This Week's Battle Plan

Your Money Manager At Work

From the front page of last Sunday's New York Times:

                            Portfolios Depressed, Traders Seek Therapy

"....I had a client who grew anxious every time he had to sell a holding. He kept saying 'I can't let go,'" said Richard Geist, president of the Institute of Psychology and Investing. Dr Geist also teaches at the Harvard Medical School and is both a psychotherapist and a financial advisor. "I asked him what that reminded him of," Dr. Geist said. "He told me he remembered as a child that he had trouble letting go of his mother when it was time to go to school."

John Ruskin-The Crown of Wild Olive

The great justification of this game is that it is truly when well played, determines who is the best man; who is the highest bred, the most fearless, the coolest of nerve, the swiftest of eye and hand. You cannot test these qualities wholly, unless there is a clear possibility of the struggle ending in death. It is only in the fronting of that condition that the full trial of the man, soul and body, comes out. Whatever is rotten and evil in him will weaken his hand.

John Ruskin wrote these words more than 120 years ago. He was talking about war. But he might as well have been talking about Wall Street. For all that is evil and rotten has been exposed. Bear markets do that...just as war does. Bear markets expose weaknesses in all businesses and in all investment styles. Buy and hold...exposed. Not using stops...exposed. Investing on analyst's recommendations... exposed. Cheating through accounting...exposed. One-way momentum investing...exposed. I can go on and on. But, if you are still in the game today, and especially if you are as successful today as you were a few years back, you have survived. In Ruskin's terms, you are "the best man" (woman). You are the most fearless, the coolest of nerve, the swiftest of eye and hand. Whereas the rest of the world has been stripped bare by this sell-off, you are still successfully playing this game. You may not have a trading methodology that trades perfectly (no one does), but you do have something that is superior to 99.99% of the people out there who are in this game. And that includes thousands upon thousands of money managers. Especially the ones who have have the honor of being in the 50-50 Club. You ask what that is? That's a money manager who is down 50% from July 2000-June 2001 and another 50% from July 2001-June 2002 (incredibly, there is an abundance of these clowns). You have survived and possibly prospered during what is, in my opinion, one of the worst markets since World War II. (And by the way, it probably doesn't get any tougher than this). Congratulate yourself. For Ruskin would.

Now let's move on to our continuing series of lessons.

This Week's Lesson: Adjusting To Volatilty

One of the reasons so many individuals become unnerved during market declines is that market declines are usually accompanied by increased volatility. Let's discuss what this means:

If, for example, a stock you trade normally trades within a two-point daily range, a doubling of volatility will mean that its daily range will increase to four points. That is what we have seen over the past two weeks. The average stock in the S&P 500 has nearly doubled in volatility over the past few weeks. This means a lot. This means that if you are trading using a fixed-point stop (lets say 75 cents/trade), you are getting stopped out at a far higher rate than you were a few weeks ago (sound familiar?) If you are placing your stops at the high or low of some bar, your stops (risk) are far bigger today than they were a few weeks ago. The same goes if you are looking at intraday swing lows and highs. Again, your stops are far bigger than they were a few weeks ago, meaning your risk (and losses) are greater.

What does this further mean? A few things. First, psychologically it's far more stressful. You are either getting stopped out more, or you are taking larger-than-normal losses (unless you've halved your position size). It also means that your thought process is likely being affected. It has to be. Increased volatility means increased anxiety. If you doubt this, go day-trade a REIT for a few days and then trade KLAC (anyone who tells you it's the same is on a steady diet of Prozac or whatever they give people to deaden reality).

So, how do you deal with this until things go back to normal? (and they will, likely very soon). The easiest way is to reduce position size until you see volatility dropping. This means that if you normally trade 1000 shares, you lower your size to 500 shares. This halves your risk and gets you back to where you were earlier in the year. And how can you tell when volatility is back to normal? There's a couple of ways. First, look at the VIX reading. Even though this is not perfect, you can still gauge the expected volatility for the near future. It's now near 40. Normal for the time being is 20-25. The other way to gauge volatility is with a short-term historical volatility filter (most charting packages have this). Look at the 10-day reading. A reading of between 18-23% is somewhat normal for this time. In the future, look at the 100-day reading as what is normal and when the 10-day shoots well above it, it's likely time to lessen your position size (if you need help on this, please e-mail me).

Again, it's easy to feel a bit un-glued from these past few weeks. But, this is what a sharp decline brings, and future sharp declines will bring the same. The key is to adapt your position size and understand how and when to adjust. We earlier talked about weaknesses being exposed in bear markets, and increased volatility during these times exposes weaknesses in stop placement, position size and trade management. It's easy to adjust and correct with the correct tools. Again, e-mail me if you need further clarification on this.

This Week

You don't need me to tell you we are oversold. But, this is a condition that has been going on for a few months and getting more oversold. What is interesting is that there have been some good opportunities to make money on the long side. They've come via 1-2 day outsized rallies (see May 8, June 14 and July 5, for example). But, there has been no follow-through from these rallies. We are again very oversold and it would not surprise me to see another sharp rally, especially early- to mid-week.

On a bigger scale, this past week was the ninth worst week since World War II. I looked at the week and month following the eight worst weeks and found that the market rallied on six of the eight occasions (the two losing times for the monthly moves were in 1987 after the meltdown) and a few times the rallies were large. Also, my fear meter (the VIX) has only had two periods of higher weekly closes since 1993. The first happened a few times in the fall of 1998. The market rallied, retested and then rose nearly 20% over the next month. The same holds for September of last year. The market then rallied about 20% over the next month. None of this means we have to go higher. Only that the likelihood of a larger-than-normal rally exists sometime soon.

I'll Be On TraderTalk This Thursday

...to discuss all this, and more. I'll be on from 4:30 PM EDT until the last question is asked. If you can make it, you will find me here.

Summary

The past two years have been the great equalizer. Turn '98-'99 upside down and you have today. And if you've profited from both markets, you are one hell of a trader. Whatever you're doing, you're doing it very correctly. I suspect you are shorting as well as buying, using stops on all your trades, not bouncing from one strategy to the next, adjusting your position size to volatility, and essentially doing the same thing over and over again. This is the key to your success, and I congratulate you.

If you feel you need help on any of this, please e-mail me, or come to this week's TraderTalk. Also, Dave Landry, and many of the other people on this site are here to help you. If you need their e-mail address, they can be found at the bottom of their columns.

Have a great week trading (and hope your 401(k) plan is not invested with the guy who had trouble letting go of his mother when it was time for him to go to school)!

Larry Connors and Brice Wightman

Larry Connors is CEO and co-founder of TradingMarkets. He is also the author of four books on trading, including "Street Smarts," co-written with Linda Raschke, "Connors on Advanced Trading Strategies", and "Trading Connors VIX Reversals."  Larry also recently released the video course ''Buy The Fear, Sell The Greed: Timing The Market Every Day For The Rest Of Your Life.”

Brice Wightman is a Market Analyst at TradingMarkets.com.