March 30, 2007

This week we have articles written by the following TradingEducation.com analysts: 

• Van K. Tharp, Ph.D.

• Jim Wyckoff

• Kevin Klombies

• Robert W. Colby

• Darrell Jobman (our Editor-in-Chief)

Greetings TradingEducation.com subscribers. Even though the Fed held interest rates steady last week, Fed Chairman Bernanke spoke this week and stated that he was uncomfortable about inflation and the economy. Combine that statement with rising oil prices, and the market dropped over 100 points this week. It is definitely a roller coast ride. On the commodities side, Coffee has been in a down trend since December. In currencies, the Australian Dollar is still moving higher as is the Euro FX. This week’s newsletter is below. Enjoy and have I hope you have a nice weekend.

Peace and Regards,

Lane J. Mendelsohn
Website Publisher

Position Sizing™ Is More Important
Than You Think

By Van K. Tharp, Ph.D.

Position Sizing™ and your personal psychology are the two most important aspects of trading and they are probably the two most neglected topics.   Chapter 14 of the second edition of Trade Your Way to Financial Freedom, is all about helping you understand the importance of position sizing.

Before we discuss this topic, let me give you some important background information.  I tend to think of trading systems by the distribution of R-multiples that they generate.   And the average R (or mean R) of the system’s R-multiple distribution is the expectancy of the system.  It tells you what to expect from the average trade.

So let me give you a simple trading system, one that is probably much simpler than any you’d trade.  Twenty percent of the trades are 10R winners and the rest of the trades are losers – 70% are 1R losers and the remaining 10% are 5R losers.   Is this a good system?   Well, if you want a lot of winners, then it certainly isn’t – it only has 20% winners.   But if you look at the average R for the system it’s 0.8R.   That means on the average, you’d make 0.8R per trade over many trades.   Thus, when it’s phrased in terms of expectancy, it’s a winning system.

Let’s say that you made 80 trades with this system in a year.   On the average you’d end up making 64R – which is excellent.   If you allowed R to represent 1% of your equity (which is one way to do position sizing), then you’d be up about 64% at the end of the year.

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I frequently play a marble game with this R-multiple distribution to teach people about trading.   The R-multiple distribution is represented by marbles in a bag.   The marbles are draw out one at a time and replaced.  The audience is given 100,000 to play with and they all get the same trades.

So let’s say we do 30 trades, and they come out as shown in the table:

R-Multiples Draw In A Game
-1R	-5R	-1R
-1R	-1R	-1R
-1R	-1R	+10R
-5R	-1R	-1R
-1R	-1R	+10R
+10R	-1R	-1R
-1R	-1R	-1R
-1R	-1R	-5R
-1R	-1R	+10R
+10R	-1R	+10R
+8R	-14R	+30R

If you look at the bottom row, you see the total R-multiple distribution after each ten trades.   After the first 10 we were up +8R, we then had 12 losers in a row and were down 14R after the next 10 trades.   And finally we had a good run on the last 10 trades, with four winners, getting 30R for the ten trades.    Over the 30 trades we were up 24R.  And if you divide 24R by 20 trades is gives us a sample expectancy of 0.8R.  Thus, our sample expectancy was exactly the same as the expectancy of the marble bag.   That doesn’t happen often, but it does happen.

Now let’s say that you are playing the game and your only job is to decide how much to risk on each trade or how to position size the game.   How much money do you think you’d make or lose?   Well, in a typical game like this, 1/3 of the audience will go bankrupt (i.e., they won’t survive the first five losers or the streak of 12 losses in a row); another 1/3 of the audience will lose money; and the last third will typically have made a huge amount of money – sometimes over a million dollars.   And in an audience of say 100 people, except for the 33 or so who are at zero, I’ll probably have 67 different equity levels.

That shows you the power of position sizing.   Everyone in the audience got the same trades, those shown in the table.   Thus, the only variable working was how much they bet or their position sizing.   And through that one variable we had final equities than ranged from zero to over a million dollars.   That’s how important position sizing is.   And by the way, I’ve played this game hundreds of times, getting similar results each time.

Position sizing is that important and I’d suggest that you take a look at chapter 14 of my book because many people have told me that it turned their trading around, making them winners instead of losers.    Next week, I’ll tell you a lot more about position sizing — how to do it and what its purpose is. 

Have a good weekend.   Until next week, this is Van Tharp.

What Are The "Big Boys" Up To? How use the Commitment of Traders Report in your Trading

By Jim Wyckoff

I have discussed in past articles how volume and open interest can be used to help identify and confirm market situations and trading opportunities. I'll take open interest one step further in this column by examining the Commitments of Traders (C.O.T.) report, issued by the Commodity Futures Trading Commission (CFTC).

The C.O.T. report is released weekly--every Friday afternoon. There is also a C.O.T. report that includes options on futures issued at the same time. The report that includes options is not as closely followed as the report that covers only futures. Reason: The combined futures and options report has less history.

The C.O.T. reports provide a breakdown of each Tuesday's open interest for markets in which 20 or more traders or hedgers hold positions equal to, or above, reporting levels established by the CFTC.

The C.O.T. report breaks down by open interest large trader positions into "Commercial" and "Non-Commercial" categories. Commercial traders are required to register with the CFTC by showing a related cash business for which futures are used as a hedge. The Non-Commercial category is comprised of large speculators--namely the commodity funds. The balance of open interest is qualified under the "Non-reportable" classification that includes both small commercial hedgers and small speculators.

What is most important for the individual trader (you) to examine in the reports is the actual positions of the categories of traders--specifically the net position changes from the prior report. To derive the net trader position for each category, subtract the short contracts from the long contracts. A positive result indicates a net-long position (more longs than shorts). A negative result indicates a net-short position (more shorts than longs).

Now, if I've got many of you lost at this point, DON'T WORRY. I've got some suggestions later on that allow you to look at some examples of reports on other websites. What I'm trying to do at this point is familiarize you with the general basis of the report, related terminology and how traders use the C.O.T. report. This stuff will sink in--it just takes a little while.

My friend, Steve Briese, is one of the world's foremost experts on C.O.T. data. He publishes the "Bullish Review," which comes out right after each C.O.T. report. It is from conversations with Steve through the years and reading some of his material that I have learned about the C.O.T. report and its value to traders.

The most important aspect of the C.O.T. report for most traders is the change in net positions of the commercial hedgers. Why? Because studies show that commercials hold a superior record to other trading groups in forecasting significant market moves. The large commercials are generally believed to have the best fundamental supply and demand information on their markets, and thus position their trades accordingly. Along with the advantage of having the best fundamental supply and demand information on their markets, large commercials also trade large size, which in itself moves markets in their favor.

It's important here to note that whether a particular trader group is net long or net short is not important to analyzing the C.O.T. report. For example, commercials in silver are the producers and they have never been net long, because they hedge their sales. In gold, however, the commercial mix is more heavily weighted toward fabricators who buy long contracts as a hedge against future inventory needs. So, again you need to look at the net change in positions from the previous report or several of the recent reports.

Individual traders that consider positioning themselves on the same side of the market as large commercials, when the large commercials become one-sided in their market view, is the best way to utilize the C.O.T. report.

Some traders do like to take the opposite sides of the trades on which the small trader (non­reportable positions) in the C.O.T. reports are shown taking. This is because most small speculative traders of futures markets are usually under-capitalized and/or on the wrong side of the market.

Also, some traders will also follow the coat-tails of the large speculators, thinking the large specs must be good traders or they would not be in the large trader category.

Briese says that contrary to what some believe, divergences from seasonal open interest averages in C.O.T. report data are not reliable trading indicators. This is even true with agricultural markets, where one would suspect that hedging is a seasonal consideration.

For more information on the C.O.T. reports, check out the Internet websites www.bullishreview.com or www.cftc.gov. 

That is it for this week. You can also visit my daily blog at http://www.traderblogs.com. Have a great weekend!

Commodity Markets Review

By Kevin Klombies 

Spike up in crude oil spooks the markets

On Wednesday morning, major U.S. stock price indexes opened lower and fell further on news of sharply rising oil prices, weak durable orders, a Fed Chairman who now says he is more concerned about inflation than promoting economic growth, a growth slowdown for the economy and corporate earnings, subprime mortgage problems, housing market weakness, growing tension over Iran's capture of 15 British sailors, and Beazer Homes fraud investigations.

Stocks bottomed at about 10:45 a.m. and spent the balance of the session chopping up and down, going nowhere. But the damage was already done.

The Advance-Decline balance finished very Bearish on the NYSE, and slightly more Bearish on the Nasdaq, as usual. Breadth on the Nasdaq has been lagging most of the time for many years.

Volume rose, reflecting increasing selling pressure on stocks.

Semiconductors fell to new three week lows and appear vulnerable to further decline.

Foreign stock markets underperformed moderately since Wednesday, 3/21/07, the day they made new multi-year highs relative to U.S. stocks. This recent mild pullback is probably normal consolidation. Longer term, foreign stocks have outperformed since the Bull Market started in 2002. Their relative strength trends are still Bullish, despite the extreme price volatility of recent weeks.

The ratio of the Nasdaq Composite relative to the S&P 500 moved lower again, within its established short-term down trend. The Nasdaq has underperformed the S&P 500 since 2/22/07. In the bigger picture, the Nasdaq has underperformed the S&P 500 since 4/16/06. So, the longer-term Nasdaq trend still appears relatively Bearish compared to the S&P 500.

The ratio of Growth stocks relative to Value stocks recovered slightly after falling steeply to its lowest level in five weeks on Tuesday. Growth clearly has underperformed Value since 1/11/07. Longer term, Growth substantially underperformed Value since year 2000, and there is no convincing sign of a major turnaround of that major trend.

The ratio of Small Cap stocks relative to Large Caps recovered slightly after falling to its lowest level since 3/14/07 on Tuesday. Intermediate term, Small Caps have underperformed since 1/22/07. Longer term, Small Caps have underperformed since 4/19/06. And so, the larger technical trends are not encouraging for Small Cap stocks relative to Large Caps.

Crude oil futures (for May delivery) briefly spiked up to 68.09, the highest price level since 9/12/06. Oil was stimulated by rumors, and it quickly settled back down below the high at 64.15 set on 12/20/06. The crude oil ETF (ticker USO) confirmed strength by moving up to its highest level since 12/26/06. The larger swings in oil are important because oil’s next big swing probably will impact all of the financial markets. Energy stocks usually take their cue from crude oil, even though they went down on Wednesday.

Gold futures (for April delivery) traded as high as 669.8, a new four week high and above resistance at the high of 667.6 set on 3/22/07. The gold metal ETF (GLD) confirmed this strength. Gold Miners (XAU) were down, however, and they continue to underperform the gold metal. Silver also is lagging.

The CRB commodity price index, which is heavily weighted by oil, moved up to its highest level in a month. But the CRB turned back down from resistance near the high of 316.40 set on 2/26/07. The larger trend for the CRB is in doubt since the high at 365.45 set on 5/11/06.

The ratio of the price of bond TIPS to 10-year U.S. Treasury Notes moved moderately lower after making a new six month high on 3/26/07. That new high indicated rising inflation expectations, and that is Bearish for bonds and stocks.

 

U.S. Treasury Notes and Bonds prices fell to new five week lows, thereby confirming that the short-term trend is still down. In the bigger picture, Bonds’ longer-term price trends have been drifting in a neutral to negative direction since 6/16/03.

The U.S. dollar rose, but only slightly. The U.S. dollar has been in a downtrend against foreign currencies since 1/26/2007. Longer term, the U.S. dollar has been in a major downtrend for nearly six years, since it peaked out at 121.29 on 7/5/2001. Beyond that, the dollar has been weakening since WWII, so the secular trend is also Bearish. These trends stack the odds against strength in the U.S. dollar in all timeframes. In other words, foreign currencies still look Bullish. These trends also favor foreign stocks over U.S. stocks.

Daily Rankings of Major Global Markets, Ranked from Strongest to Weakest of the Day:

0.92% Japanese Yen
0.12% US Dollar Index
-0.02% Energy
-0.02% Oil
-0.03% Dow Utilities
-0.12% Natural Gas
-0.12% Canadian Dollar
-0.14% Gold Mining
-0.14% 30Y T-Bond
-0.15% Swiss Franc
-0.16% AMEX Composite
-0.16% Euro Index
-0.19% Consumer Staples
-0.19% British Pound
-0.20% Utilities
-0.25% Commodity Related
-0.25% Hospitals
-0.27% Canada
-0.32% Australian Dollar
-0.33% Network
-0.37% Biotechs
-0.43% S&P Small Caps
-0.44% S&P Mid Caps
-0.50% Insurance
-0.53% Health Care Products
-0.58% Value Line
-0.59% Austria
-0.60% Italy
-0.61% Health Care
-0.62% Russell 2000
-0.62% Hong Kong
-0.65% Mexico
-0.68% Health Care
-0.73% Wilshire 5000
-0.73% Drugs
-0.75% Dow Composite
-0.75% Russell 3000
-0.75% Japan
-0.76% NYSE Composite
-0.76% Russell 1000
-0.76% REITs
-0.78% Dow Industrial
-0.79% Internet
-0.79% Oil Services
-0.80% S&P 500
-0.80% S&P 100
-0.81% Industrial
-0.83% Nasdaq Composite
-0.85% Paper
-0.86% South Korea
-0.87% United Kingdom
-0.92% Airlines
-0.92% Chemicals
-0.92% Computer Tech
-1.00% Materials
-1.00% Spain
-1.05% Belgium
-1.06% France
-1.06% Netherlands
-1.08% Nasdaq 100
-1.10% DOT
-1.12% Consumer Discretionary
-1.14% Technology
-1.17% Disk Drives
-1.21% Dow Transports
-1.25% Retailers
-1.26% Financial
-1.28% Australia
-1.29% Banks
-1.32% Switzerland
-1.35% Semiconductors
-1.39% Broker Dealers
-1.56% Germany
-1.63% Brazil
-1.66% Hardware
-1.70% Singapore
-1.91% Sweden
-2.00% Taiwan
-3.04% Malaysia

Best Wishes,
  
      

Weekly Currency Wrap-up

By Darrell Jobman  

US growth trends remained an important influence over the week. The US data was generally weak with new home sales falling to an annual rate of 0.85mn in February from a revised 0.88mn the previous month. Sales dropped to a 7-year low while inventories also rose to a 17-year high.

 

Headline durable goods orders rose 2.5% in February, but this followed a revised 9.3% decline for January. There was also a 0.1% decline in underlying orders, the fourth decline in the past five months. Fourth-quarter GDP growth, however, was revised up to 2.5% from 2.2% while jobless claims fell to 308,000 in the latest week. Inflation indicators remained firm with a core PCE reading of 0.3% for February.

 

Fed Chairman Bernanke took a generally optimistic view on the economic outlook and also stated that the Fed still had a tightening bias on policy. He also stated that the Fed wanted greater flexibility and markets were unconvinced with futures markets still indicating a 30% chance of a cut in interest rates by mid year.

 

The German economic data remained robust with the IFO index for March rising to 107.7 from 107.0 the previous month. There was also a further 65,000 drop in unemployment for March while the provisional inflation rate rose to 1.9% from 1.8%.

 

ECB officials continued to take a tough policy stance and markets continued to price in a rise in a further increase in interest rates to at least 4.0% during 2007, especially with a strong reading for money supply growth.

 

The dollar was able to resist a further attack on 1.34 against the Euro over the past week, but was unable to secure significant gains with resistance close to 1.33.

 

 

Source: VantagePoint Intermarket Analysis Software

 

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The Japanese inflation data was subdued with core prices falling 0.1% in the year to February, the first drop for 10 months. Government officials took a more optimistic stance on underlying economic trends with the bank focussing on wider economic trends.

 

The yen strengthen to highs beyond 116.50 against the dollar and 156 against the Euro, but failed to hold the gains as risk aversion eased slightly in choppy trading.

 

UK bank lending levels remained firm while there was a firm CBI retail spending survey for March. Housing surveys remained firm with the Nationwide Bank, for example, recording a 0.4% March increase in prices, although annual growth slowed to 9.3% from 9.6%.

 

Comments from Bank of England officials continued to indicate that the bank has a tightening bias, but the comments were mixed with the bank slightly less concerned over the level of wage settlements and uncertain over the economic outlook.

 

The UK current account deficit rose to a record GBP12.7bn in the fourth quarter of 2006 from GBP10.5bn previously which increased fears that Sterling is overvalued and Sterling weakened back to 1.9560 against the dollar.

 

The Canadian dollar found support close to 1.1620 as confidence remained firmer and strengthened to 1.1535 on Friday, challenging the strongest level for 2007 supported by speculation over an overseas bid for BCE.

The currency was supported by higher oil prices as crude temporarily spiked to US$68 p/b on an escalation in Middle East tensions.

There was further support from strong inflation data the previous week while Bank of Canada Governor Dodge stated that domestic demand appeared to be strengthening.

Political concerns eased over the week as separatist losses in Quebec elections reduced the potential for political tensions over the issue.

 

 

Source: VantagePoint Intermarket Analysis Software

 

Have a great day and a wonderful weekend.