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2 roads to trading success in the markets

July 25, 2008

When markets are stormy and covered with dark clouds, even the hardiest of investors and traders sometimes feel discouraged. Is this is what it's all about, they wonder? Losing money left and right, getting decimated by choppy, unpredictable markets where nothing works? For the unprepared and the tip-followers, the answer is yes. It's not for lack of trading or investing tools, though, but for alack of clarity as to the road to follow...

The time is now. Stretched out before you are the widest diversity of markets, with the most powerful leverage and the greatest opportunities - or dangers - in all economic history. You are both bewildered and fascinated by the speed of change and the plethora of technical indicators used to track that change.

However, before you can move into this new, often uncharted territory, you come to a series of crossroads, where you must make some basic decisions regarding how you will approach the markets in general.

At the first crossroad you are confronted by a stranger who asks you: "Do you want to be a picker or a follower?"

"What do you mean?"

"The pickers are all those that try to pick a market bottom or pick a market top. They say that they have technical tools which will predict the next market turn, help them get in before it really makes its move and get out just before it heads back in the other direction. For lack of a better term, we call them 'bottom-pickers' and 'top-pickers'. But more often than not, they're the ones who, in effect, get picked flies.

"Every time there's the slightest rally or correction, you can hear them shouting 'This is it! Now's the time to buy (or sell)'. Granted, there are some who do make money, but for the most part they suffer from what we call ICGAL syndrome - that die-hard belief that 'It Can't Go Any Longer'."

The stranger points towards the horizon. "See over yonder. That's where you'll find the ceremonial burial ground of the thousands of would-be traders who literally got killed trying to pick 'the bottom' in copper, lumber, sugar, gold, crude oil and virtually every commodity imaginable. Some of them actually had a better-than-normal batting average. But they bounced in and out of the markets so often, their equity got eaten alive by commissions, even discount commissions."

"The followers use a somewhat more conservative approach. Rather than trying to catch the entire move, from top to bottom, their brand of technical analysis is geared to giving them confirmation that the market is indeed trending in one direction or another. Then, and only then, do they jump on board. So they're the trend-followers."

"So what's so bad about that?"

"Nothing at all. Trouble is, more often than not, by the time they get in, the market has already moved substantially and is ripe for a correction, a sudden reversal in the opposite direction. Often the followers stick it out for a while until their losses are unbearable. Then they bail out just before the market is ready to move their way again. In the final analysis, what many wind up doing is exactly the opposite of what they should be doing; they buy near the top and sell near the bottom! You can find their burial ground adjacent to that of the pickers."

You're discouraged. Is this is what it's all about? Losing money left and right, getting decimated by choppy, unpredictable markets where nothing works? For many, the answer is yes. It's not for lack of trading tools, though. It's because they commit one or more of the cardinal errors of investing.

3 fatal errors

Error 1: Over trading

There are always traders who are too anxious to always do something and they do it with too many shares or contracts. To make profits, you must trade consistently in modest amounts so that you can always stay cool and unemotional about any particular trade.

Error 2: Being overly influenced by what you hear or see others doing

Even the most seasoned professionals can fall prey to this malady. It's only natural; humans are social animals. But to be successful, you must act independently, as a loner. If you listen to someone else, he may get you in at the right time, but will he be there to tell you when to get out?

We believe you should either make all of the trading decisions yourself or you should make none of them and employ a money manager with a good track record to do so for you. Don't get caught in the middle.

Error 3: Not having a simple set of procedures, or not following them

The indicators of technical analysis are the building blocks for you to build your system - trading rules that you can follow without ambiguity. Once you have such a system, try it out on paper for a few months. Then trade token amounts.

And finally, if it works to your satisfaction, shift into full gear. But do not arbitrarily, because of fear, greed or any other reason, break your own rules. By trading modestly, you can afford to stick with your system until it either proves itself or bombs out. If you change course midstream, however, you will never know for sure.

The 2 roads to success

Now to the two roads to success in the markets:

1. The spider strategy

The fact is that, although there are many small losers in the markets, there are also a small number of very large winners! You can pick tops and bottoms. But to do so successfully, you must follow what we call the spider strategy. The spider does not need to "feed" every day. He is content to wait until a morsel comes his way, patient and secure in the knowledge that he has taken the steps necessary for his survival.

His carefully crafted web transmits to him all sorts of information. But he knows how to identify the false signals - the wind vibrating his web, a drop of rain - from the real thing enmeshed in it. Why does he know it so intimately? Because he has carefully constructed his web himself.

No one else can build it for him. As a result, the configuration of his web is as uniquely his as his fingerprints. Most important, the spider is patient. He waits until he sees a convergence of most or all of his indicators before he acts; but when he does, he pounces aggressively and without hesitation.

If you follow this strategy, you will use, among others, those indicators which tell you when a market is "overbought" and vulnerable to a decline, or conversely when it is "oversold" and ripe for a move up. These are the so-called "oscillators" - the indicators that oscillate back and forth, like an electrocardiogram, from the top and the bottom of a predefined range.

One of the most common of these is momentum which measures and plots the net change from one period to the next. Imagine the pendulum on a grandfather clock, swinging from one extreme to another with a momentum that carries it as far as it can go in one direction - before reversing to the other direction. The same is true for markets.

2. The omnipresent approach

You can also make money trend-following. Here however you must employ what we call the omnipresent approach. In other words, you have to maintain small positions in many different markets at all times. You must be willing to go short any market that is trending down and buy any market that's trending up, not hesitating to reverse your positions when the market reverses.

You will absolutely need - at all times - a diversified portfolio. (Stocks alone cannot give you enough diversification, no matter how many different industries you're in!) Your portfolio should have at least one position in each major market sector - stocks, but also precious metals, bonds, commodities, etc.

Most important, in order to win with trend-following, you must be willing to accept a large number of relatively small losses in order to stay on board for a small number of very large gains. During choppy sideways periods, you must have enough money in the kitty to withstand erosion in your equity.

And during big moves, you need the courage to stay with your position until your trend-following system tells you to get out, no matter how anxious you may be to grab a profit. In this book you will find several methods for trend following, among which moving averages are probably the most common and easy to use.

Remember, although helter-skelter trend following is indeed hazardous; with a systematic and disciplined approach you will indeed make money using this approach. There will be ups and there will be downs. But as long as you steer clear of the three cardinal errors, you should wind up with substantial profits in most years.

(Excerpt from Timing the Market by Curtis M. Arnold, published by Vision Books.)

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