Naked I Trade, Naked I Live

No - I don't literally trade naked or live out my day running around the house naked!

I had a zen shift after getting zen slapped - I can't grasp, hold onto concepts anymore - I'm free.  That's what has made me a successful stock trader.  I no longer hide behind technical analysis or look for patterns, or expect the market to do what i think it should - I m no longer attached to the outcome.

 I just use my Stock Trading Riches system.

All I care about is the stock fluctuates - I then play the stock.  I follow it in and out - reset constantly.

That is how the rest of my life is now  - old patterns are shifting, changing.

I want to be reborn every time I trade or write.

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Zen Simplicity in Stock Trading

I developed the Stock Trading Riches system when I became fascinated with the idea of a pure Zen trading system. It would use no news reports, indicators, charts, or parameters to distract you from Now. It would be able to handle any market condition.

I turned to jazz, improvisation, Taoism, simplicity, and minimalism for inspiration.

I ended up building a simple and minimalist trading system around an old, obscure, 19th century Wall Street formula called constant value investing.

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Stock Trading vs. Football

When I was younger, and played the early versions of electronic football, I almost always went on fourth down - even from my own side of the field. I wanted to score quickly and often, and rack up points. What usually happened, however, was that I was stopped and ended up losing the game because the opponent always had better field position.

Now, being older and wiser, I always root for the Bears (my hometown team from Chicago) to play safe and conservatively. I would never think about going on fourth down unless it was late in the game and my team was behind. Also, when my team is looking at long 3rd downs (such as 3rd and 15), I don't automatically expect them to try a long pass. I'm ok with them gaining a little yardage, punting it away, and waiting until the next possession.

Similarly, you have to be patent when stock trading. When I was younger, I wanted to see success right away. I ended up losing a lot because I day traded and used futures, options, and margin trading to leverage my way to success.

My profits went up (and my stress down) when I stopped trying to make quick profits. Instead, like football, I started playing safely and conservatively.

Since day trading left me stressed with no edge, I switched to long term trading, which I found suited my personality much better. I also stopped using margin, futures, and options because they masked my edge. They left me dependent on short term luck to avoid margin calls.

I realized that one of the reasons I was impatient to day trade and make profits was that I didn't trust longer term trading systems. So, I took a few years off trading and did nothing but system design and testing until I proved to myself that my long term trading system had an edge.

I designed the system to suit my personality and needs. I then became passionate and excited about trading my system and knew that I would make money over the long term - even if I could not see profits in the short term.

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Akorn is the Second Best Performing Chicago Area Stock of 2011

In a previous post, I described Ulta, which was the best performing Chicago-based stock in 2011.

The second best stock was Akorn, Inc (AKRX), which is based in Lake Forest, IL. Akorn sells ophthalmic antibiotics, dry-eye treatments, and injectable drugs for hospitals.

This is another growth stock. Akorn's CEO, Raj Rai, took over in 2009 (when the stock was below $1) and led a remarkable turnaround - the stock increased 239% in 2010 to $6.07/share, and increased 83% in 2011, to $11.12/share.

Rai turned the company around by focusing on its profitable eye treatments and injectable drugs, selling its money-losing divisions like vaccines, investing in sales, marketing, and R&D, and acquiring factories in India to serve that country's fast growing markets.

Akorn has a lot of room to grow, so it could make a good growth stock purchase, especially at a lower price.

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Ulta is the Top Performing Chicago-Area Stock for 2011

The Chicago Tribune recently had an article listing the best-performing 2011 stocks among Chicago area-based companies.

The number 1 performing stock was Ulta Salon, Cosmetics, and Fragrance, Inc. (ULTA). The stock was up 91% in 2011.

Ulta has been called the "Best Buy" of the beauty market. It offers one-stop shopping for cosmetics at every price range, as well as a full-service hair salon.

It is a classic example of a growth stock.

On one hand, some analysts feel it could sell off this year because it trades at 32 times estimated earnings. Also, they may face competition as Walgreens and CVS increase their beauty product offerings, and from women shopping online.

On the other hand, the reason for their success is the fundamental shift of women going from malls to strip malls. Most high-end beauty products used to be bought from department stores. Now, women like the convenience of being able to drive up to an Ulta in a strip mall and find all products in one place.

As a result, Ulta is growing at a fast pace. They currently have 449 stores, and have room to expand - especially on the East Coast and Northwest. They plan to increase their number of stores by 15 - 20% a year until they reach 1,000 stores.

At the same time, they recently experienced a 12.6% increase in sales open at least one year.

In addition, since their stores average 10,000 square feet, they are experimenting with launching 300 square foot stores inside devoted to men's skin care and grooming products.

You can look to buy it on a drop for a GAARP play (Growth at a reasonable price) or buy it now as a growth play. Either way, you could then manage it with the "Stock Trading Riches" system to play the fluctuations, and pump money out to enhance your return, while reducing your risk/cost basis.

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Seven Year Return on My "Stock Trading Riches" Portfolio

For the past 7 years (2005-2011), I have exclusively used my Stock Trading Riches system to manage my portfolio.

While I lagged the market in 2011, I have beaten the S&P 500 over those 7 years:

Year, Me, S&P 500

2005, +13%, +4.91%

2006, +14%, +15.79%

2007, +22%, +5.49%

2008, -40%, -38.49%

2009, +44%, +23.5%

2010, +22%, +13%

2011, -5%, 2.11%

My portfolio has had a cumulative seven-year return of +57.38% vs. +12.32% for the S&P500.

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The Importance of Stock Market Capitalization For Building A Diversified Portfolio

Stocks can be separated into 4 groups, according to their market capitalization:

1. micro caps - below $300 million

2. small caps - between $300 million and $1 billion

3. mid caps - between $1 billion and $5 billion

4. large caps - over $5 billion

I talk in more detail about market cap analysis in my book Stock Trading Riches because it's important for investors to allocate their portfolios among all market caps to provide diversification, avoid cyclical returns, and take advantage of "regression to the mean" (e.g. one market cap segment outperforms another, but then they converge).
Market cap is calculated by multiplying the number of shares outstanding by the share price. For example, if stock ABC issued 6 million shares, and the price of each share is $6, then ABC has a market capitalization of $36 million.

In general, micro caps are new companies that are just hitting their stride. Small caps tend to have their infrastructure in place and are in growth mode. Mid caps are big regional or national companies. Large caps tend to be established multinational corporations.

Stocks within each market cap share important characteristics in the areas such as growth rate, risk, dividends, visibility, and international exposure.

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Successful Investing is Not Just About Good Stock Picking - You Also Need to Buy Low and Sell High

If you want your portfolio to beat the market over time (generating a better return with less risk), then picking good stocks is just part of the answer. In fact, you don't need to hit home runs by picking the next potential Microsoft or Apple.

You need a trading system that buys low and sells high (Looking for chart patterns is not a way to do it).

Here are 3 reliable ways:

1. Identify a stock that is about to undergo a dramatic shift. This goes beyond studying fundamental data to find good companies. You are also trying to time big moves up or down. This is the hard way to trade because, not only do you need to study the facts, but you have to figure out how the market will respond - not an easy task.

2. Evaluate the stock like a business. You calculate the intrinsic per share value of the company, and compare it to the stock price. Buy when a good company is under valued and sell when the company is overvalued. This is the system that Warren Buffett uses. It requires you to possess a high degree of financial and business knowledge. You also must spend a lot of time doing research. Unless you have an MBA and/or a background as an analyst, it is hard to really get a good edge.

3. Have an automated formula that scales in and out of stocks. This is the method that I use for trading, and I believe it is superior because anyone can use it. You don't need a lot of financial knowledge and time spent in research - only the discipline to stick with the plan.

With this method, you always have a base position in a good company, and increase or decrease the size of your position, depending on the change in the current stock price. Because you are not making a few large trades, errors caused by buying too high or selling too low are self corrected over time.

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The Scaling Flaw That Affects Trading from Chart Patterns

Many traders use charts of past prices to trade stocks. They feel that, if the chart makes certain patterns, it can predict what the stock is likely to do in the near future.

One of the problems with chart reading is that pattern recognition is fairly subjective (the human brain likes to organize random data into pictures). One trader may see a pattern where another one doesn't. This makes charting-based trading systems hard to test.

However, studies that have been done using objective definitions of patterns consistently detect no trading advantage. They show that trading on chart patterns are equivalent to buying randomly.

I think that another flaw of chart based systems, which nobody really talks about, is scaling. Chart scaling, in my opinion, is the reason that patterns looks so seductive and accurate in hindsight.

Traders develop patterns by studying charts of big moves that have already occurred. They frequently "see" consolidations and patterns before the big moves.

For example, one pattern is called sideways consolidation - where the market trades almost horizontally in a narrow range. Then, prices eventually "breakout" and make a big up or down move.

The problem is that, after a market's range has expanded, the scaling of the chart changes as well. This scale change smooths out the movements that occurred prior to the big move, and creates the sideways consolidation. Prior to the big move, traders would not have seen the sideways consolidation, because the chart scale would have been different.

Let's assume that the market moved in a range between 10 and 20 for 6 months. The chart would be scaled from 10 to 20, and the chart will show lots of peaks and valleys. After the market moves to 85, the chart now reflects a range from 10 to 85. This compresses the peaks and valleys between 10 and 20. The result is that the 6 months before the move looks like a sideways consolidation pattern.

Unfortunately, you can't trade on patterns that occur after the move.

This is why my trading system does not use charts - only prices. Numbers are objective, and not open to interpretation. I only use charts to find prices for stocks I want to back test using my spreadsheet.

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The Best Trading Systems Are Beautiful and Simple

The best trading systems are simple and minimally beautiful - at most, they only use a handful of indicators or formulas, and they implement a simple model of the market.

They don't aim to explain market behavior rigorously and precisely like an economist - instead, the model aims at robustness, where it lets you manage your risk appetite and set the odds in your favor.

The purpose is to give you an edge - like the house has in a casino game. It won't win every trade, but it will have a positive expectation where, over time, you can expect to make more money than you lose, thus letting you build your account over time.

If a trader attempts to develop a complex system that could win every trade, then that is a set-up for failure. As systems get more complex, they have more moving parts - which results in unpredictable interactions and bugs that will eventually cause your system to blow up and suffer heavy losses.

With a simple system, your ego may not be satisfied - it will tell you that you are smart enough to come up with something more accurate, so you will lose less trades - but your bottom line account balance will benefit.

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Why I Renamed My Blog To "Stock Market Zen"

Today, I renamed my blog from "Simple Trading System" to "Stock Market Zen" (however, the URL will stay the same).

I did this because I think that "Stock Market Zen" better reflects my philosophy and approach to the stock market and investing.

The old title described my system accurately, but very generically. A lot of trading systems can be simple - but many of them don't rely on concentrating on the present moment, and relying on the last price instead of a moving average or chart.

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How To Use "Stock Trading Riches"

I hope that my book helps you build a trading system that suits your risk-reward level.

I have exclusively used the basic Stock Trading Riches system on my portfolio for the last 6 years, and I have beaten the S&P 500 over those 6 years:

Year, Me, S&P 500

2005, +13%, +4.91%

2006, +14%, +15.79%

2007, +22%, +5.49%

2008, -40%, -38.49%

2009, +44%, +23.5%

2010, +22%, +13%

My portfolio had a cumulative six-year return of +65.66% vs. +10% for the S&P500.

Of course, my system is flexible and you can use the book's section on rule variations to customize the system. For example, you can increase or decrease the maximum cash percentage at the portfolio level from the basic 30%. You could implement the position growth rule, or the stop loss rule, you could change the rebalance frequency, or experiment with percent triggers.

You can back-test these variations on paper with various stocks and see if they improve the system in ways that make you more comfortable.

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The Return of Dividends

When I was a short term trader, dividends did not mean anything to me.

When I switched to long term trading, I not only eliminated stress and reduced expenses, but I started to enjoy seeing the dividends depositing into my account like a cash register. Cha-ching!!

Historically, dividends were a big component in the total return of stocks.

Then, in the 1990's, they became only a small component of the total return, and dividends were out of favor. We were in a raging bull market, and companies were pressured to favor growth over dividends.

Investors were hypnotized by the bubble and said: "Why should companies give out dividends (which were fully taxed) rather than invest that money in growing their market share, buying back stock, or buying the stock of other high-flying companies?"

Then, the Dot Com Crash happened, Bush cut the dividend tax in half, and investors pressured companies to pay out dividends.

Since the market has been choppy for the last decade, dividends have returned to their historical place as a big part of investors' total return.

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"Stock Trading Riches" is now available in Kindle format on Amazon.com

My book "Stock Trading Riches" is now available in Kindle format on Amazon.com.

Since this is a new format, it's priced for now at $2.99.

They did a good job in the conversion - I saw that the stock tables and programming scripts display well, and the links are click-able.

You don't need to own a Kindle to buy this edition. You can download free readers for PC's, Mac's, iPads, etc.

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Bought two small cap stocks: APKT and JOBS

On Monday, I bought two small cap stocks: ACME Packet (APKT) and 51Job (JOBS).

As I mention in the market cap section of my book, I try to balance my portfolio across market caps, since companies in the different caps have different risk / reward profiles, and the caps themselves follow different cycles.

APKT specializes in session border controllers (SBCs), which provide control and security at the edges of IP networks that carry voice, video, and multimedia traffic.

This is a fast growing company, but volatile stock with quartely fluctuations. The stock was up 104% in 2010, but I bought it now because it fell 50% after it missed it's third quarter estimate (due to a large order slipping into the fourth quarter).

I don't mind volatility, of course, since I will manage the position through my stock trading riches system.

51Job, based in Shanghai, is the human resources market leader in China. They provide recruiting, payroll processing, and training to companies across 25 cities in China. The stock fell into the $40's after a peak of $70. They have $10/share in cash. According to small cap guru Jim Oberweis, the stock trades for 15 times his 2012 earnings estimate, and has expected earnings growth of 55%.

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When Buying A Stock, Invest in Management

The Oct. 10 issue of Forbes had an interview with billionaire growth fund manager Ron Baron.

He listed 4 criteria for investing in a new company. He said many others look at the first three, so the fourth one is especially important:

1. The business must have growth opportunities.

2. The business must be appropriately financed.

3. There should be a competitive advantage (i.e. barrier to others from competing with them).

4. There needs to be a trustworthy leader that inspires people to follow them - who will invest in the business, even if it hurts the short term bottom line.

The example he gave was Ralph Lauren. His European franchisee was doing poorly, and Lauren realized that Europe was the next big market. He had to pay such a high price to acquire the franchisee, that it diluted the stock. In the long run, however, the move paid off.

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Gambler's Fallacy Part 1 - Casinos

The "gambler's fallacy" occurs in games of chance when a streak of one type of result happens, and the gambler then bets on the reverse. For example, supposed you were betting on coin flips and you waited until 10 heads in a row came up. You then bet on tails, because it's "due" to come up.

This is a fallacy because each flip in independent of one another. The chance of a tail coming up after 10 heads is still 50%. This same line of thinking is false in casino games such as baccarat or roulette. If a long string of black occurs, red is not more likely to come up.

Some gamblers will argue that, if there is no regression to the mean, how can the long term odds (50% in a coin toss) be so stable? In other words, say 100 tails in a row come up, how can the results regress back to 50/50 without a long streak of heads?

But you don't need a run of the other result. Suppose 100 tails in a row came up. If, as an example, the next 1000 flips alternate between head and tail, then the results become 600 tails, 500 heads. The odds have regressed toward the normal 50-50 without a corresponding run of heads.

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Don't Be Worried About The Turbulence in The Stock Market

In a wild, see-saw market like we've seen in the last few weeks, it is common for regular people to become worried and confused. In fact, even many professional traders are probably stressed out.

The thing is, there is never any reason to really worry - as long as you don't have to cash out the whole account in the next 5 years and you aren't trading with leverage.

Instead, there are only two things to know: stocks fluctuate, and fluctuations allow you to boost your return by buying low and selling high. When a stock you own goes down, buy some more. If a stock you own goes up, sell into the rise to generate your return.

In fact, buying into declines and selling into rises is the best way to trade - it does not require hindsight, luck, special knowledge or hours of research.

My book stock trading riches gives a complete trading system that follows this strategy. It also provides information on portfolio building, diversification, and choosing stocks and funds.

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L-1 Identity Solutions (ID) - Another Real Life "Stock Trading Riches" Trade

On April 23, 2007 (my birthday by coincidence), I bought 101 shares of L-1 Identity Solutions (ID) at $19.61. L-1 makes biometric security products (retinal scanners, etc.) for government agencies, border control, courts, corporations, etc.

On July 25, ID was acquired in an all cash deal for $12/share. Thus, buy and hold yielded -39% for the last 4 years.

However, I managed the position with the Stock Trading Riches system. The formula had me do the following additional transactions:

12/29/2008 buy 230 shares at $6.04

6/4/2009 sell 107 shares at $8.91

12/22/2009 buy 89 shares at $6.40

12/28/2010 sell 145 shares at $11.90

I ended up with a +$18.6% return for 4 years. This is an annualized return of 4.4% - not bad considering that, in hindsight, I bought the stock too high.

This was another example of how my Stock Trading Riches system self-corrects your positions over time.

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Trading With Charts and Technical Analysis Is A Good Way To Go Broke!

Every day, thousands of people decide that they want to "trade stocks and make millions". Unfortunately, there are no shortage of snake oil salesmen willing to encourage them, and sell books, and fancy technical indicator and charting software.

The truth is that if you approach the stock market with a small amount of capital, and expect to get rich quickly, you are setting yourself up for failure:

1. You might gamble a large percentage of your money on one or two risky trades.
2. Pay too much in expenses (commissions, fees, books, software, DVDs, seminars, etc).
3. Use technical analysis and charting.
4. Get involved in futures and options.

The stock market is a fantastic way to make your money grow and work for you, but you can't expect it to triple or quadruple a small stake. Instead, count yourself as a good trader or investor if you can reliably generate between 10 - 20% per year consistently.

Please do not buy into hype about technical analysis and charts. Now, you do need to use technical (i.e. price based) rules for deciding buy and sell points, but these are about managing risk and taking profits from positions determined through fundamental analysis. But, you need to beware of depending on charts and technical indicators to predict when stocks will go up or down.

Most of these technical indicators have been recycled and sold since the 1970's, when computers and calculators were available for the first time. "Trading gurus", who make more money from selling systems than actually trading, found they could create indicators that sometimes gave reliable signals, and then could cherry pick these examples for their sales pages.

Chart patterns and technical indicators are seductive because most people - especially successful professionals from other fields - think in an employee mentality - rather than an entrepreneurial mindset. In other words, they want a consistent paycheck and reliability. They want a boss to give them instructions. In this case, the trading guru gives them a well defined job - buy when this line crosses this, or sell if this chart pattern occurs. They don't want to think for themselves, take risks, and invent their own systems.

This is why many doctors, lawyers, and engineers make lousy traders and business owners.

I never consistently made money with traditional technical analysis. I only became consistently successful when I turned unconventional and developed my Stock Trading Riches system.

The Stock Trading Riches formula is technical, in that it works on price, and it is as easy to apply as a moving average or oscillator. But, it is not trying to predict when to buy or sell a position, or trying to predict the market. It's a tool for managing a position - lightening up when the position has increased and bulking up the position when it is down.

I found the secret to trading a stock is not to jump in and out. The key is to always hold core position and mathematically adjust the number of shares, depending on a formula.

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