Saturday, August 11, 2007

COT loss and Draw down

“Contrary to what 99% of the investment population thinks, trading is not about being right. Being right is easy. Trading is about being wrong; and navigating this inevitable occurrence distinguishes winners from the losers in the long run.”– Fari Hamzel
I love that quote. It is so true also. It's not how much you make it's how much you lose that determines whether you make money in the markets. Most investors think being right on their trades is what determines whether they make money or not. Nothing could be further from the truth. Any experience trader will tell you that the best you can do is maybe 3 to 2 in the market. (The COT has a history of 3 to 1). So it all boils down to your position size on your losing trades as to whether you will ultimately make money over the long haul. First I'm going to use an example that I think is probably playing out right now.
The bears have been consistently wrong for several years so I'm guessing they are currently betting huge trying to make back all their losses quickly. It may very well work but here's the rub. If they don't have the discipline to use correct position sizing now then they aren't going to use it when the market turns against them. The outcome is they will eventually lose all the profits that they are making from the current fall. It is the same as a gambler sitting in the casino. He catches a winning streak and makes some good money. Does he pack up and go home? Let's just say that living in Vegas I've never seen it happen. What I have seen is the gambler starts raising his bet because he's obviously hot right now. Then he loses a couple but because he was betting big he just gave back a good chunk of his winnings. Now he's pissed and wants to make that back so he keeps betting big trying to get back to where he was. We all know where this is going don't we. Yes he gives it all back and then some (usually "then a lot").
Does anybody seriously think that this mentality doesn't play out exactly the same way in the stock market? BTW I guarantee it does. I've seen the horror stories on the blogs.
Now I'm going to walk you through a losing COT trade and a draw down.
First chart the commercials flipped to an extreme short position on June 24, 03. The market started to drift down but then began climbing in Sept. The commercials realized their mistake and covered most of their shorts for a 5% loss on Sept 16th. If you were watching your position size you maybe lost 3-4%. 5% if you went all in. 5% is easily recoverable.
Now let's look at a draw down. The market appeared to have topped and rolled over in the beginning of 04. Common sense and the charts said the counter trend rally was over. But for some reason the commercials didn't dump their longs and go short here. Well with hindsight we can see why they didn't abandon their position. They weren't interested in shorting for a measly 8% gain they were too busy accumulating stocks for the multi year run that was to follow. I have found that most of the time when the commercials stubbornly stay on the wrong side of the trend it is because they are accumulating or distributing stocks. Right now it would appear that the commercials are accumulating like there's no tomorrow.