Author: Ivanhoff

What Do Charts Mean for Me

Charting (Technical Analysis) is like reading footsteps. It doesn’t only reveal the past. It gives clues about the likely direction in the near term future. It provides an understanding of likely future behavior, based on deeply ingrained psychological biases and personal incentives. When elephants dance, they leave traces. When institutions buy, they can’t hide their hands. Here is what I said about the subject in my chapter of The StockTwits Edge:

Financial markets move in cycles that are defined by institutional capital
allocation. When institutions buy or sell, they do so in volume and leave clear
traces for the experienced eye…

The bulk of the directional market moves tend to happen in just 10 – 15% of
the trading days. The rest is nothing more than noise in a range. I am looking for
the event that signals the beginning of a powerful, new trend. How does this
signal look like? Simply said – it is high-volume price expansion:

 High volume (at least 3 times the 20-day average daily volume);
 Price expansion (at least 2 times the average true range for the last 20
days and a minimum of a 10% move)…

Such combination of price and volume action guarantees institutional
involvement. My logic is simple – when institutions buy, they leave traces. They
are heavy, slow buyers; therefore I have enough time to enter and exit as they
build their position.

BTW, Peter Brandt has a good post on the subject and as usual, his perspective is worth perusing.

What If Newton Was a Trend Follower

Issac Newton is probably one of the most brilliant men ever lived on this planet, but even he lost a fortune when the so called South Sea Bubble bursted. Shortly after the crash, he reportedly declared that:

“I can calculate the motion of heavenly bodies, but not the madness of people.”

Mebane Faber has an interesting paper on Bubbles that is well worth closer examination:

Across twelve market bubbles we find that a trendfollowing system would have improved return while reducing volatility. Most importantly, it would have reduced drawdowns significantly leading to the most important rule in all of investing – surviving to invest another day.

Bubbles happen much more often that most people expect. They also lasts longer and become bigger than most expect.

A fellow student of bubbles, Jeremy Grantham at Grantham, Mayo, Van Otterloo and Co. (GMO) has collected data on over 330 bubbles in his historical studies. He points out in a recent research piece “Time to Wake Up: Days of Abundant Resources and Falling Prices are Over Forever”, that one of the key difficulties is distinguishing when a bubble is indeed occurring, and when there actually is a paradigm shift. When is this time really different?

During a typical bubble, an asset appreciates several hundred to several thousand per cent in a short period of time and then it comes all the way back where it started and even below in many cases. If you just buy and hold, you end with no gain at the best case scenario. But what happens, if you apply a simple trend following strategy, which always involves an entry and exit plan based on some derivative of price. In his research, Faber uses 10-month simple moving average as a benchmark.

Our research demonstrates that a trendfollowing approach improved returns in every bubble (except one) and reduced volatility and drawdown in all twelve of them.

There are different derivatives of price that could be used as a trailing stop in trend following – Average True Range, Trend lines, Simple and Exponential Moving Averages. The purpose of a trailing stop is to keep you long enough in a trade, so it could make a difference in your overall performance and also to protect your gains after the trend inevitably ends.

The subject of figuring out where to add to a position and where to take partial profits is way more nuanced and I am not going to elaborate on it here.

Price is not the only entry criteria I use, but price is the only exit criteria I respect.

There is a Difference Between What People Say and What They Think

For many, there is a difference between how you think you will act in certain conditions and how you actually act when the time comes. The term used to describe this condition is called empathy gap.

There are two basic scenarios in which empathy gap can impact your performance as a trader/investor:

– you don’t cut your losses when they hit your pre-established exit level. This is the single biggest reason, so many people struggle in the capital markets. One solution to the issue is to enter exit orders, immediately after you initiate an opening order (caution: it does not work with illiquid names, where market makers can easily shake you out);
– you don’t take the signals from your watchlist when they are triggered. Some stocks can really move fast after they pass their tipping point. When that happens, many traders feel like a deer in headlights and are not willing to pay the market price. They’ll put a limit order, hoping that the desired stock will come back and their order will be filled. The best stocks don’t come back. Don’t be afraid to pay the market price for proper breakouts.

In his latest post, Steve Martin reveals that:

In today’s information overloaded world, evidence suggests that 95 per cent of our decisions are made without rational thought. So consciously asking people how they will behave unconsciously is at best naïve and, at worst, can be disastrous for a business.

This is one of the reasons why I think that survey based sentiment measures have little value. Market sentiment is reflective. It mirrors short-term price action and recent performance. For example, people who have had a number of consecutive successful long trades are likely to be much more optimistic about the markets in general than people who have been on the sidelines.

I realize that there are some hedge funds that claim that sentiment could be a leading indicator, but I have a feeling that in their case they are confusing correlation with causation. The truth is that price and sentiment live in a systemic relationship, meaning that they mutually impact each other in real time. Price changes when perceptions of risk change, but also perceptions of risk change when price changes. Since I don’t have a reliable method to catch changes in sentiment, my starting point for finding new ideas is always price.