Anatomy of a Spiraling Trader (Part 2) – The Serial Rebounder

In my post a couple of weeks back, "Anatomy of a Spiraling Trader (Part 1) – Trader's Narcosis," we talked about how a trader who puts himself in a downward spiral gets a type of narcosis similar do that of wreck divers. In that narcosis, he makes more and more risky decisions and exhibits less and less logical behavior, weakens his stance in the market as time goes by. We said this is because a trader has gotten to this point because he has linked his ego to his trading, and therefore, he now subconsciously associates being successful at trading with survival, the primary business of successful wreck diving.

Steps 3-4 of the trader's narcosis are really the lynchpin of the downward spiral as you, the trader in a spiral, repeat the same negative behavior at an always accelerating pace. I wanted to go more into depth about what is really happening here. What, specifically, drives these ever sloppier choices that the trader is making? As I looked back into my past, what resonated clearly was the analogy of my rebound relationships, so I went out to Yahoo! and searched "rebound relationships." I hit the jackpot on the first selected link (http://www.romanceforeveryone.com/article/rebound-relationships.html ). This is the thought process in the mirror.

You – Making the Pain Go Away

Now prerequisite to anything I say here is the first choice you have made, which is to change your trading style. You wouldn't be in a spiral if you didn't. We can always make tweaks here and there, and in a future post, I will talk about healthy ways to do that. After all, the point of trading is to stay fairly consistent, but to put on concrete boots and be completely immobile as a result is not healthy. We want to leave some leeway to make healthy choices. The decision you have come to do something—anything—to make the pain go away is the result of a battered ego or self-esteem. Your ego is hurting, and you need to feel better about yourself.

Get a load of this, quoting from the website on rebound relationships:

"A rebound relationship is often a distraction from the pain of their sorrow and a quick fix for their damaged self-esteem."

"Their mind is often filled with questions of why their relationship failed and what they could have done to stop the breakup. They may also feel that precious time was wasted on the failed relationship and feel the need to quickly move on with their life."

So here you are. Let's just say that many of us have no idea how much emphasis we are putting on our trading success as a mechanism for validation. Your self-worth becomes increasingly based on one thing only—your success as a trader. So when you have a very bad experience as a trader, you look for that "quick fix," especially because you feel that "precious time [and money] was wasted" and wonder "what [you] could have done to stop" this great loss. So what do you do?

Little do you know that you will look for the thing that is absolutely working right now at the expense of all well-thought-out long-term logic. You are "angry at your ex" (the market) for "breaking [your] heart" (bruising your sense of self-worth), and you are going to teach it a lesson. The difference here is that the market can't reject you. You can go right back to that same market at any moment, and it will receive you with open arms. So in a way, it's worse than the perilous rebound relationship!

So you start looking for trades that "have a nice smile," or in other words, that are in a nice trend, look like a sure thing, and will erase all the pain, suffering, and losses you just experienced. You start dating the rebound stocks or options, or whatever seems to have the nicest smile. This new trade is "initially . . . very satisfying," since trends aren't just going to immediately reverse because you entered a trade. However, you are on the rebound and are "not in a healthy state of mind." You are not in a "place to make healthy . . . decisions." "[You] are thinking about the moment, not the long term," which causes you to make a "poor choice" for a rebound trade.

You know, I'm actually getting sick of quoting this thing. I mean I'm realizing that if I cut and pasted the article and did a search/replace on a few words, I'd have a better post than I probably have here. So let's shift gears about the choices you actually are prone to make here.

You – The Mean Reverter

Nature is all about equilibrium. We know this. The laws of nature always go to the norm. We have global warming and ice ages, but the average temperature over time stays the same. Species die out every day and others are created. Water evaporates, and then it rains. I could go on and on.

You, the trader and fellow human, are also are a creature of equilibrium, as are the markets, since they were created by beings of nature. Let's take you first. Above, we said that you when you are in extreme pain, you are going to reach for something of extreme comfort—that is, the trade that is working right now. However, the markets revert to the mean over time as well. This means two things:

• If you were experiencing so much pain that you had to change a hard-and-fast trading philosophy to make yourself feel better, then there is probably a not-so-small probability the trade you left was soon going to shift from a position of extreme pain to at least a position of less pain.
  
• The trade you switch to has probably been working for a while and is soon going to reverse trend to start causing acute pain.
  

So you are moving from a spot that likely would improve to one that is prone to start deteriorating! And what could be worse than that? You will repeat this over and over. Leaving the trade that is causing you pain and could soon reverse to one that has been making people feel better and will soon reverse.

In the end, the interworking between the market's mean reversion and your own, while timed about the same, are directionally opposed, and are creating a situation where you make choices that are exactly diametrically opposite to what would make you successful over time. And so what do you do? Well, going back to the diving analogy, you can't stand to be down in these threatening depths anymore. You fill your wings and blast to the surface, withdrawing completely from the market to heal, vulnerable for your next rebound move.

So what's the remedy? Well, half of the cure is recognizing the pattern. So hopefully if you are in a real bad spot right now or occasionally get into them and get into these spiral-spiral-exit patterns frequently, you will be able to begin recognizing this and thwart entry into the spiral process. I will present a structured way to recover from this and ensure that it never happens again in future posts.

Thank you so much for reading. I very much hope this helps.

All opinions expressed by the Author are solely his current opinions and do not reflect the opinions of the companies with which the Author is affiliated and may have been previously disseminated by him.  The author's opinions are based upon information he considers reliable, but the companies with which he is affiliated do not warrant its completeness or accuracy, and it should not be relied upon as such.  No part of any compensation the Author may derive from this blog is related to the specific opinions he expresses.

Past performance is not indicative of future results.  Neither the Author nor his affiliated companies guarantee any specific outcome or profit.  You should be aware o the real risk of loss in following any strategy or investment discussed in this blog.  Strategies or investments discussed may fluctuate in price or value.

Investments or strategies mentioned in this blog may not be suitable for you, and you should make our own independent decision regarding them.  This material does not take into account your particular investment objectives, financial situation or needs and is not intended as recommendations appropriate for you.  You should strongly consider seeking advice from your own investment adviser.

 

Picking Up Some Republic Airway Holdings Inc. (RJET)

This week, I look at an airline. Wait. Let me take a deep breath. Yes, an airline. Look, investing in airlines is the Wall Street version of Seppuku, but no one ever said you couldn't trade them.

Valuation

RJET fell off a cliff recently. I do like the way it fell so far so fast. The faster it falls in the face of good valuation, then the more impetus you have of seeing a snap-back rally. Again, I only invest for 3 months, so I'm looking for, at minimum, a short-term bounce, one that is already in play. Let's take a look at this juicy valuation.

First, you'll see that the PEG Ratio is .56, well below the maximum of 1 which I will tolerate, and less than half the industry. Quarterly revenue growth is lagging the industry, which could be concerning, but I focus more on the bottom line. The operating margins are better than twice the industry average. The price/earnings ratio is less than twice the industry.

Technical Analysis – Monthly

What makes this stock so appealing is the capitulation that happened last month, and the bounce back that now appears to be in place. Admittedly, the indicators that measure participation, specifically the accumulation/distribution line, looks horrible. However, when you have a volume spike on down volume the highest in 5 years in the face of horrible price action when the stock has been declining as far as it has, a short-term bounce could very well be in order, especially with a high short interest of 12% like the stock has and the awesome valuation compared to the industry. The industry has been exhibiting high relative strength compared to the broad market recently, incidentally.

Also positive here is the divergence of the relative strength line with the price action. Notice how as the price decreases, the RSI increases, as do the stochastics. I usually prefer a double signal from the stochastics, however, and I am only getting a single here. What I don't generally like is the price relative to the Wilshire 5,000. This stock has been significantly lagging the market, but again, the amount of capitulation (or sellers just losing their patience and panicking completely), is a very good sign that will likely reverse the trend, at least in the short term.

Technical Analysis – Weekly

Again, look at how nicely the Relative Strength Index diverges the price, showing the downward momentum has been weakening over time. You can also see 3 weeks of heavy selling action last month. Again, the stochastics have diverged, signifying a bottom was put in June. The Accumulation/Distribution line has been diverging from the price action for quite a while, showing that buyers have been coming in and picking up the stock as it goes down. And the most recent action in the A/D line just looks completely pathetic, signaling that potential capitulation last month.

Let's see how this one goes. I don't usually pick bottoms, but really if I were doing that, we'd be talking this past June. The momentum on this one really seems to be lightening up to the downside and the nice scare that investors got last month should be constructive for a bounce. Let's see how this looks in 90 days.

Long Hudson City Bancorp (HCBK)

Week 2 of a quandary where ever chart looks broken, nothing looks buyable, but my analyses of the broad indices is indicating that I should buy this week rather than sell. Of all the screens I ran, the best chart I could identify was that of Hudson City BanCorp (HCBK), so I grab my nose and take the plunge.

Fundamental Analysis

HCBK has a much worse growth picture than its competitors. However, HCBK went through the entire financial crisis with a clean bill of health, so I'm not too concerned. It's still expected to grow in the double digits year-over-year. Its operating margins blow away the competition at 82%. Its P/E is significantly below the industry average. Finally, the PEG ratio, which is extremely important to me in analyzing stocks is below 1 at .56 and blows away the competition (2.43).

Technical Analysis – Weekly

Again, I'm picking the best of a bunch of garbage charts, so I must say that I'm not completely impressed. The RSI is only redeemed in that it has been repeatedly touching traditional support at 50 and has held. The only other redeeming factor is that the price relative to the Wilshire 5,000 has stabilized, flattened and may be starting to outperform the broad market. If you look at the volume by price, the price has cleared most of the heavy volume resistance areas.

Technical Analysis – Daily

RSI has no bearing on anything happening with the stock. The price seems to have tested the 200-day moving average and recovered. However, the volume during that recovery was mixed. I would have rather seen a lot of volume on the recovery. Yes, the first time and no the second. The price relative to the Wilshire 5,000 has recently lagged the market, a negative. So has the Chaikin Money Flow, also a negative.

So as you can see, I'm not all that excited, but maybe, just maybe, when all charts look so broken, this might be the time the market roars back. Just following what my system tells me. I'll report back on this one in 90 days.

A Potential Whopper (BKC)

Wow, that was a sad pun.

It's a particularly difficult week. When you see price action like we saw this week, you automatically assume that you will be going short something. Then, you go look at your trusty technicals for the week, and they tell you to go long. That always makes me hold my head low because these are the most arduous weekends to find something to buy. In looking for a long position this week, it seemed that 19 out of 20 stocks had broken trend, not only on a daily, but weekly basis. There's carnage out there. It does not look good. Yet, my index analysis tells me that people were actually accumulating shares in the midst of this horrible price action, and so I forge on looking for a long.

Fundamentals

On a fundamental basis, Burger King Holdings Inc (BKC) doesn't look bad. It is predicted to have double-digit growth next year. Compared to its peers, it has gross margins, operating margins, price/earnings ratio, and PEG ratio all above the average. The PEG is the most credible metric to me when evaluating a stock, especially when the stock is this depressed. Anything below 1 is good to me, and with all the carnage this stock has been through, the fact that it's still that low tells me that the analysts haven't bailed on it.

Clearly, McDonald's, the cream of the crop, has been blowing the doors off this industry group. There often lies a virtue in being second-best, however. Wall Street will pound the second-best, especially when it's a household name because they expect the same or near the same from the second best, and they pound it when it doesn't meet those expectations. This has gone on way too long, and BKC now looks like a great buy on valuation. Now I only hold things for a quarter, so many times the financials lend little to my thesis. On to the technicals . . .

Technical Analysis – Weekly

I am not as proud as I could be about this stock. It looks pretty good, but I usually like to invest in home runs. Nonetheless, as I said, my crystal ball says to be a buyer this week, so I'm the ugliest guy at the prom this week. Not much choice. Weekly analysis trumps daily, so let's go there first. Nothing horrible here, but nothing to write home about.

Pros

The price trend is a bit rough, with a dip breaking trend back in July, but there's a moderately robust trend there since early June. What I'm a bit discouraged by is the overhead price trend that began around August of '09. When price runs into that, it will experience some significant resistance, but how it behaves at that point, no one could tell you.

See the divergence from price in the Relative Strength Index in April that is reconfirmed in July. Good to see this happen, before the trend reverses.

Price relative to the Wilshire 5,000 has underperformed the market for quite a long time now, but since November, the base has been put in, and it has begun to outperform. I'd prefer a quarter of outperform, but you can wish in one hand and do something else much less desirable in the other, and see which one gets filled first!

Cons

The stochastics really are telling me nothing one way or another, so I'm neutral on those.

The Chaikin Money Flow has been diverging to the downside, and I don't like that much, but again, I'm trying to find a sheep with strands of grey in a flock of black. I wish I had better alternatives, but don't.

Technical Analysis – Daily

Pros

You'll see from the price trend discussion below that this stock is not doing very well on a daily basis, but the weekly trend trumps that. This just looks like a short-term pullback. What convinces me more is that the "golden cross" (50-day moving average crossing the 200-day to the upside) happened right before the New Year. The 50-day is in a solid uptrend, and the 200-day just turned positive. So even thought the price action is trapped in between the 50-day and 200-day. This is a very significant positive in that both moving averages are positive for the first time since about September of '09.

Looking at volume, it looks like the longs have been winning since this trap between the 50- and 200- days.

Rather impressive is the price relative to the Wilshire 5,000. Notice how the price has been outperforming since 19^th Jan.

Cons

The Relative Strength Index tells me bupkis, really. For those of you who are enthusiasts of the resistance at 50 thesis, well, you've got me there—for now.

The price trend is down on this stock, no doubt—lower highs and lower lows.

Looking at volume again, there was a huge distribution day on January 18^th. This is good on the one hand because you may have gotten everyone short on this stock who might want to be at this point. After all, the long-term downtrend is over a year old. Short interest in this stock is about 9%, which is pretty high. There is moderate resistance at around 18 because of this big volume day, but if the shorts panic, there could be quite a squeeze here, which would hurdle it above the 50-day, and then we're off to the races.

Like in the weekly chart stochastics tell me nothing, as does the Chaikin Money Flow.

Conclusion

So here we are. I think in the final analysis, I am somewhat neutral on this stock, but in a market that's just been doggin' over the past 3 weeks, neutral can become pretty positive in a hurry. Besides, if I lose my job tomorrow, I'm poundin' Whoppers. Who makes Lipitor again? Let's see how this one shakes out. I'll be in it, so you'll know in exactly 3 months.

Anatomy of a Spiraling Trader (Part 1) – Trader’s Narcosis

The banner on this blog page states that I am imparting to you all my trades so that I may return, in kind, the favor that other bloggers do me every day by publishing their material. Over the years, I have found that having good trading skills can give you valuable fertilizer for your lifelong financial garden—a Midas touch, if you will. On the other hand, if used without the proper mindset, trading can be a nice sousing of Agent Orange for your life savings. With that in mind, I feel obligated to impart to you some the causes of the not-so-bright journeys I've taken through my trading career. I hope you will take them seriously. If you do not, and you have the right cocktail of strikingly common personality traits, you could end up damming me and other bloggers out there as a bunch of people who gave you horrible advice when it was really you who gave up the golden opportunity to have that Midas touch and be a successful trader for life.

Very rare is a trader who can tell you that he/she had double-digit gains in perpetuity. In fact, the statistic is that most traders can't beat an index. Which begs the question, "With all the time it takes to trade, in the absence of an edge in the market, why would you trade if you could give your money to someone else to do it for you?" There are two possible answers to this question, in my estimation. Either you:

• Love it to the extent that you would do it even if you couldn't make money doing it, and/or
  
• Your ego is so tied up in it that your brain mistakes trading as a survival mechanism
  

The first is a constructive motivation, and a person for which #1 holds true can also have #2 as an inherent trait at the same time. Regardless, #2 has no place in your psyche if you are going to be a good trader, and it is very hard to stave off. If you are exhibiting the behaviors below and in the subsequent few posts, you likely have #2 mixed in with your motivations to trade. This post should serve as a warning to you that you are likely headed to a bad place.

A Word on Nitrogen Narcosis

Shadow Divers, by Robert Kurson is a spectacular true read about two divers' insane perseverance in legitimizing the discovery of a World War II German U-Boat over 50 miles off the coast of New Jersey in 1991. In the book, the phenomenon of nitrogen narcosis is graphically depicted and really jumped out at me as a great analogy for what both I and other traders tend to go through before and during periods where they can't make a dime or only lose and can't understand why.

Nitrogen Narcosis results from diving at great depths for extended periods of time. It comes from a higher than normal concentration of Nitrogen in your blood, which creates much the same effects of alcohol consumption or inhaling nitrous oxide, among others.

One of the many problems with Nitrogen narcosis is that you are experiencing it in an environment where planning your plan and living your plan are of the essence because of the minefield of hazards that exist at great depths. In Shadow Divers Kruson describes the dynamics of narcosis and the downward spiral that it can create in a diver, particularly a wreck diver, leading to a self-induced disaster. You start your dive with a distinct plan. You know exactly how much time to spend in the deep, what you will and will not permit yourself to do, and with at least some precision, where you will be at various times during the dive.

Then, something unexpected happens or you make a miscalculation that derails your plan to some extent. Let's say something falls on you and pins you down for a minute or two, which is common in wrecks. Under the confusion of narcosis, you start thrashing around, which is a big no-no in wreck diving due to all the silt there and also because fast body movements and a panicky mentality consume much more oxygen. Now you are at a disadvantage physically, having less air than you originally thought. After a few minutes, you free yourself, but now you can't see due to all the silt swirling.

Narcosis also accentuates panic. Even more panicked than before, you start moving very fast around the wreck to save yourself. Wrecks often have a lot of stray protrusions because they are, well, a wreck. One of the hoses on your breathing apparatus gets caught on something and now you are stuck again—more panic and more consumption of vital air. You free yourself from that obstacle, and somehow you find your way out of the wreck.

In a panicked and extremely "drunken" state, you forget that you left a reserve bottle of air outside of the wreck that you could use to breath. You look at your gauges and manage to calculate that you have 10 minutes for an ascent that you must spend 40 minutes doing to adequately decompress. More panic and more air consumption, but in reality with all that's happened, you don't even have those 10 minutes available because of all the extra air you consumed during all your misfortunes. Feeling doomed, you cut your losses, fill your wings with air, and shoot up to the surface. That ending is a true ending—to a life—and these types of scenarios happened repeatedly during the course of the true story told in Shadow Divers.

Notice the spiral, with the catastrophes building exponentially. Notice also how the more things go wrong, the more activity you engage in to save yourself, the more air is consumed, and the worse the situation gets. It just builds and builds until the you shoot up toward the heavens, where hopefully you will be forever more.

OK, sorry for the drama, but the metaphor is perfect. In this scenario:

• Diver = trader
  
• Wreck = the market
  
• Activity = trades
  
• Strategy = trading style
  
• Air = money
  

The Anatomy of a Trading Spiral

Before I really begin on the trading side of this, you need to know one thing that I won't belabor, but if you would like to Google the words "ego" and "survival" side-by-side, see what comes up and you'll get my point. When your ego is identified with an activity, your brain's survival mechanisms mistake that activity for a survival mechanism. So if your ego is identified with your trading, you will engage in trading much with the same subconscious perspective as a wreck diver engaging in the truly life-threatening activity of wreck diving.

Step 1: You Have a Plan That You Want to Execute

Like the seasoned wreck diver with a dive plan. You have a trading style, philosophy, or paradigm that you either are convinced is going to work or you have been using for quite some time. For whatever reason, now it's gone south. Over some time, you begin to second-guess yourself. Identified with your ego, your brain starts asking you questions about your self-worth and if you will really "survive" as a trader. Your ego starts making tragic, fatalistic statements to you like "if I don't succeed at this, I don't know what I will do" or "I'll be finished." Your judgment is clouded, and trading narcosis sets in. With your sense of survival at stake, you start to panic.

Step 2: You Make an Unplanned Tweak in Your Trading Style

With panic and clouded judgment, your trading narcosis starts to cause you to reach at tweaks in your style with little or no thought. You don't go to a simulator to test out your tweaks before you implement them. Your ego convinces you that you have got the solution right now. If you implement this one thing, you will undoubtedly solve your problem. You wake up the next morning and start trading with a slightly new style. You begin losing money or more money that before. Your air (money) supply is beginning to wane.

Step 3: You Make Several Unplanned Tweaks in Your Trading Style

Rather than helping your situation, you have accelerated your losses. Your level of panic increases. You begin to thrash around looking for a solution. That paranoia familiar to divers with narcosis and the resulting panic sets into your trader's mind. You become more and more obsessed with your situation and trying to fix it. You start to play out elaborate schemes in your mind of how you can figure out the market and free yourself from the hell you are being pulled into like the grips of tractor beam. You start watching the traders on Bloomberg and CNBC with tips of the day and nuggets of wisdom, not thinking for once that 1) these interviews are orchestrated for everyone to disagree—so there's at least a 50/50 chance that in any given spot, one or both of the participants in an argument are wrong, and 2) you have no evidence that any of them are any more successful than you have been. You lay awake that night, and you put together all your information. The next morning or a couple later, you wake up with the solution to your problem. You blindly implement it.

Step 4: Repeat Step 3, Every Time . . .

. . . with less air (money) and a loftier goal (to make back what you have lost, and then some), until you . . .

Step 5: Fill Your Wings and Shoot to the Surface

After having visited the unfortunate land of step 3 several (or more than several) times with your situation getting ever worse, you acknowledge you are now in a spin. You exit all your positions and decide you need to "regroup" for a while. You check your mind into the decompression chamber of trading. You lick your wounds for a while. You wait for the dust of humiliation (that only you are aware of, by the way) settle for a while, and then you go to . . .

Step 6: Reenter, More Debilitated Than Before

Unless you really realize what caused your spiral—that is, that you let your ego take over and hence, your mind has equated survival in trading to the level of personal danger inherent in something like wreck diving—you will begin trading again, set up to repeat steps 1-6 again. You will begin, most likely, not having psychologically recovered from your last bad dive, with less confidence and self-assurance, with less money, and with the goal in mind to trade to make it all back. Maybe the diver with the lethal bends is more fortunate (I of course mean that completely metaphorically) because he won't ever be able to live the cycle of a bad dive again. You, on the other hand, can dive into the market over and over again until your money (or air) is gone.

This cycle is the chief dynamic in so many failed traders. I tell you because I have been there, but I have luckily been able to recognize it and detach that ego from my trading before making that next dive. This ego detachment is essential to surviving the markets. In this way, you have the leg up on the wreck diver.

Yes, technology in diving improves with every passing year, making it more and more safe, but the diver has to wait as time goes for the danger in his dives to lessen. You, on the other hand, can acknowledge what is happening, take a good, deep, hard look, and make a change tomorrow.

As you read this, you may have thought of the word "addiction," which is a teaser for a subsequent post.