Chapter 5. Finding Your Edge
Now that you have had a glimpse into the world of trading the trader, you must understand that before you can derive any edge from this, you must first have a viable and proven strategy in place. It is from this foundation that your versatile strategy will be supported.
Imagine, if you will, a trained chef entering your kitchen to whip up a quick dinner. With a firm knowledge of what seasonings or spices pair well, I suspect the chef could take whatever you happened to have on hand and cook an incredible meal. On the other hand, if I were to enter your kitchen with the task of making dinner, more than likely we’d be calling out for Chinese. Simply stated, I do not possess the foundational knowledge of what works well with what when it comes to cooking. Not only do I not know what pairs well, I am not familiar with most of the ingredients. If I were to consult anything more than a basic cookbook, I would have to also research the various ingredients along the way, to truly understand the instructions. Because of my limited knowledge, if my desire were to become a real chef or someone with a similar capability, the best place for me to start would be the basics. I would first have to develop a strong foundation from which I could build on over time. This is true in any profession, and trading is no different.
I am always amused when someone close to me suggests they are considering going into trading. Typically, this person hasn’t a clue about the vast workings of the markets, but may have been intrigued by a commercial or other advertisement discussing just how easy it is to take control of their investments. In the past, I would genuinely point the novice to a few books, or suggest some other means of education. Now, I just invite them to my office to discuss their desire further. It rarely fails that when someone steps into my office, seeing the multiple computers, eight monitors, and access to such tools as real-time futures charts, global markets, and forex (foreign exchange), not to mention news from every source imaginable, all being piped in at a ridiculous speed, that a light bulb goes off, and the reality sinks in, that a person like me will be on the other side of their trades. It is only then that they realize this game is not man versus market, but trader versus trader. It doesn’t mean that you must have sophisticated or robust equipment to succeed, but it does mean that you must understand the business, possess a proven strategy, and fully grasp whom it is you are trading against.
No shortcuts exist when embarking on the journey of becoming a successful and consistent trader. It is also dangerous for you to jump too far ahead, starting to analyze what other traders are doing without having a firm foundation already in place that can provide the footing for a flexible strategy. It would be easy for you to simply conclude that in a current environment all traders are buying stocks that are breaking out of consolidation patterns and therefore shorting those same stocks or betting against these traders may be the better play. In reality, this might be a time when what the masses are doing works very well and fading them is a lost cause. Rather than jump too far ahead less you become completely confused, let’s first begin with your basic strategy.
If I were to ask you to write down your trading strategy, could you? If someone were to ask you how you buy and sell stocks, could you clearly articulate for them your detailed process? More than likely, you develop a detailed list before heading out to run errands. Or maybe you follow a strict regimen when approaching a large purchase, such as checking various websites or scanning periodicals for consumer feedback. Yet when it comes to investments or trading, you might follow no defined system that you are confident provides you the edge needed to profit. However, having one is a must.
At the core of every successful trader lies a defined trading strategy, which ultimately provides a statistical and proven edge. While you will refine your strategy over time, thus also improving your edge, your job is to execute this strategy over a large enough sample set of trades to be consistently successful. For example, let’s assume that you have a proven strategy that yields you a slight edge, and over a large enough trading sample you may see 55% of your transactions as profitable trades. If this were the case, to be consistently successful you would just exercise your strategy, actually losing 45% of the time; yet because of the slight odds in your favor, you would still be profitable. For some reason, we’re led to believe that to be successful traders we have to pick incredible stocks or take unbelievable amounts of risk. The reality is that you simply need a slight edge and the patience to exercise that edge over and over again.
In my experience of training numerous individuals over the years, I have often found that most developing traders lack a solid strategy and thus have no real foundation in place to build on. The first thing I typically ask people is to articulate the trading strategy that provides them their edge. Most of the time, I hear rambling answers that contain something about buying low and selling high. Such traders and I often spend the first several hours together defining a new strategy from the beginning and laying the initial bricks that will ultimately serve as the foundation for success.
I have read that upward of 90% of those attempting to trade stocks fail. I would actually argue that this number is much higher. The greatest paradox is that failure in trading does not at all correlate with a lack of proven strategies available for you. Countless strategies provide a proven statistical edge. The problem with most people, I believe, is that quite often the strategy selected does not mold well with their own unique personalities. Furthermore, traders often believe that a set strategy should work in all environments, when, in fact, the best traders alter their strategy to adjust to the environment they’re in at the time. This continuous failure leads to the endless search for a new strategy, which ultimately creates more frustration and soon leads to yet another failure. The truth is that most people spend a lifetime searching out new trading strategies, on a cycle of continuous failure, whereas the successful trader spends a lifetime honing the strategy already consistent in bringing gains.
Value Investing
The mother of all strategies known to traders is value investing, made most popular by the great Warren Buffett. This buy-and-hold strategy is typically taught in the academic world and traditionally passed through various generations. Although many traders debate the merits of this strategy, particularly during bear markets, there is no question that the strategy has proven successful for those who have mastered it. You might be able to argue against a buy-and-hold strategy for a random set of stocks over a given time period, but the argument that Warren Buffett has not been successful adhering to this strategy simply does not hold water.
I firmly believe that if you want to set off on this path, enough resources are available for you to become extremely successful. You can still find all of the late Benjamin Graham’s material, the individual who taught Warren Buffett, and any number of other books on the subject.
You need to ask yourself one question when you approach a style such as this: Do I have the patience and the fortitude to wait for my analysis to come to fruition? I believe that although you might want to invest like Warren Buffet, you will not stomach watching your nest egg decline by tremendous amounts in the short term as you wait for your analysis to be proven right by the market in the long term. When asked about a declining investment such as Coca Cola (KO), a stock Warren Buffett has owned for decades, he traditionally states that he cares not where the stock price is but rather how the business is doing. He argues that you should never act as if you own shares of stock but instead act as though you own the entire business. Although this might work well for him, most traders cannot sit through the incredible ups and downs in price over the years. It is a sound strategy, but it might not suit your personality.
While reviewing the performance in 2008, I read up on some of the most notable value investors of our time. It was not uncommon to see negative 60% and 70% returns during a time of terrible market performance. I have no doubt that most of these investors will do extremely well over the next decade and make back their unrealized losses and much more. However, you must honestly ask yourself whether you could handle such a decline. Typically, that answer is no, yet value-based investing remains one of the most popular and widely accepted strategies around. If you set off down this path, yet cannot accept the drawdowns in your account, you are once again destined for failure.
Day Trading
Despite being shunned by the general public as a credible way in which to approach the market, day trading is one of the most efficient and successful ways in which to make consistent profits. Most of the successful traders I know, while they may follow a different strategy to select and manage their trades, share a common bond in that they go to cash each and every night before closing up for the day and are therefore deemed day traders. Their goal is to possess no overnight risk whatsoever, coming into each day with a clean slate, an open mind, and the willingness to deploy capital as their strategy dictates in either direction depending on what the market presents them.
I have great experience with day trading, and I can tell you the exhilaration and freedom from day trading is fantastic. Markets have become increasingly volatile, and to see the market shift in an extremely short time period is not uncommon. A day trader has the unique advantage of playing the day’s move regardless of whether that move correlates with the previous day’s move. In contrast, if you come into the day holding positions, you will already be biased as to the direction you desire. Holding positions over night means that you are more than likely positioned for the previous day’s trend, when the next day may be different.
On the surface, the life of a day trader looks attractive, and I suspect that is one of the reasons so many traders are initially drawn to the style. However, more often than not, most learn that day trading is not for them and is an unrealistic venture for them to pursue (because of their schedules, their temperament, or perhaps a combination of both). Furthermore, you might make the classic mistake of believing that day trading is the actual strategy, when in reality day trading is merely a general term that means an individual ends the day with no positions. Within this general style lie hundreds if not thousands of different strategies. Individuals often believe that day trading may be the style for them and move head long into this world without having a set strategy to follow, once again setting themselves up for failure.
It reminds me of someone driving along on a nice sunny day and noticing a jogger out for a run. The driver thinks to himself how nice it would be to be back in shape, outdoors, enjoying a run on a beautiful day. When he returns home, he puts on the old tennis shoes, throws on the shorts, and heads out for a run. Within a block or two, he is reminded of the harsh reality that running isn’t as easy as it looks and that he is incredibly out of shape. When watching the runner strutting along, the driver failed to see the countless hours that the runner had been training. He didn’t see the early mornings, the runs in the rain, the cold, or the early days when just running a mile or two was exhausting. He saw the end result, appreciated the beauty of it, and wanted to skip all the work and enjoy the prize. Clearly that isn’t going to happen in running, and it won’t happen in trading.
Most people who observe a day trader, or start to study the craft, set themselves up for immediate failure because they do not properly assess their own personality, much less their own schedule, before determining whether day trading is even an option for them. At its most basic, day trading generally requires an incredibly demanding schedule. To capitalize on the opportunities presented on any given day, you must be able to sit at your computer throughout the entire trading day. Unfortunately, you cannot dictate when the great opportunities will come. Instead, you are at the mercy of when the market wants to make these opportunities available. Although this might be a reality for some, odds are that you may have other obligations throughout the day to attend to that do not allow you to sit and monitor markets each and every day, all day long. Furthermore, like myself, some people just don’t enjoy being tied to the computer and positions all day long. As I mature through adulthood, I have begun to once again appreciate stepping outside during the day, enjoying lunch with friends and family or the occasional vacation. I do dabble with a day trade here and there, but I much prefer to see a position work for me over time, not a trade mandating I watch its every tick.
As stated previously, don’t be confused by assuming that day trading is a strategy within itself. It is not. You cannot just adopt the term day trading to supplement your lack of a solid trading strategy. Once a strategy has been put in place, you might decide to day trade that strategy. However, the time frame does not come before the strategy. Day trading is a world within itself that comprises many different strategies, most of which do share a common bond with our next general category, the world of technical analysis.
Technical Analysis
Unlike its counterpart fundamental analysis, technical analysis is not traditionally passed on from generation to generation, nor is it taught at the academic level as a method of successful investing. In fact, technical analysis often receives negative press despite the fact that the foundation of technical analysis, a chart, is used to display a stock’s movement on almost every media outlet that discusses investment information. Many of the same people who refuse to respect technical analysis will actually talk about uptrends, support, and resistance. It’s really quite humorous.
Although the popularity of technical analysis has grown to unprecedented levels, and therefore has become quite saturated, it remains one of the best investment methods for you to follow when developing your own personal investment strategy. Like the world of fundamental value investing, technical analysis may be broken into several categories with a primary principal woven throughout. The common principal is the adherence to quantifiable evidence shown through historical price and volume, allowing you to infer where a stock may move next. Based on my experience, the best way to describe technical analysis to a novice is by explaining that charts graphically represent other traders’ emotions. I explain how historical price, which is directly tied to the emotions of other traders, enables you to find key inflection points whereby a move may begin or end. After these inflection points have been determined, you can then position your capital accordingly (in your attempt to profit).
The world of technical analysis is vast in that the individual strategies within the general investment methodology are too numerous to mention within the scope of this book. I have seen technical traders find their edge mastering such indicators as trend lines, moving averages, pivot points, stochastics, relative strength, and Fibonacci numbers. To assume that one method is superior to another is arrogance. Over the years, I have learned to greatly respect most individual strategies within the world of technical analysis. This respect has not come blindly. It has come over many years from directly witnessing traders gaining an edge via these methods.
Over the past decade, markets have punished buy-and-hold investing, which encompasses many of the traditional investment styles widely taught and accepted. Therefore, basic technical analysis has boomed in popularity as traders seek yet another style that might be their ticket to riches. For the astute trader, this new popularity and shift toward technical analysis has created another layer of incredible opportunity. It is no longer enough just to follow the basics of technical analysis. Instead, the real edge now is trading the traders who are trading the basics. Never before has a “trade-the-trader” style incorporated into the foundation of an existing strategy been more important, or more lucrative. Unlike other styles of investing that may remain true forever, technical analysis must always be tweaked, because of the ever-changing landscape and mood of the trading world. However, never view this as insurmountable. Instead, accept this fact as one of the many routine challenges on the way to consistent profits. I have come to learn that embracing this is half the battle.
We have covered only a few brushstrokes here. Literally hundreds, if not thousands, of proven strategies exist from which you may choose to find your edge. These are proven strategies that traders at this very moment make consistent profits from year after year. However, despite the large number of strategies available, most people will continue to struggle and fail at trading, regardless of the relevant resources available to them. With so many successful and consistent strategies available, it raises the question as to why more people are not successful at trading stocks? I believe that even though the number of proven strategies is great, if you do not seek to master the strategy that fits your personality, temperament, and schedule, you are certainly doomed to fail. Adhering to a proven strategy that fits your personality is the foundation of successful investing.
Imagine, if you will, pursuing a passion for golf. You study professional players’ swings, play hundreds of rounds, and ultimately seek professional help. Despite your best efforts, you still can’t improve your score, and your frustration builds with every passing day. One day, however, you learn that there is an appropriate club length for each person and that you have been playing with clubs 6 inches too short. The short clubs never allowed you to have an adequate swing. In fact, they were slowly damaging your physical health, placing strain on your lower back and shoulders. Finally, you are fitted for the appropriate-sized clubs. Upon swinging the clubs, you immediately notice a world of difference. The clubs themselves do not immediately improve your score, but they no longer hinder the success you desire. Well, friend, if you are attempting to trade without a strategy that suits you, you are like the golfer with short clubs. You are doomed from the start and will never be in a position to prosper until you alter the basic foundational issues.
The truth is that most traders never truly subscribe to a specific strategy. Even if you do, it might not be the one that fits you best. Furthermore, you may desire a strategy to work consistently, on every given trade, when in reality this is impossible. You might not be willing to ride out the lean times (nor are you taught how to). Therefore, you might become frustrated with a strategy during one if its natural downtimes and abandon it altogether. Whether it is for a lack of a good fit, or a period of drawdown, the trader who ventures down this path mistakenly believes that it is the strategy that is at fault, when it is really the trader who is in the wrong. Once one strategy is abandoned, the trader moves on to the next strategy, ultimately repeating the process, and thus sparking the vicious cycle I call the endless strategy search.
Perhaps you are on the endless strategy search right now, and that is why you are reading this book. Those traders on the endless strategy search hop from book to book, website to website, trading service to trading service, trying to find that magic strategy that will make it all click. Although they might enjoy brief periods of success, failure always ensues, and frustration builds. The idea of abandoning stock trading altogether seeps in, yet they see others supposedly having success and so they refuse to give up until they have discovered the secret. Eventually, some either become skeptical of the stock trading community as a whole, never truly believing that anyone is really successfully trading stocks, or they go broke. A few lucky ones, those who make up the small percentage of those finding success, finally find a strategy right for them and ultimately learn the tools needed to succeed over the long term.
Your strategy is like the foundation of a house; it must be sturdily in place before other layers can be built on it. Furthermore, you must know it is successful (in that it gives you the edge needed to make consistent profits over time). So far, we have discussed various strategies and could discuss many others, but the purpose of this book is to walk you through a strategy that I have developed over the years and that has worked very well for me, and will work well for you. It might not be something you adopt completely, but it will set you on the proper path to developing your own unique and ultimately successful strategy.