Least week was a banner week for economics with nearly every major report for the month crammed into the last four days. Next week the calendar is almost bare. The earnings cycle is nearly over and there are only a few majors left to report. The markets will have to look hard to find something to provide direction. Linda and I called Thursday conviction day where the bulls had to decide if the Fed outlook supported their bullish views. Next week could be seen as conviction week now that the economics and earnings are behind us. Do we continue higher or does the sell in May strategy now appear more attractive?
Dow Chart - Daily
There were so many economics last week I thought I would provide s short recap today. I doubt everyone caught all the reports and this was a pivotal week for economic news.
Consumer Sentiment 62.6, 26-year low. This is a level consistent with a severe
The Non-Farm Payrolls on Friday saw a loss of 20,000 jobs but that might as well have been a gain of 100,000. Analysts had expected a fourth consecutive month of more than 75,000 jobs. This was a positive report and had the bulls speculating the worst was over. It would be tough to make that leap of faith given the internal data but any improvement helps investor sentiment. I should note that the drops over the last four months have been very mild compared to prior recessions. The initial 4-month average loss was -123,000 in 1990 and -120,000 in 2001. That compares to the current 4-month average of -65,000 in 2008. This was a very good report for the markets and relieved a lot of worries. There were a lot of whisper numbers for well over 100,000 job losses. It was kind of anticlimactic after the Fed failed to signal a definite pause and after their pre-market announcement on Friday.
Non-Farm Payrolls Chart
Compared to last week the calendar for next week is positively boring. There is nothing on the calendar that should concern traders. There will be very little chance for any of these reports to move the markets.
The Federal Reserve surprised the markets again on Friday. Just before the open they announced they raised the Term Auction Facility amount from $100 billion to $150 billion per month. They said they would now accept AAA asset backed securities including auto loans, credit card balances and student loans. They also increased the ECB swap line to $50 billion from $20B. That means the Fed is going to give the ECB $50 billion in dollars to loan to European banks who need liquidity support. Swaps with the SNB (Swiss) rose to $12B from $6B. Obviously that was to benefit Credit Suisse, RBS, DB, etc. The markets reacted very positively to the announcement as shorts who entered on Thursday's rally were crushed again at the open.
The opening rally did not last long. Traders and analysts began to ask themselves why did the Fed increase all their liquidity tools so strongly when the last round of borrowings under these facilities was under subscribed? Did the Fed know something we don't know? Is the banking system still under that much stress? This is clear evidence that banks are still not lending to each other and the Fed is the bank of last resort. Maybe I should say the taxpayers are the bank of last resort since we will ultimately pay for any failures in these loan portfolios. It concerns me that the Fed is willing to backstop auto loans with gasoline heading for $4 and credit card loans when bankruptcies are up 47% and foreclosures 112%. Granted they are only going to take AAA securities but given the problems with the rating agencies how do you know what a rating is worth?
On the earnings front Sun Microsystems (JAVA) said it would cut 1500-2000 jobs in a plan to reduce expenses by $100-$150 million a year. Sun will take a restructuring charge of $130-$220 million in the current quarter relating to these cuts. Sun predicted revenue would be flat and below street estimates. The Sun CEO said they saw "a substantive change in U.S. sentiment" during March. "In subsequent weeks we experienced a significant number of deferrals of purchases from many of our large U.S. end user customers." Also channel partners were not seeing the sell-through products they had expected. Sun was the first major tech company to report a significant slowdown in U.S. orders. Others said orders were sluggish and relied on overseas sales to bolster profits. This news from Sun was not well received. JAVA fell -22% on the news.
Berkshire Hathaway Chart - Daily
Berkshire Hathaway reported earnings of $1,247 per share or $1.93 billion. Analysts had expected earnings of $1,447 per share. Were Berkshire shares crushed by the news? Not a chance unless you count a $300 drop on a $134,000 share a crush. Berkshire saw a 24% drop in revenue and profits fell -64%. The problem was tied directly to insurance premiums and about $2 billion in derivatives that did not go as planned. Berkshire said it booked a $1.2 billion pre-tax "unrealized" loss on put options it "wrote" on the S&P-500. Writing puts on the S&P is a bullish strategy if you expect the S&P to go up. Obviously we have not seen a lot of that until just recently. Berkshire also reported a $490 million loss on some high yield bond puts but those positions are good until 2013 so that loss could also evaporate. In February Berkshire reported they had $40 billion in exposure to these kinds of derivatives. Buffett has always called derivatives "financial weapons of mass destruction, carrying dangers that, while not latent, are potentially lethal." In his February letter discussing these derivatives Buffett said Berkshire had already been paid for its contracts, giving it cash to invest, and there was no counter party risk. He warned that investors should be prepared for gains or losses that could "easily" top $1 billion in any quarter. Berkshire's annual meeting is Saturday where Warren will take up to 6 hours of questions from shareholders. We will see on Monday how that derivative position weighs on shareholders.
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Chevron reported earnings of $5.17 billion or $2.48 per share. I know what you are thinking. Along with high oil prices those record high gasoline prices are fueling the profits. You would be wrong. Chevron's division that refines and sells gasoline only made $252 million for the quarter. That is down from $1.6 billion in the comparison 2007 quarter. The big oil companies and refiners in general are not making money from high gasoline prices. They simply cannot raise prices on gasoline fast enough or high enough to cover their costs at $120 oil. I heard today that Hillary has a plan to remove the 19-cent Federal gasoline tax and make the big oil companies pay it instead. Some politicians never learn. If you raise taxes on oil companies they raise their prices to compensate. Consumers will pay the same regardless of whose hand is in their pocket. There were two key points in the Chevron earnings report. The average price they received for a barrel of oil was $90, not $110 or $120. Those record high prices are spot prices not every day contract prices. Secondly Chevron's production fell by 44,000 bpd in Q1 over the same period in 2007. It is getting tougher to replace falling production with new discoveries. Older fields are in permanent decline and new fields cannon be brought online fast enough to compensate.
Gas Prices Palo Alto California on May 1st
Earnings are nearly over with more than 75% of the S&P-500 reported. Goldman was rather upbeat on the earnings cycle saying the results were not as negative as they expected. They also said guidance was not as bad as many had predicted. The majority of the earnings disasters came from the financial sector. That sector was ravaged by the Bear Stearns implosion in late March. There was simply not enough quarter left for the good news to overcome the bad after the BSC debacle crushed the sector. The BSC problem caused valuations for many types of securities to plummet and that caused even larger write-downs than their current value today. The financial sector is in strong rebound mode and that suggests Q2 earnings will be substantially better overall even though the economy is still weak.
I had a hard time finding enough stocks with names you might recognize to put on the list for next week despite there being hundreds of companies still to report. The big dog next week is Cisco Systems (CSCO) on Tuesday. Many expect Cisco to beat their estimates due to sales overseas. BUT, the put call ratio is rising and that suggests there is a lack of conviction by the bulls. Cisco broke out over $26 last week on positive expectations but there are still fears that the U.S. side of the business will drag down their overall results. The Sun Microsystems earnings on Friday are a prime example of slowing U.S. tech sales. I believe it was symptomatic more to Sun Micro's product line rather than the Cisco line. Cisco is the current 800lb gorilla where Sun is a past Y2K vintage superstar fallen out of favor with the mainstream tech sector. It will be interesting to see how Cisco reports and more specifically how they guide since CEO John Chambers is seen as always bullish on his outlook.
Deal or no deal? The Microsoft/Yahoo deal may be back on again. The news services reported late Friday that the companies were in heated negotiations in an effort to strike a deal that would not involve a hostile bid or a prolonged battle. Microsoft was reportedly offering $33 in an effort to conclude the deal peacefully. Yahoo was reportedly holding out for $35-$37 but was feeling the heat after their shares fell to below $26 last week. The stock spiked in late trading to $29.75. Analysts cautioned that should Yahoo remain stubborn in the face of a revised offer Microsoft could walk, let the stock fall then start buying it on the open market for a lot less than $31. It was $19 when Microsoft made the first offer for $31 and would be $19 again in a heartbeat if Microsoft officially terminated the deal.
Crude Oil Chart - Daily
It would not be a market commentary without a short look at oil prices. After falling from $119.89 to $110.30 in four days oil rebounded strongly to close at $116.36 on Friday. A $10 drop and $6 rebound in only five days. Oil was up +$3.80 on Friday alone. It appears, and I emphasize appears, that there was a combination of several factors. Shorts loaded up once the decline began and were heavily short at Thursday's lows. Thursday's close saw a commodity buy program hit just like we saw a major equity sell program at Wednesday's close. It had all the appearance of sector rotation on better than expected Fed news. Commodities had corrected as a group all week. When May arrived funds started putting new money to work and what better place than oil after nearly a 10% correction ahead of the normally strong summer driving season. That buy program at Thursday's close triggered some short covering but caught most traders off guard. On Friday news broke that Turkish planes were bombing Kurdish rebels in oil rich northern Iraq. This was the first series of strikes since December. Fears of a halt to the oil flowing north across Turkey sent futures higher again overnight. Suddenly shorts were in trouble and more fund money chasing oil higher on Friday caused a major short squeeze. The news pundits continue to tell you that oil is moving higher because of the falling dollar. The dollar had its best two days (Thr/Fri) since mid April and closed at a 2-month high. That should squash that rumor somewhat. Oil trades primarily on oil news and speculator involvement. The value of the dollar is only a miniscule portion.
U.S. Dollar Index Chart
The markets celebrated the better than expected economics and the lack of a pause statement by the Fed. It was a very good statement. Inflation is still expected to decline and the economy is still expected to be weak but the "downside risks to growth remain" comment was removed. Goldman says earnings were better than expected and expectations for Q2 could be raised. There should not be anything in our way for a continued rally but that is normally when lightning strikes.
The Dow rallied over resistance at 12900 before the closing sell program on Wednesday. Bulls bought the dip to 12800 and pushed the Dow to a high of 13132 on Friday before easing back to close at 13058. That is the highest close this year! The bulls appear to be finally in control and we are definitely in dip buy mode. That Friday afternoon dip was back to 13000 and to what appears to be growing support. The next major resistance level is just over 13500.
S&P-500 Chart - Daily
The S&P-500 mirrored the Dow with a resounding breakout over 1400 and a continuation of the bullish trend out of the March lows. The next material resistance on the S&P is around 1425 followed by 1485. To say the bull is back may be premature but the signs are definitely encouraging.
The Nasdaq had been leading the other indexes higher and came within .96 of hitting 2500 on Friday. If it were not for the drag caused by JAVA, GOOG, BOOM and BIDU it is entirely possible it could have closed at that resistance. Support is now 2400 and well below our current level.
Nasdaq Composite Chart - Daily
Russell-2000 Chart - Daily
Of all the indexes the Russell-2000 is showing the least conviction. It touched major resistance at 735 on Friday but it was a struggle. Until the Russell makes the same breakout as the other indexes this is not a bull market. The Russell is a sentiment indicator for mutual funds. If fund managers are not investing in small caps they are not convinced the market is going to move higher. So far that conviction is still lacking.
Volume is also showing a lack of conviction. You can't count Wednesday because of the post FOMC meeting gyrations but even with all the hedge funds playing Fed games it only came to about 7.5 billion shares for the day. Thursday was stronger at 7.6B but Friday was back in the high 6B range again. After all it was Friday and maybe we should count that as decent. It is simply not enough to claim the rally has legs. We need to be long and continue to buy the dips but do it cautiously. If the Russell moves over 735 I would be more aggressive. I would buy dips back to 1380 on the S&P and turn bearish below that level.
The next two weeks are the start of the "sell in May and go away" cycle. The selling normally begins when earnings are over and after the influx of new money fades around the 10th. I have said repeatedly that I think the current setup will negate that strategy this year but we still need to see if institutional investors feel the same way. That is the reason we need to be cautious over the next couple weeks and probably the reason the small caps are lagging. Fund managers are also watching to see how the cycle will play out in 2008. Hopefully there will be a couple dips to buy as those inclined to sell in May take their leave. Just make sure to watch that S&P 1380 level as a key inflection point.
Play Editor's Note: I wanted to list a couple of more candidates here. Keep an eye on SSL. Traders bought the dip in SSL near broken resistance. This could be an entry point here but we'd rather buy a dip near $56.25. COF looks like a potential bearish play. The stock has rallied right to resistance in the $57.50-58.00 zone. If the stock was going to see a correction this would be the place for it to begin. Aggressive traders could buy puts on COF now with a stop above Friday's high. UBB, a Brazilian bank, might also be a bearish candidate. The stock soared from $130ish to $160 on news this past week that S&P had upgraded the country's debt rating. UBB is very short-term overbought and trading right near resistance at $160. I would consider buying puts if UBB traded back into the $159.00-160.00 zone with a very tight stop around $161.50-162.50ish. This would be considered a very speculative play.
CF Ind. - CF - close: 134.76 chg: +2.72 stop: 126.45
Why We Like It:
BUY CALL JUN 135 CF-FV open interest= 94 current ask $13.10
Picked on May xx at $ xx.xx <-- see TRIGGER
Gilead Sciences - GILD - close: 53.63 chg: +0.63 stop: 49.99
Why We Like It:
BUY CALL JUN 50.00 GDQ-FJ open interest= 144 current ask $4.70
Picked on May 04 at $ 53.63
Mosaic - MOS - close: 124.63 change: +2.08 stop: 115.49
Why We Like It:
BUY CALL JUN 125 MTJ-FE open interest=2422 current ask $11.10
Picked on May xx at $ xx.xx <-- see TRIGGER
Arcelor Mittal - MT - close: 89.15 change: +1.55 stop: 85.99
Why We Like It:
BUY CALL JUN 85.00 MT-FQ open interest=2875 current ask $7.50
Picked on May xx at $ xx.xx <-- see TRIGGER
POSCO - PKX - close: 124.64 change: +1.09 stop: 119.75
Why We Like It:
BUY CALL JUN 120 PKX-FD open interest= 12 current ask $11.10
If PKX hits our trigger at $119.50 to buy puts then we'd suggest the June puts in the $125, 120, 115, 110 strikes.
Remember, it's up to you, the individual trader, to decide which month and which strike price best suits your trading style and risk.
Picked on May xx at $ xx.xx <-- see TRIGGER
Aracruz Celulose - ARA - cls: 80.65 chg: +0.71 stop: 75.49
The Brazilian Bovespa market rallied another 2% to yet another new high. ARA spiked to a new high this morning but gave back most of its gains to end Friday up 0.8%. The trend is still up but more conservative traders may want to tighten their stops. We have two targets. Our first target is the $84.50-85.00 range. Our second target is the $88.50-90.00 zone. As expected the rally over $80.00 did produce a new P&F chart buy signal, which currently points to a $94 target.
Picked on April 28 at $ 80.25 *triggered
Cytec Ind. - CYT - close: 59.08 change: -0.18 stop: 57.95
We would give serious thought to cutting our losses in CYT right here. The stock has been under performing the market the last few days. The "tone" of its trading changed on the April 29th decline. Shares did bounce near $58.00 as expected. At this time we would not consider new bullish positions until CYT traded above $60.00 or $61.00 depending on your risk tolerance. The MACD on the daily chart appears to have produced a new sell signal. We have to label this a more aggressive play because the spreads on the options are pretty wide. There isn't much we as traders can do about that except try to minimize its impact with good entry and exit strategy. We're listing two targets. Our first target is the $64.75-65.00 range. Our second target is the $68.00-70.00 zone.
Picked on April 27 at $ 60.64
HSBC - HBC - close: 87.67 change: +0.12 stop: 84.90 *new*
International bank HBC continues to rally after breaking out from its sideways consolidation. We remain bullish on it here. If the stock does dip then look for an entry point in the $86.50-86.00 zone. We're adjusting our stop loss to $84.90. We have two targets. Our short-term target is the $89.75-90.00 range. Our more aggressive, longer-term target is the $94.00-95.00 zone. The P&F chart is bullish with a $113 target.
Picked on April 28 at $ 86.19 *triggered/gap higher
Home Depot - HD - close: 30.12 chg: +0.25 stop: 28.99
HD tried to rally again but was rebuffed at the $30.50 level and its 200-dma. The overall trend still looks like HD has bottomed and is moving higher. We would expect shares to breakout higher next week. If they do not then more nimble and aggressive traders might want to consider buying a dip near $29.00. Our suggested entry point to buy calls is the $30.55 mark. If triggered our target is the $34.00-35.00 range. We do not want to hold over the May 20th earnings report.
BUY CALL JUN 30.00 HD-FF open interest=12762 current ask $1.50
Picked on May xx at $ xx.xx <-- see TRIGGER
Hovnanian - HOV - close: 11.85 chg: +0.03 stop: 10.74
The homebuilders are still languishing sideways. The DJUSHB index, the XHB, and shares of HOV all look similar. On a positive note they all have a bullish trend of higher lows. The path of least resistance seems to be up but the group just doesn't have any gas to get there. Buying dips in HOV in the $11.30-11.00 zone might work but more conservative traders may want to keep inching up their stops (potentially toward the $11.00 level). On the other hand you could just wait for a breakout over what looks like resistance near $12.50. The consolidation in HOV appears to be coming to a point so a breakout is almost imminent. We have two targets. Our first target is the $13.50-14.00 zone. Our second, more aggressive target is the $14.75-15.00 zone. FYI: The P&F chart is bullish with a $25 target. HOV still has a high amount of short interest. The most recent data listed short interest at almost 65% of the 37.2 million-share float. That really raises the odds of a short squeeze, which would be great for us. Don't forget that we do not want to hold over the late May earnings report.
Picked on April 16 at $ 11.86
Harsco - HSC - close: 60.55 change: +0.17 stop: 57.99
Friday's action was a mirror of Thursday's. HSC was up in the morning, drift down midday and then rebound higher into the closing bell. We don't see any changes from our previous comments. We'd still consider new bullish positions here. Our four-week target is the $64.50-65.00 range.
BUY CALL JUN 60.00 HSC-FL open interest= 43 current ask $3.70
BUY CALL JUL 60.00 HSC-GL open interest=121 current ask $4.60
Picked on May 01 at $ 60.38
Intl.Bus.Mach. - IBM - cls: 123.18 chg: -0.43 stop: 118.49
We remain bullish on IBM following the mid April breakout over resistance at $120. The stock hit our trigger this past week in the $120.75-120.00 zone. We suspect that readers will get another chance to buy a dip near $121.00 soon. More conservative traders might want to cinch up their stops toward $120, which should be new support. We have two targets. Our first target is the $124.90-125.00 range. Our second target is the $128.00-130.00 zone.
Picked on April 30 at $120.75 *triggered
ImClone Sys. - IMCL - close: 47.06 change: -1.01 stop: 45.85
Biotech stocks were mostly lower on Friday. Shares of IMCL slipped toward $46.75 before bouncing. We remain bullish here and would use the dip as a new entry point to buy calls. Overall we don't see any changes from our Thursday night comments. We are trying to use a tight stop at $45.85. We have two targets. Our first target is the $54.00 level. Our second target is the $58.00 level. Please note that any time we play a biotech company it is considered an aggressive, higher-risk play. You never know when an FDA decision or some clinical trial result might come out for this company or one of its rivals and send the stock gapping one direction or the other at which point our stop loss might become worthless.
BUY CALL JUN 45.00 QCI-FI open interest= 1224 current ask $4.90
Picked on May 01 at $ 48.07
iShares Russ.2000 - IWM - cls: 72.52 chg: -0.23 stop: 69.49
The Friday morning rally in the small cap stocks faded but traders seemed to be buying the dip by the afternoon. The IWM spiked toward potential overhead resistance at its exponential 200-dma. We remain bullish on the IWM but it's up to the trader to choose new entries here or wait for a potential dip near $71.50 and jump in then. Our four to six-week target is the $77.50-80.00 zone. The P&F chart is bullish with an $87 target.
Picked on April 28 at $ 72.55 *triggered
iShares DJ Transports - IYT - cls: 94.87 chg: -0.62 stop: 89.95
The IYT just turned in a very impressive week. The stock has surpassed our first target in the $94.85-95.00 range. The intraday high on Friday was $96.46. While we remain bullish on the IYT we are not suggesting new positions at this time. The transports are actually up six out of the last seven weeks. Keep an eye on crude oil, which will continue to impact the transports, although honestly the group has been ignoring oil's strength this past month. Our eight-week target is the $98.00-100.00 zone.
Picked on April 27 at $ 91.48 /1st target exceeded
Joy Global - JOYG - close: 76.97 chg: +2.93 stop: 69.95
Shares of JOYG soared on Friday. The stock gapped open at $75.08 and rallied toward the top of its current trading range in the $72.00-77.50 zone. The intraday high was actually $77.61. We remain very bullish on JOYG but we would not launch new positions at this time. We strongly suggest readers consider adjusting their stop loss toward Thursday's low (around $71.50). Our target is the $79.50-80.00 range. We are going to add a secondary target in the $84.00-85.00 zone. However, we will plan to exit ahead of the late May earnings report. The P&F chart is already bullish with an $88 target.
Picked on April 16 at $ 72.55 *triggered
Nucor - NUE - close: 74.30 change: +0.48 stop: 69.75
Many of the steel-related stocks suffered some profit taking this past week. NUE might be done digesting its previous gains and ready for another leg higher. We would still consider new positions here but traders could try and pick off an entry near $72.00 or a new move over $75.50 depending on your style. More conservative traders might want to place their stop loss under Thursday's low at $71.68. Our initial target is the $79.50-80.00 range. Our second, more aggressive target is the $84.00-85.00 zone. The Point & Figure chart is bullish with a $93 target.
Picked on April 22 at $ 74.63
Textron - TXT - cls: 62.00 change: +0.27 stop: 59.85
Shares of TXT continue to inch higher and really look poised to burst from its three-week consolidation pattern. We are still suggesting new positions right here but more conservative traders could wait for a new relative high over $62.50. Our short-term target is the $64.85-65.00 zone. Our secondary, more aggressive target is the $68.00-70.00 range. The Point & Figure chart is bullish with an $83 target. FYI: TXT is due to present at an investor conference on May 8th.
Picked on April 27 at $ 61.39
United States Oil - USO - cls: 93.40 chg: +3.02 stop: 94.65
The USO completely erased Thursday's losses with a 3.3% bounce on Friday. Part of the challenge was news of Turkish planes bombing Kurdish rebels in northern Iraq. That sent crude oil futures higher. The rally in the USO failed to breakout past short-term resistance at its 10-dma. However it wouldn't take much for the USO to spike higher and hit our stop loss. We're not suggesting new positions at this time. Our target is the $88.50-88.00 zone. FYI: The intraday low last week was $88.89.
Picked on April 21 at $ 94.38
Alliant Tech - ATK - close: 113.69 chg: +0.40 stop: 109.45
Target achieved. ATK continued to rally and hit $114.29 on Friday morning. Shares have already surpassed our early target at $110 and Friday hit our second target in the $114.00-115.00 zone. We would keep an eye on ATK for a pull back toward what should be support in the $110 region.
Picked on April 21 at $106.00 /2nd target hit $114.00
Goldman Sachs - GS - cls: 200.27 chg: +1.22 stop: n/a
Target achieved. Shares of GS have turned in an exceptional rally over the past three weeks with a $41 bounce from its lows near $161. This past week shares broke through resistance at its 200-dma and on Friday GS broke through round-number, psychological resistance at $200. The stock hit $203.39 o Friday morning and that was enough to push the May $190 calls to $14.50. Our target happened to be $14.50 for this strangle. Our estimated cost was $8.70. While the play is closed for us we suspect that GS will continue to trade higher and thus more aggressive traders, who choose to let this run, could build on these gains. GS' strength is also its biggest risk if you choose not to exit. Nothing goes up in a straight line for very long and GS is up 25% in the last three weeks. Plus May options expire in two weeks. Any profit taking or correction in this stock could easily kill the options premiums.
Picked on April 06 at $175.40
All who traded through this last year have accumulated war stores or battle scars. Hopefully, for our subscribers, those war stories won't include the one about how you ran through your entire trading account. The battle scars won't be so deep that you've lost the ability to trade.
If you've survived this past year with your trading account intact, it's time to talk about how much traders should allocate to their trades. The easy answer? Not more than they can afford to lose.
The harder answer becomes a lot harder. That answer involves so many variables. Some trading experts believe that answer begins with setting up each trade so that it comprises a certain percentage of account equity. When the account is growing, the size of trades increases. When the account's value drops, so does the money invested in each trade.
This means trades comprise bigger dollar amounts when trades are going well, and account balances are swelling; smaller when they're not, and account balances are dropping. Sticking to a certain percentage of the account equity for each trade guarantees that traders are putting less at risk when trades appear less likely to succeed, either due to changing market environments or distractions in traders' lives that cause mistakes. I've heard trading professionals suggest anything from two to five percent of total trading equity being put at risk for each trade.
If only it were that easy. This article would be finished and subscribers would have fewer decisions to make.
It's not that easy, of course. By now, most subscribers will have already spotted one missing input in the decision-making process. Even if traders allocate only two percent of equity for each trade, they'll eventually blow through trading accounts if all of their trades are losing ones.
Notice that I didn't say "if a majority of their trades are losing ones"? Surprisingly, to some, traders can grow their accounts even if their trades are successful less than half the time.
How? Take the example that Christian B. Smart, PhD did in "Fixing the Flaws in Fixed-Fractional Position Sizing" (STOCKS & COMMODITIES, AUG 2007, pg. 32). He posed the instance of a trader whose system is successful only 40 percent of the time. If that trading system requires that losses be half of gains, Smart calculates that the "system expectancy," defined as the expected or average amount the trader anticipates making for each dollar at risk in a trade, to be $0.20 or 20 percent. The calculation is as follows, with the 40 percent winning percentage converted to the decimal 0.40 and 60 percent losing percentage converted to 0.60:
0.40*2 - .60*1 = 0.20
This means, Smart reminds readers, that traders would expect to get a return of 20 cents for each dollar put at risk. Another way of thinking of it is that the traders would expect a return of 0.20 times each amount put at risk.
Imagine that a trader's system met those parameters, including 40 percent of trades being profitable and limiting the losses to half the gains. Then that trader enacts a practice of putting four percent or 0.04 of the trading equity into each trade. If that same system expectancy or 0.20 multiple is used, the trader would expect on average a return of 0.008 or 0.8 percent of the account equity for each trade.
If that trader's account equity was $5,000 account, the trader would put $200 ($5000 x 0.04 or 4 percent) at risk on a first trade and expect a return of $40.00 ($200 x 0.2 system expectancy) for the first trade. The trader's account would then equal $5040, and the return on the next trade would be expected to be $40.32. The account would then equal $5080.32, and it goes on and on. Smart offers a more complicated formula, a geometric mean, to show the expected account values after N trades. Supposedly, the trader could plug in the number of trades and calculate what the account equity could be expected to be after that many trades.
It's still not that easy. In real-life trading, the system would always underperform, not producing the expected equity, Smart concludes. The reason proves complicated for all but math nerds, but it involves the difference between the arithmetic mean, which is the system expectancy, and the geometric mean, which is the average amount per trade that would be achieved after N trades with each trade being a fixed percentage of the account equity. Arithmetic means are always greater than or equal to geometric means, it turns out, so the system underperforms expectations.
Smart has a fix for that, but it's still not that easy. Imagine that Trader 1 began trading early this year when many indices chopped violently back and forth as they began setting up the widest portions of the triangles many formed on their daily charts. Perhaps the trader had back tested a system and found that it had that 40 percent ratio of winning trades. However, what Trader 1 actually encountered was a period of time in which a whole lot of those 60 percent of losing trades were experienced right away, right at the beginning of the time that trader began to place live trades.
Imagine that Trader 2 had begun trading two years earlier, when markets were trending up. That trader's system had the same 40 percent of profitable trades, but that trader entered the markets with live trades at a time when eight profitable trades were encountered right in a row, a loss was taken, and then another eight profitable trades were placed. It doesn't take much imagination to figure out which trader is likely to have more in account equity after 30 trades are placed.
Computations that determine an average expected gain don't go far enough. Remember when you spent a day back in third grade math class flipping a coin while a member of your group toted up the number of heads versus tails? If so, you know that the 50 percent heads/50 percent tails ratio is often not achieved until many hundreds of coins are tossed, not after the first hundred. You would have noticed many times when six heads or nine tails in a row were flipped. That can happen to traders, too, so figuring out all those system expectancies and ratio of winning trades just isn't enough.
There's a little something called "risk of ruin," a term borrowed from gamblers, that measures how likely traders are to experience ruin, or the loss of their entire trading equity, due to those periods of drawdowns. Risk of ruin calculations for traders vary from source to source, and can be complicated or simple. One of the simplest but perhaps not most accurate, for a reason I'll explain later, can be found on page 66 of Perry Kaufman's SMARTER TRADING. Kaufman introduces the calculator by warning that the greatest risk of ruin exists at the beginning of a period of trading. Why that's true is clear from the hypothetical examples of Trader 1 and Trader 2, mentioned previously. Kaufman notes that "once profits accumulate, the chance of ruin decreases."
His formula doesn't include everything some others do, but it does illustrate a couple of important points and doesn't involve calculated mathematics. This formula calculates risk of ruin as a probability.
Risk_of_Ruin=((1-Edge)/(1 + Edge))^Units_Capital
Kaufman's description of edge differs from his use in sample calculations, at least as far as I could tell. In those calculations, he employs the probability of win as the "Edge," and that's what we'll do. He defines units of capital by providing an example. Perhaps a unit of capital might be $10,000, he suggests, allowing calculations for risk of ruin to be made for investments of 1 unit or $10,000 or 2 units or $20,000. This can be done to see how increasing the size of trades increases or decreases the risk of ruin.
Let's make some sample calculations to see how this works. Imagine that Trader 3 has a trading account of $5,000. Trader 3 wants each trade to put at risk 4 percent of the trading account or $200. That amount will now constitute one unit of capital. Trader 3's system has a 40 percent or 0.40 probability of winning or being profitable.
Risk of Ruin by this calculation for Trader 3 is ((1 - 0.40)/(1 + 0.40))^1 = 0.4286 or 42.9 percent.
That's a fairly hefty risk of ruin. This calculation has some shortcomings since it doesn't factor in whether Trader 3 keeps losses small in proportion to profits. That's why I noted earlier that it's perhaps not the best calculation to use, at least when traders are attempting to calculate their own risk of ruin. Still, we're going to stick with it because following several sample computations still shows some important points.
Now imagine that Trader 3 tinkers around with the trading system and achieves a 50 percent or 0.50 probability of winning or being profitable.
Risk of Ruin for Trader 3, with the new, improved trading system is ((1 - 0.50)/(1 + 0.50)^1 = 0.333 or 33.3 percent.
Imagine that Trader 4 also has a 50 percent or 0.5 probability of winning or being profitable and invests the same 4 percent of the trading account. Trader 4, however, has a $10,000 trading account, so Trader 4's four percent equals $400. Since our unit of capital is $200, Trader 4 would have 2 ($400/$200) units of capital.
Risk of Ruin for Trader 4 is ((1-0.50)/(1 + 0.50))^2 = 0.111 or 11.1 percent.
This tells us that the trader with the larger trading account has a smaller risk of ruin. Of course, the mathematicians among you have already noted that if Trader 3 doubles the amount put at risk with each trade but keeps the arbitrary definition of a unit of capital the same, that trader would seemingly lessen the risk of ruin to the same as Trader 4's risk, and that doesn't make sense intuitively.
Logic tells us that risk of ruin won't work that way, that this computation is too simplistic, not taking into account all the parameters and employing an arbitrary definition of a unit of capital. If Trader 3 regularly risks 80 percent of the $5,000 trading equity, or $4000, which would be 20 units of capital, the calculation would produce an even lower risk of ruin, but we know intuitively that some one with a $5000 trading account, regularly risking $4000 for each trade, is going to come to ruin sooner rather than later.
On succeeding pages, Kaufman's formulas become more complex, incorporating more and more inputs. Other writers talk about the complexity of the risk-of-ruin formulas, too. A search of the Internet turns up some risk-of-ruin calculators, although most are geared toward gamblers, and articles in magazines such as FUTURES have covered the topic, too.
However, the necessary points have been made. A conservative approach to determining how much should be risked on each trade involves risking a certain small percentage of an account on each trade. It's a type of diversification, if you will. Furthermore, the smaller the trade or the lower the percentage of winning to losing trades, the higher the risk of ruin. Risk of ruin also rises when losses are not kept small in relationship to profits, something not addressed in Kaufman's original and most simplistic formulas, but certainly addressed in all those calculators on gambling sites.
You might be drawing an unfortunate but true conclusion by now. That unfortunate truism is that the smaller the account, the higher the risk of ruin. The calculators prove it, but we already knew it intuitively. Traders with small accounts just can't hold out through a prolonged period of draw downs. Commissions eat up a larger percentage of a small account than they do of a larger account.
What can traders with small accounts do? For one thing, they can be vigilant about setting stops so that losses don't grow too large in relationship to gains. Although much of the previous discussion has not strictly applied to those who trade credit spreads or other types of combination trades, as I do, this admonition certainly applies. How many months of profits does it take to make up for one 10-point credit spread gone bad and not exited in time?
Traders with small accounts can keep checking the percentage of winning versus losing trades. That percentage will drop when the inevitable string of losing trades occurs, but over time, it should remain near the percentage originally settled upon, if not improving.
They can determine that they will not trade unless setups are stellar. That
sometimes means trading less often even in the best of times and may mean
trading infrequently in the current climate.
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda
Piazza, and all other plays and content by the Option Investor staff.
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