Five Fatal Flaws of Trading

By Jeffrey Kennedy

Close to ninety percent of all traders lose money. The remaining ten percent somehow manage to either break even or even turn a profit – and more importantly, do it consistently. How do they do that?

That's an age-old question. While there is no magic formula, one of Elliott Wave International's senior instructors Jeffrey Kennedy has identified five fundamental flaws that, in his opinion, stop most traders from being consistently successful. We don't claim to have found The Holy Grail of trading here, but sometimes a single idea can change a person's life. Maybe you'll find one in Jeffrey's take on trading? We sincerely hope so.

The following is an excerpt from Jeffrey Kennedy’s Trader’s Classroom Collection. For a limited time, Elliott Wave International is offering Jeffrey Kennedy’s report, How to Use Bar Patterns to Spot Trade Setups, free.

Why Do Traders Lose?

If you’ve been trading for a long time, you no doubt have felt that a monstrous, invisible hand sometimes reaches into your trading account and takes out money. It doesn’t seem to matter how many books you buy, how many seminars you attend or how many hours you spend analyzing price charts, you just can’t seem to prevent that invisible hand from depleting your trading account funds.

Which brings us to the question: Why do traders lose? Or maybe we should ask, 'How do you stop the Hand?' Whether you are a seasoned professional or just thinking about opening your first trading account, the ability to stop the Hand is proportional to how well you understand and overcome the Five Fatal Flaws of trading. For each fatal flaw represents a finger on the invisible hand that wreaks havoc with your trading account.

Fatal Flaw No. 1 – Lack of Methodology

If you aim to be a consistently successful trader, then you must have a defined trading methodology, which is simply a clear and concise way of looking at markets. Guessing or going by gut instinct won’t work over the long run. If you don’t have a defined trading methodology, then you don’t have a way to know what constitutes a buy or sell signal. Moreover, you can’t even consistently correctly identify the trend.

How to overcome this fatal flaw? Answer: Write down your methodology. Define in writing what your analytical tools are and, more importantly, how you use them. It doesn’t matter whether you use the Wave Principle, Point and Figure charts, Stochastics, RSI or a combination of all of the above. What does matter is that you actually take the effort to define it (i.e., what constitutes a buy, a sell, your trailing stop and instructions on exiting a position). And the best hint I can give you regarding developing a defined trading methodology is this: If you can’t fit it on the back of a business card, it’s probably too complicated.

Fatal Flaw No. 2 – Lack of Discipline

When you have clearly outlined and identified your trading methodology, then you must have the discipline to follow your system. A Lack of Discipline in this regard is the second fatal flaw. If the way you view a price chart or evaluate a potential trade setup is different from how you did it a month ago, then you have either not identified your methodology or you lack the discipline to follow the methodology you have identified. The formula for success is to consistently apply a proven methodology. So the best advice I can give you to overcome a lack of discipline is to define a trading methodology that works best for you and follow it religiously.

Fatal Flaw No. 3 – Unrealistic Expectations

Between you and me, nothing makes me angrier than those commercials that say something like, "...$5,000 properly positioned in Natural Gas can give you returns of over $40,000..." Advertisements like this are a disservice to the financial industry as a whole and end up costing uneducated investors a lot more than $5,000. In addition, they help to create the third fatal flaw: Unrealistic Expectations.

Yes, it is possible to experience above-average returns trading your own account. However, it’s difficult to do it without taking on above-average risk. So what is a realistic return to shoot for in your first year as a trader – 50%, 100%, 200%? Whoa, let’s rein in those unrealistic expectations. In my opinion, the goal for every trader their first year out should be not to lose money. In other words, shoot for a 0% return your first year. If you can manage that, then in year two, try to beat the Dow or the S&P. These goals may not be flashy but they are realistic, and if you can learn to live with them – and achieve them – you will fend off the Hand.

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For a limited time, Elliott Wave International is offering Jeffrey Kennedy’s report, How to Use Bar Patterns to Spot Trade Setups, free.

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Fatal Flaw No. 4 – Lack of Patience

The fourth finger of the invisible hand that robs your trading account is Lack of Patience. I forget where, but I once read that markets trend only 20% of the time, and, from my experience, I would say that this is an accurate statement. So think about it, the other 80% of the time the markets are not trending in one clear direction.

That may explain why I believe that for any given time frame, there are only two or three really good trading opportunities. For example, if you’re a long-term trader, there are typically only two or three compelling tradable moves in a market during any given year. Similarly, if you are a short-term trader, there are only two or three high-quality trade setups in a given week.

All too often, because trading is inherently exciting (and anything involving money usually is exciting), it’s easy to feel like you’re missing the party if you don’t trade a lot. As a result, you start taking trade setups of lesser and lesser quality and begin to over-trade.

How do you overcome this lack of patience? The advice I have found to be most valuable is to remind yourself that every week, there is another trade-of-the-year. In other words, don’t worry about missing an opportunity today, because there will be another one tomorrow, next week and next month ... I promise.

I remember a line from a movie (either Sergeant York with Gary Cooper or The Patriot with Mel Gibson) in which one character gives advice to another on how to shoot a rifle: 'Aim small, miss small.' I offer the same advice in this new context. To aim small requires patience. So be patient, and you’ll miss small."

Fatal Flaw No. 5 – Lack of Money Management

The final fatal flaw to overcome as a trader is a Lack of Money Management, and this topic deserves more than just a few paragraphs, because money management encompasses risk/reward analysis, probability of success and failure, protective stops and so much more. Even so, I would like to address the subject of money management with a focus on risk as a function of portfolio size.

Now the big boys (i.e., the professional traders) tend to limit their risk on any given position to 1% - 3% of their portfolio. If we apply this rule to ourselves, then for every $5,000 we have in our trading account, we can risk only $50-$150 on any given trade. Stocks might be a little different, but a $50 stop in Corn, which is one point, is simply too tight a stop, especially when the 10-day average trading range in Corn recently has been more than 10 points. A more plausible stop might be five points or 10, in which case, depending on what percentage of your total portfolio you want to risk, you would need an account size between $15,000 and $50,000.

Simply put, I believe that many traders begin to trade either under-funded or without sufficient capital in their trading account to trade the markets they choose to trade. And that doesn’t even address the size that they trade (i.e., multiple contracts).

To overcome this fatal flaw, let me expand on the logic from the 'aim small, miss small' movie line. If you have a small trading account, then trade small. You can accomplish this by trading fewer contracts, or trading e-mini contracts or even stocks. Bottom line, on your way to becoming a consistently successful trader, you must realize that one key is longevity. If your risk on any given position is relatively small, then you can weather the rough spots. Conversely, if you risk 25% of your portfolio on each trade, after four consecutive losers, you’re out all together.

Break the Hand’s Grip

Trading successfully is not easy. It’s hard work ... damn hard. And if anyone leads you to believe otherwise, run the other way, and fast. But this hard work can be rewarding, above-average gains are possible and the sense of satisfaction one feels after a few nice trades is absolutely priceless. To get to that point, though, you must first break the fingers of the Hand that is holding you back and stealing money from your trading account. I can guarantee that if you attend to the five fatal flaws I’ve outlined, you won’t be caught red-handed stealing from your own account.

For more information on trading successfully, visit Elliott Wave International to download Jeffrey Kennedy’s free report, How to Use Bar Patterns to Spot Trade Setups.

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Jeffrey Kennedy is the Chief Commodity Analyst at Elliott Wave International (EWI). With more than 15 years of experience as a technical analyst, he writes and edits Futures Junctures, EWI's premier commodity forecasting package.

Dr. Paul gives an Austrian response to the idea of giving the Fed more power

Dr. Paul gives an Austrian response to the idea of giving the Federal Reserve more powers. The Fed caused the problems, so why would giving them more power help? Congressman Paul also states that the Fed, a quasi-governmental agency, is now more powerful than Congress itself.

A Grocery Store that Accepts Gold and Silver

I found this interesting. It seems that individuals and markets are forming in rejection of fiat (not backed) money. The fact that this is occurring even in a semi-free market burdened with legal tender laws that protect a private banking cartel which issues unbacked notes is a testament to the creativity of the marketplace.



While I expect there to remain demand for US dollars simply because there is a lot of debt out there that requires liquidation, we see that even the semi-free market we live in is beginning take steps towards commodity backed money.

Don't Fly Blind

I was doing a little planning today involving back up systems in case of hardware and software failure, and it hit me. I talk a lot about price trends, but some people probably don't know where to go to get free charts that are readily available online.

When trading and investing, the news is not what is important. In fact, as many legends in the field, including Ed Seykota in a song posted recently, recommend filing the news in the trash bin. Objectivity requires we turn to price action itself. This is true whether we are trading/investing on the very long term or very short term. Even if you find that you have a psychological need to know the "news" surrounding the markets, the price trend should be respected in your executions of entry and exit. It is the supply and demand of the market we are interested in, not what some talking heads believe, or want us to believe, might affect that supply and demand. The market's final say on supply and demand for the investment vehicle is reveled in price action and price action alone, while the talking heads are usually wrong anyway.

Here are some decent free chart sites that can help anyone wishing to look at the markets and past the hype:

www.quote.com
www.timingcharts.com
www.futures.tradingcharts.com
www.barchart.com
www.bigcharts.com

You will need to play around on the sites a bit to figure out how to use each one the best regarding your personal preferences and markets.. These chart sites can also help you as an emergency back up or even a primary charting platform for trend following trades. Some of the sites will focus on Futures markets, some Stocks, and some will have both. For more advanced technical analysis, you will probably need to upgrade. Just remember that generations before us simply used graph paper, pencil and ruler. Ed Seykota used computer punch cards before some of us were even born!

Here is a sample of a free chart of the Globex EURO futures contract (continuous contract) from www.timingcharts.com as an example of what you can find on the web:

Does Gold Always Go Up in Recessions and Depressions?

By Robert Prechter, CMT

The following article is adapted from a brand-new eBook on gold and silver published by Robert Prechter, founder and CEO of the technical analysis and research firm Elliott Wave International. For the rest of this revealing 40-page eBook, download it for free here.

I have often read, “Gold always goes up in recessions and depressions.” Is it true? Should you own gold because you think the economy is tanking? Whenever we hear some claim like this, we always do the same thing: We look at the data.

The first thing to point out is that gold did not make a nickel of U.S. money for anyone in any of the recessions and depressions from 1792, when the gold-based dollar was adopted, through 1969, a period of 177 years. Well, to be precise, there was a change in the valuation in 1900, when Congress changed the dollar’s value from 24.75 grains of gold, the amount established in 1792, to 23.22 grains, a devaluation of just six percent total over 108 years. The government did raise the fixed price from $20.67/oz. to $35/oz. in 1934, but that action occurred during an economic expansion, not during the Depression. In 1968, gold finally began trading away from the government’s fixed price. Even then, it slipped to a lower price of $34.95 on January 16 and 19, 1970. So the idea that gold always goes up in recessions and depressions is already shown to be wrong. It did not go up in terms of dollars in any of the (estimated) 35 recessions or three depressions during that period.

What almost always does happen during economic contractions is that the value of whatever people use as money goes up as prices for goods and services fall. When gold is used as money, its value in terms of goods and services goes up. But gold can’t go up in dollar terms when gold and dollars are equated. So no one “makes money” holding gold under these conditions. It is a fine point: What tends to go up relative to goods and services during economic contractions is money, and when gold is officially money, that’s how it behaves. What we want to know is how gold behaves in recessions and depressions when it is not officially accepted as money.

Many gold bugs say that because gold was a good investment during the Great Depression, it is a “deflation hedge.” We addressed this topic in At the Crest of a Tidal Wave (1995, p.357) and Conquer the Crash (2002, pp. 208-209). At the time, government fixed gold’s price, so it didn’t go up or down relative to dollars. Gold was a haven during that time, the same as the dollar was, since they were equated by law. But gold served as a haven because its price was fixed while everything else was crashing in price during the period of deflation. Gold bugs like to claim that gold would have gone up during that period had it not been fixed, but the crashing dollar prices for all other things suggest that in a free market gold, too, would have fallen. It would have fallen, however, from a higher level given the inflation of 1914-1929 following the creation of the Fed. So gold became worth more in dollar terms than it was in 1913, which is why it began flowing out of the country. In 1934, the government finally recognized the new reality by raising gold’s fixed price. Since 1970, markets have been in a large version of 1914-1930, except that gold has been allowed to float, so we can clearly see its inflation-related, pre-depression gains.

Observe that gold’s price remained the same for a Fibonacci 21 years after the Fed was created in 1913; it was revalued in 1934. [Ed. Note: For a full chapter on Fibonacci time considerations for gold, download the 40-page Gold and Silver eBook.] Then it held that value for 35 (a Fibonacci 34 + 1) years, through 1969. So aside from the revaluation of 1934, the inability to make money holding gold during recessions, depressions, or any time at all save for the day of the revaluation in 1934 held fast for 56 (a Fibonacci 55 + 1) years following the creation of the Fed. So even after Congress created the central bank, no one made money holding gold in a recession or depression for two generations.

In 1970, things changed dramatically. Investors lost interest in stocks and preferred owning gold instead, for a period of ten years. The same change occurred again in 2001, and so far it has lasted seven years. But, as we will see, recession had nothing to do with either of these periods of explosive price gain in the precious metals.

The period of time one chooses to collect data can make a huge difference to the outcome of a statistical study. If we were to show the entire track record from 1792, gold would show almost no movement on average during economic contractions. If we were to take only 1969 to the present, it would show much more fluctuation. To give a fairly balanced picture, combining some history with the entire modern, wild-gold era, I asked my colleague Dave Allman to compile statistics beginning at the end of World War II. This is what most economists do, because they believe “modern finance” began at that time and that things have been “normal” since then. It’s also when many data series begin. So our study fits the norm that most economists use. It also provides results entirely from the Fed era, making it relevant to current structural conditions.

[Ed. note: To study the six tables revealing gold's performance record vs. stocks and T-notes since WWII, download the 40-page Gold and Silver eBook.]

Table 1 shows the performance of gold during the 11 officially recognized recessions beginning in 1945. Although one could make a case for different start times, we took the 15th of the starting month and the 15th of the ending month as times to record the price of gold. The results speak for themselves. Even though it is accepted throughout most of the gold-bug community that gold rises in bad economic times, Table 1 shows that such is not the case.

The only reason that the average gain for gold shows a positive number at all is that gold rose significantly during one of these recessions, that of 11/73-3/75. The average gain for all ten of the other recessions is 0.16 percent, almost exactly zero. The median for all 11 recessions is also zero. If we omit the five recessions during which the price of gold was fixed, the median gain is 3.09 percent.

For long-term forecasts and more in-depth, historical analysis for precious metals, including the six revealing tables mentioned in this article, download Prechter’s FREE 40-page eBook on Gold and Silver.

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Robert Prechter, Chartered Market Technician, is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

The Whipsaw Song

This is truly hilarious but educational and honest at the same time! For those who don't know, Ed Seykota is a trading legend. Just pick up a book called "Market Wizards", and you can read a little about him. I have learned a lot from reading about Ed Seykota over the years, and really wish I would have met him when I lived in Tahoe. This song sums up his simple and objective trend following strategy.



"What do we do with a hot news flash, honey? We stash that flash right in the trash...." - The Whipsaw Song, by Ed Seykota.

Profitable Trading and Investing in a Bear Market: Not Just for Pros

Many times I have been in a discussion about markets with acquaintances in which I notice an odd look on their face when I start talking about profiting from downtrends as well as up trends. I suppose this is because of a bullish bias at retail brokerage houses that leads to the belief that uptrends are good and downtrends are bad.

In my view, good is not up or down. Good is an objective strategy for profiting from major price trends. Good is risk and money management procedures for keeping the inevitable loosing trades at a linear level, while allowing the winning trades and investments to become exponentially profitable. Good is cutting losses short and letting winners run. Good does not have to be up or down. Good is objectivity.

Every investor and trader has a fiduciary responsibility to himself or herself and family. The first line of action is getting out of the way of markets that have negated your investment hypothesis and therefore are causing losses. The next line of action is catching the waves that are profitable. Overvalued stock markets are not something that is good for the country, and investing blindly in them is foolish, not patriotic. Invest in these markets when they have become undervalued. You can participate actively or passively in ways that will result in your having more capital available for the rebuilding process after a recession or depression ends.

Before we get into the more proactive ways to benefit from major bear markets, we must realize the passive way of gaining value. Sitting in cash during major stock market downtrends is in itself a profitable venture. This is because the value of stocks that you can buy at a later date are losing value relative to the cash you are sitting on. Sitting on cash and liquidating stocks (real estate and other asset classes) when the market is trending down increases your net worth relative to the things that the cash can purchase. And, no, I did not just start preaching this.

I don't want to get too far off the original subject here, but even cash held does not have to be held in a bank. As we have seen, bank failures that are due to over-leverage and bad loans are not out of the realm of possibilities. Instead of using a bank or savings-and-loan, you could simply store your cash in short-term U.S. treasuries. Short-term U.S. treasuries should provide the most safety unless or until the currency is completely destroyed (likely in the long run, due to inflationary fiat monetary policy). For currency protection, have some physical gold too (real money). The easiest way to access short-term treasuries is through treasury only money market funds. You can also buy them directly from the treasury if you want. A money market fund (remember: we are suggesting treasury only, for safety) can even be used like a checking account, although without the debit card. I wanted to put this general information out there, because I often hear "well, do I just keep my money in the bank; sitting there!?" after being solicited as to my opinion of what to invest in right now. In a secular bear, we are primarily interested in wealth protection, while wealth perpetuation is the secondary focus. With all of this out of the way, perpetuation is what we are going to talk about now.

Never before has profiting from investments and trades geared towards declining markets been as accessible as it is today. We used to have to either sell stocks short, sell futures contracts, or buy put options in order to profit from a downtrend. None of these (with the exception of options, possibly) are as difficult or complicated as most people think. Regardless, none of this is currently necessary for the investor looking to profit from market downtrends.

Many different Exchange Traded Funds (ETFs) are now available. These allow you to invest in the movement of the indexes and sectors they are designed to track and follow. Some of these ETFs are even leveraged to twice the price action of the underlying index. Yes, you can sell the ETFs short, but you don't even need to do that anymore. There are inversely correlated ETFs. Inverse ETFs will go in the opposite direction from the price of the underlying index. For example, an ETF which is inversely correlated to the S&P 500 stock index will increase in value when the stock market declines. An ETF that is inversely correlated to the S&P 500 by a 2x multiple, will approach a price change of 200% more than 100% of the market decline in which the leveraged inverse ETF was held. When the markets bottom out, and we get a signal that the secular bear market is complete, you can even use the directly correlated ETFs to participate in the upside if you want.

Under the label "Trader and Investor Education" I have previously laid out some really simple technical trend identification and trend following approaches that can be applied to both long and short term time frames. A simple approach for using the ETFs would be to use trend rules and approaches we discussed, then pick the appropriate ETF for the directional trade or investment you want to make. Of course some of your trend signals will be wrong, leading to some of your trades and investments being wrong. The use of ETFs does not change the fact that we need to cut losses short and let winners run.

I personally think some of the most useful ETFs and Inverse (short) ETFs are found through ProShares: www.proshares.com. No, I don't make any money from the link. I just like their product offering. I've been more of a macro styled trader / investor over the years, so the funds that really catch my attention as potential trading and investing vehicles at the proshares site are:

SH: Short S&P 500
SSO: Ultra S&P 500
SDS: Ultra Short S&P 500
DOG: Short Dow 30
DXD: Ultra Short Dow 30
DDM: Ultra Dow 30
ULE: Ultra Euro
EUO: UltraShort Euro
YCL: Ultra Yen
YCS: UltraShort Yen
UGL: Ultra Gold
GLL: UltraShort Gold
AGQ: Ultra Silver
ZSL: UltraShort Silver

There are many more ETF's listed at the site, but these are the ones that caught my attention the most as potential vehicles for even the small and non-professional trader who wants to trade and invest in both the uptrends and downtrends of major macro markets.

There is no holy grail to trading or investing. Losses are inevitable, but can be limited with good money and risk mangement. Downtrends are as profitable (sometimes more) as uptrends. Hopefully knowledge that these vehicles exists will help anyone who has been watching their portfollo shrink while not getting any objective advice from the retal investment community.

As I have stated in previous posts, we currently view upside moves in the S&P 500 as bear market rallies, and would use them as selling opportunities within the paramaters of our directional, risk and money management rules. I am posting this during a multi-month rally in the S&P 500, hoping it to be useful to anyone who has found to much comfortable complacency in the hope that the current rally is the end to the secular bear. We don't think it is. If we are wrong, then following the price trend will eventually put us on the right side of the market. If we are right, then doing nothing will lead to the financial ruin of many.