Five Market Insights from Tom Claugus

    1. The most difficult part of managing other people’s money

The responsibility of having other people’s money really weighed on me. If you have a 10-year time horizon, you can make good decisions and make a lot of money. If you have a three-year time horizon, you could probably still do well. But if you have only a three-month time horizon, anything can happen.

2. Claugus uses Bollinger Bands (2 standard deviations) on S&P 500, the Nasdaq 100 and Russell 2000  to define his market exposure to indexes.

I am a reversion-to-the-mean thinker. We use standard deviation bands to define extreme readings.

At the lower band, we would be 130 percent long and 20 percent short. At the midpoint, we would be 100 percent long and 50 percent short. We are 50 percent net long at the midpoint rather than neutral because of the long-term secular uptrend in stock prices. At the upper band, we would be 90 percent short and 20 percent long, or 70 percent net short. Our net exposure will increase as the market goes down and decrease as the market goes up.

After determining the portfolio net exposure, we do a similar analysis by sector, trying to identify sectors that are cheap and sectors that are expensive.

3. Incentives matter. For many money managers, career risk trumps market risk. As the saying goes – it is better to fail conventionally than to succeed unconventionally.

During the fourth quarter of 1999, when the market was skyrocketing and I was net short, I was losing my ass at the same time most other hedge funds were making a ton of money. When your investors look around, and you’re losing money, while everyone else is making money, they are much more likely to pull their investment. Being short in a rising market is very difficult from an investor relations standpoint. In 2008, we were losing money, but so was everyone else. It’s a lot easier to keep your capital base in that type of scenario.

4. Bull markets are low-correlation markets of stocks. Bear markets are high-correlation stock markets.

When the market sells off really hard, as happened in late 2008 to early 2009, it is usually a matter of liquidity. There’s no place to hide in a liquidity sell-off; people sell everything because they have to, not because they want to. The reverse rarely happens on the upside. People don’t run out and buy everything. There are always some stocks that are going down. The interesting thing is that shorts are actually easier to find than longs. It is easier to spot a broken company than a good company. It is easier to identify bad management than good management.

5. The market is forward-looking and myopic at the same time. It does not look too far into the future because the further in time, the higher the uncertainty of cash flows. Some managers take advantage of this short-term nature of the market by being proactive and looking further than the market could see. The single most important concept in his stock selection process – look for future revenue generation that can be reasonably anticipated but that is not reflected by the current market price.

I often find that the market won’t pay anything for production potential that is more than a year away.

I look for anomalies. When I screen quarterly earnings, I look for quarterly earnings that are up more than 50 percent or down more than 30 percent.

One of Claugus’s major themes in selecting individual stocks is looking for companies that will benefit from a future development that is not being priced into the current market. The source of the improvement can take many forms including anticipated new sources of production, new technology, an expected increase in asset values, and so on. Claugus says that if a revenue source is more than a year away, the market will often fail to assign any significant value to it.

Sometimes, you will take a look at a momentum stock that is trading at a P/E of 50 and you will quickly dismiss it as richly valued. P/E reflects market expectations and a P/E of 50 is way too high. Well, if this stock continues to double revenue and triple earnings, trading at P/E of 50 could actually be cheap – a bargain. Context is really important.

Source: Schwager, Jack D. (2012-04-25). Hedge Fund Market Wizards. John Wiley and Sons.

Don’t forget to check out my newest book: Top 10 Trading Setups – How to find them, when to trade them, how to make money with them.

The Four Biggest Trading Challenges

People have issues with trading for four main reasons:

1.They trade the same setup in every market expecting similar results. Markets don’t work that way. Markets change all the time. Different setups work in different markets. For example, breakouts work amazingly during rising markets, but they will lose you money during range-bound, choppy and corrective markets. When your bread and butter setup stops working, you have two options – find a setup that works or sit on the sidelines until market conditions come back in your favor.

2. They expect to be right almost all the time. This doesn’t happen, even in a bull market. Having a 50% success rate is a very good hit rate. Think about that. If you can be profitable only 50% of the time, how big should your losses and gains be in order to achieve great returns? Not taking a small loss and letting it turn into a big loss has many consequences. The impact on the mind can be even worse than the impact on your account. A big loss influences your future position sizing – you trade small when you have to trade bigger because you are scared. A big drawdown can impact your objectivity and ability to spot and take great setups.

3. They expect regular income from trading. It doesn’t work this way.  Periods of making a lot of money are followed by periods of making no money and periods of losing money. The goal is to keep losses to a minimum and be aggressive only during the right circumstances. Twenty percent of your trades will account for most of your profits. The rest should be small wins and losses that cancel each other out.

4. They trade too big. Most aspiring traders are undercapitalized and they want to get rich quickly. This leads to trading too big, putting all of your money in one small-cap stock, trading illiquid penny stocks, trading options directionally. To sum things up, they trade crappy stocks with a lot of leverage and then they get wiped out quickly.

George Soros and Stanley Druckenmiller became famous for putting 50% or more of their capital into a single position. People assume that they can trade like Soros and Druckenmiller and this is a huge mistake. Never put yourself in a situation where a small market move could shake you out of a perfectly good position just because your sizing was too big. Never let a trade impact your sleep and overall happiness. You don’t want to be in a position where you own two stocks and they are the only two that are not moving with the rest of the market. You should never put more than 20% of your capital into a single stock.

Check out my newest book: Top 10 Trading Setups: How to Find them, When to Trade them, How to Make Money with them 


5 Insights for Aspiring Traders

1. The most important thing is to learn how to learn. Study past winners from different time frames and reverse engineer. Keep a journal, set goals, and work deliberately towards achieving them, one step a time. Improve yourself every week.

2. Less is more. First, learn everything about one great setup – how to find it, when to trade it, how to trade it, when not to trade it. Become a master in trading that setup. Understand that this one setup is not going to work in every market environment, so there will be a time when you will have to stay on the sidelines and do nothing. As you get better at trading your one setup, gradually start adding more setups to your arsenal until you have the right tool for any market environment.

3. Find a mentor who can accelerate your learning curve. There are two ways to learn – from your own mistakes and successes and from other people’s mistakes and successes. You can learn a lot by studying your past trades and reading practical and thought-provoking books and blogs. In most cases, those efforts are not enough. Most people need the help of an outside mentor on their journey to profitable trading.

There has never been a better time in financial history to find a good mentor. There are many tools that could help accelerate your learning and building of trading skills. Some of them are free sources like StockTwits, Twitter, Sparkfin, and various trading blogs. There are also many amazing paid trading services. Find one or two or three that best meet your personality and desired trading style. Try different services that can help you learn new skills and offer you new and insightful market perspectives.

Be honest with yourself. It takes a lot of time and efforts to properly prepare for the trading day/week. If you have a full-time job outside of trading, time is an extremely valuable resource. Becoming a fully independent trader and idea generation machine can be your ultimate goal, but to get there faster you can use the help of an outside mentor – someone who can share good trading ideas, teach you how to approach financial markets and manage risk.

As Christian Siva-Jothy says in “Inside the House of Money” – “ No one gets paid for originality. You get paid for making money. I am happy to take other people’s good ideas and run with them, as long as I understand why I am in a trade.”

4. Take the occasional mental breaks from trading. Trading could be very emotionally draining. Find a balance between work and life. Have a hobby outside of trading to occupy your mind. Trading can be a joyful and a profitable experience. If it is not, you are doing it wrong and you need to look for some help.

5. Take care of your health – physical, mental, and emotional. Your trading results depend on your overall well-being. Eat healthy, move a lot, sleep as much as you need to, practice empathy, travel to new destinations to nourish your creativity. Regular 2-minute meditation per day may help to improve your focus and alleviate your anxiety. Do you know what is three times better than meditation for reducing stress? – laughing. Watching some stand-up comedy every day can boost your immune system and make you a sharper thinker.

Check out my new book: Top 10 Trading Setups – How to find them, when to trade them, how to make money with them.