How I messed up an easy trade of Opexa Therapeutics Inc. (NASDAQ:OPXA)

In medicine they talk of “never events” or things that should never happen, such as leaving a surgical instrument inside a patient. Failing to buy OPXA on strong drug news today as it broke above its recent high of $2.85 was a “never event” for me … I messed up a trade with an almost perfect setup. It should have been an easy $1 per share trade from $2.88 to $3.88 or so. Learn from this so you don’t mess this up in the future.

opxa

By the way, it is still not too late to sign up for Tim Sykes’ Las Vegas Seminar on October 18th and 19th.

Daily profit: ($331.00)

Disclosure: No positions. I have a disclosure policy.

Top 8 reasons why you should attend Tim Sykes' 2-day seminar in Las Vegas on October 18th & 19th

1. Tim Sykes is the top-ranked trader on Covestor and he has been in the top spot for over a year.

2. The seminar is only $847 for two full days ($497 for one day). For getting access to Tim Sykes for two full days this is a very good price. For the price of the 2-day seminar you will also receive a complimentary copy of any of Tim’s DVDs (I recommend Pennystocking Part Deux, a $497 value). So in essence you are receiving two full days of small-group instruction for only $350. That means that you are essentially paying only $22 per hour of Tim Sykes time. Now that is a good price.

3. Attendees will receive a set of DVDs of footage of the entire conference (this only applies to those who who pay for both days of the seminar).

4. If you cannot attend, you can still see a live webcast of the conference! If you choose this option (only available for the full two-day seminar) you will receive all the goodies I mentioned above (free DVD set of your choice and DVDs of the entire conference). More info on the live webcast here.

5. He feeds you! As you can see in the photo below of me and Tim Sykes, there are plenty of tasty pastries and fruits for breakfast and the gourmet boxed lunches were also quite good.

seminar_1

6. The seminar is in Las Vegas! What can I say! It will be great to party it down with other pennystockers.

7. I attended last year’s one day conference and even though I had already purchased Tim Sykes’ DVD Pennystocking and I had been a TimAlerts subscriber for five months (having made over $40,000 in profits using Tim’s system during that time!) I still learned from the seminar. (Others who were less experienced learned even more.) Perhaps the most useful aspect for me was seeing Tim Sykes trade a stock during the seminar and seeing how he examined the trade, watched it, and decided to exit the trade. I also liked having the ability to ask him questions about how he thought of a stock’s price action as we were watching that stock during the trading day. I am sure this year’s conference will be even better because it will be twice as long and attendees will get to see how Tim does his research Sunday to find stocks to watch and see how he watches (and potentially trades) them the next day.

8. If six or more people sign up for Tim’s seminar using my affiliate link before September 11th, I will come to the seminar too and buy a round of drinks for everybody after the seminar is over [edit 9/11/2009 — I am definitely going now!].

Disclosure: I am an affilliate of Tim Sykes as well as a customer (although I did not become an affiliate of Sykes until after I had gained over $20,000 in trading profits using his system), having purchased multiple of his DVDs (I recommend Pennystocking Part Deux; it is by far the best) and being a Lifetime TimAlerts member. I own Pennystocking, Pennystocking 2, and TimRaw. I have a disclosure policy.

How to track your stock trades

I am a firm believer in tracking all your stock trades. In fact, you can see how all my trading strategies are performing by visiting my trading profits page. By tracking your trades according to which strategy you are using you can identify how profitable a strategy is and whether you should be using more or less money to trade it. Furthermore, tracking your trades will help you to avoid trades that are based on hunches and not on specific strategies, because it will quickly become clear how quickly you lose money on such trades.

Download below a version of the trade log spreadsheet I use. Use a separate sheet in the spreadsheet for each different trading strategy. Watch the video below if you need guidance in how to use the spreadsheet.

Excel 2000 trade log spreadsheet
Open Office trade log spreadsheet

[Edit 2013-12-3]: I created a new version that has separate columns for commissions because some people find this to be simpler (I just use formulas to include them in the trade price) and I saved this in the current Excel format. Download here.

[Edit 2015-3-24]: I finally uploaded a version to Google Docs and improved the formulas. Go to “File” > “Make a copy” to save a copy to your Google Docs so you can edit it.

Disclosure: No positions in any stocks shown in the spreadsheets or in the video.

The truth about Tim Sykes from a former critic

Is Timothy Sykes a fraud? The former trading wunderkind and small-time hedge fund manager now sells stock-trading DVDs and trading advice. Should you listen to him? Should you ignore him? Read on for the answer.

When I first came across Tim Sykes over a year ago I was skeptical. One year later, after $77,775.01 in profits using his trading strategies, I have turned from Sykes’ greatest critic to his most ardent fan. This is the story of how he changed my mind.

I first came across Sykes in March of 2008 and I wrote this critical post:

Timothy Sykes, the boy wonder who turned $12,000 into $1.65 million while still a teenager, has abandoned his hedge fund Cilantro to re-create his day-trading achievement in full view of the internet on his new blog. Sykes is best described as young, brash, egotistical, and annoying. Of course, an impartial observer would describe me in much the same way. Timmay and I also share the preference for shorting stocks over buying them. But rather than being two peas in a pod, we are polar opposites: Tim is the quintessential short-term trader and I am the archetypal buy-and-hold value investor.

I am not like some people who say that day trading is a crock and that it never works. It can work for some people some of the time. The problem with Tim Sykes is that he encourages others to follow in his footsteps by buying his happened to Richard Dennis, the noted commodities trader, who famously lost tens of millions of dollars in 1988 after his trend-following strategy stopped working. Sykes of course likes trading microcap stocks with relatively thin markets. This means that his system is especially prone to break when too many people start using it.

  • Trading takes a lot of time; this is particularly true for Timmay’s day trading and momentum trading. Most people have jobs, and very few people have enough in savings and enough trading talent to make a lot of money trading. So for most people, time learning to trade would be better spent nurturing their career or working a second job.
  • Trading any system takes incredible self-restraint and guts. Very few people have the self-control to be able to stick to a system even when it is not making money. This is even harder if a trader buys a system (say, from Tim Sykes), because it is harder to become truly convinced in the system if that trader did not invent it himself or herself.
  • Traders and investors should steer clear of Sykes’ DVD and his trading system. Those few who could be good traders would likely do better developing their own system rather than following Tim’s. Of course, I find Tim amusing, so I encourage you to read his blog for its amusement value.

    Sykes and I had a rather entertaining back and forth in the comments on that blog post. After that exchange, I decided to do some deep research. I went back over every single one of his blog posts. I looked up the stock charts on every stock he mentioned to see whether his predictions about stocks were accurate. I looked at every single one of his previous trades (all verified by Covestor, on which he is the #1 ranked trader; please note that Covestor does not account for cash in a trader’s account when it measures performance; so while according to Covestor Sykes is up 48,000% since November 2007, and he would be up this much if he invested 100% of his account in each trade, his account is up only 475%). I realized that Sykes’ trading system worked. He was right far more often than he was wrong. His trades were consistently profitable. I bought his Pennystocking DVD and his book and I subscribed to his TimAlerts trading alert service.

    I started trading using both by following his trading alerts and by trading on my own using what I learned from the DVD and book. Slowly, almost inexorably, the profits piled up. And it wasn’t just by piggybacking on his trades that I made money; when I traded stocks he did not trade I made even more money. As I write this, my total profit from TimAlerts is $28,093.77 while my total profit from doing similar trades on my own is $49,667.25.

    In September of 2008 I wrote  Why I paid Tim Sykes $2000:

    I previously wrote about Timothy Sykes and his attempts to teach stock trading to the masses. That post is now my most commented-upon post on this blog and one of the most frequently viewed. Since writing that post I have changed my views on Timothy Sykes.

    First, I have concluded that at least at the present time Sykes’ trading system works quite well. This does not mean that it will necessarily continue to work, and anyone using his system should not put blind faith in it. That being said, the basic premise of short-selling hyped-up stocks should continue to be successful far in the future, although the details of how best to do that will certainly change. I believe in Sykes’ system enough to trade a decent amount of money with it, and so far I have made quite a bit of money trading his system. You can see some of my successful trades on Covestor (note: I no longer use any brokerage accounts that Covestor can auto-follow, so my trades are no longer there).

    I have become so convinced of the benefits of Sykes system that I bought his DVD, subscribed to a year of his TimAlerts service (whereby he sends his followers alerts every time he makes a trade, and I even recently bought the first Lifetime TimAlerts subscription (for which I paid him $2,000). I even signed up to be an affiliate to sell his products.

    Normally a trading system will either produce a good probability of a profit (i.e., a high percentage of trades will be profitable) or a good ratio of average profit to average loss. Sykes’ system generates both a high percentage of profitable trades and profitable trades that make far more money than unprofitable trades lose. In this sense it is the Holy Grail of trading. The system’s major limitation is that it generates very few trading opportunities where more than a few thousand dollars can be easily deployed, although there are occasional trading opportunities where hundreds of thousands of dollars can be easily used. Also, there are relatively few trading opportunities. This limits the amount of money that can be made with this system to maybe a couple hundred thousand dollars a year at best. However, this limitation of the system also minimizes the chances that hedge funds will exploit the same inefficiencies that the trading system exploits and thus render the system ineffective.

    The other problem with a trading system that produces few trading signals is that it is hard to keep from over-trading. The hardest thing to do is sit and wait, as evidenced by Sykes’ own history of impulsive, forced trades. While he was still able to reap huge profits, others may be less disciplined. I have already seen evidence of followers of Sykes’ TimAlerts service trading way too much (and Sykes himself has criticized his followers for this numerous times). I think it likely that some of them will trade away all their profits by forcing trades when the risk/reward ratio is poor.

    My Original Criticisms Still Stand

    In my original article on Timothy Sykes, I laid out three criticisms of his plan to teach trading to the masses. These criticisms still stand, although these criticisms point out the limits of an otherwise powerful system, rather than revealing the ineffectiveness of the system as I argued in my original article. Anyone considering following Sykes should consider the following:

    1. While Sykes’ system will degrade gracefully (meaning that if it stops working it will gradually generate smaller profits, not change quickly from generating profits to generating large losses), I have already noticed cases where he and his followers’ actions have changed the chart patterns his analysis relies upon. He has enough TimAlerts subscribers that they can easily move the market in certain illiquid stocks. This makes using his system more dangerous than if he did not have so many followers.

    2. Trading takes time. For many of Tim’s followers, with tiny $5,000 accounts, the amount of time they spend trading the system (especially if they do not follow his advice and ignore non-ideal trades) can be disproportionate to their gains. While I am a full-time trader (I utilize a few strategies, not just Sykes’ strategy), many of his followers have other, full-time jobs. Those people would be wise to concentrate only on the most ideal trades, lest they ruin their careers in a vain attempt to get rich trading.

    3. Most people do not have the emotional restraint to be successful traders, no matter how simple and effective the trading system they use. This is my most important criticism. As even Timothy Sykes points out, over 95% of stock traders lose money. Those who cannot handle the emotional demands of trading will likely lose money even if they try to trade a system as simple and profitable as Timothy Sykes’ trading system.

    Conclusion

    If you want to try trading stocks, try following Tim Sykes’ system (I suggest just reading his website and analyzing his trades for a few months, although you can go ahead and directly buy his DVD or TimAlerts trade alerts service if you are rash); it is the best stock-trading system I have seen, as evidenced by Sykes’ top rating on Covestor and his multi-year performance record. However, most stock traders will lose money because they let their emotions rule them; using a profitable system will not prevent them from losing money. Recognize your limits and do not try to trade if you do not have the requisite emotional control.

    Conclusions about Tim Sykes

    Tim Sykes’ trading system works. He is selling the real thing, not a scam (unlike most other trading gurus). Trading based on his TimAlerts service has given me more than ample profits. Trading based on what I learned from his DVDs (I recommend Pennystocking 2, it is by far his best DVD) has been even more profitable. He is one of the few stock traders selling their trading systems who has an impressive and verifiable record. Furthermore, he is honest about the limitations of his trading system: it is not scalable. It would be hard to put more than $100,000 into many of Sykes’ trades and the best percentage returns often come in illiquid stocks where a $10,000 position would be the prudent maximum. But this Achilles’ heel of Sykes’ trading system is also a key feature, because it ensures that hedge funds and other sophisticated investors will not come to dominate this niche.

    sykesprofit_med

    Disclosure: No Positions. I am an affilliate of Tim Sykes as well as a customer (although I did not become an affiliate of Sykes until after I had gained over $20,000 in trading profits using his system), having purchased multiple of his DVDs (I recommend Pennystocking Part Deux; it is by far the best) and being a Lifetime TimAlerts member. I own Pennystocking, Pennystocking 2, and TimRaw. I have a disclosure policy.


    Profit from Penny Stocks. Learn from a millionaire who shares everything! Learn from Timothy Sykes.

    August 10th trading recap: 3 wins, 1 loss, +$80

    SPDE was a nice short on the morning panic. It would have been easy to play it profitably for 40 cents as it went red, just like I said on yesterday’s watchlist. OPXA did almost nothing. Rather than trade SPDE, I saw Rentech (RTK) up big in pre-market trading on a great earnings release. It hit a high in pre-market trading of $1 and then opened around $0.88. Buying it was a good idea:

    + BOT 2,000 RTK false Stock .910 USD SMART 09:30:46 9.10
    + SLD 2,000 RTK false Stock 1.000 USD SMART 09:37:31 10.00
    +$160 (8.74%)

    Pre-leaders that have strong news but open significantly below their highs in pre-market trading are often great longs. Another good trigger for going long pre-leaders (or any volatile stock) is when it crosses an even-dollar amount.

    BOT 1,000 YMI false Stock 1.03 USD ARCA 09:33:35 5.00
    SLD 1,000 YMI false Stock 1.10 USD AMEX 09:40:35 5.00
    +$60 (5.80%)

    YMI was another pre-leader with news (drug news that was not that great in my opinion). I bought it as it crossed $1 (when it was alerted by Muddy in the Investors Underground chat) and I sold it after it backed off of its high of $1.20.

    My lone loss of the day was a TimAlerts scalp play that I should never have traded. It was my watchlist stock SPDE that he shorted, but by the time I got the alert it was way off the price he traded it. Some may ask why I scalp stocks that Sykes trades. I do it because it is easy money (as long as I am quicker than most of his subscribers). Rarely does one come across a situation where one can predict exactly when a bunch of buying or selling pressure will occur. It is imperative to derive profit from such circumstances. This does not mean that I do not also often trade alongside Sykes on his alerts: I do. It just means that this is one other little niche for me to profit from. (For those searching for easy profits from mindlessly following Sykes’ trades, be aware that I have made almost twice as much money by making trades in the style of Tim Sykes than by following the trades of Tim Sykes.)

    + SLD 2,000 SPDE false Stock (SCM) 2.630 USD DRCTEDGE 09:41:03 10.00
    + BOT 2,000 SPDE false Stock (SCM) 2.743 USD ISLAND 09:48:00 10.00
    ($246.00) (4.69%)

    My last trade of the day was a traditional Tim Sykes-type trade. I bought a steady runner that was finishing the day strongly, in anticipation of a gap up tomorrow. That stock was of course RTK; I sold it in after-hours trading while dealing with my website troubles. If I had not had to work on my blog I would not have followed it after hours and I would have planned to sell the next morning.

    + BOT 1,000 RTK false Stock 1.270 USD SMART 15:47:57 5.00
    SLD 500 RTK false Stock 1.3900 USD DRCTEDGE 17:52:13 BookTrader 2.50
    + SLD 500 RTK false Stock 1.382 USD DRCTEDGE 17:52:15 BookTrader 2.50
    +$106.08 (8.32%)

    Today’s profit: $80.98

    Disclosure: No positions. I have a disclosure policy.

    How to scan for pre-market gainers with Interactive Brokers

    I often talk about pre-leaders or pre-market gainers. These are stocks that are up in pre-market trading. They often make for good trades. This video shows how to scan for them yourself. As to trading them, I will write about that in the future; I suggest checking out Muddy’s post about pre-leaders in the meantime.

    Disclosure: No positions. I have a disclosure policy.

    How I missed an easy $8,000 on Georgia Gulf Corp. (NYSE:GGC)

    GGC an easy short once it went negative on the day. It was quick, but a smart trader would have nailed it for $4 per share in under 20 minutes. Unfortunately, despite anticipating this and having my 2000 share short order ready at SogoElite (which had shares of GGC to short), I completely missed the trade.

    See the video:

    Short 2100 GGC  @ 31.062 (at SogoElite)
    Cover 2100 GGC @ 30.977
    +$177.24

    Other trades for the day:

    SLD    200    WUHN    false    Stock (SCM)    4.00    USD    ISLAND    09:31:17        1.00
    SLD    200    WUHN    false    Stock (SCM)    4.00    USD    ISLAND    09:31:22        1.00
    SLD    200    WUHN    false    Stock (SCM)    4.00    USD    ISLAND    09:31:29        1.00
    BOT    600    WUHN    false    Stock (SCM)    3.84    USD    ISE    11:06:20        3.00
    +$90

    +    SLD    2,050    SCLN    false    Stock (NMS)    4.200    USD    ARCA    09:39:12        10.25
    +    BOT    2,050    SCLN    false    Stock (NMS)    4.170    USD    ARCA    09:40:08        10.25
    +$40.50

    Short 1300 WUHN @ 3.798 (at SogoElite)
    Cover 1300 WUHN @ 3.585
    +$277.28

    +    SLD    6,000    CHINA    false    Stock (NMS)    2.792    USD    SMART    15:41:25        30.00
    +    SLD    6,000    CHINA    false    Stock (NMS)    2.780    USD    SMART    15:41:28        30.00
    +    BOT    6,000    CHINA    false    Stock (NMS)    2.763    USD    SMART    15:42:58        30.00
    +    BOT    6,000    CHINA    false    Stock (NMS)    2.770    USD    SMART    15:43:30        30.00
    +$118.30

    Today’s profit: $703.82

    Disclosure: No positions. I have a disclosure policy.

    So you want to be a stock trader? Finding a trading system & dealing with emotion (Part two of many)

    This article will address the emotional requirements, discipline, and risk controls necessary to be successful at trading. I will then address how to find a trading strategy that works. This is the second article in a series. I suggest reading the first article (on the extreme difficulty of trading profitably).

    Types of Trading

    There are a few different types of trading (as opposed to investing) that distinguish traders. My definitions are not going to be the same as others’ definitions, and I will make some broad generalizations that are not always true–keep that in mind. There is daytrading (rapid trading intra-day, usually not holding positions overnight), swing trading (buying stocks based on longer-term charts and news), and fundamental speculation. Day-trading can be subdivided into scalping (going for small 10 cent stock moves), trend following, and dip buying (counter-trend trading). Day traders typically do not trade on news (although they may adjust stop losses or profit targets if there is particularly good / bad news). Day traders do not care about fundamentals; all they care about is a stock’s price movement. I do a decent amount of day-trading. Swing trading, on the other hand, is a longer-term trading style. The classic example is Bill O’Neil’s CANSLIM system. Most swing traders I know like to hold stocks for a few weeks or months at the longest. They often use a combination of fundamental and technical analysis. I have never swing-traded. The last kind of trading I will address is fundamental speculation. This involves taking a directional bet on some security for some fundamental reason. My profitable short sale of Silver State Bancorp from $2.00 to $0.09 (in bankruptcy) was a fundamental speculation.

    There are other types of trading but they are not particularly relevant or they fall within one of the above classifications. Most fake arbitrage (merger arbitrage, pairs trading, statistical arbitrage, and anything else called arbitrage that involves risk) is simply a type of fundamental speculation.

    Disclipline is the Key

    No matter what kind of trading you are trying to do, you need to be disciplined. Ego, greed, fear, and any other emotions only get in the way. When a trader is undisciplined or trades based on emotion, he will make costly errors and lose money. In the book of Chuang-tzu there is a story about a discussion the philosopher had with a student. Master Chuang stated that a man who could not swim would make a poor fisherman, a man who could swim would make a decent fisherman, and a man who is as much at home in the water as on land would be an excellent fisherman.  That last man would be free to concentrate on fishing because he would have neither fear nor excitement at the prospect of being out on the lake.  So it is with trading: the best traders are emotionally detached from trading and the prospect of winning or losing large sums of money.  This emotional detachment allows them to focus solely on carrying out their trading plan. It may sound odd, but I have gotten very excited about a small $100 gain (because I had made a perfect trade albeit using little capital) and I have become despondent after a $6000 gain (because I had failed to implement my trading strategy correctly, missing out on far larger profits on what was a perfect trade setup).

    Anything that will prevent a trader from being detached, calm, and focused will lead almost certainly to losses.  Stress in other aspects of a trader’s life will distract a trader and likely cause losses.  Outside stressors that cause a trader to focus on money are the worst.  Whether it is a need to make money to impress a girlfriend, sustain a lavish lifestyle, or provide for the family, the need for money will cause the trader to lose focus and will almost certainly lead to losses.

    Discipline Requires A Plan

    Dictionary.com defines discipline in the following ways:

    1.     training to act in accordance with rules; drill: military discipline.
    2.     activity, exercise, or a regimen that develops or improves a skill; training: A daily stint at the typewriter is excellent discipline for a writer.

    The first definition perfectly captures what discipline should mean for a neophyte.  Discipline means sticking to rules.  That is why chess students study famous games and strategies and first learn to implement classic strategies whole cloth before trying to mix and match bits of different strategies.  Likewise young doctors learn to follow a clear diagnostic protocol when diagnosing a disease.  Only with much practice will a doctor, chess player, or trader reach a level of knowledge and skill that they do not have to consciously implement a set of rules.

    How Not to Trade

    In my previous article I discussed several trading strategies that I believe to be very poor.  Simply put, any trading strategy that relies upon the trader implementing that strategy being smarter, better, or faster than other traders is a poor strategy.  When analyzing potential trading strategies, the key is to identify niches that besides offering opportunity for profit, exist for some reason, will likely continue to exist for some time, and do not suffer from a lot of competition from other (potentially better) traders.

    A great example of a trading strategy that does not meet any of the above criteria is trying to swing-trade the stock market.  There is little evidence that any one can predict where the stock market will go in the next week, month, or year. The CXO Advisory Group has a good analysis of various stock market commentators, none of whom show any evidence of being able to reliably predict the direction of the market. The best among them was accurate only 63% of the time, while the group average was 48%. Mark Hulbert, who tracks many stock-investing newsletters, agrees that market-timing does not work (this is compounded by market timing becoming more popular during market lows and less popular at market highs). If predicting the market were possible, there would be a lot more smart traders (such as hedge funds) that time the market. Instead, the traders who try hardest to time the market are small retail traders (suckers). (I should add that I believe that sometimes it is possible to beat the market by making fundamental calls, such as betting that housing was going to cause a recession, but past experience shows that the people who bet correctly on the current market downturn have no more ability than you or I to predict where the stock market will be in a year. John Paulson, for example, has been sitting on his bearish bets on mortgages for a couple years.)

    Now, for an example of a trading strategy that works and that meets all the above criteria.  This is my strategy for arbitraging the differences in value between Berkshire Hathaway share classes.  While this has made me money, it is niche trading strategy; the strategy produces bond-like returns, requires that I pay close attention at all times, requires a minimum of $200,000 to trade, and cannot be scaled up past maybe a few million dollars because the shares are relatively illiquid.  The problems with this strategy preclude all of the following types of traders from competing with me in this niche: hedge funds, part time traders, traders with little capital, and traders who have enough capital and time but use their capital all of the time for other trades.  In essence, the very problems with this strategy are its strengths for me–its problems keep other traders away, meaning that I will likely be able to continue profitably trading this strategy far into the future. (Disclosure: I am currently short BRK-A and long BRK-B.)

    The Characteristics of a Good Trading System

    Most people believe that the only thing that matters about the trading system is how profitable it is.  This is incorrect.  There are many different aspects of trading systems to which a trader must pay attention.  Profitability per se is actually not one of them.  Instead, profitability is best thought of subdivided into its component parts: percentage of winning trades vs. losing trades and the average profit per winning trade / loss per losing trade.  Many good trading systems will produce about the same number of winning and losing trades, but they produce much greater profits on winning trades than losses on losing trades.  It is a rare trading system indeed that produces both a large percentage of winning trades and significantly larger profits on winning trades than losses on losing trades.

    Besides these measures of profitability, there are many other important aspects of trading systems.  The frequency of trading opportunities is one of the more important; the trading system that produces three trade opportunities per week will be three times as profitable as the system that produces only one trade opportunity per week.  Conversely, anything that makes the trading system more profitable can be tweaked to make it that much less risky instead.  So if a trading system produces many trades, the trader can devote less capital to each trade, reducing the probability of losing large sums of money on any one trade.  Another benefit to a trading system that produces many trades is that allows for quicker evaluation of a system and higher statistical certainty that a trading system actually works (given equivalent profitability profiles, we can be more statistically sure that the trading strategy with thousands of trades is not due to chance than we can of the trading strategy with just 50 trades).

    Another important facet of a trading system is its scalability.  It is a lot easier to devise a trading strategy that generates 100% annual profits with $100,000 in capital than it is to generate such profits with $10,000,000 in trading capital.  If you’re reading this article, you are likely not a hedge fund manager with over $50,000,000 or $10,000,000,000 in capital.  You should use your size to your advantage by pursuing non-scalable strategies.  Pursuing non-scalable strategies also guarantees that you will not be competing against the best and brightest traders.  A good example of this is my recent arbitrage trade in KV Therapeutics stock.  Over the last week, my trading was over 2% of the trading volume in KV B shares (KV-B); on the days I actually traded the stock, my trades accounted for up to 10% of the volume!  A hedge fund with even $50,000,000 (tiny for a hedge fund) that does the same type of arbitrage trading I do would not be able to build up a meaningful position in such an illiquid stock, forcing it to trade other pairs of securities that offer much less profit potential.

    How to Find or Design a Trading System

    There are many different ways to trade stocks profitably.  These do not generally include common trading systems that you find advertised everywhere.  There are multiple problems with these systems.  The main problem is that there is no way to know if these trading systems work.  I have not heard of one trading guru whose returns are not only audited but also can display the great audited returns of a random sample of their followers.  The only trading guru of whom I am aware that has great audited returns is Timothy Sykes (who has plenty of educational materials to sell you).  He has the website Covestor.com tap into his brokerage account automatically to verify all his trades.  So at the very least you know that the trades he has been reporting are trades that he has actually made. If you run into any trading guru selling some system, ask them why they don’t use Covestor (it is free) or have a well-known auditor audit their trades. The evasive answers will likely be amusing.

    So with anyone selling a trading system (or with just random trading bloggers) it is impossible to know if they are telling the truth or not.  There was actually a recent case where a trader I am acquainted with exposed a  generally respected trader/blogger who had blatantly lied about a trade he said that he made.  While that blogger was not selling anything, I am sure people have lost money following his free advice. If there is not a reputable source that has verified the trades of a trading guru or system, I would recommend following trades in real time (for a long period, such as a few months) to see if a system actually works before committing money to trading the system or paying the guru.

    Other than fraud, the main problem with using someone else’s trading system is that it is easy to mess it up.  In any probabilistic endeavor, whether shooting a basketball or trading stocks, there will be long streaks of hits and misses.  If a person is shooting a basketball and knows that on average he hits 60% of his shots, he will not give up in disgust and quit basketball when he misses seven shots in row (which should happen by chance alone 0.16% of the time, although much more frequently in games due to variation in a defender’s skills).  (I should also point out that there is no statistical evidence that such a thing as a hot hand exists in basketball; people simply misinterpret the chance occurrence of a long string of good shots; the same is probably true for stock traders).  If a person is confident in a trading system that she has developed (or that she has rigorously tested and understands) and is confident that the trading system will continue to work, she will not abandon it.  A trader who uses another person’s trading system without fully understanding it and testing it will be prone to abandoning it when by chance alone the system produces a string of losses.

    Another important caveat for those who would consider purchasing a trading system from some guru is that the best trading systems will never be sold.  Take me, for example: I use four main trading systems; my most profitable trading system I will never disclose to anyone (unless they wish to pay me $500,000 right now) because I can make far more money trading that system than by selling it.  On the other hand, I’m perfectly willing to discuss my other trading systems because they are far more limited (as I have done above with my share class arbitrage trading strategy).

    Designing Your Own Trading System

    By now it should be obvious that I believe it is much better for a new stock trader to design her own trading system, or at least plan on adapting an existing trading system to her own personality and style.  If you are interested in designing swing-trading systems based partly on technicals and fundamentals, I would recommend Portfolio123.com.  I successfully used Portfolio123 to design trading systems that have helped my IRA outperform the stock market by 20 percentage points over the last 18 months (when I stopped using Portfolio123 last July and switched my IRA to other stocks I was outperforming by 40 percentage points!).  If you are interested in purely technical trading, I recommend Stockfetcher.com. I use Stockfetcher to
    scan for my day-trading stocks.  As far as books go, I think most trading books are utter crap; I recommend James Altucher’s “Trade Like a Hedge Fund“. It encourages the right kind of critical thinking in designing a trading system.

    One last note: as far as technical analysis goes, 99% of it is crap. I only use the simplest kinds, all of which I can justify by understanding the psychology of traders. No happy prime Fibonacci retracement levels for me!

    Note: I have not yet published a followup to this article, although I will eventually.

    Disclosure: Short BRK-A and long BRK-B. This article was originally posted on my investing blog on 2/7/2009. I have paid Tim Sykes money, have successfully used his system, and am an affiliate of his. See my disclosure policy for details.

    So you want to be a stock trader? (Part one of many)

    I am a professional stock trader. I sit in my home office all day and look at numbers on my computer screen clicking here and there. For some reason, people believe that stock trading is sexy, fun, or a worthwhile hobby. It is not. It is perhaps one of the most difficult pursuits available because it is a zero-sum game. For every winner there is a loser. Whereas if you are a hand surgeon or a statistician or a synthetic organic chemist or an entrepreneur you can make money just by being good at what you do, if you are a stock trader you make money only if you are better than the traders that take the opposite side of your trades. In other words, the second best entrepreneur might become a billionaire. The second best trader will lose money. If you are interested in trading stocks I will give you some pointers, but first I will explain why most of you should not trade stocks.

    Types of Games

    Negative-Sum Games

    In game theory, there are three basic types of games. There are negative-sum games, in which everyone who plays loses (and the outcome determines only the extent of the loss). The classic example of this is global thermonuclear war (if you have not seen the movie War Games, see it). In any conceivable global nuclear war every side incurs massive loss of life and infrastructure. The unrealistic best-case scenario for a country might involve losing 2/3 of its population and having 50% of its land mass rendered uninhabitable. A more realistic ‘victory’ scenario would involve 95% loss of life and 90% of a country’s land mass rendered uninhabitable. Clearly no one would wish to play such a game.

    Yet, another example of a negative-sum game is mutual funds (and particularly the largest funds). On the whole, they make up so much of the market that they cannot realistically outperform the market. And after expenses, they are guaranteed to underperform the market. So on average, mutual fund investors would be better off if they all invested in low-cost index funds. This is exactly the point of Warren Buffett’s Gotrocks parable in his letter to shareholders (excerpted here).

    Okay, you say, you think other people should use index funds, but you are smart enough to pick good fund managers. Oh really? But what if the probability of any one fund outperforming is not better than random chance (and that is before fees)? Oh, and those “growth fund managers” that outperform their benchmark? That is only because there is such dreck in their benchmark (like American Superconductor or Ener1 at the moment), stuff that is so odious it is easy to avoid. But growth benchmarks on the whole underperform the broad stock market, meaning that even if growth fund managers can reliably beat their benchmark, they will underperform the broad market (as measured by the Dow Jones Wilshire 5000 or a similar index).

    I could go on, but this article is not focused on mutual funds. I just wanted to illustrate the concept of negative-sum games in finance.

    Positive-Sum Games

    The opposite of course is a positive sum game, where each player expects to win, although the degree of winning may differ. Spin the bottle is of course an example of this type of game. Any cooperative game (the type I hate playing, which is why I cannot think of more examples) would qualify as a positive-sum game.

    The stock and bond markets are positive-sum games for long-term investors, because the expected return from stocks and bonds is positive. So in picking stocks, on average everyone makes money. Some people will lose money because they invest emotionally or stupidly and are not diversified, but on average stocks and bonds provide a certain positive return. That return on the whole (for stocks) comes from economic growth (ultimately driven by population growth and productivity growth) and dividends.

    Zero-Sum Games

    Zero-sum games are of course the most common when we think about games. Some common games include chess, checkers, and betting on football games (although that becomes a negative-sum game if you place it with a bookie, because the house takes a cut). Stock trading is also a zero-sum game. When you are literally day-trading stocks (buying them), holding nothing overnight, your expected market return will be about zero, because your transaction costs will nullify the tiny expected daily gain of the stock market. Looked at another way, the market return on such a short timescale is irrelevant; all that matters is whether you can outsmart another trader who takes the opposite side of your trade.

    Even if you buy and hold stocks as an investor, you are betting that the stocks you buy will beat the market. In that sense, you are playing a zero-sum game (trying to beat the market) with professionals who are a lot better and smarter than you. Why would you play that game?

    A Million Grand Masters

    Do you play chess? Would you imagine that by studying chess for a few hours a week you could become a master, let alone a grandmaster? Would you then believe that you could go up against Garry Kasparov? Studies of experts in various fields have generally shown that to reach an elite level of performance (whether playing a musical instrument or chess or catching a football) takes something on the order of 10,000 hours of practice. That is three hours a day for ten years. Worse, those who achieve that elite level of performance start when they are very young, when their capacity to learn is much greater.

    You surely would not attempt to take on Garry Kasparov if you were but a lowly chess master, let alone a dilettante who cannot beat a simple computer chess game. Yet many people, knowing little about analyzing companies, think that a few hours and a couple books prepares them to beat professional investors who spend 60 hours a week on investing or trading.

    It is not necessary for the stock market to be efficient for amateur investors or traders to have very low odds of succeeding. It is only necessary that there be professionals who can profit off of the idiocy of the amateurs.

    The Impossibility of Mastering Multiple Skills

    If you spend 40 to 50 hours a week at your day job and a significant amount of time with your family and friends, then you do not have enough time to master another skill. I am a great example of this–when I first started to learn about investing and trading while in graduate school I devoted more and more time to learning investing, such that by the time I decided to leave school my advisor was unsurprised, because I had not been a very productive or good graduate student. Mastering one subject left me little time to master another. Even a man much smarter than myself, the famous cognitive psychologist Richard Shiffrin, experienced the same problem. In graduate school he started playing the game Go and eventually reached the level of 6 dan, perhaps roughly equivalent to a chess master; yet he realized that he had to quit either Go or psychology if he wanted to master one. Thankfully, he chose psychology. You are probably not smarter and more dedicated than Rich or myself, so don’t believe you can master a skill without devoting absurd amounts of time to it.

    While stock trading is not as difficult as Go, it requires a lot of time to study patterns and learn what does and does not work. Most dilettants do not have the time or focus required to do it right.

    Most Traders Lose Money

    Most stock traders lose money. For day traders in Taiwan, the figure is 80% over any 6-month period. The figures are probably similar in the USA (one study finds that 20% of US daytraders make decent amounts of money). Many of those are just lucky or trade using a strategy that ceases to work; they do not continue to make profits over a period of months and years. Keep in mind that studies like these greatly overestimate the probability of a trader making money because they focus on those who trade the most; by using that there is a selection bias: traders who make money will trade more; those that lose money will tend to quit. If you could survey all the people who have tried daytrading, even just briefly, I am sure that fewer than 1% make any money while many lose large sums.

    Okay, I Warned You

    If you still wish to learn about trading, read on. Hopefully I have scared you enough so that you will not try it. In the followup article to this I will address different trading methodologies and strategies.

    Okay, I’m Warning You Again

    If you want to stand a chance at making money trading, here are a few suggestions of things not to trade: Apple (AAPL), GE (GE), Amazon.com (AMZN), and any other well-followed large-cap stock (or index or ETF). The big hedge funds have programs and experienced traders that trade these stocks based on thousands of statistical factors, news, and many other things I cannot even imagine. There is no point in trying to trade these. You have no edge whatsoever.

    Another bad idea is to trade based on news or rumors. The hedge funds and iBanks hear the rumors first, so you won’t stand a chance (I’ve ignored that one a few times). The same thing goes for news as for rumor–the big traders hear it first. And with news they have programs to read the press releases and SEC filings and instantly make trades (that is what happened when a years-old report of United Airlines’ bankruptcy mistakenly hit the wires back in September: program trading sent the stock down 50% in minutes). If you trade solely based on what you do know (price momentum), you can make money, but you will be trading blind. This is what some traders I know did with UAUA and what I did with Constellation Energy (CEG) when there were rumors that it would go bankrupt. If you do this you are at a huge disadvantage.

    If you do wish to trade stocks, the key is to have an edge. Whenever you want to do something, whether investing in a random stock or trying a quick day-trade, ask yourself: “What are the risks?” and also ask yourself, “Why aren’t other smart investors / traders / hedge funds doing this trade and taking this opportunity away from me?” You will quickly realize that most “trading ideas” have no value and that you almost never have an edge.

    I recommend reading the next post in this series on emotion and developing a trading system.

    Disclosure: No positions in any stock mentioned. This article was originally posted on my investing blog on 2/2/2009. I have a disclosure policy.

    How the NYSE and SEC abet stock fraud by limiting short selling of penny stocks

    This is a classic trading post from my investing blog, GoodeValue.com.

    I’ve been going over Regulation T (Reg T; you can see it in its full glory here), which is the SEC rule that governs margin loans, as well as the NYSE margin rules for margin accounts. And if I were designing regulations to increase stock fraud, I could think of no better way to do it.

    Why is this? The margin requirements for short selling stocks are greater than for buying stocks, at least for cheap stocks (below $2.50 in value). Here is how it works for stocks above $5. You will note the nice symmetry between short and long margin requirements. While the margin requirement for buying stocks is 50%, the requirement for short-selling stocks is 150%. Here’s an example: if I buy a stock for $10 per share (let’s say 100 shares), I only need to put up $500, or half the total value of the stock. If I want to sell the same stock short, I need to put up $500 (plus the $1000 in proceeds from the sale of the borrowed stock). So there is symmetry between short and long margin requirements. (Investopedia has an in-depth explanation of this). If the price of a stock is below $5, there is no margin allowed on either long or short sales. So if I want to buy 100 shares of a stock at $3, I must have $300 in cash (or margin from a higher-priced stock). If I want to short sell the same stock I would likewise need the same amount of cash or margin available.

    The symmetry between long and short breaks down, however, with stocks under $2.50 per share. The NYSE has a rule (rule 431 (c) 2) that requires $2.50 in cash or margin for every stock below $2.50 per share sold short. A comparable rule does not exist for long positions. So if I want to buy 1000 shares of a penny stock trading at $0.40, I need $400 in cash or margin ability from marginable stocks. But if I want to short 1000 shares of a $0.40 stock I need $2,500 in cash or margin. So any time someone shorts a stock under $2.50, they have negative leverage: the position value ($400) is but a fraction of the money needed to hold the position ($2,500). For this reason, very few short sellers sell short cheap stocks. Fraudulent companies or worthless shell companies trade at absurd valuations because their share prices are too low to attract short sellers.

    Most of the financial fraud in public companies nowadays is with penny stocks. The reason is because short sellers cannot afford to sell short cheap stocks. If the NYSE $2.50 rule were eliminated, more short sellers would be willing to take short positions in overvalued penny stocks. Pump and dump scams would not be as effective because short sellers like myself would easily be able to short sell the pumped-up stocks earlier, at cheaper prices, reducing the harm to the poor rubes who fall for such scams.

    Removing the $2.50 rule would increase the amount of information available about penny stocks as short sellers like myself would write critically about the overvalued stocks they sold short. This would give the poor rubes a chance to learn the truth about the worthless stock they were considering buying and this would further reduce the success of pump and dump scams.

    Please, contact the NYSE and urge them to stop supporting scammers and fraudsters. Urge them to remove the $2.50 requirement.

    Disclosure: I love short-selling penny stocks.