Market-Philosophy.Pdf

How I Make Money In the Stock Market [email protected] First of all… There should be a clear distinction between trading and investing. What is the difference between trading and investing ? Long-term investing is essentially a bet on how other people’s perceptions will change over time. It is about answering the question - what are the catalysts that will change market’s expectations? Trading is about understanding the constant cycle of range contraction and range expansion, it is about taking highly asymmetric bets, it is about adapting to changing markets. What do Investing and Trading Have in Common? Investing or Trading without an edge is gambling. Two market edges have survived the test of time: • Price momentum • Earnings momentum Price momentum • Past performance impacts future performance. • Recent trends are likely to continue longer than most people expect. • Stocks that have outperformed in the past 3 to 12 months are likely to continue to outperform in the next 3 to 12 months. Most of the Momentum edge is due to: • Closeness to 52-week highs - an important benchmark level which attracts a lot of interest and new capital regardless of past performance. • Industry momentum – when an entire industry starts to break out or break down, there’s usually a strong catalyst that is likely to sustain trends for multiple months. • Short-covering – every trend needs skeptics and doubters; otherwise there won’t be anyone left to buy. Earnings Momentum • Post-earnings-announcement drift - stocks that initially receive favorable market reaction to earnings tend to continue to outperform. A new earnings reports often provides new information which changes people’s expectations and starts a process of price discovery. Prices change when perceptions change. • The cockroach effect - the first big earnings surprise leads to more earnings surprises in the following quarters as it usually takes time for analysts to catch up and for the market to discount properly the surprise. • Pre-earnings announcement drift - everyone is trying to be one step ahead of the crowd in financial markets. As a result, some speculators might start buying up a stock that has already surprised big to the upside before its next report. The cockroach effect – one big earnings surprise is followed by more surprises Post-earnings-announcement drift Pre-earnings-announcement drift Combining Momentum & Options = Explosive Opportunities Momentum Investors make money in two major ways: 1. Trend following - Hunt for several huge winners in a year. Build large positions in them and ride them for monstrous gains. 2. Swing Trading - Hunt for hundreds of 5% to 30% short-term winners, where the goal is to compound capital quickly by actively moving in and out of them. There is no right or wrong approach here. Both have a place in the arsenal of each active market participant. Long-term Trend Following • If you sell all your winners, when they are up 20%, you will never catch a double or a triple. • You never know in advance which trade or investment will be profitable and how profitable it will be. • If you want to catch a 100% long-term winner, you have to be willing to sit through multiple consolidations and several bigger than 20% pullbacks. • Not everyone has the stomach to ride big stock market gainers. Long-term Trend Following • The major benefit is lower taxes on longer-term capital gain if you ride a trend for more than a year. • The major drawback is deep drawdown. • In order to ride a trend, you have to be willing to sell on weakness and give back a substantial portion of you profit when you exit. Long-term Trend Following – TSLA Long-term Trend Following – YELP Swing Trading • Swing Trading can achieve the same and often a lot better after-tax returns than long-term trend following with a lot SMALLER DRAWDOWN. • The drawdowns are smaller because we sell on strength and we go to cash during unfavorable market conditions. • Stocks often move in 10% to 50% momentum bursts that last between 2 and 20 days before they mean-revert or go into sideways consolidation. • The goal of every swing trader is to capture a portion of a short-term momentum burst while avoiding consolidation periods. • Then to repeat the same process hundreds of times in the year by risking between 0.5% and 2% of capital per idea. • Small gains can compound very quickly. Swing Trading • The beauty of swing trading is that it provides many signals. • In any given year, there are a lot more 20-30% moves than there are 100% moves that you can capture. • You don’t need to risk a lot per signal, which means that you won’t second-guess yourself whether to take a signal or not. • One trade is not going to make your year or your month, but it also won’t ruin it. Swing Trade Example - OKTA Swing Trade Example - AMZN Swing Trade Example - NKTR The Most Important Ingredient of Swing Trading is Risk Management A proper risk management approach can allow you to compound your capital quickly with very little drawdown. The Five Secrets to Proper Risk Management • Trading the right stocks. • Taking asymmetric bets. • Using the right position siZing. • Having an exit strategy. • Market Timing. Picking the right stocks • Trading without an edge is gambling. • Only two market edges have survived the test of time: momentum and earnings drift. • Range contraction in stocks with established momentum provides a great risk/reward entry point. • Focus on stocks that poses those characteristics. Taking asymmetric bets • Risk a little to potentially make a lot, so you can make a lot of money even if you are right only half of the time. • In swing trading, this means risking 6% to 7% per position while trying to make 10%-50%. Taking Asymmetric Bets - How Can You Make Money By Being Right 50% of the Time? An edge doesn’t necessarily comes from being right more often than being wrong. In financial market, you can still make a lot of money by being right less than half of the times IF your average winner is much bigger than your average loser. A Hypothetical Example 10% capital allocation 50% success rate Average winner: 20% Average loser: 7% Average holding period: 3 weeks Projected gain on 100 trades: 65% Projected gain on 200 trades: 130% Choosing the right position sizing • How much of capital to allocate to a position. • We typically risk between 0.5% and 2% of capital per trade idea, which often means about 10% capital allocation. • This approach allows us to diversify our ideas and not to rely on only one of two to make our year. Having an exit strategy • Sooner or later every trend ends, so you need to have a very clear exit plan. • In swing trading, we take partial gains on strength, which allows to keep our drawdown to a minimum. The Purpose of Market Timing • Being Aggressive in the right market conditions and protecting capital the rest of the time. • Most market participants try to be equally active regardless of the market. This is a big mistake. • We have to be selectively active, because not all markets provide the same opportunities. How I Think About Market Timing • They say that the definition of insanity is doing the same thing over and over again and expecting different results. If you do the same thing in the market, you are guaranteed to get very different results because the market constantly changes. • Different setups work in different markets. Everyone makes money in a bull market. Not everyone keeps it when the market environment changes. • There are three different types of markets and each of them requires a different approach: uptrend, downtrend, range-bound. How I approach Uptrends • We are 100% long and on margin when the market is in confirmed uptrend. • The definition of an uptrend - all four major market averages (SPY, IWM, MDY, and QQQ) are trading above their 50-day simple moving average. Russell 2000, which represents small caps (IWM) is trading above its 10-day EMA. Most long setups work well in this environment. This is the time to be extra aggressive in the market and to build up our returns. How I approach Range-bound Markets • We are less than 50% invested when the market is range-bound. • The definition of a range-bound = the four major market averages (SPY, IWM, MDY, and QQQ) are trading all over the place. For example, QQQ might trade above its 50-day SMA. SPY is above its 10- day EMA but below its 50dSMA. IWM is below its 10-day EMA, which is below its 50dSMA. The first thing to do in this type is to raise our cash levels and cut our usual position siZe in half. Then, focus on setups in industries that show notable relative strength. Also, post- earnings-announcement drift setups. How I approach Market Corrections • We are in 90% to 100% cash when the market is in confirmed downtrend. • The definition of a downtrend - all four major market averages (SPY, IWM, MDY, and QQQ) are trading below their 10-day EMA and below their 50-day MA. Correlations and volatility are very high in this type of market. My number one priority during this type of market is to protect capital. Thank you! [email protected].

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