Monday, March 23, 2009

Survive the Slaughter

Bulls make money, bears make money, pigs get slaughtered!

This market adage has become increasingly popular in recent years as it’s been a favorite mantra used by a famous, and to some infamous, market pundit who often bellows, “Bulls make money, bears make money, pigs get slaughtered!”, after which he hammers a button which squeals like a hog. Entertainment aside, there is value in understanding why pigs get slaughtered and learning how to avoid becoming someone else’s side of bacon.

It’s crucial to understand that the participants of the financial markets aren’t objective, emotionless robots, but human beings. Thus, the subjectivity of people’s perceptions, beliefs, and emotions often drive the market, rather than the objectivity of reality and the fundamentals. We could purport that there is often times a gap between what the stock market *should* be doing based off of reality and the fundamentals, and what the stock market actually *is* doing. Therefore, truly understanding the market isn’t as simple as learning economics and fundamental analysis, rather it requires a solid understanding of human psychology and how it’s intertwined with the financial markets.

There is a spectrum of emotions that we as human beings can experience, such as happiness, sadness, panic, regret, embarrassment, etc… However, when dealing with money, greed and fear tend to be the most powerful emotions influencing your decisions. Unfortunately these emotions wreak havoc on your trading performance. We’re all in a constant battle striving to overcome these emotions and eliminate their ability to lose us money. One of the most common phrases used to help discourage greedy behavior is, “Pigs get slaughtered”. This helps to convey the notion that greed is your enemy, not your ally. Being greedy would perhaps be beneficial if the market moved straight up, as staying in longer would always result in more profits. However, the unfortunate reality is that the market moves in swings and cycles, often causing your unrealized profits to turn into realized losses. The 2007 market top and subsequent bear market serve as a prime example of what can happen when greed controls your actions.

Consider those who bought in 2002 or 2003 and participated in the bull market run from 2003 to 2007. The S&P 500 nearly doubled within that 4 ½ year time period, moving from sub 800 to over 1550. Now, what do you think is the prudent action to take given a colossal gain in any position? While the greed of the moment may be enticing you to kick back, relax, and watch the money flow into the coffers, the disciplined investor would be tightening up stops, placing hedges to lock in gains, or taking partial profits. Although the prime time to take profits on long term holdings was the 2007 market top, there have been subsequent opportunities to exit bullish positions. These bear market rallies of 10, 15, and sometimes more than 20%, have provided an opportunity for savvy traders to exit bullish positions at higher prices.

Since the beginning of the 2008, the S&P 500 has experienced seven different bear market rallies of 10% or more.

Although each has varied in length and magnitude, the sad conclusion to each of these bullish forays is the exact same; a failure of the short term uptrend and subsequent resumption of the bear market. The same greed that prevented investors from taking profits at the peak of the market, is the same little devil that has probably prevented them from exiting their bullish trades on these bear market rallies. In other words, rather than unloading their bullish positions once the short term uptrend has exhausted itself, many investors have allowed their greed and hope of more profits to cause them to remain in their positions too long, thus missing these opportunities. Then, as the bear market rolls forward these investors learn firsthand what “pigs get slaughtered” is all about!

Shun the Slaughter House:
Here are a few techniques that will aid in controlling greed and curtailing your inner pigness.. oink oink.

Develop a Target: Lacking a trading plan may just be the cardinal sin when it comes to trading. If you lack a trading plan you are bound to be driven by emotions, tossed to and fro by whatever your feelings of the moment may be. If your approach is one of shooting from the hip, then you’re never going to experience consistent results. Ironically the only consistent thing you’ll probably experience is inconsistency. Building a trading plan consists of determining where to enter a trade and where to exit. You should establish a plan A for how to react if the stock rises in value, and a plan B for how to react if the stock declines in value. We can decrease the effects of greed merely by establishing pre-set targets to serve as benchmarks for when to take action to lock in profits. Setting a target will depend on a myriad of variables, such as your style of trading, strategy, and personal preference. There isn’t one right method in establishing targets; the key is to make sure it’s realistic and fits your comfort level.

Scale Out: A dilemma that always presents itself when you have a winning trade is that of deciding when to take profits. When sitting on a profitable trade, fear and greed will begin to create some inner turmoil. Picture yourself in front of your computer with two little demons, Fear and Greed, perched on either shoulder, ranting in both your ears in an effort to incite you to action. While Fear is urging you to exit the trade to lock in the gain before you lose it, Greed is whispering promises of windfall profits and goading you to stay in the trade. Rather than fully satisfying one emotion or the other by staying all in or getting all out, we could compromise and sell a portion of our position (such as half), thus partially appeasing Fear as well as Greed.

Scaling out can be considered a win-win technique. If after selling half, the stock moves adversely, resulting in giving back some of your gains, you will be glad that at least you exited part of your position with profits. On the other hand if the stock continues to rally after scaling out, you will be relieved that you still have a portion of your position enabling you to continue to profit.


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