There Is No Such Thing As A Hot Tip

1. An attempt at making a quick buck often leads to losing much of that buck. The people who suffer the worst losses are those who overreach. If the investment sounds too good to be true, it is. The best hot tip I’ve found is “there is no such thing as a hot tip.” 
2. Don’t let a small loss become large. Don’t keep losing money just to “prove you are right.” Never throw good money after bad (don’t buy more of a loser). When all you’re left with is hope, get out.
3. Cut your losers short; let your winners ride. Avoid limited-upside, unlimited-downside investments. Don’t fall in love with your investment; it won’t fall in love with you. 
4. A rising tide raises all ships, and vice versa. So assess the tide, not the ships. Fighting the prevailing “trend” is generally a recipe for disaster. Stocks will fall more than you think and rise higher than you can imagine. In the short run, values don’t matter. 
5. When a stock hits a new high, it’s not time to sell something that is going right. When a stock hits a new low, it’s not time to buy something that is going wrong. 
6. Buy and hold doesn’t ALWAYS work. If stocks don’t seem cheap, stand aside. 
7. Bear markets begin in good times. Bull markets begin in bad times.
8. If you don’t understand the investment, don’t buy it. Don’t be wooed. Either make an effort to understand it or say “no thanks.” You can’t know everything, so don’t stray far from what you know. 
9. Buy value, and sell hysteria. Paying less than the underlying asset’s value is a proven successful investing strategy. Buying overvalued stocks has proven to underperform the market. Neglected sectors often offer good values. The “popular” sectors are often overvalued. 
10. Investing in what’s popular never ends up making you any money. Avoid popular stocks, fad industries and new ventures. Buy an investment when it has few friends. 
11. When it’s time to act, don’t hesitate. Once you’re in, be patient and don’t be rattled by fluctuations. Stick with your plan… but when you make a mistake, don’t hesitate. Learn more from your bad moves than your good ones. 
12. Expert investors care about risk; novice investors shop for returns. If you focus on the risks, the returns will eventually come for you. If you focus on the returns, the risks will eventually come for you.

Trend Is Your Friend

The rule of the trend says that trend persists much longer than one can imagine and if you are on side of the trend - you will be right - 7/10. That’s the job of the trader. The trend of the market is down and that’s what counts. And when the trend of the market is down, do not waste time on predicting bottom because that will only stress your mind. There is no technical indicator that can predict the bottom. No one knows where all this will stop - here, 100 points down, 500 points down. You will know when the trend changes…How…your short trades will stop working. Concentrate on big picture and not on small individual data points or what some one is saying. All that matters is the trend. Never take your eye from what market has been doing recently.

Don’t Make Bets With No Upsides

At the end of the day, options can be as simple or complicated as you want to make them. But every complex spread is comprised of little single options and those little single options are all probability bets. You can combine them many different ways but they are still a total of all the other probability bets you are making. Over time, what determines your success in trading "volatility" is probability and having an edge. Legging out early on a trade is the same as opening a new a trade. Obviously buying back .05 or .10 options always makes sense, but if you are doing spreads for .30 to .50 credits then those nickel and dimes represent substantial costs to the position. Too many times option traders think they can overcome negative edge through adjusting a position a thousand times or they can simply "manage" the risk well. At the end of the day you are simply just making even more trades with negative edge. Over a long enough time horizon and enough trades, the negative edge will become realized through the erosion of your account. Many guys are afraid to trade the underlying and they often end up in the options arena because they are told or they believe that they can be successful without trading direction. Simply not possible. Either you are trading the direction of the underlying or the direction of volatility. Either way, you have to make a bet.

The best solution for a guy that tells he has no feel for direction is to take a very small position. Once you have money on the line, you get a feel for the market really fast. You can replicate the long term returns of an iron condor through the underlying by simply trading a mean reversion strategy with small size. Think about the p&l distribution of both and you will see they mimic each other with about 95% correlation. You trade very very small and you simply add shares on the way down and sell them on the way up. Now this might sound like gamma scalping except you are accumulating deltas as the market goes against you just as in an iron condor. In the end if your volatility assertions are correct, you should make money on both. All you have to do is replicate the deltas of the iron condor. Execution costs are not that great as you will not really be making that many trades and your p&l will be greater most of the time. You might even get lucky and catch a flyer. If you really want to trade volatility, you should be trading 6 to 9 months out. Even selling naked ATM straddles produces very little delta risk as there is no gamma out there with much greater reward. Much easier to remove the delta risk and trade pure volatility. Selling 5 delta spreads is not really trading volatility regardless, you are simply selling the tails that smart money is usually buying. Tails really don't have any useful greeks associated with them, they lie dormant until awakened. And when they awake, it's usually to remove equity from your account, lots of it.

At the end of the day, options are incredibly useful at manipulating your payoff structure. But there has to "be" a payoff. Earning small credits is not a payoff unless you are able to do that thousands of times a day via market making. The idea is to "manipulate" your payoff structure to actually "increase it" not decrease it. It's analogous to a futures trader who trades direction and moves his stop to break even once he is 10 ticks in the money and adds another contract. As the underlying moves higher he is able to geometrically expand his upside while keeping his risk fixed. There is a quote from the book "Ugly Americans". There is a section in there on the eight rules of Carney. Here is number 4: You walk into a room with a grenade, and your best-case scenario is walking back out still holding that grenade. Your worst-case scenario is that the grenade explodes, blowing you into little bloody pieces. The moral of the story: don’t make bets with no upside. Options in general are severely under priced. All of them! But there is more to this statement. Over short periods of time and data sets, option values will appear to be over priced. It's a function of the small data set. This is because of the fat tails. Over long periods of time, option prices resemble nothing even close to being fair. The reason for this is simple. The rare and isolated events that blow options up 100 to 1000 fold simply cannot be factored into the pricing equation. Otherwise there would be no buyers and no liquidity in the market.

The concept of fair value is similar to the concept of God. You are not going to know what it is until it's too late. But all options have realized volatility at the end of any period of time and that we know after that period concludes. Therefore we can look back and see if the implied volatility at that time matched what the actual volatility was. Again, you will find under most circumstances that the realized volatility matches the implied volatility pretty closely. Except on those rare occurrences where it's actually under priced by magnitude of orders. The error is always to the upside, not the downside. In other words, sure in some circumstances the implied volatility was 34 when it should have been 32. But on the upside you see examples where the implied volatility was 25 and it should have been 200. As you can see, if one is going to error, they are better off assuming volatility is priced too low rather than too high because the payoff for volatility being a little too high is minuscule vs volatility being too low.

Contrarian Investment Rules

1. Do not use market-timing or technical analysis. These techniques can only cost you money.
2. Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth information does not translate into in­-depth profits. Having too much information and thinking that one has mastered the details causes the investor to become overconfident. 
3. Do not make an investment decision based on correlations. All correlations in the market, whether real or illusory, will shift and soon disappear.
4. Trade carefully with current investment methods. Our limitations in processing complex information correctly prevent their successful use by most of us.
5. There are no highly predictable industries in which you can count on analysts’ forecasts. Relying on these estimates will lead to trouble. Analysts cannot predict the future any better than you and me. 
6. Analysts’ forecasts are usually optimistic. Make the appropriate downward adjustment to your earnings estimate.
7. Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.
8. It is impossible, in a dynamic economy with constantly changing political, economic, industrial, and competitive conditions, to use the past accurately to estimate the future. The past gives some frame of reference but cannot be exact.
9. Be realistic about the downside of an investment, recognizing our human tendency to be both overly optimistic and overly confident. Expect the worst to be much more severe than your initial projection.
10. Take advantage of the high rate of analyst forecast error by simply investing in out-of-favor stocks.
11. Positive and negative surprises affect “best” and “worst” stocks in a diametrically opposite manner. Interesting point is saying that beaten down stocks don’t go down as much because nobody expects much, but if it does better, everyone is surprised and up it goes. Vice versa for darlings. 
12. (A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites. (B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites. (C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks. (D) The effect of an earnings surprise continues for an extended period of time.
13. Favored stocks under-perform the market, while out-of-favor companies outperform the market, but the reappraisal often happens slowly, even glacially.
14. Buy solid companies currently cut of market favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.
15. Don’t speculate on highly priced concept stocks to make above-average returns. The blue chip stocks that people traditionally choose are equally valuable for the more aggressive businessman or woman.
16. Avoid unnecessary trading. The costs can significantly lower your returns over time. Low price-to-value strategies provide well above market returns for years, and are an excellent means of eliminating excessive transaction costs.
17. Buy only contrarian stocks because of their superior performance characteristics.
18. Invest equally in 20 to 30 stocks, diversified among 15 or more industries (if your assets are of sufficient size).
19. Buy medium-or large-sized stocks listed on the New York Stock Exchange, or only larger companies on Nasdaq or the American Stock Exchange.
20. Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group.
21. Sell a stock when its P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable prospects may appear. Replace it with another contrarian stock.
22. Look beyond obvious similarities between a current investment situation and one that appears equivalent in the past. Consider other important factors that may result in a markedly different outcome.
23. Don’t be influenced by the short-term (3 or five year) record of a money manager, broker, analyst or advisor, no matter how impressive; don’t accept cursory economic or investment news without significant substantiation.
24. Don’t rely solely on the “case rate.” Take into account the “base rate“– the prior probabilities of profit or loss.
25. Don’t be seduced by recent rates of return for individual stocks or the market when they deviate sharply from past norms (the “case rate”). Long term returns of stocks (the “base rate”) are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.
26. Don’t expect the strategy you adopt will prove a quick success in the market; give it a reasonable time to work out. 
27. The push toward an average rate of return is a fundamental principle of competitive markets.
28. It is far safer to project a continuation of the psychological reactions of investors than it is to project the visibility of the companies themselves.
29. Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don’t sell. 
30. In a crisis, carefully analyze the reasons put forward to support lower. Stock prices more often than not they will disintegrate under scrutiny
31. (A) Diversify extensively. No matter how cheap a group of stocks looks, you never know for sure that you aren’t getting a clinker. (B) Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.
32. Volatility is not risk. Avoid investment advice based on volatility.
33. Small-cap investing. Buy companies that are strong financially (normally no more than 60% debt in the capital structure for a manufacturing firm).
34. Small-cap investing. Buy companies with increasing and well-protected dividends that also provide an above-market yield.
35. Small-cap investing. Pick companies with above-average earnings growth rates.
36. Small-cap investing. Diversify widely, particularly in small companies, because these issues have far less liquidity. A good portfolio should contain about twice as many stocks as an equivalent large-cap one. 40-60 small caps in a portfolio?
37. Small-cap investing. Be patient. Nothing works every year, but when smaller caps click, returns are often tremendous.
38. Small-company trading (e.g., Nasdaq). Don’t trade thin issues with large spreads unless you are almost certain you have a big winner.
39. When making a trade in small, illiquid stocks, consider not only commissions, but also the bid/ask spread to see how large your total cost will be. Many brokers usually charge more for sub $1 stocks. Commissions get out of control. 
40. Avoid the small, fast-track mutual funds. The track often ends at the bottom of a cliff.
41. A given in markets is that perceptions change rapidly.

Develop Your Own Trading System

Computers are among the most common pieces of equipment that traders use. Unfortunately, the vast majority of traders are engaging their computer to enter into trades, without engaging their mind to think! There is a huge difference between buying a computer trading system and sitting down to do the research to develop your own computer-based trading system. Any computer-based trading system that you buy might be profitable (in sales or trading) to its author; however, to a trader that is not intimately familiar with the research behind it, and why the rules exist, the program is basically worthless. The vast majority of successful traders developed a methodology by building their own trading system from the ground up. As they devise their trading strategy, they very well could have used indicators, beliefs, and subsystem rules by purchasing them, studying them, or learning them from a more experienced trader. The distinction is that until the techniques have been verified, studied, and invariably modified, the trader will not use them. Only after constant experimentation with the new idea, and after verifying and internalizing, and then deciding that the idea is valid and valuable, does the trader add the new concept to his or her methodology.

Unfortunately, designing a computer trading system that accurately reflects your trading methodology demands a lot of time. It is not something that you can put together over a weekend. However, the huge advantage is that when you are done, you have accomplished something that 98 percent of all traders never do. Consequently you will see your trades produce consistent results. Once you are producing consistent results, either profitable or not, you can begin working on your ability to perceive the market better. As your perception increases, your ability to produce consistent profits will increase. It should be stressed that in order to have the internal beliefs required to do the research necessary to develop your methodology, you must make a decision to become responsible for all your beliefs. At some point all traders must confront how they will use the power of the computer to optimize their trading methodology. Optimization is achieved when you have written a mathematical formula or theory that describes the market action (in part or wholly) through variables. By programming the computer to literally perform all the mathematical permutations possible on the variables, and then correlating these permutations to the profitability, you can determine the variables that created the most profit. In other words, by determining the best combination of variables to maximize profitability, you can create a highly profitable methodology. The only problem is that it is good only for historical data; it is absolutely worthless in real time.

Say we have a simple moving-average crossover trading system. Our rules are very simple. First, if the short-period moving average goes above the longer-term moving average, go long. Second, if the shorter moving average goes under the longer moving average, go short. Consequently we are always long or short. By writing (or buying) a program, we can specify that we want to vary the shorter moving average from a period of 2 to 20, and the longer period from 21 to 60. Then by allowing the computer to test all the permutations that could occur by varying the periods of the shorter and the longer moving average, and by keeping track of the profitability, we can determine the most profitable short-term and long-term moving average. For example, the computer might indicate that a shorter moving average of 15 days and a longer-term moving average of 57 days generates the best profit. Typically the second most profitable combination of variables will generate less than half as much profits as the most profitable combination! At this point most beginning traders are very excited, convinced that they have just found the Holy Grail! There is a huge problem here. These traders have just wasted some very valuable time programming, because all they have accomplished is to curve-fit their variables to historical data. While it appears to be an outstanding combination of variables, it is an outstanding combination because it is only looking at the specific data used to perform the permutations. In other words, if they modified the data by changing either the dates used or the contracts, and re-performed the computer optimization study, they would come up with different short-term and long-term moving average values.

All traders use optimization studies to one degree or another. It is important to realize that by varying the length of the data used and by using different contracts, the value of your variables will vary. If you do in fact optimize your indicators and trading system, your goal is to find a group of variables that perform equally well on different contracts and different time periods. When you start analyzing the profitability of the various variables, you should automatically discard the variables that generated profits far in excess of any other profitable variables. Why? Suppose that a certain set of variables generated profits of $2000 and the second most profitable set of variables generated profits of $1000, and the third most profitable set of variables generated profits of $950. Then it would be safe to say that the variables that generated the profits of $2000 are so optimized that they are worthless. Your goal whenever you are doing optimization studies is to come up with a set of variables that perform equally well on different commodities, using a wide variety of different data lengths and, perhaps most important, using commodities that are clearly in bull and bear markets. Lately there have been some very good computer-based systems that have generated profits. Typically, however, the system is geared only toward a bull market. When the market goes sideways or actually drops, the system loses a lot of money. It is important as you devise your system to look at the widest possible variety of markets, trends, and time frames. When you are developing your methodology, keep in mind that you will be trading in markets dominated by bulls, markets dominated by bears, and markets where everyone is snoozing. You want your trading methodology to reflect this fact. An outstanding methodology will be profitable in all markets, in all time frames, and across all trends.

How To Build A Position?

One thing you need to understand about options is that most professional options traders don't just put on a position. They build them. They spend weeks building their positions. They look at each of their positions as a whole position, not the individual trades that compose that position. Each trade on its own has negative expectancy, but as a combined position, it can be morphed into a positive expectancy trade. At the end of the month you should care about your position as a whole and your p&l. Let's look at an example of a trader. He is selling the ATM combo on a stock and looking to offset with the purchase of the wings 7 to 10 days down the road. His goal is to try to capture as close to a full 5 pt credit as possible. So let's say he sells the Sep ATM combo in XYZ for 3.70. Now the 42.5/47.5 wings are trading around 1.95. He is going to wait on the purchase of the wings to try to get them cheaper. Maybe he thinks volty will continue to drop and perhaps 10 days from now he can purchase the wing combo for 1.20. He now has a net credit of 2.50 in the trade. What is his risk? He has none! His risk is the difference between the 2 strikes minus the credit. So 2.50 minus 2.50 is 0! He now has a risk free trade. And his expectancy is certainly positive. If he ran a simulation on his trade going forward from that date to exp 1000 times and summed the results and divided by the number of trial runs, he would get a positive expected return. This trade certainly has a positive expectancy.

Now you might be saying that he took risk when he sold the first ATM combo. Of course he did. All option traders take risk when they are building the positions. There is no way around that. The idea is to be able to offset as much of that risk over the course of that trade as possible and create a positive expectancy trade. Neither the sale of the ATM combo nor the purchase of the wings carried a positive expectancy on their own. But combined, in this example, they turned into a risk free trade with the upside of 2 1/2 pts! Not a bad trade. All successful option traders try to build their positions towards a positive expectancy. This is why in order to be successful; you need to be a good trader. You can't just slap on a fly or a condor and sit back and watch. At some point, a trader has to trade. There is no escaping this. But the beauty of options is you can create all sorts of combinations and permutations that offset risk with each additional trade and increase your upside! That is why we trade options. Not to blindly sell juice and count our theta! It just doesn't work that way.

Every trade begins with a negative expectancy. Nothing you can do about this. However, many traders make most of their money on adjustments. In other words, when you put on trades, they are just a shell. You don't expect anything out of this shell. But somewhere down the road, you expect to have opportunities to morph this trade into something with positive expectancy. Options traders do not make binary bets. The nature of their speculation is neither so apparent nor as black and white as outright directional traders. They put their pieces on the table and play a game. They arrange their pieces in such a way so that they can make favorable moves down the road. Then they are patient and wait. By adding to your initial position 'after' the favorable move you don't change the expectancy of the trade. The expectancy 'after' the favorable move is already positive. What you change is your payoff distribution. You are making the small payoff more certain by sacrificing some of the upside potential.

Trend Following

In trend following, the trader attempts to capitalize on large price movements over the course of several months. Trend followers enter trades when markets are at historical highs or lows and exit when a market reverses and sustains that movement for a few weeks. Traders spend a lot of time developing methods to determine exactly when a trend has begun and when it has ended; however, all the approaches that are effective have very similar performance characteristics. Trend following generates excellent returns and has done so consistently for as long as anyone has traded futures contracts, but it is not an easy strategy for most people to follow for several reasons. First, large trends occur fairly infrequently; this means that trend following strategies generally have a much higher percentage of losing trades than winning trades. It may be typical for a trend following system to have 65 or 70 percent losing trades. Second, in addition to losing money when there are no trends, trend-following systems lose when trends reverse. A common expression that the trend followers use is “The trend is your friend until the end when it bends.” The bends at the end can be brutal both on your account and on your psyche.

Traders refer to these losing periods as draw downs. Draw downs usually begin after a trendy period ends, but they can continue for months when markets are choppy, and the trend-following strategies continue to generate losing trades. Draw downs generally are measured in terms of both their length (in days or months) and their extent (usually in percentage terms). As a general rule, one can expect draw downs for trend-following systems to approach the level of the returns. Thus, if a trend following system is expected to generate a 30 percent annual return, you can expect a losing period in which the account may drop 30 percent from its highs. Third, trend following requires a relatively large amount of money to trade using reasonable risk limits because of the large distance between the entry price and the stop loss price at which one would exit if the trade did not work out. Trading with a trend-following strategy with too little money greatly increases the odds of going bust.

9 Trading Mistakes

Mistake 1: Fishing for Bottoms: Bottom fishing — trying to catch a stock as it bottoms out — is a great way to get soaked and lose a bucketful of money. In a bear market, stocks get much cheaper than most of us ever expect or want. They won't stop falling until they've run out of gas.
Mistake 2: Timing the Top: Tops and bottoms share something in common. They rarely arrive when they're supposed to. When traders and investors are exuberant, they keep buying even after doing so no longer makes fundamental sense. That's why shorting a stock that's trending higher makes no sense, even if its price is far beyond reasonable.
Mistake 3: Trading Against the Dominant Trend: Trading against the dominant trend in the market leads to costly mistakes. Unfortunately, misidentifying the trend by focusing on the chart in front of you and forgetting to look at the next higher level chart is an easy thing to do.
Mistake 4: Taking Trading Personally: A losing trade is bad for your trading account, but you can't let it get to you. Sure, it makes you feel bad, but a losing trade doesn't impugn your honor or disparage your heritage. A bad trade may reduce your net worth, but it shouldn't damage your self-esteem.
Mistake 5: Falling In Love: When you fall in love with your stock, you risk large losses. It's easy to fall in love. After doing hours of research and analysis, you want to be right. You want your trades and your trading plans to generate profits, but hoping doesn't make it so. Be smart. Don't fall in love. Dow Jones doesn't have feelings and your stock won't love you back.
Mistake 6: Chasing Runaway Trend: If you miss the breakout entry point for a stock that you want, waiting is better than entering a position as a trend accelerates. Often, stocks will pull back and test the breakout point. Wait for that point, or wait for the stock to take a short breather after its first leg up. If you're still interested, that's a better entry point than chasing a stock as it accelerates into the trend. Like a fine wine, you sometimes need to let a stock breathe.
Mistake 7: Fishing for Bottoms: Averaging down is a below-average idea. You sometimes hear advisors suggesting it as a way of reducing your cost basis, but it's really merely a technique to throw good money after bad. The logic of averaging down is completely contrary to the logic of trading. Traders sell losers. They don't reward them with infusions of trading capital.
Mistake 8: Ignoring Your Stops: Talking yourself out of honoring your stops is an easy thing to do. You'll be tempted when a trade goes against you. You'll look at your indicators and the support levels on your charts, and you'll be certain that the stock soon will stop falling. When you start thinking you want to give a position a little room to work its way out of losing territory, you're on your way toward a trading debacle. Its wishful thinking, it's hoping against hope, and it's a good way to lose a lot of money. Unless you're omniscient, close the position when the price hits your stop. Take your loss.
Mistake 9: Enduring Large Loss: To trade is to lose. No matter how good your trading system is, no matter how experienced you are, no matter which stocks you pick, you're going to have losing trades. Your success as a trader depends on how you handle those losing trades. If you dispose of the losers quickly, you can become a very successful trader. But if you hold onto those losing positions, you can lose so much money that it may knock you right out of the trading business

Bulls, Bears And Pigs

1. Bulls, Bears Make Money, Pigs Get Slaughtered. It's essential for all traders to know when to take some off the table. 
2. Its OK to Pay the Taxes. Stop fearing the tax man and start fearing the loss man because gains can be fleeting. 
3. Don't Buy All at Once. To maximize your profits, stage your buys, work your orders and try to get the best price over time. 
4. Buy Damaged Stocks, Not Damaged Companies. There are no refunds on Wall Street, so do your research and focus your trades on damaged stocks rather than companies. 
5. Diversify to Control Risk. If you control the downside and diversify your holdings, the upside will take care of itself. 
6. Do Your Stock Homework. Before you buy any stock, it's important to research all aspects of the company. 
7. No One Made a Dime by Panicking. There will always be a better time to leave the table, so it is best to avoid the fleeing masses. 
8. Buy Best-of-Breed Companies. Investing in the more expensive stock is invariably worth it because you get piece of mind. 
9. Defend Some Stocks, Not All. When trading gets tough, pick your favorite stocks and defend only those. 
10. Bad Buys Won't Become Takeovers. Bad companies never get bids, so it's the good fundamentals you need to focus on. 
11. Don't Own Too Many Names. It can be constraining, but it's better to have a few positions you know well and like. 
12. Cash Is for Winners. If you don't like the market or have anything compelling to buy, it's never wrong to go with cash. 
13. No Woulda, Shoulda, Couldas. This damaging emotion is destructive to the positive mindset needed to make investment decisions. 
14. Expect, Don't Fear Corrections. It is not always clear when a correction will strike, so expect and be prepared for one at all times. 
15. Don't Forget Bonds. It's important to watch more than stocks, and bonds are stocks' direct competition. 
16. Never Subsidize Losers With Winners. Any trader stuck in this position would do well to sell sinking stocks and wait a day. 
17. Check Hope at the Door. Hope is emotion, pure and simple, and trading is not a game of emotion. 
18. Be Flexible. Recognize and be open to the unexpected shifts in the market because business, by nature, is dynamic, not static. 
19. When the Chiefs Retreat, So Should You. High-level executives don't quit a company for personal reasons, so that is a sign something is wrong. 
20. Giving Up on Value Is a Sin. If you don't have patience, think about letting someone who does run your money.
21. Be a TV Critic. Accept that what you hear on television is probably right, but no more than that. 
22. Wait 30 Days After Preannouncements. Preannouncements signal ongoing weakness, wait 30 days to see if anything has gotten better before you pull the trigger to buy. 
23. Beware of Wall Street Hype. Never underestimate the promotion machine because analysts get behind stocks and can keep them propelled in an up direction well beyond reason. 
24. Explain Your Picks. Buying stocks is a solitary event, too solitary in fact, so always make sure you can articulate your reasoning to someone else. 
25. There's Always a Bull Market. It's OK if you have to work hard to find it, just don't default to what's in bear mode because you are time-constrained or intellectually lazy.

Smart Money Ratio (SMR)

While rollovers paint a pretty bullish picture, there are quite a few indicators that suggest it’s about time the bears reinforced their presence. Though the volatility index (VIX) is commonly known as the fear index and is considered to be one the best indicators of fear and recklessness, it can often be misleading for a trader. While an extremely low VIX may push a trader into going short with the expectation that recklessness will give way to panic (because of a meltdown in prices), if the former exists along with a bearish mood in the market (or an adequately hedged market), the expected panic may not materialize. This was exactly the case right through this series, as traders were quite often fooled into going short in the market looking at the low VIX levels. The expected meltdown never materialized, as the market was almost always adequately hedged. So, as a derivatives trader, one should ideally see it in conjunction with another indicator that reflects the bullishness/bearishness in the market. An ideal indicator for such a thing can be the put-call ratio (PCR). If we divide the daily VIX with the daily near month put-call ratio, the resulting ratio probably takes care of this inefficiency of the VIX. More importantly, it’s probably a better tool for someone trying to make a trading decision. This is called as SMR.

Making Sense Of VIX Index

You would have heard of VIX (Volatility index) before. It is a term often used to gauge volatility in the financial markets. But what is VIX (Volatility Index)? VIX provides a benchmark for the pricing of options. Options are like insurance products in financial markets. The insurance premiums shoot up when insurance provider becomes extremely uncertain about future or have high risk perceptions. In the same way, in uncertain and fearful times, the option writers (insurance provider) jack up the premium prices on insurance products when they are extremely fearful and uncertain about future. This gets reflected in VIX. The VIX is derived from a real-time calculation that averages the weighted prices of out-of-the-money puts and calls on the index. The resulting measure provides a benchmark for anticipated volatility in the index as a whole over the next 30 calendar days. VIX is also called Fear index. VIX is not a reflection only on equity markets but tells us the state of complete financial market landscape.

Why Leverage of 30 times was completely acceptable in 2004-2007? Large Financial Institutions across the world are collapsing and everyone is blaming that management of these companies took too much risk, much more than they could have handled. Is that so? Fact: The management of these companies knew that they were taking excessive risk but they also knew that they can handle it. Remember, in markets risk perse is not bad...what matters is risk management. Most of the companies assumed that their risk management practices were sound. This was not just the management's belief but also the belief of analyst community. That's why no one raised any red flag on business model of investment banking business till things started falling apart. Where management of the companies went wrong - is in their assumption: World will be like this forever. Stability leads to Complacency. "Perception is Reality". 2004-2007 was an era of low volatility. (Low VIX). Low Volatility = Low Risk = More Leverage. It was much easier to manage risk in a stable market environment. And that's why everyone was ok with the excessive leverage. What changed in 2008? - were not the leverage levels but the Volatility. The sudden spike in Volatility changed the risk perception and suddenly the entire business model started collapsing. It became just too difficult to manage risk and price assets in an unstable market environment. The "mark to market" accounting became too difficult to manage and companies suddenly found themselves going under water in no time.

2008-2011: Welcome to Period of High Volatility. Now times have changed and with it the thinking. Leverage now is a bad word because it is just impossible to manage now-a-days, and hence people are getting rid of it. The level of 40 on VIX is now considered as level of low volatility, which in 2004-2007 - was an extreme level. The stable market environment of 2004-2007 created a sense of complacency in financial market system and every financial engineering innovation that happened during that period is now collapsing. This will no doubt create excessive pain for everyone. Periods of High Volatility signifies risk perception and uncertainty market participants have about future. As long as VIX remains at elevated levels, the market will remain a traders market; and gains will be difficult to stick. As per psychological studies, human beings become extremely short term in their thinking in stressed conditions. Hence, in periods of high VIX, gains will be smaller and short lived. The normal old fashioned market will not return till we see a substantial cool down in VIX. Hence, keep an eye on VIX to formulate your strategy. May be Instability is the new world order, and we need to learn to live in times like these.

Money Management (Risk Management)

We look at a trade; it’s a good trade.... a beautiful clean sideways pattern just itching to breakout. Our plan is to buy the breakout and ride the trend, trail stopping upwards at every pivot low. Cool. So far so good. We now need to ascertain how many shares we plan to buy. For example, the stop is 20 away from our entry point. Right, do we buy 10 shares (which means we lose 200 if stopped), or do we buy a 100 shares (which means we lose 2000 if stopped), or a 1000 shares (which means we lose 20000 if stopped)? The amount of money lost if stopped is the risk on this trade. Don't let it get past 2% of your equity. Which means, first calculation is: How much capital do I have in my trading account? (trading account only, not the worth of your house and car and jewellery all put together).

Let us say that I have 10 million in my trading account, that means the maximum risk that I can take on any single trade is: 2% of 10 million=20,000. Which is to say that if I enter into a trade, and the trade goes against me, I will lose 20000? So whether you paid 2.5 million for that stock or not, you are not risking 2.5 million, but 20000, as that is where your stop is. Now must it definitely be 2% of the capital.... not necessarily. Can be anywhere between 0.5-2%, but no more than that. So, therefore, first I look at my trading capital at the end of the month. I then assess how much my risk would be the next month. For example, let us say I have 10 million at the end of July. Let us say I take 1% loss in each trade. Therefore for the month of August, I would be risking 10,000 per trade (to reiterate, that means the amount lost if stopped out).
Now I have my ups and downs in August, and landed up in August with an equity of 10.5 million, now my risk in the month of September would be 1% of 10.5 million=10,500 per trade.
So too, if my equity had dropped that month to 9.5 million, then my risk of 1% for the following month would be 9,500 per trade... so on so forth!!

Right, I now know my trading capital, the amount of percentage risk that I am willing to take, and the amount of money risked for the following month at the end of each month..... now how do I calculate share size: Share Size= (% risk * trading capital) divided by (entry-predetermined stop loss). So, therefore, we look at our charts, we get our entry point let us say 200, and our stop loss is at 175. Now presuming our capital is 10million, and our percentage risk per trade is 1%. Therefore, Share Size= (1% of 10 million) divided by (200-175)
= 10,000 divided by 25 = 400. Therefore in the above example we would buy 400 shares with an entry at 200 with a predetermined stop loss at 175. The max we should lose in this trade if stopped would be 10,000. The 2% rule for assessing position sizing is vital, but there is more to be done. Another major part of money management that must be looked into..... just as how crucial having a predetermined stop is and proper share sizing, this part is vital for the survival of our trading account and therefore our survival as traders.

If we were to risk 2% per trade and we get into 20 stocks, a move down would trigger all the 20 stops.... we have put proper stops, great... we have taken small losses, great... and yet, our account is down 40%. If our trading capital was 10 million, well 4 million has vanished into thin air!! This is unacceptable.... and unpardonable as far as the trader is concerned. We therefore have another set of percentages in place so that we are protected from market movements.... now what that percentage is basically comes back to the individual trader and his comfort levels. There are many absolute truths in the world of trading, but no absolute methods, all relative to what our psyche allows us. For example, I believe that a 2% risk is just too much to bear; I am on the other hand comfortable with a risk of 0.5-0.75%.... so there are as many methods as there are traders. Basically tweak to your individual comfort levels. Now what are these percentage rules of max risk?

1. In an intraday position, take no more total risk than 4% in that day. Which means that I would take no more than 4 trades at the same time? Why? Because I am risking 1% per trade, and if I take more than 4 trades, I would be risking more than 4% in that day. Therefore, I enter into a stock with my stop loss at the previous pivot low at a risk of 1%. Then I see a great setup in another stock, same thing as above. Now I see a great trade in yet another stock, I grabbed that as well. Then yet another stock. Now I have 4 trades running simultaneously, and I risking 4% as of now. I then see a great play in one more... But my rules prevent me from taking that 5th trade, however juicy that set up. Now I get a great move in 2 stocks, and that gives me the opportunity to raise my stops in the two to breakeven. Now I can take that fifth stock if it still looks great… if it has already run off, well, nothing can be done about it. Missed money better than lost money!!  Also make sure you have your max percent loss in a week after which you wouldn't trade any more, and your max percent loss in a month after which you are no more than a bystander. If I lose 10%, that’s it....I am out for the month. Many put that figure to 6% or 8%.........once again, your comfort levels.

2. In a swing position that may last up to 4-5 days, once again similar rules come into play. I basically take a max risk of 6%.......now why these figures, well, basically no real reason except years of toying around and tweaking it to comfort levels. As said before you will have to do the same. So, here again, a risk of 1% per trade allows me to take 6 swings that week. Every time I am able to raise my stop to break even, I am allowed another trade. Else that's that...
3. In a position trade, that can take up to weeks to months, I tend to take a max risk of 12%, meaning that if you are taking a 1% risk per trade, max number of stocks that can be got into is 12. And then, once you get to breakeven stop in a trade, you are allowed to get into a new position, or add to the previous position. If you are the type that can take on a bigger amount of risk, fine... but total portfolio risk no greater than 20%.Greater than that, think you would be fishing for trouble. So careful on that one.

It is very important that these rules are in place.... very, very important!! The percentages you as the trader will have to work out. But you MUST have a stop, you MUST adhere to them, you MUST have a risk per trade and share size accordingly, and you MUST have a max risk that you are willing to take, after which you are going to pull the plugs. And you MUST have a point where a bad day or month is accepted as it is..... and all trading comes to an end. If you are out on the 15th day of the month, that does not mean that you sleep and watch TV for the rest of the month.... You come to work as in every other day, you paper trade, and you do it till the end of the month. Your first trade would be the first day of next month. Discipline is discipline, and rules are rules..... These are like commandments in the Holy Scriptures of the Trader. Not observing them is sacrilege, a blasphemy. They, once drawn up, MUST be followed at all cost.

How To Spot Bubbles?

Rapidly rising prices
High expectations for continuing rapid rises
Overvaluation compared to historical averages
Overvaluation compared to reasonable levels
Several years into an economic upswing
Some underlying reason or reasons for higher prices
A new element, e.g., technology for stocks or immigration for housing
Subjective “paradigm shift”
New investors drawn in
New entrepreneurs in the area
Considerable popular and media interest
Major rise in lending. Increase in indebtedness
New lenders or lending policies
Consumer price inflation often subdued (so central banks relaxed)
Relaxed monetary policy
Falling household savings rate
A strong exchange rate

Turtle Always Wins The Race

1. Analysts Recommendations: These analysts would appear to be doing the investment world a great service by giving ratings on different stocks. In fact, these analysts often have hidden agendas that the average investor is not aware of. Ever notice how analysts issue buy recommendations when a stock is at its all time high and sell recommendations when stocks are at their all time low?
2. Money Management: One of the important things to learn about investing is how to manage risk. Anyone who has no respect for risk is on the road to complete financial disaster. You often hear these great stories about the guy who turned a small amount of money into a million dollars. But what you don’t hear is that, years down the road, these same people are often wiped out as a result of not respecting the risks that go with investing. Learning how to pick investments that can appreciate in both good and bad times is the key to successful investing. Keep your reward-to-risk ratio at a minimum of 2:1, and preferably 3:1 or higher. In other words, if you are risking 1 point on each trade, you should be making, on average, at least 2 points.
3. NO CRUSHING DEBT!!!! I have seen it a million times, an investor sees a once great company trading at what appears to be a bargain price, so he buys the stock. The company is often very well known, such as At&T, AOL, Kmart, Xerox, Lucent and Tyco, and it may even still be growing both earnings and revenue. But these are companies that are at risk, and they will have to continue to sell off assets just to stay afloat. And don’t expect them to get anywhere near the market value in a distress sale. And, even worse, in bankruptcy these assets go for only 20 cents on the dollar. After a bankruptcy, typically all common shareholders receive nothing and ownership of the company goes to the debt holders. The debt holders can decide either to sell off assets to repay debt or to take the company public again. If you can add 1+2=3 then you should be able to read a balance sheet. And it doesn’t hurt to check the SEC reports such as the 10-Q. The fact is that no company with zero debt has ever gone bankrupt. The general rule we like to use is to buy stocks that have their interest expense to income ratio at less than 25%.
4. IPO’s: Start investing in IPO’s after they begin to trade and you will be able to count the days till you are done doing that! IPO’s can start trading anywhere from 20% to 400% up on their first day of trading and go straight downhill from there until they bottom out. About 75% of all IPO’s are trading below their IPO price one year after trading.
5. Low Priced Stock Myths: Low priced stocks are not better value than high priced stocks, and they don’t go up any faster than high priced stocks. Even in these days of free information, there is still a feeling that if you buy a stock that is trading at $5 a share, you have more upside potential than you would with a stock trading at $65 a share. Even crazier is the feeling that by having more shares, you are better off than by only having a few. In fact, it is only the company’s market cap, representing the total value of all shares, that is important when it comes to putting a value on a company.
6. Margin Trading is a Fools Game: The key to successful investing is having available cash to choose the next best investing opportunity that comes along. When you get into debt, you begin to lose your options and get trapped into your original investments. Remember that all stocks can crash, and the odds are, if you are high in margin, you will soon have a margin call in which you could lose 75% of your money. As a general rule, buying stock on margin is bad money management. The fact is that 90% of margins players get margined out.
7. OTC Stocks: OTC or penny stocks defy all logic as they move up mostly on hype instead of actual net profits. There are 2 main ways OTC stocks move up rapidly. 1. A pump and dump tactic, in which a group of people front-load the stock, then issue a big newsletter, etc. in which they sell into the rally. After the rally, the stock moves back down almost as fast as it went up. 2. Massive PR campaigns which are used to bring awareness to an OTC stock. These campaigns work great for a while but by the time the average investor sees the stock the money runs out as the price starts to head downhill again.
8. Don’t try to hit the home run on every pick. Everyone wants to be the one to have their portfolio shoot up 200% in a short amount of time. Fact is, there is no way to achieve this without taking on severe risk. Have you ever heard of “The Tortoise and the Hare”? The rabbit has more speed, but the turtle has more determination, stamina, and consistency. The rabbit may get a fast start, but the turtle wins the race.
9. The Urge to Trade: Emotions work against you in investing and it’s very easy to want constant action. The problem is that great picks don’t come along daily. Idle periods are a natural part of business. You should never force yourself to find stock to invest in, because it may go against you at the worst possible time. You need to be emotionally clean and ready to take on a new investment, rather than get caught in a deteriorating position. As a rule: the more you trade, the more risk you take.
10. All Stocks Can Crash: This is a hard lesson to learn for new investors who ride out a single stock only to see it crash later on. As we have seen recently, even great stocks like Microsoft, Cisco, Citigroup and Home Depot have all crashed. While these stocks are likely to hit their highs again in the future, they, just like any other stock, are bound to crash sometime, no matter how great the company is.

Accumulation v/s Distribution

Lot of times, we hear this phrase - Smart money is accumulating and price-volume breakout on the upside may happen anytime OR smart money is selling and price-volume breakout on the downside may happen anytime. But the issue is - How can we spot such patterns on a chart?
The issue of Accumulation or Distribution comes when stock consolidates after a strong price move either up or down. During consolidation, stock price does not make any progress, but they do not do any damage either. Consolidation has a tendency to create lot of anxiety. It is also called as tug of war between smart money and dumb money. On TV channels, you will see lot of analysts interpreting the consolidation as accumulation or distribution. And by the time we know it, it is too late to act. There are only two things that matter on chart, price and volume. Volume action precedes price action. So, one should keep an eye on volume to determine price move. It is the duty of the leader to lead. The opposition only offers resistance. In an up trending market, bulls are in charge; and in down trending market; bears are in charge. So, if the stock/market is in uptrend, then it is the duty of the bulls to take the stock/market up. Similarly, if the stock/market is in downtrend, then it's the duty of bears to take the market down. The job of the opposite party is to only offer resistance. The resistance gets reflected in volumes.

Let's say a stock/market is in uptrend - And after a strong price move, the stock/market has entered in a consolidation mode. It's the time when some people decide to book profits (but they are in minority), and new set of buyers are not willing to jump in yet big time. The stock gets into slumber - and there is no significant price move either up or down. The volume dips. Generally, it means, sellers are not offering significant resistance, and all the minor selling (resistance) is getting absorbed strongly. And then one day, buyers jump in big time in the stock/market, and sellers do not offer much resistance, and price break out on the upside.
The reverse happens in distribution. The resistance gets stronger. Distribution occurs when volume picks up but there is no price progress. This could indicate that sellers are getting a little tougher with the buyers, and selling big time, and buyers are finding it hard to counter that force. This becomes little dangerous and can be easily spotted on the price-volume chart by looking at the volumes. If during consolidation, volumes are high but there is no change in the price - it’s time to book profit or have tight stop loss. This happens because of institutional selling into strength and often precedes a substantial sell off that occurs few days later. 

Another point to note - Distribution (High volume days with no price move) happens for at least few days before the actual breakdown day. So, one should not get perturbed by single day of distribution, but should get cautious. So, in simple words, Accumulation means low volume days followed by big price-high volume day whereas distribution means high volume days with no price move. Since, in bull market, you give benefit of doubt to bulls - the way it works - if it is not distribution, then its accumulation. So, the best way to spot - Look for signs of distribution. In downtrend, it's the buyers who offer the resistance. Accumulation means substantial volume pick up without price declines. It means all the selling is getting resisted by buyers; and sellers may be soon out of energy, whereas Distribution means drop in volumes after a sell off. It means buyers are still not willing to step in big time, and even small buying is getting sold into and sellers still have the energy to take the market down. So, the next time when stocks consolidate, keep an eye on the volume to determine the next move.

Loss Aversion

In terms of trading, loss aversion affects one’s ability to follow mechanical trading systems because the losses incurred in following a system are felt more strongly than are the potential winnings from using that system. People feel the pain of losing much more strongly when they follow rules than they do when they incur the same losses from a missed opportunity or by ignoring the rules of the system. Thus, a $10,000 loss is felt as strongly as a $20,000 missed opportunity.

Baltic Dry Index

How many of you have heard of Baltic Dry Index? This is one chart every investor/trader should look at because it gives a true picture of real economy. Ok, first things first - What is Baltic Dry Index (BDI)? It's a number issued daily by the London-based Baltic Exchange, which gives an assessment of the price of moving the major raw materials by sea. The index measures the demand for shipping capacity versus the supply of dry bulk carriers; and indirectly measures global supply and demand for the commodities. It is an accurate barometer of the volume of global trade. How does it work? Every working day, the Baltic Exchange asks brokers around the world on how much it would cost to book various cargoes of raw materials on various routes—150,000 tons of iron ore going from Australia to China or 150,000 tons of coal from South Africa to Japan. Brokers are also asked to consider variables such as the type and speed of the ship and the length of the voyage. Based on the answers, a number is arrived at which represents the shipping costs. The Baltic Dry index represents the true price at which shipping is done and has no speculative content. People don't book containers unless they have cargo to move. BDI is termed a leading economic indicator because it predicts future economic activity.

All You Need Is Big Winners

Selling a put is very much like owning stock, except for one huge difference. When I sell a naked put in AAPL for 1.00, if I win, I make a dollar. If I lose, I could lose 20 dollars. If I buy the stock, I could also lose 20 dollars, but I could make an infinite amount of money. This is what people simply don't get. If you want to make money in this business over the long run, you need to have big winners, even if they come merely by luck. Because every trader is going to have their fair share of hits. Taking an unlimited amount of risk for .50 or 1.00 or some finite amount is not going to add up over the long run. This is why a good stock trader will kill a good option seller over the long run. Same is true for selling naked calls with the exception that a stock can only go to zero, so the short stock seller actually has a finite return, albeit, usually a very large one.

Good News Crashes Markets

Markets don't crash on bad news, they crash on good news. We get selloffs on bad news. 
Here is an excerpt on the 87 crash: "A lot of work has been carried out to unravel the origin(s) of the crash, notably in the properties of trading and the structure of markets; however, no clear cause has been singled out. It is noteworthy that the strong market decline during October 1987 followed what for many countries had been an unprecedented market increase during the first nine months of the year and even before. In the U.S. market, for instance, stock prices advanced 31.4% over those nine months. Some commentators have suggested that the real cause of October's decline was that overinflated prices generated a speculative bubble during the earlier period."

Here is an excerpt on the 1929 crash: "The Roaring 20s--a time of growth and prosperity on Wall Street and Main Street--ended with the Great Crash of October 1929. The Great Depression that followed put 13 million Americans out of work. Two thousand investment firms went under, and the American banking industry underwent the biggest structural changes of its history, as a new era of government regulation began. Roosevelt's New Deal politics would follow. The October 1929 crash is a vivid illustration of several remarkable features often associated with crashes. First, stock market crashes are often unforeseen for most people, especially economists. "In a few months, I expect to see the stock market much higher than today." Those words were pronounced by Irving Fisher, America's distinguished and famous economist and professor of economics at Yale University, 14 days before Wall Street crashed on Black Tuesday, October 29, 1929. "A severe depression such as 1920-21 is outside the range of probability. We are not facing a protracted liquidation." This was the analysis offered days after the crash by the Harvard Economic Society to its subscribers. After continuous and erroneous optimistic forecasts, the society closed its doors in 1932. Thus, the two most renowned economic forecasting institutes in America at the time failed to predict that crash and depression were forthcoming and continued with their optimistic views, even as the Great Depression took hold of America.

The reason is simple: the prediction of trend-reversals constitutes by far the most difficult challenge posed to forecasters and is very unreliable, especially within the linear framework of standard (auto-regressive) economic models. A second general feature exemplified by the October 1929 event is that a financial collapse has never happened when things look bad. On the contrary, macroeconomic flows look good before crashes. Before every collapse, economists say the economy is in the best of all worlds. Everything looks rosy, stock markets go up and up, and macroeconomic flows (output, employment, etc.) appear to be improving further and further. This explains why a crash catches most people, especially economists, totally by surprise. The good times are invariably extrapolated linearly into the future. Is it not perceived as senseless by most people in a time of general euphoria to talk about crash and depression? The political mood before the October 1929 crash was also optimistic. In November 1928, Herbert Hoover was elected president of the United States in a landslide, and his election set off the greatest increase in stock buying to that date. Less than a year after the election, Wall Street crashed.

Doctors v/s Traders

The only way you can be profitable over the long run trading options is if you can predict volatility or price better than 95% of the other market participants. End of story. There is no getting around this. This is a non debatable fact. Nobody wants to hear this. It's kind of like telling an average slop that he will never marry a supermodel. There is nothing inherently wrong with trading condors or calendars. It's just that both of those trades happen to be volatility trades. If you predict volatility correctly, they will make you money. If you don't, they will not. It's that simple. There are some very very bright people in this business that spend tens of millions of dollars and hire 100's of quants to predict volatility for them and they have a very tough time making money. But wait, some newbie with no option knowledge in the world is going to just slap on some volatility trades and consistently make money? Think about that for a second. Just try to use some common sense here.

Let's pretend we are in the medical profession, which is not even a good comparison because there are far more successful doctors in the world then traders. Do you honestly think you could perform brain surgery on a patient after a few webinars, some e-mail exchanges, a few live phone calls and a booklet? Anyone? Of course not. Even a trained surgeon with 7 years of medical school, 3 years of residency and possibly thousands of hours of surgery under his belt still has trouble and loses many patients in surgery. Yet some guy is going to go through a quick course and just like that, become a surgeon. Laughable of course. But this is exactly what guys believe with about options trading. The only way you will make money trading options is to be able to predict either direction or volatility better than 95% of all the traders out there. There is no way to get around this mathematically.
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