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Friday, January 25, 2008

What is your Lifetime Bias? What is your Methodology Bias?

A couple of days ago I mentioned that in my trading accounts, I was all cash. This prompted a very good question by "A", that reads:

"I was sort of under the impression that with 'trading' especially options, one can make money if the market is up,down,or the same...just wondering if you could elaborate a bit more on why your trading accounts are all cash - or what factors you are taking into account when you decide its not a good time to trade?"

That is a fantastic question, and I'm glad it was asked. It relates to a few things I'd like to touch on.

First of all, we all have what I term "a lifetime bias". Some folks are like me. I love to be long in stocks. I'm a bull. I always have been. I've come to understand why I have this bias, and it's based on a few factors. Suffice to say, I like the 'feel' of being long in the markets.

Some folks are straight bears. All they do is short. Very, very few short players become successful. I was watching a statistic on "Wall Street Warriors" that stated that 99% of all short stock players lose eventually. It's a difficult game to play. But it's been done, and can be done. There is, afterall, that 1%.

Some folks don't care. One way or another. They are long just as much as they are short.

Why is it important to know your bias? Well, let's take the bulls. This is the camp I fall into. Historically, the stock market always goes up in the long run. So what does this say? I should have a long term investment portfolio that I look to accumulate shares in for dividend investing. Bulls make the best dividend investors. Bulls make great portfolio keepers. And when we have a bull market (which is most of the time) bull can make some good money trading.

What about the bears? The most successful short sellers (I've seen a couple) I've seen stick to the penny stocks that have been pumped up to around $4 to $5 region, and short those. I do agree that bears who are good at what they do provide a valuable service. They uncover the "Enrons" of the world. But shorting huge Blue-Chip companies is a way to get quickly burned. The Street is littered with people who have tried it. But some folks just have that bias.

What about the third camp? That really don't care? They make the best overall traders. And these folks, make a lot of money. They'll go short as much as they'll go long. So why they may have a long term portfolio? That really isn't where their interest lays. They are fantastic for understanding, not what the news means, but what the news means to the market and how the market reacts.

Ok, now how does this fit into your methodology? As I hinted above, I think your methodology should match your bias. There are many ways to trade the market. Some methodologies fit some people better than others. Why? Because of two things. 1) As I already mentioned, your lifetime bias, and 2) Your risk tolerance.

Let's take myself as an example. When it comes to trading? What's my risk tolerance? Well, trading, my psychology (something I have to talk about a bit more) is more short term. I'm no day-trader. That's just too frantic for me. But I like short term trades lasting, ideally, from 3 to 5 days. That's it. That fits my personality. To meet me in real life, you'd find I have a very gregarious, fast-paced personality. I'm not focused enough to be a day-trader. But I do like getting in and out quickly.

If I'm in a trade for a long period of time? I've found that it starts wearing me down. Emotionally and physically. Thus, I don't have the risk tolerance for longer trades. Thus, I'm no good when it comes to selling options. It drives me batty. I can make money doing it? But over the long haul, I'm just going to get burned out. And I'm in this for the long haul. With my chosen methodology (which is pretty discretionary) it does very well in bull markets (thus my boredom) and short term swing trades. I also look for increases in volatility. Thus, though other people have a hard time buying naked options? I do well at it, as my money management numbers attest to. It fits me.

It's sort of like the Forex. Some people do very well at it. I've tried my hand at it. But truth be told, I just don't like it. It's hard for me to explain. I don't get the same excitement and satisfaction from Forex currency trading. Some people do, and more power to them. If I tried to concentrate on the Forex, I could probably do well for a while. But I'd burn out.

Basically, what it comes down to is this. I enjoy my methodology. It fits my personality. It fits my psychology. It fits my risk tolerance. Now this leads to what I believe is your primary question. When do I know not to trade the markets?

I have to be aware of when my discretionary methodology does well? But equally important is when it does not. My methodology struggles during bear markets, and it struggles with odd market intervention. In other words, with the current market conditions? With interest rate cuts all over the place? With a stock bear market? My methodology does not perform well. I'll still be taking some trades. I have my eye on one at the moment as a matter of fact. But I just won't be taking as many. In the end, my methodology performs very well, because a bear market will offer us the gift of cheap stock prices. But with the state of the economy, it means I have to develop that oh so important quality of patience.

Now, this moves to a third area - this blog. My primary goal is to demonstrate the most important aspect of trading and investing. Money management. For instance, I performed a Sugar Trade this month. We took a loss. The primary thing I'd like to get across is not neccessarily how I implemented a trade in Sugar? But my risk reward ratios, as it relates to the rule set for the Challenge Accounts, as that relates to account equity preservation. The fact that I risked a total of $89.00 for a reward possibility of $200.00 using a methodology with a given set of accuracy and drawdown - is much more important, than the method I used to get there. How I'm managing such low funds is the most important thing. The risk per trade. The rule set. Those sorts of things.

What does this mean if you have a methodology that is different? But still apply the money management decisions that I apply? If you still keep your methodology to sound performance analysis numbers? Then once these accounts start to grow, people may have a methodology that lets their small funded accounts grow faster than the ones I display here. Heck, some people may decide that they see what I mean, and they can add another $600 of at-risk funds to their account, and try to trade with the account money management principles that I've mentioned. More power to em! 8^) I have to keep to the rule set I engaged in, well, for consistencies sake.

But the important thing, is performance and growth. The most important thing, is money management principles.

Again, great question, and I thank you for asking it!

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