Brian Shannon on Bear Market

Let me repeat the mantra that using P/E, cash flow and other fundamentals can be harmful as crucial trading determinants in a downward market. During downtrend, hope tempts market participants to look at these traditional measures of valuation to justify establishing a long position. But only price pays and the message of declining prices says do not buy. In a bearish environment, these valuation tools will drop much lower than most people expect, then revert back outside the mean. Price is the only objective measurement of value, and as perceptions change, prices and valuations change.

Another temptation is to get long a declining stock because you feel the stock is “down too much”. This thinking is based on the hope that sellers will “come to their senses” and recognize the value. They won’t. Logic and reason get thrown out of the window when participants act on emotion. Recognize that a stock in a downtrend will bring about those emotions at quick to sell at first signs of trouble. A stock is never down too much when there is a simple absence of demand.”

Nicolas Darvas

Chairman Maoxian managed to find some great links with Nicolas Darvas interviews:

(1959 Interview):

“Since he has to do trading from wherever he is dancing he ignores tips, financial stories and brokers’ letters, and has never been in a broker’s office. Basically, his approach is that of a chartist: he watches price and volume … When a stock makes a good advance on strong volume, he begins watching it, buys when he feels that informed buyers are getting in. For example, when he was playing in Calcutta, he noticed E. L. Bruce moving up in the stock tables. Suddenly, on 35,000 shares it moved from 16 to 50. He bought in at 51, though he knew nothing about the company, and ‘I didn’t care what they made.’ (They make hardwood flooring.) He sold out at 171 six weeks later.

Darvas places his buy orders for levels that he considers breakout points on the upside. At the same time, he places a stop-loss sell order just below his buy order, so that if the stock does not move straight up after he buys, he will be sold out and his loss cut. ‘I have no ego in the stock market,’ he says. ‘If I make a mistake I admit it immediately and get out fast.’ Darvas thinks his system is the height of conservatism … If he has a big profit in a stock, he puts the stop-loss order just below the level at which a sliding stock should meet support. He bought Universal Controls at 18, sold it at 83 on the way down after it had hit 102.

Darvas trained for the market just as methodically as he had studied his dancing, read some 200 books on the market and the great speculators, spent eight hours a day until saturated. Two of the books he rereads almost every week: Humphrey Neill’s Tape Reading and Market Tactics and G. M. Loeb’s The Battle for Investment Survival. He still spends about two hours a day on his stock tables.”

That line, “[He] buys when he feels that informed buyers are getting in,” made me chuckle. It should read “He buys when he suspects that uninformed fools are piling in.”

An Interview With Nicolas Darvas in 1974:

“Don’t forget I too went through a period of learning from 1953 to 1958 where I lost a substantial amount of capital before I worked out what worked and then was lucky enough to time it in the 1958-1960 bull market.”

Marketsci on what overnight gaps tell us about the stock market

  1. The idea that the overnight market (close to open) doesn’t influence the daytime market (open to close) is usually correct, but NOT when the overnight market is moving violently like it has recently.
  2. Large gaps down exhibit a relatively strong negative correlation to subsequent daytime changes indicating a tendency to reverse some of the overnight gap in the daytime. I haven’t shown it in these statistics, but the larger the gap down, the higher the average return and the more negative the correlation (but also the higher the volatility) of the daytime reversal.
  3. Large gaps up do not exhibit a consistent influence in all market conditions. Also not reflected in these statistics is that as the size of the gap up increases, the correlation to the daytime market becomes more and more asymmetrical based on the broader trend. In up trending markets, these very large gaps up exhibit strong follow-through (positive correlation), but in down trending markets, very strong reversal (negative correlation).’

Dr. Brett Steenbarger on market bottom

Bottoms are made when selling becomes exhausted and long-term participants perceive value and lift stocks sharply off their lows. That exhaustion can occur over a period of months, as fewer stocks and sectors make new lows over time and individual stocks and sectors find fresh buying interest. Thus far, we’re not seeing such selling exhaustion; weakness has, so far, begotten further weakness. While it is tempting to call market bottoms and pick up bargains, all we can say Wednesday is that a historically weak market just got weaker.”

How to define a stop loss?

“Place your stops at a point that, if reached, will reasonably indicate that the trade is wrong, not at a point determined primarily by the maximum dollar amount you are willing to lose.”

Bruce Kovner

If you are using automated trading systems, the most appropriate approach for stop loss’ defining is applying Average True Range. For example you might use 1.5 times or 2 times 10 days ATR. It will depend on your trading horizon.

If you are proprietary trader (most likely trend follower), it is reasonable to put your stop loss 10-20 cents below major area of support. Again, the area of support would be defined by your investing horizon.