Is the market headed for a reversal or an “up” trend continuation?

I don’t know nor does anyone else but what we can do is sit tight and get ready to trade the confirmation, whether it is up or down. A break of support is a signal to begin shorting the market. A move above resistance will be a signal to buy breakouts.

It’s that simple. See below for the three major indexes and their current support and resistant levels:

• May 17, 2010: Trader Vic 1-2-3 Trend Reversal Pattern
• May 23, 2010: Trend Reversal Watch
• June 17, 2010: Trend Reversal Coming…?

I have been trading my own accounts for a decade now and I continue to learn more with each passing day. However, I never thought that a game, a hobby of mine, would advance my understanding and the importance of expectancy and position sizing as much as playing poker. Trading the markets and playing poker both require strict money management rules, stable emotional balance and a solid game plan. If you don’t consider and employ these tools, you will most likely fail sooner rather than later and lose a lot of money along the way.

So, how could a person learn so much from a game that most people consider luck? And why do some traders continually profit year after year while others lose their shirt while making the same mistakes? I will discus the basics of position sizing and expectancy and show you how both items are extremely important when trading and playing poker for profits. I will also close the gap of how each entity (trading and poker) have helped me become better at both.

Many people consider trading and poker pure luck but this is not an accurate observation. Average traders and average poker players taint the outside world with images of luck, quick riches and pure fantasy of the actual grind that is required to succeed. Many factors run parallel with poker and trading but the average Joe would never understand ‘why’ because he or she just listens to what the “talking heads” of television say. Luck may and will play a small part under certain circumstances but rules, odds, risk and money management are the largest components of the two entities.

It’s a grind; trading for a living and playing poker for a living is a grind – a full time business.

I don’t trade for a living but I do trade/ invest to grow my personal wealth. The savings and income from my main career is put to work through investing.

When investing in the stock market, it is essential to have a sound set of rules or a system that has been tested in real time, (back testing or historical testing is not required but can be used, my opinion of course). Back testing helps but playing sports has taught me that Monday morning quarterbacking is for theorists. Once a system has been tested profitably in real-time, the trader or poker player must follow clearly defined rules in order to preserve capital and cut losses. Both traders and poker players must consider the odds of their stock or hand making a gain or making a loss. Price objectives and targets should be a large part of every investor’s system but it is not the essential ingredient to success. Understanding how much to trade or how much to bet and exactly when to make that bet will be based on the system’s expectancy – and this should be the top priority.

So where does system development start? It starts by properly understanding position sizing techniques and calculated expectancies. Using these tools, the investor will be armed to trade only in situations where the odds are in his/her favor. A system that has been tested will have an approximate expectancy that will tell the trader or poker player how much will be gained or lost during each trade or hand over a period of time. Using this as one part of the equation, the investor or trader will now determine how much risk to undertake by calculating a position sizing algorithm that tells them how much to place on a specific trade or poker hand. The word “algorithm” may scare many people away but I have developed very simple position sizing and expectancy spreadsheets that can be found as a link on my blog. They can be downloaded, studied and tweaked without any advanced mathematical experience. This spreadsheet is strictly for trading, not poker.

Most traders and poker players look for three major factors when developing a system:

• How much to trade or bet
• The right odds or positive expectancy
• Multiple trades or hands to play (opportunity)

How do we Calculate Position Size (stock trading example)?

We can determine how much to place on each trade by assuming a $100,000 account with 1% risk on each trade. Using a basic CANSLIM style trading approach, I will place my stops approximately 7-10% below the ideal entry area or pivot point (8% in this example).

$100,000 Account
1% Risk = $1,000
8% Stop Loss
Position Size will be $12,500

We calculate the position size by dividing the 1% risk by the 8% stop loss or
$1000 / 8% = $12,500.

If the stock we are watching has an ideal entry of $50, we now know that we can buy 250 shares or $12,500 worth of stock. Our stop loss is $46 or 8% of $50 and our maximum loss is $1,000 of the original $100,000 portfolio. We can now start to develop system expectancy if we use this basic position sizing algorithm with every trade.

What exactly is expectancy?

Expectancy tells you what you can expect to make (win or lose) for every dollar risked. Casinos make money because the expectancy of their games is in their favor. Play long enough and you are expected to lose and they are expected to win because the “odds” are in their favor. Most games at a casino are completed in a short period of time so they can increase their odds of winning. The only game that does not benefit the casino is poker because the game is played between individuals, not against the house. They do take a rake or a percentage of each pot so we will consider this commission fees. The same holds true for investing. If your expectancy is positive; you can make more money with multiple trades in shorter periods of time. Make sure this style suits your personality before trading or playing poker for a living.

Expectancy is your profit percentage per win multiplied by your win rate minus your loss percentage per loss multiplied by your loss rate. I will use an example of Expectancy from Dr. Van K. Tharp’s Book: Trade your way to Financial Freedom:

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)

Expectancy = (PW*AW) less (PL*AL)
PW is the probability of winning and PL is the probability of losing.
AW is the average gain (win) and AL is the average loss

So let’s do an example using a basic CANSLIM style approach (assume $12,500 per position, a $100,000 portfolio using 1% equity risk):
If my trades are successful 40% of the time and I realize an average profit of 20% but I lose an average of 5%, my expectancy is $625 per trade.

(0.4 * $2,500) – (0.6 * $625) =

$1,000-$375 = $625

I lose 60% of the time yet I show a profit of $625 per trade. If I have a system that produces 65 trades per year, I would realize an annual gain of $40,625 (hypothetical scenario). A 40% gain on the original $100,000 (minus all commissions, fees, taxes and compounding).

Let’s look at the calculation one more time using only percentages:
PW: 40%
AW: 20%
PL: 60%
AL: 5%

(40% * 20%) – (60% * 5%) = 5.00%

What this tells me is that I have a positive expectancy of 5% or $625 per trade from the original $12,500. It doesn’t mean that I will make $625 on every single trade but my system will average a profit of $625 per trade over the course of a year with a combination of winners and losers. I can always make more trades or fewer trades in a year so my total profit will be adjusted accordingly.

With the basics of position sizing and expectancy explained, I would like to explain why poker has made me a better trader. I will start by taking you through a game plan that has helped me use expectancies, emotional balance and position sizing to consistently win money at the tables. I admit that I am not a high stakes poker player but I can hold my own when I feel comfortable with a decent amount of money risked in any one hand ($1-$2 or $2-$5 no limit is my preferred choice – cash games only). As with investing, don’t over trade or trade more money than you are comfortable with. Tournament play is similar to options as a premium is paid up front in exchange for chips or the right to exercise those chips during a specific hand.

As I sit and start to play, my first goal is to become familiar with the character traits of the players around me. Typically 9 or 10 players will be at the table so I will have plenty of time to evaluate the people I am playing with, without risking a great deal of money. After several rounds of play, I will be aware of the character traits of the people I am playing with and will understand that some players may be tight and only bet high odd hands. These players may typically be edgy and nervous and fold cards with force as I have observed in the past. Other players may also play hands with high odds but will mix it up and call bets with cards that carry more risk along with lower odds. Every table has the quintessential bluffer that typically talks a big game, smirks a lot and sports a pair of dark sunglasses. You also may meet the hot shot, “TV-type” player that wants to win the World Series of Poker on ESPN. These players are very similar to traders that buy late night trading systems from infomercials and lose most of their money by incorrectly trading the system or making impulse trades. They also remind me of the people that scour internet web forums, blogs and twitter looking for justifications on their trading ideas or they simply pump their own ideas without following basic rules.

When playing poker, you must pay to gather information from certain types of players and this means calling a hand that you know may lose but the risk and money committed is minimal. Essentially, your overall position size relative to the pot odds justifies the call which allows you to make better or more informed decisions later in the game or tournament. The same holds true when trading. You may have a setup flashing on your screen so you take the trade but it quickly reverses so you close out the position. Don’t consider this a loss; consider this valuable information that warns you that the ideal entry is not now. Instead, you cut the loss while it is small and continue to monitor the situation so you can place another position if the ideal opportunity arrives in the future. You must pay for information in the trading and poker worlds; it will only make you understand the games better.

Don’t forget this rule:

“You must pay for information in the trading and poker worlds; it will only make you understand the games better.”

While poker players are their own characters; stocks are made up of human character traits, similar to the type of people that trade them. Some stocks are risky and volatile while other stocks are conservative and predictable. The market repeats cycles and specific chart patterns because humans repeat their actions and character tendencies. By learning how to target character traits at the poker table, I have started to understand that certain stocks act in predictable ways because the people trading them can’t change their emotional make-up. Many poker players will make the same mistakes and place the same erratic bets no matter how much they try to play differently. Most stocks will act according to historical patterns and follow the trend no matter how much you think the chart will do otherwise.

I won’t get into the exact rules of playing poker but I can tell you that only two players are required to bet per round while the other eight can view their first two cards without risking a cent (my game of choice is Texas Hold’em). The two players required to bet represent the big and small blinds. The dealer and all other player at the table can view the first two cards for free without a bet. If the hand is weak, you can fold and keep your gambling stake.

Here is where it gets interesting; if I have a decent hand, I can decide to call the larger blind and see the next three cards on the flop, which is still a low risk investment. If the flop doesn’t provide me with the cards I need, I can immediately cut my losses short by folding and wait for the next game. The same is true in investing; I can cut a loss short and wait for the next opportunity without risking the farm if I realize an immediate loss. If the cards are good and my probabilities of winning the hand are high, I can call or raise the bet. When I place a trade and it shows a profit, my belief was correct and I will consider adding to the position.

A fourth and fifth card (the turn and the river) are placed on the table after the flop and betting continues with each round. Again, I can decide if I would like to call, raise or cut my losses. The connection I am trying to make with investing in the stock market and playing poker relates directly to cutting losses short (capital preservation and money management) and my odds of winning the game (in the stock market this is called expectancy as explained earlier).

All investors and poker players bring emotions to the table, some people control them better while other people employ more efficient systems and understand the odds on a higher level. The bottom line is to understand the situation around you and to use a sound system to raise your odds. Never bet a hand that represents a low chance of winning and never ride a loss that could multiply overnight. Cut losses short and get out of the game and wait for the next opportunity because they are always around the corner.

While watching a re-run of the 2005 US Poker Championships, a statistic caught my attention so I paused the show, wrote it down and thought to myself that it would serve as an excellent example on expectancy.

Poker expectancy example (this relates directly to trading):
Nine players at the table
34 total hands were played in this round

Player A saw the flop 28 of 34 hands or 82% of the time
Player A won hands 16 out of 28 tries for a 57% winning percentage

Player B saw the flop 11 of 34 hands or 32% of the time
Player B won hands 4 out of 11 tries for a 36% winning percentage

Looking at these numbers and assuming that both players had equal chips (they were close), who do you think made more money during the round?

Most people would guess Player A due to the 57% winning percentage on 16 hands. Player B fails in comparison with only 4 wins, a quarter of the wins of Player A.

Well, Player A actually had a net loss of 5,500 chips while Player B actually had a net gain of 10,000 chips.

So what is my point?

The point is that being active is not a way to guarantee success unless you are following a system with a profitable expectancy. You must formulate a positive expectancy system that balances the opportunities with minimal risk and maximum gain. Player B took on less opportunity but made the most of it when the opportunity arrived.

Player A was erratic and played several hands that gave him poor odds and this is what I see so many traders do when the market is weak. They trade for the sake of trading and they lose. Traders must battle their patience and stick to their rules so they don’t trade erratically and play the game for the sake of playing.

By playing poker, I have cemented my understanding of how people act, how to play the right odds, how to develop expectancies based on the cards I am dealt and how to position my trades properly. Watching these techniques and rules in a live situation really drove home the importance of a system that follows the proven rules. Trading can be a long, tedious and impatient road to travel but following the rules and employing proper position sizing and expectancy calculations will almost guarantee success if the rest of you system does it’s job. If your system is broke, find one that works and understand that you won’t go broke by properly placing your trades or bets and understanding how much you can and will win from each trade and/or bet.

Good luck trading and playing poker!!

Time will tell, give it another 1-3 months to confirm (September may be the time but I can’t tell you for sure). Wait for the confirmation before taking the short trade. A move above the “blue” line breaks the pattern setup!

I can tell you this: The trend has been challenged, the minor low has been established and now we are looking to work on “point #2″. A failure to recover the blue line will establish point #2. A violation of the horizontal red line will confirm point #3 and trigger the short play: TREND REVERSAL CONFIRMATION.

I can’t say that all or even if many will confirm but if the major indices confirm the pattern, it will be like taking candy from a baby on the short side. As you may know, nearly 75% of the stocks in the market follow or move in the same direction as the overall indices.

This could get fun. I am currently looking for a short term bounce in the general market and the stocks on my “short” watch list (point #2 confirmation). After point #2 forms, we then start to load up (on the action watch list) and look to short upon confirmation.

Recent posts reviewing the 1-2-3 Pattern:

• Trend Reversal Watch
• Trader Vic 1-2-3 Trend Reversal Pattern
• Google (GOOG) 1-2-3 Trend Reversal Confirmation

Two sample stocks confirming the 1-2-3 pattern and two starting to confirm the pattern: MSTR, PKX, ADBE and TECD

Notable stocks with the 1-2-3 pattern potentially forming:
MA, V, GOOG

Stocks with their 10-week moving average crossing below their 30-week moving average (this week):
NBL, JNJ, AGU, BBL, HPQ, SNN, UNF, MAN, ACN, HMC, MR, MEE, DWA, PEGA, ASML, CE, MSFT

As you can see:

• GOOG broke the up-trend after establishing a new 52-week high above $629 (point #1).
• From there, it consolidated and formed what is referred to as the minor sell-off (the lower horizontal red dotted line).
• Prices started to rise but failed to make another new high. This test of the previous high failed near point number 2 (March & April).
• A failure to make a new high is usually (not always) a signal that the trend is about to change. This is where some traders jump in early.
• Lastly, we reach point number 3 where prices drop below the previous short term minor sell-off (this is trend reversal and the signal to short). If missed, you can short on the first failure to recover the major moving averages (or #3 area which then turns to resistance).

This is the pattern I am watching setup in dozens of stocks across multiple industries. I am also watching this pattern to potentially setup in the major indices as well.

Remember, have patience and be prepared to sit on the sidelines for a while as this pattern takes time to build and then confirm (4 months for GOOG). The key word is CONFIRMATION!

You may play GOOG up and down short term but long term, the trend has changed!
Follow me on twitter to watch the stocks currently setting up this pattern (prior to confirmation).

I am watching the major indices for a reversal pattern setup. For example, the NASDAQ and DOW have both violated their long term trends but they are yet to establish a definite “minor low” and then a failure to close above the previous high.

Let’s see if the NASDAQ and DOW will continue to form a chart similar to BLK.

Do not jump the guy and start shorting before the SIGNAL is given. Be patient, these patterns can take months to confirm.

We are looking for point #2 and point #3 to confirm before establishing a short (trend reversal position).

Point #1 has confirmed but that is not enough to place a short position, the risk is still high as the odds have not been confirmed in our favor. Without confirmation, the market could move higher which will lead to unnecessary losses.

Back to Victor Sperandeo’s book about the 1-2-3 setup:

At the point where all three of these events have occurred graphically, there exists the equivalent of a Dow Theory confirmation of a trend change. Either of the first two conditions alone is evidence of a probable change in trend. Two out of three increases the probability of a change in trend. And three out of three defines a change in trend.

Three out of three defines a change in trend : that is what I am looking for. At that point (if it happens) is when I will short and short heavily!

Lastly, keep in mind that this 1-2-3 pattern also works for reversal to the up-side:

As you can see:

• BLK broke the up-trend after establishing a new 52-week high above $242.
• From there, it consolidated and formed what is referred to as the minor sell-off.
• Prices stared to rise but failed to make another new high. This test of the previous high failed near point number 2.
• A failure to make a new high is usually (not always) a signal that the trend is about to change.
• Finally, we reach point number 3 where prices went below the previous short term minor sell-off (this is trend reversal and the signal to short). If missed, you can short on the first failure to recover the major moving averages (or #3 area).

In addition to the 1-2-3 setup, the stock has also allowed its 10-week moving average to cross below the 30-week moving average with typically signals a change in trend when both lines are starting to point down.

Victor Sperandeo says this about the 1-2-3 setup:

At the point where all three of these events have occurred graphically, there exists the equivalent of a Dow Theory confirmation of a trend change. Either of the first two conditions alone is evidence of a probable change in trend. Two out of three increases the probability of a change in trend. And three out of three defines a change in trend.

Take a look at the picture I scanned from Sperandeo’s book on page 76:

This is essentially the pattern I am watching for in several of the stocks starting to churn (run out of steam) that I posted to my twitter stream. However, have patience and be prepared to sit on the sidelines for a while as this pattern takes time to build and then confirm (nearly four months for BLK).

Twitter stream for 5/17/10 (stocks down on heavy volume, trading near 30-wk): $PCLN, $GMCR, $V, $MA, $TCK, $BUCY, $BTU, $MR

Recent Tweets on BLK:

• 7:33 PM Apr 6th via web: $BLK – 198.55, clearly falling apart (but gap down has to fill before ultimate slide).
• 10:02 PM May 5th via web: $BLK…Trading @ 174.80 & going down!

This is a game of odds with developed expectancies so take the trades and follow the rules.

Only one other date surpasses Friday’s total: Monday, October 11, 1982 when the DJIA closed at 1,072.79. The market recorded 653 NH’s, 7 NL’s, 1,504 advances, 292 decliners and “up” volume outpaced “down” volume by an almost 10-1 ratio.

The NASDAQ closed at 202.31 on the same day with 418 NH’s, 14 NL’s (not even in the top 10 for the highest number of NH’s ever recorded). Do note this: the highest NASDAQ reading ever came later that year on Thursday, November 4, 1982 with 525 NH’s (following that week’s election day).

So what does this all mean? Well, by mid-1983, the market surged higher by 20%. It continued to move higher until the crash in 1987 but long term, the market is up well over 10-fold since this NH extreme.

How about today’s market? I can only tell you this: we are in an up-trend as of today and until the market breaks that trend, do not try to “guess” when it will reverse.

I have my “opinions” of the market but as you all know, we must trade what is actually happening, not what we think should be happening. Yes, I am concerned the market would like to correct longer term based on poor economic policies, tremendous debt levels, a depreciating dollar and most important: possible inflation. But, until we get the true catalyst, trade what the market is telling you.

The 634 NH’s represents an extreme in the market and I will be watching for further catalysts. How long can this market sustain higher stock prices based on faulty growth? You can only take so many cash advances on your credit cards without paying before they cut off your borrowing capacity. Maybe I have it all wrong but I am concerned long term. Short term, the market is higher unless it says otherwise.

I leave you with this: the vast number of “gap-ups” in stocks making new highs concerns me. Do they want to fill? If so, we will have an almost endless supply of high quality shorts to trade.

Chart provided courtesy of www.Decisionpoint.com

How did I determine that? A new high, a failed high and now a challenge to the minor low (see chart for visual). It’s essentially a Dow Theory reversal setup.