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Sunday, October 16, 2005
Market Recap
For the second week in a row the market closed the week on a positive note after heavy selling earlier in the week. The Dow gain 70 points on Friday, with the Nasdaq and S&P gaining 17 and 10 points respectively. As bad as the market may have seemed until Friday, the Dow only lost 5 points for the week. Most of the selling came the week before last, and this last week the Dow just drifted lower all week and made most of the losses back on Friday. The Nasdaq suffered heavier selling last week, falling 25 points for the week even after the 16 point gain on Friday. The S&P 500 dropped 9 points for the week and closed at 1186, still well below the 1200 resistance level and its 200 SMA. In fact, both the Dow and the Nasdaq are still below their respective 200 SMA's and volume on Fridays rally was well below the volume we saw in the recent selling. The good news is that all three of these indices closed at the high of the day on Friday so maybe they will be follow through to the upside on Monday. Keep in mind, there are plenty of hungry bears just waiting to short the market into resistance.
Market Outlook
At this point, it is difficult to figure out whether or not a sustainable rally will occur. The market did not bottom the way we expected it would with capitulation selling. Instead, we got a bounce off all the over sold indicators. There were too many indicators pointing to a rally and the market just gave in and rallied. This is not they way I like to see bottoms put in the market, but nevertheless we could have seen the bottom last week. It is hard to try and guess at where the bottom will be. There are still many factors that will give the market fits going forward. If we do rally, I find it hard to believe it will be sustainable but you never know. As long as the Fed remains in tightening mode, I have to believe any rally will be short term at best, but we will play the short term rally on the long side and take what the market is willing to give albeit only the most attractive risk/reward opportunities will be looked at.
The Paper Trade: Part 1
What is your biggest problem with your trades? I will bet it is not your stock picks or the entry. Let me guess…it's your losses. The way to reduce the long term effect of the losses is with proper money management.
Money management is the most neglected, and the most important aspect of trading any market. This is why I believe in first setting a risk reward ratio on a potential trade and then once I identify the risk reward is at least 3 to 1 upside vs. downside the next step is to put the same dollar amount into each trade. As your winning trades accumulate, you are compounding your profits and rolling them over into the next trade and as this process continues, your portfolio balance will accelerate even faster when this compounding effect takes place. This is what I call good money management and making good productive use of every dollar made in the markets. Without a good money management plan, you will simply spin your wheels.
Here's the deal. If you lose 50% of your money in one trade, you need a 100% gain on your next trade to just get even. Lose 75% in one trade and you need an amazing 300% winner just to get that loss back. This is why cutting your losses is so important. If you lose 100% of your money, you have none left and you will be looking for another job.
Position sizing is a very important part of money management and to grasp this aspect from a psychological point of view, a popular way to begin this concept is to "paper trade." That is you gain experience by “trading” for a while without using real money. You go through the motions of buying and selling without using real money. And utilize your trading strategy you have as if you were trading "for real."
While paper trading is a good way to get started it does not take into account the true reality of trading. Emotions are over 85% of trading, and paper trading does not take this into account. Thus, you are missing the most important aspect of trading when you are trading on paper. You do not experience fear, greed, happiness or panic when you paper trade.
The emotions from paper trading are not real and have nothing to do with the roller coaster of emotions you feel trading when your money is on the line but it does have some practical uses. We will cover more on paper trading in Part 2 of this commentary later this week.
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