Tuesday, November 19, 2013

The Way of the Elf (Technical Analysis)

Poker is not a game of chance. It is a discipline that involves the use of probability theory, logic and psychology; strategic thinking, bluffing, and reading the opponent. Yes, even the best players can’t win if they don’t get the cards, but the same faces seem to have a way of appearing over and over again at final tables of the big tournaments. Although poker is a game popular with millions, very few people will ever earn a living as poker players. To most it will become an occasional distraction. They will lose or make a few bucks playing with their drinking buddies. Even in those games, I expect the winners and losers are pretty much the same people from week to week.

Technical analysis is a method of predicting the movement of stock prices by studying past market data including opening prices, closing prices, daily highs and lows, market volume, as well as historical averages and derivatives calculated from this data using various mathematical formulas.

Let me be honest. I am not a trader. When I buy a stock, I do so with the expectation of keeping it forever. Of course, if a stock gets so high I can’t sleep at night or it drops and doesn’t come back, I will sell it. However, trading is not what I do. There are people who make their living studying and practicing the discipline of technical analysis. In fact, the hedge funds that were at least partly to blame for the crash of 2008, applied the principles of technical analysis to what is termed high frequency trading. They used sophisticated computer programs that analyze real time trading data looking for anomalies that signal large scale movements such as those made by mutual or pension funds. Their computers then execute orders faster than the human players in the market can possibly respond. These programs are the result of decades of research and millions of dollars invested in programming and hardware. They really work; at least most of the time. When they fail, it is spectacular. It isn’t illegal, but don’t think for a minute the little $3,000 technical analysis program running on your PC will ever be able to compete with great investment banks or even the major hedge funds.

Most of the people who attempt to practice technical analysis are frequently called day traders. They are not investors (those who buy for long term gains) or traders (those who buy and sell for short term gains). They are gamblers. They buy and sell on hunches, instinct, and emotion. They tend to end up in bankruptcy court.

If you decide that you want to try your hand at technical analysis, decide in advance how much are you willing to lose in this experiment? Set that amount and no more aside and account for it (including all brokerage fees) in an Excel spread sheet.

Become an expert. Decide what you are going to trade, a particular stock, stocks from a particular area, an individual commodity or something similar. Learn all you can about that stock, its price history and absorb all the fundamental research you can find. Yes, just like all value investors are aware of technical analysis techniques, all traders need to understand the underlying fundamentals of their stock. Consider, Bank of America. Its price is extremely sensitive to public perception, changes in accounting rules, law suits, and major moves by powers like Warren Buffet. Even as you buy and sell on price movements, you still need to understand what is driving these changes.

Once you have decided on an area of specialization, take a few months to play the game with “practice money.” This is good advice for any novice investor who wishes to make their first move from a balanced portfolio of low cost index funds and conservative dividend stocks to more exotic, risky investments like precious metals, technology stocks, small cap pharmaceuticals, covered calls and the like.

Before you make a buy using real money, write down something coherent in your Excel spreadsheet explaining why you are making that buy. Recording your logic for further study is an important part of the learning process. It will help you build your decision making model and then constantly refine it.

Likewise, when you sell a stock, write down why you sold it and study the results.

Successful traders recommend setting price targets and using stop loss orders as a further discipline that will take emotion out of the decision making process. Emotion is always the enemy of successful investing. It will cause you to buy at market peaks and sell at market bottoms, exactly what you should not be doing.

Here is how the process works. At the time you put in your order to buy a stock at market price. Set a stop loss limit. What this limit might be is up to the individual investor. Some people recommend 10% as a maximum acceptable loss in any given trade. The stop loss order will trigger a sale if the price drops to your predetermined number. Do this on the day you purchase the stock and never, ever, for any reason change it to a lower number. If you lose 10%, so be it. Learn from your mistake, take the tax loss, and move on. If your stock goes up in value, reset the stop loss number to reflect that increase. That way you will never lose more than 10% of the current value of your investment.

Some traders take it a step further. They will set a price target on the same day they buy the stock. I remember one author thought that if one of his trades went up by 25%, he should take his winnings and look for a new opportunity.

As you make your trades, always entering them into to your spread sheet calculating the gains or losses, you will watch your starting number (the maximum you are willing to lose) increase or decrease. If you lose all your money, you are obviously not a trader. If the process makes you excessively nervous, you are not a trader. If your stake increases and you find the adrenaline rush of buying and selling is better than sex (just kidding) you are a trader.

Also, remember if any given investment is small, say 1% or 2% of your total portfolio, even a bad loss in that particular stock won’t kill you.

P.S. The title? The practitioners of technical analysis are frequently termed "elves" in the financial press.

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