When the market is rallying and bulls stampeding, it’s easy to get caught up in the hype. But every trader must learn when its time to step back or step out altogether if he or she is to survive in the trading game.
Like the run from 1998 to 2000, the 2003-7 rally offered the bulls lots of opportunities to make money. Those who bought and held over this period looked liked geniuses. It wasn’t until the rallies had ended and markets became more volatile that greater skill was required to play the game. When the going gets tough a simple buy & hold gets very expensive as does the age-old practice of buying dips.
“It would be great if making money in markets was as simple as buying a stock and holding it for a few months or years,” says Dan Zanger, host of ChartPattern.com and author of the Zanger Report stock newsletter. “Unfortunately, markets only work that way a small part of the time but that doesn’t stop folks from trying thanks to the 18-year bull market that ended in 2000. Over the long-haul, stocks spend a lot more time either in a trading range or bear market and that can wipe out a static portfolio. ”
Zanger should know. Since he started trading seriously more than thirty years ago he’s made and lost a few fortunes. Dan will be ever remembered for parlaying an ante of $10,775 from the sale of his Porsche into more than $18 million during an 18 month period in 1998-9 and in the process set the stock trading world record with an audited annualized return of more than 29,000%. It wasn’t until he learned how to recognize an impending market top and get out in time that he was able to keep his profits.
“I never held on to my gains until I learned to unload and scale back positions when they sold off on high volume with poor bar action,” he laments. “It was an expensive lesson but one that every trader must learn one way or the other.”
According to Zanger, silver provided one of the best examples of a classic market top that he’s seen in a while.
“It was an active trader’s dream on the way up showing a beautiful parabolic move. But like most such moves, those who overstayed their welcome got creamed.”
Diary of a Market Top Trader
Those unfamiliar with Zanger’s newsletter and chatroom will be interested to know that he also offers regular updates at no charge on his Twitter page www.twitter.com/DanZanger But as well as giving followers insights into what the market and his favorite market leading stocks are doing, it provides another valuable learning tool. Traders can go back and see what he was saying at key points in the market since the site provides a record of his calls.
For example, here is a brief overview of what he was saying as silver ran up in the spring of 2011. Not only does it show his buy points but also when he began to get cautious. The Zanger Report subscribers who also have access to the intraday chatroom have a ring-side seat.
The Proshares Ultra Silver ETF (AGQ) moves twice as much as the underlying silver benchmark index in a single day. So when silver is rallying strongly like it was in early 2011, it’s a trader’s dream. These characteristics made it one of Zanger’s trading candidates. As the next chart shows, it gave a beautiful buy signal following a bullish cup & handle pattern around $150. From there it rocketed to more than $350. Then on April 25, Zanger issued this warning in his newsletter.
“Gapping up $23 at the open attracted strong selling interest on record volume… The leading averages rested today while a number of recent selections noted here moved up as much as $8 each. The market seems like it needs a rest.”
In his chatroom that day, he offered this advice, ““Locking in some profits on a big gap after a run like this might not be a bad idea.”
Figure 1 – Daily chart of the ProShares Ultra Silver ETF (AGQ) showing a classic parabolic move and peak as of April 27, 2011 and Zanger’s comments. Chart courtesy ChartPattern.com
And as the above chart shows, AGQ looks to have hit a ceiling by April 27 then failed to break above it. What signals provided the clues that silver was due for a correction?
It was a combination of three factors says Zanger.
First and foremost, parabolic moves usually signal an end to a rally because it shows that investors and traders are getting irrationally exuberant in their frenzy to buy the stock. But the biggest challenge is that profits increase since momentum accelerates into the peak. Traders who exit too early risk leaving money on the table. Those who exit too late risk giving all their profits away. It’s not the type of move for the faint of heart.
Figure 2 – Post mortem on the rise and fall of the Ultra Silver ETF AGQ with Zanger’s notes. Note the clear parabolic move and blowoff in late April, 2011 followed by the cliff dive. Daily Chart courtesy ChartPattern.com
Second, parabolic runs often experience exhaustion gaps near the end of the move. There are three types of gaps that provide trading opportunities – breakaway gaps that occur at the beginning of a move, measured or continuation gaps that occur around the middle of a move and exhaustion gaps that occur near the end of a move (see Figure 2). AGQ flashed three brief exhaustion gaps during the third week of April.
Third, AGQ posted something Zanger calls a naked bar on April 28 in which the stock moves strongly higher early in the day but then gives back those gains to close at or below the midpoint of its daily range. A naked bar is a good topping indicator and is confirmed when the stock closes lower the following day. (Bearishness was further confirmed by the appearance of an engulfing bear candlestick pattern on April 29).
Next, we’ll look at another banner market top indicator – the bearish head & shoulders chart pattern. We saw an example of this pattern on the S&P500 Index forming in June 2011 (Figure 3). That it appeared on the SPX had bearish overtones for the market. It was one reason that motivated Zanger to go to all cash in his portfolio. A fully formed head & shoulders top pattern has bearish implications and they often occur at major tops.
Figure 3 – Daily chart of the S&P500 showing a head & shoulders top pattern in the process of forming. To be confirmed, the SPX would have to drop to near 1250 (neckline) rise to form the right shoulder then drop decisively through the neckline again. Chart courtesy ChartPattern.com
Another good indication of a top forming is the bearish rounding top pattern (Figure 4) which became clear on the Russell 2000 Index in June. A break below the horizontal neckline under the index confirms the pattern. Zanger posted this chart in the June 10, 2011 Zanger Report and warned his readers to get ready for a larger move down.
Stocks rarely reverse direction without giving powerful warning clues according to Zanger. Some are clearer than others so it’s important to learn how to recognize these chart patterns and volume profiles he says.
Here is a list of the biggest mistakes traders and investors make which prevent them from being successful long-term in the market. As trader and teacher Mike Epstein once said, “Ours is not to say what should be, but to analyze and exploit what is.”
Figure 4 – Daily chart of the Russell 2000 Index (RUT) showing a bearish rounding top chart pattern in the final stages of formation. Chart courtesy ChartPattern.com
10 Errors That Can Wipe Out Your Portfolio
1. A belief that markets are efficient. The efficient market hypothesis is a myth that has been promoted by factions of the fundamental investment community that would have you believe that since all that is known about a stock is already built in to the stock price, any attempts to time the market are futile. Famed investor Warren Buffett perhaps exposed this myth best when he said, “I’d be a bum on the street with a tin cup if the markets were efficient.”
As traders or proactive investors, our job is to exploit market inefficiencies until they no longer exist. A large part of this skill is learning how to read a stock chart and understanding rates of change in stock prices as well as fundamental and economic data.
2. A belief that markets are random. Another self-limiting Wall Street myth is the Random Walk Hypothesis. Like the efficient market myth, it is an excuse for those who can’t make money. As one smart trader once said; markets are either efficient/random or they are emotional. They can’t be both. Learning to recognize how crowd behavior works in both bull and bear markets is essential to making money in markets.
3. A failure to recognize a parabolic curve and other signs of a top. A parabolic move, also known as a hockey stick pattern, is hard to miss but it’s amazing how many can be fooled into thinking it will last forever. But tops aren’t always made by parabolic moves.
4. A failure to recognize important chart patterns. Other formations that warn of a top include double or triple tops, head and shoulders patterns and rounding tops (see Figures 3 and 4), exhaustion gaps, and naked bars. Here is a list of some of the more powerful chart patterns that Zanger still uses to make money. Take as much time as you need to recognize them on stock charts. It might take months or even longer but the effort is well worth it. Like the fighter pilot who spends countless hours learning how to recognize enemy aircraft in a heartbeat, chart pattern recognition is a valuable skill that will help you make money. One of the best chart books on the market is Thomas Bulkowski’s Encyclopedia of Chart Patterns (2nd Edition, Wiley & Sons).
5. Inability to read volume. An understanding of how volume works is another essential money-making skill. If a chart pattern is the vehicle, volume is the fuel that drives it. Volume can be used to help confirm chart patterns, measure the strength of a rally or bear market move and forecast a potential trend change. It is also important to remember that stock price can fall by its own weight but a rally generally needs expanding volume to power it. Once volume starts to fall in a rally, look out below. Spiking volume in a bear can also warn of an impending trend change.
6. Focusing on the wrong fundamentals. Knowing how to read corporate profit and loss statements, determine PE ratios and calculate price-to-book or price-to-sales ratios is great but there is one major problem with this type of data. No matter how current, they are all lagging indicators. The same holds true with many economic indicators. More important when looking for stocks that have the potential to soar is focusing on how quickly revenues and earnings net of expenses are increasing (i.e. rate of change). This information provides an indication of where a company is headed. For example, it is far more desirable to buy a company where earnings growth is accelerating not slowing down.
When looking at the macro economic picture, government produced statistics like unemployment, the consumer price index (CPI) or GDP are subject to nearly constant revisions for a year or more after the fact. It is therefore fool’s play to rely on revised data since it’s a moving target.
7. Misinterpreting the news. There is an age-old saying in markets – buy the rumor, sell the news. Less well known but even more useful is this simple measure of whether the bulls or bears are in control. Bad news – good action, means players are discounting the bad news and buying stocks anyway and the bulls are in control. Good news – bad action means just the opposite and shows that the bears run Wall Street. Regardless of the market, it is a bad idea to hold through earnings report of any company. Granted, if earnings are better than expected you’ll make money but if they disappoint, especially in an uncertain market, you could lose your shirt.
8. Letting someone else tell you when to buy and sell. Hot tips and rumors run rampant on Wall Street but trading or investing without doing your own homework is a suckers’ game.
9. Not using a trading plan. It may sound corny but it’s true. Those who fail to plan, plan to fail. To be successful it is essential the all traders develop a written plan outlining their goals, risk tolerances, stop losses and profit targets.
10. Letting your emotions rule your trades. Where money is involved, emotions run high. Although it’s impossible to be like a robot and eliminating emotions altogether, it’s important to realize that your emotions can be very expensive if they are not kept in check. It is also important to remember that trader specific errors are the greatest risk to any portfolio. Put another way, of all the challenges to making money, you represent the greatest single risk to your portfolio. That is why it’s important to have a rule book to keep you on track when emotions threaten to get in the way.
Suggested Reading and Links
My 2003 interview with Dan Zanger – Chart Patterns, Trading and Dan Zanger
Death of the Efficient Market Hypothesis and Japanese Centenarians
Warren Buffett on the Efficient Market Hypothesis
Matt Blackman, CMT is the host of TradeSystemGuru.com. Matt’s articles have appeared in publications such as Technical Analysis of Stocks & Commodities magazine, SFO (Stocks, Futures & Options) Magazine, Trader Monthly Working Money, Physicians Money Digest, Laffer Economics, The Wellington Letter, Traders.com Advantage, Traders Mag (Europe), Active Trader and Investopedia.com. Matt is a member of the Market Technicians Association (MTA) and the Canadian Society of Technical Analysts (CSTA). He earned the Chartered Market Technician (CMT) designation and a B.Sc. (Honors) degree from Simon Fraser University.
Follow Matt’s latest trading ideas and market comments on Twitter at @MattBlackmanCMT