then the big selloff last spring and summer that drove the S&P down to just below 1,100 on Oct. 3 will have been a great buying opportunity that just about everybody missed — and which many investors even fled.
U.S. investors pulled an astonishing $134.5 billion out of U.S.-equity-oriented mutual funds in 2011, and since 2007 they’ve taken a net $469 billion out of U.S. stock funds while pouring nearly $800 billion into taxable bond funds, according to the Investment Company Institute.
Clearly, something is out of whack.
“Investors are terrified of stocks,” Gartman told me. “You can’t get people to buy Procter & Gamble (NYSE:PG) with a dividend of 3.3%.”
Besides bond funds, people have been sticking their cash into the proverbial mattress. “Baby boomers are laden with cash,” Gartman said. “Checking-account balances are outrageously high. They’re paying out nothing at all.”
What’s going to get these terrified people with bulging checkbooks back into stocks? “Greed,” Gartman replied simply. “Greed and the need for yield will bring them in. That’s what the Fed wants them to do.”
Take note, conspiracy theorists and Ron Paul supporters (not necessarily the same people): Gartman largely agrees with you — the Fed is behind the whole thing.
By promising that short-term interest rates will stay near zero until 2014, Federal Reserve Chairman Ben Bernanke is offering savers what is in effect a Hobson’s choice: Earn nothing and watch your capital deteriorate, or jump in the pool and take some risk. And don’t worry: The water’s fine.
“Keeping rates low and long will force boomers to … move into the equity markets,” albeit kicking and screaming, Gartman told me.
But it’s not only boomers; the large contingent of Generation Y — the ones who aren’t living in their parents’ basements or sleeping in tents with Occupy Wall Street — have been quietly accumulating wealth, but they’re the most conservative investors of all.
A recent Harris Poll found 41% of people between 18 and 33 say their savings are primarily in savings accounts and CDs — nearly twice as high a percentage as boomers and significantly more even than retirees. Read more about that poll’s findings at USNews.com .
And less than 20% have invested in money-market funds, stocks, bonds, or a mixture of stocks and bonds — again, the lowest percentage of any demographic group surveyed.
So, at an age when its members can afford to take the most risk, Gen Y is hiding under a rock. But not forever, according to Gartman. From risk avoiders, “they will become risk accepters,” he said.
When? Who knows? But probably as the market moves higher and people become more confident. Crazy, right? But that’s how it works.
In fact, Gartman thinks there’s time for that to play out, he said, because he believes stocks have been in “a multiyear secular bull market” since March 2009. That would make the secular bear market of the 2000s one of the shortest on record, at nine years.
If the economic recovery gains traction and especially if employment growth picks up, that would also entice investors to return to the market.
See readers’ ideas on how to bring jobs back to the U.S. and take our poll on the Independent Agenda. Click to visit IndependentAgenda.com .
He also thinks, he said, that “we’re still in a long-term bull market in gold,” which he started buying again three weeks ago, after stepping to the sidelines when “too many people” had grown bullish.
Now he expects gold — especially priced in euros or yen — to move higher. How much higher? All he’ll say by way of clarification is that “it will go higher until it stops.” That doesn’t help much if you’re looking for a round number, but there you have it.
Gartman favors U.S. multinational dividend-paying stocks, he said, explaining that he’s “too old” to invest in emerging markets and is avoiding Europe because he thinks a Greek default is inevitable. The terms being offered to Greece are too onerous for the Greek people — and their political leaders — to accept, he believes, in spite of the enthusiasm with which markets greeted Thursday’s austerity agreement. See full story on the Greek agreement and read Market Snapshot for details on U.S. investors’ reaction , plus a look at ETFs that stand to benefit if the Greek crisis truly ebbs .
“If you were Greek, you wouldn’t [accept the austerity measures being demanded. You wouldn’t think about it,” Gartner told me. “I think [Greece would be] better off … out of the euro.”
He expects other countries to leave the euro, too, he said, and the euro zone to shrink to a more modest size, with lots of pain along the way.
But he doesn’t expect much pain from the currencies of countries like Australia, Canada and New Zealand. He thinks the recent strong performance of the Aussie dollar is a good bellwether for the markets, he said, adding that he thinks “people should be investing in the Australian stock market” because of its strong natural-resource sector, rule of law and stable government. “What’s not to like?” he asked.
Gartman didn’t recommend specific stocks or funds, but there’s an ETF that tracks the Australian stock market, iShares MSCI Australia index (NAR:EWA) . Full disclosure: I have owned a small stake in the Currency Shares Australian Dollar ETF (NAR:FXA) for some time.
Here’s my view: The market’s move since October has been impressive — the fact that the S&P (SNC:SPX) held the 1,100 level then was a good sign that we weren’t entering a prolonged global bear market. In November, after being bearish for months, I wrote that 2012 was likely to be a good year for stocks. Read Howard Gold piece on why 2012 could be a good year for stocks in MoneyShow.com .
And in late December, the venerable Dow Theory Forecasts said a bullish trend in the markets had been confirmed by the Dow industrials and Dow transports.
Right now, I’m nervous. The market’s had a huge run and looks overbought, as technician Larry McMillan wrote in MarketWatch recently. See Lawrence G. McMillan column: Overbought market due for a correction .
Technically, we’re running into strong resistance near the 1,364 level, where the S&P topped out last April 29.
VIX, the so-called fear gauge, is well off last fall's levels.
Also, the CBOE’s volatility index (MDE:VIX) is just above 17, down from around 45 at the market lows of last Oct. 3. The midteens level for the VIX, which signals complacency among traders, is around where we saw the corrections of 2010 and 2011 begin. We’re almost there.
So, I wouldn’t pile into stocks now, but if you’re bullishly inclined, I’d wait for a correction into the mid-1,200s to add a little to my stock portfolio. I’d stick to a conservative allocation — 50% or less in equities — and focus on dividend-paying stocks.
If Dennis Gartman’s right — and who knows whether he is? — this market has a long way to go.
Negative real interest rates and growing global money supply power the Fear Trade for the precious metal
After prices fell 10 percent in December, many investors wondered if the bull market in gold was running out of steam. That was before Federal Reserve Chairman Ben Bernanke swooped in with a “red cape” and fired the bulls back up. Since the Fed reassured the world that interest rates will remain at “exceptionally low levels” for another two years, gold has jumped more than three percent.
UBS described the situation simply, “if investors needed a (further) reason why they should be long gold now, they got it yesterday … a more accommodative policy is a very good foundation for gold to build on the next move higher.”
To gold bugs, two more years of near-zero, short-term interest rates means negative real interest rates are here to stay, and this has historically been a strong driver for higher gold prices.
Bernanke and the Fed aren’t the only central bankers in the fiscal and monetary bullring. Brazil has cut its benchmark interest rate a few times and China lowered its reserve rate for banks in December. According to ISI Group, 78 “easing moves” have been announced around the world in just the past five months as countries look to stimulate economic activity.
One of the main weapons central bankers have employed is money supply, which has created a ton of liquidity in the global system. Global money supply rose eight percent year-over-year in December, or about $4 trillion, according to ISI. I mentioned a few weeks ago how China experienced a record increase in the three-month change in M-2 money supply following China’s reserve rate cut.
Together, negative real interest rates and growing global money supply power the Fear Trade for gold. The pressure these two factors put on paper currencies motivates investors from Baby Boomers to central bankers to hold gold as an alternate currency.
Adrian Ash from Bullionvault says global central banks are on a buying spree and they have been since the Fed cut interest rates by 25 basis points in 2007. Central bankers’ shift to buying gold was a significant sea change for the yellow metal.
You can see from the chart below that official gold reserves have historically been much higher, averaging around 35,000 tons. In the 1990s, central banks began selling, with reserves hitting a 30-year low right around the time the Fed began cutting rates. Adrian says that gold holdings are now at a six-year high with the current amount of gold reserves just less than 31,000 tons.
These are countries large and small. In December, Russia, which has been routinely adding to the country’s gold reserves since 2005, purchased nearly 10 tons; Kazakhstan purchased 3.1 tons and Mongolia bought 1.2 tons. UBS says “although reported volumes are not very large, it is still an extension of the official sector accumulation trend.”
Not all central banks are recent buyers, though. The “debt-heavy West” has sold its gold holdings, while emerging markets increased their gold reserves 25 percent by weight since 2008, says Adrian.
Reserves as a percent of all the gold mined has also declined, with “a far greater tonnage of gold ... finding its way into private ownership,” says Adrian. Since 1979, you can see the percentage of reserves to total gold has declined at a much faster pace as individuals increasingly perceived gold as a financial asset.
Adrian points to China’s Gold Accumulation Plan as a recent example of this trend. A joint effort between the Industrial & Commercial Bank of China (ICBC) and the World Gold Council (WGC), the program allows Chinese citizens to buy gold in small increments as a way to build up their gold holdings over time. The WGC reported in September that the program had established two million accounts during its first few months in operation and the amount is growing by the day.
These programs open the door for gold as an investment to a whole new class of people in China but that’s only a fraction of the tremendous demand for gold that we are seeing from China. In addition to the Fear Trade, gold is driven by the Love Trade, which is the strong cultural affinity the East, namely China and India, has to the precious metal.
In 2010, the Indian Sub Continent and East Asia made up nearly 60 percent of the world’s gold demand and 66 percent of the world’s gold jewelry demand, according to the WGC.
Indian jewelry demand has historically increased during the Shradh period of the Hindu calendar, but last year, high prices and a volatile rupee kept many Indian buyers on the sideline.
If you thought $1,900 was too much to pay for an ounce of gold, imagine how Indians felt when the rupee fell against the U.S. dollar, causing a gold price spike in rupees. Gold in Indian rupee terms rose more than 35 percent from July to November, roughly three times the magnitude of gold priced in U.S. dollars, yuan or yen. This currency swing significantly impacted Indian gold imports, which dropped 56 percent in the fourth quarter, according to data from the Bombay Bullion Association.
“Indian buyers will be back” after they adjust to the higher prices, says Fred Hickey. In one of his latest editions of “The High-Tech Strategist,” he cites late 2007 as a recent example when the Indian gold market experienced a similar rough patch. That year, gold demand in India fell off a cliff after prices spiked more than $1,000 an ounce in one quarter, tarnishing the country’s love affair with gold for a “brief period.” Fred says their cultural affinity for gold as an important store of wealth and protection against inflation will drive Indian buyers back into the market.
The trend was already changing in 2012, as UBS reported that the first day of trading saw physical sales to India were twice what they usually are, according to Fred. Although this is a very short time frame, I believe the buying trend will continue in this gold-loving country.
In China, “just as in India, gold is seen as a store of wealth and a hedge against inflation,” says Fred. Demand has been growing, especially in the third quarter, when China’s gold purchases outpaced India. “Physical demand for gold from the Chinese has been voracious all year,” says Fred. As of the third quarter, China had already obtained 612 tons, eclipsing its total 2010 demand, according to the WGC.
Across the Chinese retail sector, gold, silver and jewelry demand was the strongest performing segment in 2011, says J.P. Morgan in its “Hands-On China Report.” Growth in this segment far outpaced clothing and footwear, household electrical appliances, and even food, beverage, tobacco and liquor, all of which experienced more modest growth.
J.P. Morgan says the bulk of the increase came from lower-tier cities “where income levels are rising the fastest and improvements in retail infrastructure have allowed for rapid store expansion.”
Increasing incomes coupled with government policies that support growth have been the main drivers for rising gold prices. Take a look at the chart below, which shows the strong correlation between incomes in China and India and the gold price. As residents in these countries acquire higher incomes, they have historically purchased more gold, driving gold prices higher.
We anticipated that the Year of the Dragon would spur an increase in the buying of traditional gifts of gold dragon pendants and coins. Gold buying did hit new records, says Mineweb, with sales of precious metals jumping nearly 50 percent from the same time last year, according to the Beijing Municipal Commission of Commerce.
This should serve as a warning to all of gold’s naysayers. Gold bullfighters beware—you now have to fight the gold bull while fending off a golden Chinese dragon.
U.S. Global Investors, Inc. is an investment management firm specializing in gold, natural resources, emerging markets and global infrastructure opportunities around the world. The company, headquartered in San Antonio, Texas, manages 13 no-load mutual funds in the U.S. Global Investors fund family, as well as funds for international clients.
For more updates on global investing from Frank and the rest of the U.S. Global Investors team, follow us on Twitter at www.twitter.com/USFunds or like us on Facebook at www.facebook.com/USFunds. You can also watch exclusive videos on what our research overseas has turned up on our YouTube channel at www.youtube.com/USFunds.
All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.
There is an old saying in business: "Fail to plan and you plan to fail." It may sound glib, but those who are serious about being successful, including traders, should follow these eight words as if they were written in stone. Ask any trader who makes money on a consistent basis and they will tell you, "You have two choices: you can either methodically follow a written plan, or fail."
If you have a written trading or investment plan, congratulations! You are in the minority. While it is still no absolute guarantee of success, you have eliminated one major roadblock. If your plan uses flawed techniques or lacks preparation, your success won't come immediately, but at least you are in a position to chart and modify your course. By documenting the process, you learn what works and how to avoid repeating costly mistakes.
Whether or not you have a plan now, here are some ideas to help with the process.
Disaster Avoidance 101
Trading is a business, so you have to treat it as such if you want to succeed. Reading some books, buying a charting program, opening a brokerage account and starting to trade are not a business plan - it is a recipe for disaster. "If you don't follow a written trading plan, you court disaster every time you enter the market," says John Novak, an experienced trader and developer of the T-3 Fibs Protrader Program.
Once a trader knows where the market has the potential to pause or reverse, they must then determine which one it will be and act accordingly. A plan should be written in stone while you are trading, but subject to re-evaluation once the market has closed. It changes with market conditions and adjusts as the trader's skill level improves. Each trader should write their own plan, taking into account personal trading styles and goals. Using someone else's plan does not reflect your trading characteristics.
Building the Perfect Master Plan
What are the components of a good trading plan? Here are 10 essentials that every plan should include:
Are you ready to trade? Have you tested your system by paper trading it and do you have confidence that it works? Can you follow your signals without hesitation? Trading in the markets is a battle of give and take. The real pros are prepared and they take their profits from the rest of the crowd who, lacking a plan, give their money away through costly mistakes.
How do you feel? Did you get a good night's sleep? Do you feel up to the challenge ahead? If you are not emotionally and psychologically ready to do battle in the markets, it is better to take the day off - otherwise, you risk losing your shirt. This is guaranteed to happen if you are angry, hungover, preoccupied or otherwise distracted from the task at hand. Many traders have a market mantra they repeat before the day begins to get them ready. Create one that puts you in the trading zone.
Set Risk Level
How much of your portfolio should you risk on any one trade? It can range anywhere from around 1% to as much as 5% of your portfolio on a given trading day. That means if you lose that amount at any point in the day, you get out and stay out. This will depend on your trading style and risk tolerance. Better to keep powder dry to fight another day if things aren't going your way.
Before you enter a trade, set realistic profit targets and risk/reward ratios. What is the minimum risk/reward you will accept? Many traders will not take a trade unless the potential profit is at least three times greater than the risk. For example, if your stop loss is a dollar loss per share, your goal should be a $3 profit. Set weekly, monthly and annual profit goals in dollars or as a percentage of your portfolio, and re-assess them regularly.
Do Your Homework
Before the market opens, what is going on around the world? Are overseas markets up or down? Are index futures such as the S&P 500 or Nasdaq 100 exchange-traded funds up or down in pre-market? Index futures are a good way of gauging market mood before the market opens. What economic or earnings data is due out and when? Post a list on the wall in front of you and decide whether you want to trade ahead of an important economic report. For most traders, it is better to wait until the report is released than take unnecessary risk. Pros trade based on probabilities. They don't gamble.
Before the trading day, reboot your computer(s) to clear the resident memory (RAM). Whatever trading system and program you use, label major and minor support and resistance levels, set alerts for entry and exit signals and make sure all signals can be easily seen or detected with a clear visual or auditory signal. Your trading area should not offer distractions. Remember, this is a business, and distractions can be costly.
Set Exit Rules
Most traders make the mistake of concentrating 90% or more of their efforts in looking for buy signals, but pay very little attention to when and where to exit. Many traders cannot sell if they are down because they don't want to take a loss. Get over it or you will not make it as a trader. If your stop gets hit, it means you were wrong. Don't take it personally. Professional traders lose more trades than they win, but by managing money and limiting losses, they still end up making profits.
Before you enter a trade, you should know where your exits are. There are at least two for every trade. First, what is your stop loss if the trade goes against you? It must be written down. Mental stops don't count. Second, each trade should have a profit target. Once you get there, sell a portion of your position and you can move your stop loss on the rest of your position to break even if you wish. As discussed above, never risk more than a set percentage of your portfolio on any trade.
Set Entry Rules
This comes after the tips for exit rules for a reason: exits are far more important than entries. A typical entry rule could be worded like this: "If signal A fires and there is a minimum target at least three times as great as my stop loss and we are at support, then buy X contracts or shares here." Your system should be complicated enough to be effective, but simple enough to facilitate snap decisions. If you have 20 conditions that must be met and many are subjective, you will find it difficult if not impossible to actually make trades. Computers often make better traders than people, which may explain why nearly 50% of all trades that now occur on the New York Stock Exchange are computer-program generated. Computers don't have to think or feel good to make a trade. If conditions are met, they enter. When the trade goes the wrong way or hits a profit target, they exit. They don't get angry at the market or feel invincible after making a few good trades. Each decision is based on probabilities.
Keep Excellent Records
All good traders are also good record keepers. If they win a trade, they want to know exactly why and how. More importantly, they want to know the same when they lose, so they don't repeat unnecessary mistakes. Write down details such as targets, the entry and exit of each trade, the time, support and resistance levels, daily opening range, market open and close for the day and record comments about why you made the trade and lessons learned. Also, you should save your trading records so that you can go back and analyze the profit or loss for a particular system, draw-downs (which are amounts lost per trade using a trading system), average time per trade (which is necessary to calculate trade efficiency) and other important factors, and also compare them to a buy-and-hold strategy. Remember, this is a business and you are the accountant.
Perform a Post-Mortem
After each trading day, adding up the profit or loss is secondary to knowing the why and how. Write down your conclusions in your trading journal so that you can reference them again later.
The Bottom Line
Successful paper trading does not guarantee that you will have success when you begin trading real money and emotions come into play. But successful paper trading does give the trader confidence that the system they are going to use actually works. Deciding on a system is less important than gaining enough skill so that you are able to make trades without second guessing or doubting the decision.
There is no way to guarantee that a trade will make money. The trader's chances are based on their skill and system of winning and losing. There is no such thing as winning without losing. Professional traders know before they enter a trade that the odds are in their favor or they wouldn't be there. By letting their profits ride and cutting losses short, a trader may lose some battles, but they will win the war. Most traders and investors do the opposite, which is why they never make money.
Traders who win consistently treat trading as a business. While it's not a guarantee that you will make money, having a plan is crucial if you want to become consistently successful and survive in the trading game.