A Few Important Lessons I Learned This Year

Whenever a person dedicates himself to mastering a certain skill, that person will experience many setbacks. Some people call these failures. Others call them lessons. I am in the second camp.

When I was 17 I remember reading the following quote from Napoleon Hill:

"Every adversity, every failure, every heartache carries with it the seed on an equal or greater benefit."

That quote, and the book 'Think and Grow Rich', has never been far from my nightstand ever since. I have my original tattered copy near me right now. The pages are yellowed and torn, and the spine is held together with duct tape, but I still refer to it at least once a month. I just ordered a copy of 'The Law of Success' which is a compilation of Hill's studies...a Christmas gift to myself that I hope to receive in the mail today.

A trader's day to day life will have more "failures" than most other lives. That's one of the great difficulties of being a trader. There are very few moments when you can sit back and say, "Wow, I handled that perfectly!" Usually any trade can be critiqued from many angles after the fact: "I could have gotten in sooner"; "I should have held on longer"; "I should have cut my losses faster"; "I should have taken my profits while I had them"; "I should have had more money in the trade"; etc., etc., etc.

For that reason, a trader can not look on setbacks as failures...it would be way too demoralizing. He must look on his setbacks as lessons. Lessons that cost real money, but that, once learned, will yield fortunes.

I learned a few important lessons this year:

1. Never, ever seek out anyone else's advice on the market or on a particular stock. That is: don't ever watch Cramer, don't ever listen to tips, don't watch CNBC, don't watch NBR, don't subscribe to any newsletters, don't even read IBD too much anymore. Rely solely on yourself. Use Daily Graphs, Briefing.com, McClellan Oscillator, your quote screen and intraday charts. (Listening to others, even very intelligent traders, cost me money earlier this year because their style was not my style. Every trader is unique. He must develop and be coherent with his own style. Until you find your style it is good to learn from others; but depend on no one but yourself.)

2. Concentrate your stock dealings around earnings. When a stock gaps up to new highs on massive volume after announcing earnings of 75% or more make sure you get in that stock - and hold on as long as you can. Stocks like that often double within six months to a year. Keep those stocks on your radar screen if you miss them the first time and get in later as a base sets up. Also, along those lines, be very wary of holding large amounts of stock just before earnings announcements.

3. When you are sure that a correction has set in - get out of the market totally and immediately. There is no point in suffering through 20 to 30% drawdowns while the market sorts itself out. Even the best stocks will be sold off with brutal force. Just get out and stay out until the market has a follow through day.

4. Once a Follow Through Day has occurred, wait for the rally to finish. Then await the end of the first retracement before taking any long term positions. This usually takes a week or two. Most FTDs experience some sort of retracement and the great majority of stocks that break out close to the FTD will fall back into their bases at least once or twice before any real progress is made. Trying to get in with long term positions too early is a frustrating experience that more often than not results in losses as your gains evaporate on volatile retracements.

5. The stocks you want to get into after a FTD are the same ones you sold once the correction set in ~ stocks that within the last quarter or two gapped to new highs on massive volume on earnings.

There were many other smaller lessons I learned this year. But the above mentioned ones are by far the most important. They all cost me money to learn, but some day those costly lessons will appear invaluable.

Follow Through Day Charts

Courtesy Daily Graphs

You can click on the above charts to view them more closely. They illustrate stock index action around Follow Through Days. See log below for more information.

Follow Through Day Information

Afer a brutal pullback that essentially wiped out all gains from the previous Follow Through Days (IBD proprietary indexes FTD 11/28, NASDAQ Comp FTD 12/5), the markets are rallying again.

According to William O'Neil, a Follow Through Day (FTD) usually signals that a new rally has begun. It is supposed to signal the "all clear" for investors to get into the market. A FTD is a gain of 1.7% or more on any of the major indexes (and now IBDs proprietary indexes) 3 to 1o days after the first rally attempt. Not all FTDs are valid, but according to O'Neils studies, no Bull Market has begun without one. That does appear to be the case.

Given the brutal pullback that accompanied the last FTD on December 5th, I went back and studied all the valid FTDs starting with the new bull market in 2003.

Essentially there was one (FTD) in 2003, one in 2004, one in 2005, one in 2006 (a strange one), and three in 2007. That makes seven follow through days in 4 1/2 years. Of those FTDs, all rallied for 2 to 7 days after the FTD. They then corrected for 2 to 6 days. In the process of correcting they retraced at least 60% of the FTD rally gains almost every time. This year in particular all the FTD rallies have been accompanied by very strong retracements of 80% or more.

Thus, trying to obtain long term positions beginning on the Follow Through Day or on the 2 to 4 days afterwards seems to be a futile undertaking in almost all circumstances, as all the gains post-FTD will usually be wiped out and, at least for a time, you will be sitting with losses and a lot of gut-wrenching worries. The majority of breakouts will also fall back into their bases at least once or twice. Just look at FCSX, CF, DECK, MICC, PCLN, AG, FSTR, VIP, LIFC, MTL, AGU, CMG, FSLR, MA, ISRG, POT, etc....They all broke out and fell back into their bases. I went back to study how 2003's biggest winning stocks acted around the 3/17/2003 follow through day - same situation. They broke out, broke down, and sputtered for a couple weeks before they finally got traction. In the meantime though they chopped investors to bits (COH, CECO, NTES, UNTD, JCOM, IGT, HOV, SCHN, MATK).

It took me a while to figure this out. Sometimes it takes being painfully chopped up into tiny bits and pieces to figure things like this out....but I think we may have come to the the point where the Follow Through Day phenomenon is so well known that it is no longer as valid an indicator as it used to be. This happens often in the financial markets. Currently, it appears that the proper time to enter a new rally is AFTER the FTD and its subsequent rally has been retraced. This normally takes two to six days for the FTD rally to run its course and two to six days for the retracement of the FTD to occur.

The Follow Through Day does appear to be a valid indicator of the beginning of a new uptrend. However, if you don't wish to suffer the extreme volatility that occurs around it, and if you want to save some money, you may want to wait for a week or two before entering the market after a follow through day.

Another benefit of waiting for a couple weeks after a FTD is that most times the false FTDs will reveal themselves before you have to lose your own money finding that out.

Answer to a Question from previous post

"Mr. Solitary, my hat is off to you. I am a CANSLIM trader as well. I have read all of your posts twice and still find them informative. I think you are great and value your posts.
I used the McClelan Index to get early positions in AAPL, FCSX, MA, MR, and CF. We quickly went to overbought and I'm a lil nervouse. I have nice gains and wanted to know what you think the trend is.
Any books recommendations outside of O'neil and Livermore will be appreciated as well."

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Thanks for the kind words, Chris.

You know, these pullbacks are always painful. Much more so than you can imagine before they actually occur - even when you KNOW they are coming and you brace for them. It can be very emotionally draining watching your profits evaporate day after day...and not knowing for sure if the market is going to just keep going down or what...tough to deal with...and the bad news from the media that comes along with these pullbacks can be downright terrifying.... Four days can feel like four months sometimes.

I don't really have any answers - no one does - about what the market will do from here. All I can go on is probabilities. I know the following:

• 80% of all follow through days signal the beginning of a new rally (One of William O'Neil's studies);
• Strong leading stocks have broken out to new highs (MOS, AAPL, MA, ICE, CME, etc);
• It is normal for a follow through day to be retraced almost 100%.
• It is also normal for stocks breaking out after a correction to fall back into their bases 1 to 3 times because the volatility at these market turning points is tremendous (Look at COH, CECO, NTES, UNTD, JCOM, IGT, HOV, SCHN, MATK - all big winners that broke out back in March 2003 - they all struggled to get traction after the Follow Through Day on 3/17).

So as far as I can tell we are in a rally. The stocks you have look very strong. I have a few of them myself...and I'm holding and suffering along with you..haha...you're not alone. But What can you do? This is a tough business and it demands a lot of emotional control if you want to make big money. Suffering is just a part of the game.

....A book that I have read at least 20 times and continue to read on a daily basis is Nicolas Darvas' How I Made 2 Million Dollars in the Stock Market. Every time I read that book I learn something new.

Follow-Through Day on December 5th

The NASDAQ had a follow-Through Day on December 5th. Stocks are rallying. However, we are currently deeply overbought so if you aren't in yet you may want to wait until the oscillator returns to around zero.

http://stockcharts.com/charts/indices/McSumNYSE.html

http://stockcharts.com/charts/indices/McSumNASD.html