Article: The Grace Approach

At www.edesks.com we believe that human emotion drives the direction of all markets that human beings trade. Our instruments are living; their mental and emotional states of consciousness are constantly changing, and thus varying the conditions under which our research is conducted. Above all else, there is required a state of mind which is content to sit down humbly before the markets and follow them were they lead you.

It is fear and greed that are the two factors that jolt the average person out of his usual thought habits. In all human thinking there is a tendency to fall into step with the majority, and every advance is instinctively resisted if it seems to go against what is already held. Not only is it resisted, it is often passionately resented, and the history of human emotion which even shows only too clearly the depths to which even a rational personal may sink. This is because of the power of the herd instinct within each one of us, making us emotionally biased against any new idea, which might upset the established order of things. So human beings tend to do the same things repeatedly. And this tendency, established through millions of years is a deeply rooted in all human psychology.

The measurement of Greed and Fear and knowing when to use them to your advantage is what we are interested in understanding at www.edesks.com. How fear and greed are controlled is first and foremost by proper money management! Once you have learned to use proper money management the risks that are associated with trading various markets will diminish greatly. This is because once you have a set amount of money that you are willing risk in any one transaction you will know how much jeopardy your money is at in any given moment. This is the key to money management and to the controlling of Fear and Greed. Through the establishment of simple money management rules you control the value of your portfolio in a method that will allow you to grow your money in a stair step manner. Large bursts of cash are not proper and the only way you get them is through luck or improper money management. If you can be right even 40% of the time you have the ability to make money by using proper money management. So the first thing that we believe in and know that works is proper money management.

The next step is the understanding the measurements of fear and greed are systematic in nature. There are various tools that we use in our assessment of the markets that we deal with. Through the use of technical analysis in conjunction with sentiment we come to the conclusions of market direction. The process is repeated in the same fashion over and that is the key to creating calmer investors or traders which lead to better decisions. We believe that markets repeat themselves because people continue to act the same way at tops and bottoms of markets as they have throughout history and it can be measured. In other words HUMAN NATURE never changes. This method is used in stocks, bonds and commodities.

Words of wisdom from a Market Trader

Accept the rules that govern the markets and subordinate your will to the will of the markets. Because the only place that you are going to find a helping hand in this game is at the end of your arm. The bottom line is you can and will fail many times, but you will not fail until you begin to blame some else. So the first rule is to remember that you are in a place where we all need to live by the rules that govern our actions. These are the practical laws that direct what goes on day to day in the markets. The rules that govern the markets are not made not to be broken, and yes there are always exceptions to the rules, but I always try to deal with the highest probability of what is going to happen.

I am personally responsible for every transaction I make, and never feel that any market has taken advantage of me. But that is what we all want, the opportunity to use our intellect to change our lives.

As each day unfolds in the markets, I have a specific mental attitude that I try to keep. I never dwell on the past in any aspect of my life, because there is nothing I can do about it. I always look toward the future and maintain a positive attitude. I think it’s very wise to have a thought out scheduled time for studying the markets. By setting a set time to do this, you will add to the discipline that is so necessary to be successful in life as well as in the markets.

Remember the market judges you based on your actions, not your intentions. It’s a big step to take, admitting that you are in charge of yourself, and that your decisions will make or break your own fortune. Every trade outcome is my responsibility. The market never goes against me personally, and in fact it doesn’t know that I even exist. I am personally responsible for every transaction I make, and never feel that any market has taken advantage of me. That is what we all want, the opportunity to use our intellect to change our lives.

As you go through your trading life, remember that most people will not accept losses. Without the reality of accepting loses, the trader/investor puts themselves in the position of continually losing money because they are willing to ride losing positions indefinitely. The damage that goes on in riding a losing position goes way beyond the dollar amount of the loss.

The damage is to your confidence and to your ability to think clearly. By hanging onto your losers, you hurt yourself mentally. This starts a chain reaction that for many traders becomes insurmountable, and thus they have already lost before they even had a chance to really start. A loss never brothers me when I take it, because I know that I’m following the predetermined set of rules that I trade by. What is harmful is when you rationalize yourself into not taking the loss, even though you know that this is the proper course of action. Hope is not a good thing in the markets, because it keeps you from doing what you must do.

As opposed to hope, fear is actually helpful because fear will help you in the protection against catastrophic loss. This one act is what makes the difference between becoming a truly successful trader, and or falling into the abyss with the rest of the world. Thus the use of stops, no matter what time frame you are using, is the difference between a professional investor/trader and the rank amateur. The conclusions that I have reached after spending the last 20 years trading is that the market is the smartest animal on earth. It is the meanest, and the most unconscionable beast that mankind has ever had to deal with. It is right to fear this beast, for it has taken many a man’s soul. I respect the great beast beyond any living thing, for it knows all, and I subordinate my will to its will at all times.

Try to make greed and fear work for you, not against. Understand that these are the normal human emotions of the masses, and that the masses are usually wrong. At the top in whatever market you are trading the bullish consensus is usually high, and at the bottom the bearish sentiment is usually high. Sentiment indicators are of great importance, because it gives you some idea of what the masses are doing. There are various ways to measure sentiment readings in the markets. The oldest published service is the Bullish Consensus out of Pasadena, California with a product called Market Vane. There are other services that measure market opinion: Investors Intelligence, Consensus Index, and AAII Index and all are measures of market sentiment. The trick with all these services is that you must look at the historical ranges to see if indeed there is consistency in the numbers at market tops and bottoms.

Every time I buy something, I never think of what I can make. Rather, I think of what I can lose. By addressing the downside, I set my parameters of risk right away and become discipline in my approach. This discipline allows me to be wrong more than half the time and yet still make money. I’m not saying I’m wrong half the time, but with proper money management I can be and still make money.

As I progressed as a trader/investor, I began to understand that I had a very good opinion of the markets and that I approached each market in the same manner.

Once I understood this approach, it made it much easier to trust my own opinions. Where before I used to listen to other people, I have evolved into a state where I just listen to myself. The one undeniable truth that was beat into my head was that facts were priceless, and opinions of others were worthless. So I found myself going through the process of trying to justify my sources of information, and trying to make sure that they have some experience, some reason that I should listen. The reality of the markets is that successful traders/investors isolate themselves from the opinions of others. With the advent of the Internet, it is very easy for someone or some company to become a market pundit. Do you really know who these people are? Are they any good? With the Internet, even more care must be taken about the type of information you get.

There are trading rooms around the country that actually have very smart people that trade together. If you know these people or the type of information or strategies they utilize, they can be of a great help.

One important thing to do is always know your source. I have actually received many good ideas by people who have pointed to parts of certain markets that I have missed. As I received those good ideas, I archived the people who made these calls. In the future, I will be willing to take a look at what they are saying. If I can have others that I trade with look at the same areas, and use the same set of rules that I use to trade, then I will have a team I can trade with.

This process of trading takes a complete understanding of oneself to be successful. If you don’t know who you are, this is not the arena to find out; the cost is just too expensive. Overconfidence is death to the trader, and there is no price too high to pay in order to keep from becoming overconfident. A person must know themselves thoroughly if they are going to make a living out of trading.

Patience is a major key in being able to ride a winner. Fear of a big loss is so important, because it helps you to cut losses short, and this improves your emotional well being, as well as your outlook for future transactions. To persevere in this game, it is imperative to keep your head clear and think rationally and have the determination of a bulldog. There is a never-ending battle to continually strive for patience, perseverance, determination and rational action. If you don’t know where you are, it is impossible to know where you are going. When I’m in the market, I have a set course of action and I try to always look at the time frame of the day, the week, and the month that I’m in.

The markets are seasonal in nature, and must be approached in an aggressive manner at different times during the year. Statistically, the stock market’s best months are the last two months of the year followed by the first month of the year.

There are more reasons for this than just the "January effect" on stocks. Mentally, this is the typical period when the public and money managers have their great expectations, and feel they have done the necessary homework to profit in the coming year.

We all know that statistically the best months are November, December, and January. Since I know that January has a large influx of cash from mutual fund buyers, it makes sense to be long coming into January.

This leads us into another strategy that I use each year that I call Year Enders. Every year there is tax loss selling, and in some years more than others. The key point being made here is that stocks are getting thrown away because they have not performed. Because of their lack of performance, they are being sold into the year-end whether their outlook is bright or not, so that the investors will be able to take advantage of the loss on their tax returns. So you can see what is coming, these stocks have already had bad years. Then they are punished and even more towards year-end in order to take the tax losses. This act of tax loss selling depresses stocks by even a greater margin than normal.

As a result, I buy into this action at the end of each year, and hold for the January effect in the stock market. This is a powerful tool and can give some very big gains early in the year. The usual way I operate is to look for quality issues that have large cash on their books, and will not go out of business in the next 12 months.

Again volume is a key in anything that I do, so the stock must trade size. By size this usually means over a million shares a day. Stocks need volume to move, and volume dictates price. This is a key element in all the markets that I trade. Volume is the cornerstone of price direction. So I always check the average volume on all stocks I trade to make sure there is enough liquidity to enter and exit at will.

I like to call stocks that trade large or "thick" volume." This not only applies to stocks, but also to any market I trade, whether it is currencies, bonds, crude oil, and so forth. You will never find me trading anything that does not have liquidity, for this is a great way to get trapped into a position that is not working out. I fear no market that has a free flow of volume because I have the confidence that I can figure out the direction as long as human beings trade it. From the chaos of the masses is where opportunity manifests itself.

I like the fear of the public because I know among the ruins there are great opportunities. So what I look for is the fear from the public and of friends, family, traders and anyone who is a so-called pundit. I know myself and that is the most important part: the fear and greed game. Know your stress point.

So how do we find something that fits this type of year-end stock? In the winter of 2000, the NASDAQ took one of the worst beatings in the history of the stock market. There were many stocks that traded in the triple digits in March that ended the same year below $10 a share. At the peak in prices of these various securities, the investment community on Wall Street was busy placing buy recommendations on stocks and talking about the new paradigm in the economy. It was a sad thing for me to watch, because all the classic signs of a top were there. I could not bring myself to buy at these levels because the market has told me history does repeat itself.

The prices that are made in the minds of men at market tops are driven far beyond the rational expectations of rational men and are solely based on greed. There was a massive bubble that was made in March of 2000 which could be a top that will not be seen in many years in the NASDAQ stock market. The point is that many Internet stocks were at extreme valuations that could never be lived up to, yet Wall Street kept recommending these very issues. At the top of this foolishness, it was very difficult to find very many differing views. The sad reality of any market is that the majority is always wrong at the top and the bottom.

It is important to keep a logical perspective. Valuations do not grow to the sky, and neither do they go to zero in a straight line. I’m in the constant search for securities that no one wants, and looking to sell my positions when everyone wants them. The crowd in the market is usually on the wrong side.

The keeping of records is of great importance in your life as an investor/trader. Limit the risk in any one position to a maximum of 10% of your capital, and the risk in all open positions to a maximum of 25% of your trading capital. Determine this each day, adding profits and subtracting losses in open trades, and combine this net figure with your trading capital. Remember the term "mark to market." This is what you must practice everyday to understand the amount of equity you have. Always gather the amount of available equity and margin daily.

I think that it is appropriate that I discuss the manner in which I deal with losses. If I have taken a loss, I forget it quick. If I have taken a profit I forget even quicker. I always try to keep my greed and fear on the same level. It is important to keep your thought processes clear. Celebration and lament have no place in the middle of the trading day. No one can do anything about yesterday, and when one opportunity ends a greater opportunity nearly always lies in front of us. I try to take advantage of every loss to improve my knowledge of the action of the market.

When I take a loss, it makes me become even more studious. On the other side of the coin, the gains I make rarely give me reason to study them. I expect losses and I have learned to accept them gracefully. I have found that people who brood over losses tend to miss the next opportunity, which could have the possibility to be profitable.

Money does not sleep, and there is a change occurring somewhere in the world that can make you wealthy. In trading, I regard fear as the greatest sin and giving up as the greatest mistake. The art of accepting failure is the step toward staying humble and a leap toward victory. The preservation of capital is just as important as the appreciation of capital. Losses never brother me when I take them. When I fail to take a loss is I have put myself in jeopardy. This is a key point, because this is how you can do permanent damage to your equity and your ability to trade. Not to mention your confidence! I have tried to get myself in the habit of taking my profits too soon. I try not to torment myself if a trade continues winning without me. Because most of the time it won’t continue long. When they do continue, I simply look back on all the times when I sold early to protect myself and helped preserve the gains that I would have otherwise lost.

I never add to losing positions. I will buy on a scaled down basis if that is the way I intend to enter a certain market. But I never add to a losing position in order to average out. I stick to the plans that I laid out.

I tend to worry about how much I can lose. I figure a risk reward ratio ahead of my trades, and try to strive for at least three times the potential profit versus the loss. A major point is not to overweight without regard for the amount of capital that you have to work with. When it comes to profits, it’s a good idea to split them down the middle, and to never risk more than 50% of them again in the market. Another mistake is to take small profits just because you have them. This will slowly kill you, and you will give away good positions and not reap the rewards of the risk you have taken.

The money that is lost in the short term is small compared with the large sums lost by those who let their investment "ride". Long-term investors are the biggest gamblers because after they make a trade they often times stay with it and end up losing it all. The intelligent thing to do is act promptly to hold losses to a minimum. Wealth that is slowly built will continue to grow, but wealth gotten quickly will dwindle away. I always regard that I’m at risk of ruin when trading. It is important not to overweight your capital in any one thing by taking huge positions. One wrong move, one wrong report, one non-knowing event can end your career as a trader.

I try to keep everything simple when I trade. It is a very simple act to place a mental stop loss on a trade, and yet executing it is another thing. People tend to come up with many reasons not to take a loss when it occurs. This is the most important aspect of trading, whether it’s long term or short term. There are a couple of ways to use stops, either by actually physically placing the order in the market, or by using a mental stop and selling it when it gets to that price. The one good thing about putting it in the market is you will not come up with reasons not to sell it or buy it depending on your position.

"But wait, it may come back, the market is going to get better, and it’s different this time!" I have heard them all, believe me. Never cancel a stop loss order after you have placed it at the time you make a trade.

I have a scheduled, planned time for studying the markets. I have used the weekends on Saturday morning to pick up my weekly issue of Barron’s newspaper for the last 16 years. This is part of the work that I do each week in preparation for the following week. I like to get a macro economic view of the world, week to week, and the statistical information in Barron’s (not articles) allows me to take my time over the weekend and slowly let my thought processes work through the necessary information. I have key areas that I work through that let me understand the historic levels of greed and fear in the marketplace. This paper is very useful in the sense of having statistics that make it easy to get quick overview of the U.S. economy. My study of the markets is a constant affair that never ends, and each market day I wake at 5:00AM West Coast time. I like to get up at this time in order to get prepared each morning. I see what has gone on around the world, and what the bond market and other various markets are doing each morning. The beauty of this massive information flow is that the markets react right away to what is going on, and you can capitalize on it. I try to think of each market in its own world, and how one market may have an effect on the other market.

The Proverbs of Trading and Investing

To know wisdom and instruction, to perceive understanding, and to receive the fruits of proper judgment are what give a stable income and the knowledge and the discretion of financial freedom.

By planning what you do, and following your plans, you will separate yourself from the common man who will drive you away from proper teachings. The reward of seeking wisdom is the building of wealth.

Keep records of your trading results.

Make sure you take a break from the markets. Get a detached view of the markets, and a fresh outlook of the markets for the coming several weeks.

Above all, the most important thing to do is to subordinate your will to the will of whatever market you are involved in. As long as you follow this commandment you will be safe. The day that you lose sight of this you will be lost.

Always consider the amount of money that you could lose on any transaction. The limiting of losses is the key to the markets, and your life as a trader or investor. If you protect yourself, you will be surprised by how far your winners will go.

Do not forsake the value of the gap. I will urge you not to buy gap ups nor to sell gap downs in various markets. Study them. Remember we are about always putting ourselves toward the highest probabilities.

The beauty of the markets is that they all function the same way. The one constant is that human natures dictates the movement of prices based on fear, panic, greed, insecurity, anxiety, stress and uncertainty.

Know your equity every day and understand the amount of money in your account without exception.

Never let the minute to minute swings change your conviction of where the market is going. Remember the key is to stick and stay to make it pay.

The biggest mistake you can make is keeping a losing position and selling a winning position. Remember sell your losers and keep your winners.

Be more interested in a market’s reaction to new information than to the piece of information itself.

Take care of yourself, and be mentally prepared for the rigors that each day of trading brings. Try to keep this mental state from the time you get up until the time you go to bed. By working hard and understanding the key factors that are affecting the markets you are in, you will have good fortune. In other words, the harder you work the more luck you will have. Chance favors the prepared mind.

Article by Alexander Grace

Editors note: This method is used in stocks, bonds and commodities.