Would You Light My Candle(stick)?

It's been a while since I updated this blog since I've been so focused on Chronicles of a Daytrader, but here's a useful little tidbit that explains why I think candlestick charting is so valuable to understand. Before we get into that though, you should understand what I mean when I say candlestick charting.

When you look at the chart of a stock's price, there are a number of ways that it can be displayed. It can be a line chart, a bar chart, an OHLC (open, high, low, close) chart or a candlestick chart. There are other, less popular variations like the Chinese candlestick chart and the point and figure chart, but for this post we'll stick to the most popular ones. By far the two most popular charts are OHLC charts and candlestick charts, with, for technical traders, candlestick charts being the most popular. This is a candlestick chart:

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This might look confusing at first but it's really quite simple if you understand some basic conventions. Of course there are hundreds of ways to customize your charts, but the basic and most popular configurations always include something like the following conditions:

• Each of the bars in the "price history" (top) part of the chart is called a "candle" or a "candlestick." Each candle represents a specific period of time. In the case of the chart above each bar represents one day of price movement (a "daily" chart). If you were looking at a 30 minute chart, each bar would represent 30 minutes, and on a five minute chart each bar would represent five minutes. 
• Green bars represent an increase in price. 
• Red bars represent a decrease in price.
• Bars can either be filled or unfilled. This is completely up to personal preference. I fill red bars because I think it makes the chart more visually appealing. You can also change the colors all you want.
• The green and red bars at the bottom represent volume. This is not included by default but I don't know a single technical trader who doesn't use it. Volume simply represents the number of shares of the stock that changed hands.

Now that you know the basic design of a candlestick chart, let's dissect an individual candle and see why these little bars are so powerful. Here is the candle for 8/21/12:

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If we look at this candle we can immediately assume one thing: we know that price went down because the candle is red. But how do we know where the price actually opened, and where it closed? What was the high of the day and low of the day? That's where candlesticks shine:

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The "boxy" part of the candle is called the body and shows you the relationship between the open and the close. The "wicks" or "tails" represent the high and low of the day. Everything in between is what the price did during the day. Since this candle is red, and we know red bars mean the price went down, we know that the top left corner of the box must be the open, and the bottom right must be the close (since the close was lower than the open). If this candle were green, we would still read from left to right, except since the close would be above the open, the bottom left corner of the candle would be the open, and the top right the close. Also, the whole candle would be green. If you want to know the exact prices of the open, high, low and close, most charting programs will simply pop up a box telling you what they are when you click on the candle.

When you look at this candle you can see why it is so powerful. It gives you four pieces of valuable information in a very small amount of space. For me, it helps to visualize the candle as a fluid representation of price (as strange as that sounds). Let me show you what I mean. Did the price do this?

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Or maybe this?

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The only way you can really tell is to go to a smaller timeframe...like a 30 minute or a five minute chart. If you look at a five minute chart of this day (8/21/12) you will see exactly what this candle represents:

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From the five minute chart we can gather that price went up in the morning, then slowly ticked down all day, and rose slightly at the end of the day. Most of this information, however, can be quickly attained just by looking at that one candle on 8/21/12 on the daily chart! You can easily see that the price closed in the red. You can see that the price rose significantly above its opening price at some point, and that it closed above the low of the day. Candles make it extremely easy to quickly gather data about what market participants were feeling that day (or 30 minutes, or 5 minutes, or even 1 minute). For example, did the stock open at a certain price, never dip below that price, and then close at the high of the day, as in this candle?

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What does this tell us? Since the open equals the low and the high equals the close, it tells us the people trading the stock drove the price up hard right from the get-go and sellers were not even able to push the price down below the open. It also tells us that the buyers were able to keep the stock rising all the way until the end of the day. That could mean the price might continue to go up the next day!

Or maybe the stock opened at some price, dipped way below that price, but then buyers came in to push it back up and it closed at the high of the day, above the open, like this:

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This is called a "hammer," (since it looks like a hammer, obviously) and is one of the most promising candlesticks you can see if you want the price to go up. If you think about it logically you can see why. What it tells us is that the price opened at the bottom left corner of the body of the candle, was driven down hard by sellers, but by the end of the time period the price had been driven all the way back up, not only to the opening price, but to a high and a close above the opening price! From a psychological standpoint this tells us that the stock has strong buying pressure (demand for it is strong) and that sellers were not able to drive the price down even though they tried. The reverse could also be true. If we see a candle that opens at some price, is driven way up during the day, and then there is a sell off into the close and the closing price is at the low of the day, below the open (an "inverted hammer" or "falling star,") it could mean that the price has hit a top where people simply are not willing to pay any more and that the price must come back down soon:

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If you understand these basic principles about how candlesticks are used you will be able to quickly gather lots of information about the sentiment of market participants. Understanding sentiment is a huge step towards predicting future price action. There are hundreds of candlestick patterns that can represent all sorts of different things but the meat of your understanding should be here, in understanding what each part of an individual candle represents, and what the overall shape of the candle can tell us about the price action and thus the feelings of market participants during that time period. It doesn't matter whether it's a day, a week, five minutes, or one minute. The design of the candle is the same, and the feelings of the people buying and selling the stock are still represented by its shape.

Once you become good at reading candles and drawing conclusions about what they represent, you'll find yourself able to better predict what the price might do in the future based on the price action during the time period that the candle represents. As you do this more and more, you'll start to develop a sort of intuition for what might happen next. And if you can predict price action accurately, well then making consistent money trading stocks becomes as simple as buying before the price goes up and selling before the price goes down.

Understanding a Financial Crisis - Part III

This is the final part of a three-part series on understanding a financial crisis. Click here for Part I and here for Part II.

After TARP was established in late 2008 and just before President Obama's inauguration, The Dow was down over 6,000 points (nearly 50%) and testing the lowest levels in a decade. There was no time for delay and Obama needed to quickly assemble his cabinet. He was faced with a tough decision to make: pick advisers that would force tougher regulations on the banks or pick those who would allow more leniency in order to prevent chaos. Some of the major players were as follows:

Paul Volcker: A former chairman of the federal reserve who is very pro-regulation.
Tim Geithner: A major player in the Bush administration during during the onset of the financial crisis.
Larry Summers: Treasury secretary under Bill Clinton.

While Obama knew that Paul Volcker would likely lead to more effective reform on Wall Street, he didn't have the time to allow Volcker to learn the intricate details of the crisis. Geithner already knew the details, so he was chosen as Obama's Treasury Secretary. Larry Summers would act as the Chief Economic Adviser to Obama. The American people viewed this not as an effective method of "hitting the ground running" but rather as manipulation of the system by the Obama administration, in that the administration had stacked the odds in favor of the banks.

To prove the American people wrong, Obama, before Geithner had even established a staff, made a public press announcement that Geithner would be announcing his plan to fix the economy the next morning. Geithner, of course, wasn't ready at all and completely botched the presentation. His plan (which he had come up with in only a few days) was to "stress test" the internals (i.e. financials) of the nation's biggest banks in order to decide which ones were the most at risk of failure. Those banks would be the ones that were bailed out first using the TARP fund created in October, 2008.

The American people were outraged at what they thought was nothing more than Geithner and the administration beating around the bush and not serving the banks with the justice they deserved. People protested, lobbying for Obama to replace Geithner with someone who would make the banks pay for their greed, but Obama believed that Geithner's plan would work and that it was low-risk since it would keep the banks on the side of the government, and therefore the American people. In response to the erupting anger from the public, Congress called the heads of the nation's 13 largest banks to Capitol Hill to question them. Unfortunately the meeting had no real goals other than to make a public spectacle out of the CEOs and to make it look like the Obama administration was doing its job. The public didn't buy it.

In order to keep pressure on the banks and to prove to the American people that the Obama administration really did want to resolve the problems, rumors began to circulate over firing the CEO of one of these "superbanks" in order to make an example of them. Tim Geithner warned against this because he felt that if the public believed the government was stepping in to take over the financial industry it would scare them off and cause more pandemonium. Larry Summers, Obama's chief economic adviser, took the other side and believed that now was the time for aggressive reform and not simply more investigation as Geithner was suggesting. On March 15th, 2009, there was a meeting at the White House. In attendance were Geithner and all his proponents as well as Summers and all his proponents. The only goal of the meeting was to decide which plan to go with: Geithner's stress tests or Summers' aggressive reform.

Each team presented their case but no decision was made that day. In late March, 2009 President Obama called the heads of the nations banks together at the White House. The impression they had was that they would be slapped with heavy regulation and possibly even fired. Ultimately, Obama chose Geithner's plans. While he had all the bank heads in one room and had the opportunity to take whatever actions he deemed necessary, he chose to do nothing aggressive and instead keep the banks on the side of Washington by delivering a "we're here to help" message. Publicly, Obama wanted to shame the banks but behind closed doors he was afraid of them. The banks felt like they had gotten away with murder. There were no regulation changes, no stipulations, no nothing. All they had to do was prepare for Geithner's stress tests.

In April 2009, Bloomberg News took the Federal Clearing House Association to the US Supreme Court over whether or not they would need to make public the loans that the Federal Reserve had been making to the banks since the crisis began. Bloomberg won, and the papers were made public. It became apparent that the Fed had loaned over 7.75 trillion dollars to the banks since the beginning of the financial crisis, and not just to American banks, but to foreign banks as well. The money was used to prop up the banks' daily operations while legislation was passed over whether or not they would receive the bailouts they ultimately did receive. It was at this point that the American public started to understand the true depth of the financial crisis.

By May of 2009, most of the largest banks that had been bailed out had absorbed the bailout money they'd been given and had begun to recover. Geithner's stress tests showed that all 19 of the banks under investigation were fundamentally healthy. But how could they possibly be fundamentally healthy? In August of 2009 the American public would ask this question via the Tea Party protests, in which they argued that the bailouts had only made the banks profitable again at the expense of the American taxpayer. At this point to relieve pressure on the White House, the White House Chief of Staff Rahm Emanuel urged President Obama to deliver "old testament justice" to the banks. He wanted aggressive reform and he wanted it now. In September of 2009, on the one-year anniversary of the Lehman Brothers collapse, Obama addressed the nation and swore to push for aggressive reforms for Wall Street. None of the nation's top bankers showed up to hear the speech. It was business as usual for them.

Finally, by 2010 as healthcare reform started to take the front burner, Wall Street reform was pushed aside and since the banks were profitable again they began to spend massive amounts of money on lobbyists that would help push for less regulation, just as they had done at the beginning of the crisis. After many months of debate and deliberation, on July 21, 2010 President Obama signed the Dodd-Frank Act, which was designed to produce more transparency in the financial industry and make sure the world's biggest banks were not taking on too much risk. Unfortunately for the American people, the Dodd-Frank Act is a very vague bill that leaves many things open to interpretation. Since many of the provisions in the bill are not clear, it allows for bank heads to pay lobbyists to sway reforms in whichever direction they prefer. In this sense, the financial crisis still has not ended. Unfortunately for the vast majority of Americans, the collapse of the financial system will affect us for years to come, and it is likely that before the end of the century there will be a similar collapse. This is why it's important to take control of your financial future, which is what this blog is designed to help you do! If you understand the mechanics of a financial crisis, perhaps you'll be a little better at recognizing when one is starting to occur and can protect yourself before disaster strikes.

Understanding a Financial Crisis - Part II

This is Part II of a three-part series on understanding a financial crisis. Click here for Part I.

Systemic Risk:

By early 2008, investors and the rest of the world were starting to lose confidence in the world's largest banks. News was starting to roll out about banks' heavy investments in sub-prime mortgages and risky derivatives and people were beginning to see just how interconnected all these banks had become. In March of 2008, rumors began to swirl about risky investments and a looming failure of Bear Stearns, one of the largest banks in the world. The stock began to drop, people were calling the bank asking to withdraw their money, and the bank was scrambling to meet all the demands and stop the pandemonium.

As Washington had gotten word of this, the president of the Federal Reserve, Tim Geithner, was called to assemble a team of investigators to determine how bad the books looked at Bear Stearns. In their investigation they discovered what central bankers fear more than anything: systemic risk. Systemic risk is easy to understand. Since all these banks owed each other money, if even one bank were to go bankrupt who would pay all the banks they owed money to? Then, if the banks who were owed money were not getting paid, how would they pay off the banks that they owed money to? Systemic risk is feared because it puts you in a situation where if one piece of the system fails the entire system goes down. In this case, the system was the global economy.

A Way Out:

Upon the completion of the investigation Geithner's team conducted at Bear Stearns, Geithner called Ben Bernanke, then Chairman of the Federal Reserve, and informed him that he believed Bear Stearns was "too big to fail" (in other words they were too interconnected with the rest of the world in order to be allowed to go bankrupt). Bernanke knew that if Bear failed it would bring down the entire financial system, so he suggested to Henry Paulson (then Treasury Secretary) that they "bail out" Bear Stearns by allowing another bank to buy their assets. In this way, Bear would be able to pay its creditors and avoid bankruptcy. Henry Paulson was very free-market in his way of thinking and called this a ridiculous idea, telling Bernanke that the market rewards and the market punishes. Paulson originally believed that Bear should be allowed to fail because they were in trouble due to their own greed, but changed his mind after he realized how bad the situation was. The Federal Reserve agreed to give JP Morgan $30 billion if JP Morgan would agree to buy Bear Stearns, and they did. Bear was sold for a mere $10 a share, only 7.5% of their 52-week high stock price before the crisis.

Average, hard-working investors who owned Bear Stearns stock lost more than 90% of their investment.

Paulson warned America of moral hazard. Moral hazard basically asks "if you bail someone out of a problem that they created themselves, what incentive do they have to not do the same thing again?" Paulson warned the major banks that the $30 billion Bear Stearns bailout was a one-time deal and that they were on their own and needed to manage their risks accordingly.

The Summer of Assurances:

After the Bear Stearns bailout, President George Bush gave control of the management of the spreading financial crisis to Henry Paulson. Paulson realized that in order for the system to continue to function and avoid failure, they had to keep money flowing into the banks. Since the main source of the banks' money was people, the Bush administration spent the summer of 2008 trying to reassure Americans and the rest of the world that everything was fine in the financial system and that they should trust the banks. They should continue to keep their money in the banks and trust that the situation would work itself out as long as confidence stayed high.

This reassurance campaign became known to some as the summer of assurances. Unfortunately no matter how much Paulson and the Bush administration reassured the world, a disaster was already inevitable. In the fall of 2008, it became obvious that Lehman Brothers, one of the United States largest investment banks, had become so riddled with toxic debt in sub-prime mortgages and risky derivatives that they would need to file for bankruptcy since they simply couldn't pay their bills to other banks and their investors.

The Aptly-named Dick Fuld:

Dick Fuld was the CEO of Lehman Brothers. While his bank made billions of dollars trading derivatives and collecting interest on loans, he took massive bonuses, lavish vacations and bought excessive material things. This was the kind of guy who would buy a yacht just because he could. Dick Fuld truly is, well, a dick. Anyway, Dick Fuld remembered that Paulson had bailed out Bear Stearns, and he knew that Lehman Brothers was in a similar if not worse situation. He tried to call Paulson's bluff and believed that the government would bail them out. He did nothing to mitigate the risk posed to the global economy and showed zero remorse for his lavish spending and ignorance of clear issues on Lehman's books. Paulson would stand firm though (as he rightfully should have). In early September on a Monday morning, Lehman Brothers announced that it had filed for bankruptcy and the Dow Jones Industrial Average plunged over 600 points.

Paulson was sitting on an incredibly difficult situation. He knew that since Lehman Brothers had failed, AIG would be right behind it since AIG had credit default swap agreements totaling over $400 billion with banks that Lehman Brothers owed money to. The financial crisis was starting to become uncontrollable. Paulson again switched teams in an effort to save the economy and the Federal Reserve reached an agreement to bail out AIG for over $180 billion. These inconsistent signals Paulson was sending (while somewhat understandable) had investors unsure of what to expect from the banks and from the Fed. People knew the problem was bad, but they didn't know how bad and they didn't know how long it would go on or what the government and the banks were doing to fix the problem. While Paulson and other members of the Bush administration tried to reassure Americans and the rest of the world that the crisis was under control, they all knew it really wasn't.

TARP:

As Lehman Brothers filed for bankruptcy and AIG was bailed out, shockwaves of financial panic began to rip through the market. There was no end in sight and no one knew how deep the roots of the problem went. Because of this uncertainty, Ben Bernanke recommended that Paulson go to Congress and establish a bailout "fund" which would allow them to relieve the pressure on the markets by setting money aside that the banks could use if they needed it to pay each other off. The idea was to restore confidence to the financial system so that banks could lend each other money again in a healthy way. Of course Congress was split down the middle on this, with some people believing that a bailout was the only way to resolve the problems and others believing that a bailout just sent a signal to the banks that they could do whatever they wanted, make billions, and taxpayers would pick up the pieces.

After much debate a program was finally created called TARP - or the Troubled Asset Relief Program. This was a $700 billion bailout "fund" that would be divided up amongst the banks that had the biggest financial problems. While it seems like this would take months to resolve, you should understand that the speed at which this whole situation happened was such that Paulson was only able to get the bill passed by telling congress that if they didn't pass it, the financial system of the world would melt down in a matter of days.

And it would have. The entire process happened in a matter of weeks.

After TARP was established, Paulson called the leaders of the largest investment banks together in New York and told them that they needed to take the money or they would face severe ramifications.   While one CEO tried to deny receipt of the money because he believed it was wrong (Dick Kovacevich of Wells Fargo), they were all ultimately forced to sign the agreement that day and over $125 billion of the TARP fund was divided up between them. The money came with no stipulations. No regulatory changes, no limitations on bonuses or salaries, nothing. The banks were paid billions of dollars and received no punishment for their terribly risky and greedy behavior.

Understanding a Financial Crisis - Part I

Between 2008 and 2011 the debacle that took place in the American banking system cost Americans 8.5 million jobs and erased over $11 trillion of their net worth. Headlines both old and new have instilled fear and raised questions, and still do, over whether this "crisis" or that "crisis" will soon be the end of the world. As an investor, I wanted to understand whether I should care about any of this or if it was just useless drivel designed to improve the news agencies' ratings. While much of it is indeed (in my opinion) useless drivel, the underlying theory and the danger of a financial crisis is real, and as an investor, a home buyer, a saver, or even a spender, you should care because it can directly affect the amount of money you possess.

This is part one of a three-part series that will detail in easy-to-understand terms how the 2008 financial crisis started, how it affected the global economy, what could have been done to prevent it, and how it is or is not still affecting the world (and your wallet) today.

A Little Background:

The first thing to understand is how a bank works. When you put your money in a bank, the bank doesn't just keep it there. It loans it out to others. If you put your money into a savings account that earns interest, the bank loans that money out to others who want to buy homes and cars or start businesses. Banks charge interest on their loans, and logically, more than they pay on things like savings accounts, CDs, and other interest-bearing accounts. This is how banks make money. They "buy" money from people and pay in the form of interest rates, and "sell" it to others as loans which they charge higher interest rates on. Additionally banks charge fees for various things and make investments in stocks, bonds and other investment vehicles. These practices all exist so the bank can pay you a fair interest rate and still make money by loaning your money out to others.

Today, most banks in developed countries function under a system called fractional reserve banking which basically means that they can loan out a set percentage of the deposits they have on hand and the rest they have to keep available in cash in case the depositors (you and I) want their money. The amount they must keep on hand is known as the reserve requirement or reserve ratio, and in the United States it's set by the Federal Reserve (aka the Fed). If you clicked the link above, you'll see that if you deposit $100 into a bank, at a reserve rate of 10% it would keep $10 and loan out $90. The person who gets that loan will either buy something with it or put it into another bank. If they buy something, the seller will put that money in the bank. Ultimately it will just end up in another bank. The second bank then has $90 and they must keep 10% on hand, so they keep $9 and loan out $81. The money is spent again and the next bank loans out $72.90 and keeps $8.10 on hand. This continues until the supply of the original $100 is exhausted. Theoretically, this system will never break down as long as the people that the banks are loaning money to continue to make their payments. The problem is that the system is entirely built upon trust, and this is where a financial crisis begins.

The Setup:

As we noted above, when a bank loans out money it is required to keep a certain amount of cash on hand in case of a default on that loan, but banks don't want a lot of cash; They want to loan out money so they can charge interest on it and make money for themselves (like any other business). In the early 90's, a group of young JP Morgan bankers (mostly in their 20s) were tasked with finding a way to reduce the risks associated with loaning out money, since if the risk on the loan were lower the fed wouldn't require the bank to keep as much cash on hand and they would have more money to loan out and charge interest on. The idea that they came up with to reduce risk was called a credit default swap. It was sort of like an insurance policy protecting against the possibility of default on a loan. Basically, the bank would loan out money and then turn around and say to another bank "we want to make another loan, so if you guarantee us that you will pay us if the person defaults, we'll pay you a monthly payment for that protection." Of course other banks agreed to this because they were being compensated with money they could then loan out and charge interest on, making more for themselves.

The Growth of a New Kind of Banking: 

At first, credit default swaps were only made on very secure loans (those that the bank made to companies that they trusted would pay back what they borrowed). The first major credit default swap involved JP Morgan, ExxonMobil and the European Bank for Reconstruction and Development (EBRD). After ExxonMobil spilled 11 million gallons of oil off the coast of Alaska in the Exxon-Valdez oil spill, they took out a multi-billion dollar loan from JP Morgan to handle lawsuits and reconstruction/fallout costs. JP Morgan knew this was risky but they trusted ExxonMobil so they agreed, loaned them the money and then turned around to EBRD and made a deal to pay them if they would agree to assume the multi-billion dollar liability if ExxonMobil couldn't pay it back. This type of credit default swap quickly spread as banks realized that they could make a lot more money by reducing their reserve requirements through using credit default swaps. It allowed them to loan out way more money than they could ever repay if there were a string of defaults on the loans or a run on the bank in which everyone wanted their money at once. Still, this practice was accepted and utilized for a long time, mainly with big, well-known companies that the banks trusted. Companies like Johnson and Johnson, Proctor & Gamble, Microsoft, Apple, and WalMart. But there was a problem with all of this.

Obviously, for the banks who were obligated to pay another bank's loan back should the borrower default, the credit default swaps were a form of risk.  If ExxonMobil defaulted on their loan, for example, JP Morgan would stop making payments to EBRD and EBRD could potentially owe JP Morgan billions of dollars. Of course EBRD and JP Morgan would have agreed to terms they both thought were favorable in terms of risk to reward, but it was still risk for EBRD. JP Morgan realized that they could offset more of their loan risk if they pooled the loans together and split them into different risk levels. For example, there might be a pool of very low risk loans to companies like Microsoft, Apple and ExxonMobil, and a pool of loans with more risk (i.e. the borrower was more likely to not be able to pay it back) to smaller, unknown companies or businesses that had poor earnings or credit ratings. Likewise, it would theoretically be less risky for EBRD to agree to pay out on a collection of low risk loans than it would for them to agree to pay out on a collection of high risk loans. And so JP Morgan pooled their loans together into things called CDOs or Collateralized Debt Obligations and split them into different risk levels, then tried to make deals with other banks to offset the risks of the various CDOs. Other banks ate it up because it basically gave them the ability to say "If you want us to agree to pay you if these high-risk loans default, you'll have to pay us more each month." Cha-ching! More money. 

This form of "risk reduction" spread like wildfire throughout the financial world. Banks everywhere were starting to become more and more willing to give credit to riskier and riskier borrowers, because they could slap high interest charges on the loans and make more money. The goal, obviously, was still to charge a high interest rate on the high-risk loans and pay other banks slightly lower monthly payments to assume the risk if the borrower defaulted. In this way, the banks giving out the loans could make a profit and have more money to loan out and continue the process. For them, the sky was the limit. In theory, there is absolutely no limit to the amount of money that can be made with this system.

Unless the borrowers start to miss their payments. 

Warnings:

As this process began to spiral out of control, Washington started to get wind of it and a fierce battle ensued. The argument was over whether or not the trading of these financial instruments should be regulated (like the stock exchange is regulated by the SEC) or not. Up to this point, all of these transactions involving loans, credit default swaps and CDOs occurred in what is known as a dark market, or a market that is not regulated by any federal or international agency. In the dark market there were no reporting requirements. The banks weren't obligated to tell anyone, not the SEC, not the federal reserve, and certainly not the public how much risk they were taking on or how much money they were making on it. So congressional representatives (the smart ones, if there are any of those) lobbied for more regulation. Unfortunately for Washington, money is power, and the banks had no problem at all funding the campaigns of the political representatives who would side with them and vote for no regulation. 

Ultimately, the banks would win because they had the money and the power. The chairman of the Federal Reserve at the time, Alan Greenspan, argued that regulation was not required because the transactions were being carried out by seasoned professionals who could manage their own risk and regulate themselves. To him establishment of a regulating agency for these types of markets would be a waste of taxpayer money. The lack of regulation continued, and banks soon learned that they could apply the same principles they had used on corporate loans to consumer loans. They began pooling together groups of mortgages and trading the CDOs amongst themselves. 

A Looming Disaster:

As banks pooled more and more mortgages and corporate loans together, stranger and stranger derivatives of these securities began to appear. Consider the JP Morgan/EBRD/ExxonMobil example from above. EBRD could offset the risk of having to pay JP Morgan by paying Citigroup or another bank monthly premiums to assume the risk. In this way, if ExxonMobil defaulted on the loan, JP Morgan would activate its agreement with EBRD, and EBRD would activate its agreement with Citigroup. Citigroup would pay EBRD, who would then pay JP Morgan, and ExxonMobil would go bankrupt. Just like banks bundled groups of loans together, they learned that they could bundle groups of credit default swap agreements together and trade them as synthetic CDOs. The problem with all of this is that the risk of ExxonMobil defaulting (no matter how small it was) never actually went away. It was just passed from JP Morgan to EBRD and then to Citigroup. Because these markets were not regulated, banks could simply pass the risk along to anyone else who would agree to take it. And why wouldn't you agree to it if you could get paid for it and then just pass it off to someone else?

The system seemed to be working perfectly. Stocks were booming, the financial world was experiencing heavy growth, housing prices were rising, and all was well. As banks became more and more greedy though, they started to write mortgages to riskier and riskier borrowers. Some borrowers made very little monthly income, had low credit ratings, a history of not paying their bills, or simply couldn't afford what they wanted to buy based on their income. This didn't matter to the banks because the more money they could loan out the more money they could make by trading the derivatives of the loans such as credit default swaps, CDOs and synthetic CDOs. These mortgages that were given to people sometimes had extremely high interest rates or very long payback terms, some rates as high as 42% and terms longer than a person's lifespan. Many regulators and banking professionals now admit that there were a slew of mortgages handed out that they knew didn't make any financial sense. These mortgages were known as sub-prime mortgages and were the main ingredient in the "sub-prime mortgage crisis" we hear so much about. 

The Inevitable Crash:

As time went on, some banks, particularly Goldman Sachs, began to realize that something wasn't right. Because they realized that a crash was coming, they decided to "prepare" by taking advantage of it. Goldman is now known to have pooled together collections of CDOs backed by sloppy sub-prime mortgages and sold them to their customers, then bet against their own customers by issuing credit default swaps against the CDOs! As Goldman knew that the mortgages would never last, they made agreements with other banks to pay them attractive fees in exchange for a payout if the borrowers defaulted. One of these banks was a German bank called IKB. They continued to assume Goldmans' "risk" (which was at this point almost a certainty) because they assumed it was unlikely that all the loans would default at once and Goldman was paying them attractive fees for the protection. Their assumptions were wrong. In 2007, IKB was the first bank to fail because it couldn't pay off its credit default swap obligations when the underlying mortgages and loans started to go bust. 

As the news of the IKB crash spread, other banks quickly (and cleverly) began attempting to write off their risk to each other, but it was too late. Housing prices were plummeting and defaults were everywhere. Because of the string of defaults (which should be been forseeable since these borrowers were known to be high-risk!) a chain reaction of credit default swap payment requirements was initiated. Basically, everyone in the world owed everyone else in the world money. In 2008, AIG was on the hook for over $440 billion in credit default swap payments and  there was no conceivable way they could pay it.

In Part II:

We'll talk about how the failure of IKB led to a loss of confidence in the global financial system and what happened to AIG with that $440 billion in debt. You'll also see how the crisis really became a crisis and how it affected average investors. Read on!

The Importance of Happiness

One of the things that many traders and investors take for granted is their happiness. Investing, and especially daytrading, can be extremely stressful and emotionally demanding. Thus as silly as it may seem, your success in this business is vitally dependent upon your health and your happiness.

Recently I found myself falling into a depression-like state of chronic boredom and general blasé. Of course I wasn't actually depressed, but if you know me you know that normally I'm a very upbeat person. I have a dry, sarcastic sense of humor, am full of energy and love to, for lack of better terminology, give people crap. That all started to change because I was working so hard at trading and at my full time job and trying to tackle a million things at once. I had stopped going to the gym, stopped eating healthy food, started staying up way too late and reduced the amount of time I spent doing things I am really passionate about, like playing keyboard and singing karaoke.

I found myself constantly listening to slow, ambient music when I got home from work, simply dimming the lights down and settling into a chair to read or review my trades for the day. I would keep telling myself, "I'm dead tired, I need to crash at like 8pm tonight" but I never would. Instead I would sit up reading or browsing Facebook or Twitter, or watching mindless TV shows on Netflix, until the next thing I knew it was 2am and I realized I needed to go to bed because I had to wake up at 7am for work the next day. I'd do this all week long until the weekend when all I'd want to do is sleep.

I live ten minutes from the ocean and I didn't even want to go to the beach. 

Instead I'd sleep until 12 or 1pm because I was so exhausted from the week and when I got up, I'd literally walk around the apartment in my underwear all day putting off doing laundry, doing the dishes, cleaning my apartment and exercising. I would just sit around and read about trading or waste time on Twitter, Facebook or Netflix, using "I'm 100% focused on my desire to become a professional trader" as an excuse.

Then one of my good friends did something that started a chain reaction of rapid change - a return to the way I used to be - for me: he decided to boycott social networking for 30 days and committed himself to doing it by posting his farewell on Facebook, to his 100,000 Twitter followers, and on his blog.

Of course it seems like this would be completely unrelated to investing, but it wasn't. At least not for me. I had become a zombie. It's not that this is necessarily a bad thing sometimes. Sometimes you do need to cut everything out and focus 100% of your energy on one thing, but that lifestyle is not sustainable if you want to maintain happiness and good health over the long term. I decided to join my buddy in his crusade to exile the social networking scene from his life and I cut Facebook and Twitter out of my life entirely.

With the extra free time, I now suddenly had time to read all I wanted about trading and investing but still accomplish other things. Things as simple as cleaning my apartment regularly so I wasn't annoyed by having to wash a plate just to eat dinner since I had put off doing the dishes for 4 days (that is, if I actually had any decent food as I would have if I hadn't put off grocery shopping too). I had time to go to the gym. I could still go to bed at a reasonable hour and wake up feeling well-rested, strong and ready for work.

The point is that I had no idea how much time I was wasting and just how much I had neglected my physical health and my happiness and how it was affecting my ability to accomplish the things I really cared about in life (my career, my goal of going pro as a trader, spending time with my best friends, and generally being happy). My trading suffered because of it: I pushed through a period where almost every single trade I made was a complete failure. I would get annoyed at my failures because I was tired and overly irritable and caught myself overtrading in an attempt to recover losses, and this would only lead to more losses which would make me more irritable and give me an excuse to go home and fill my brain with new things to try the next day. It was an unhealthy path of destruction leading only to ultimate failure of my major goals if I had continued.

What I really needed to do was take a step back and fix myself. 

I started going to the gym again. I went grocery shopping and bought healthy food. I bought tons of fresh produce and red meats. I cooked amazing dinners from recipes I had or new ones I found online. I started coming home for lunch to make fresh food instead of going to eat at Subway. I made a pact with myself to stop putting things off - stupid things like doing the laundry, doing the dishes and cleaning my apartment - until the last minute when I had to do them under stressful conditions since I had to do them all at once.  I started doing karaoke again on Thursday nights with another good friend of mine, going out to grab a beer or two, and started jamming on the keyboard again with a buddy who plays guitar. All of this and I still managed to get to bed earlier so I would be well-rested the next day. Most importantly, I spent some money on me. I signed up for a daytrading bootcamp and bought myself a brand new laptop that will allow me to use all the expensive recording equipment I have to record some new music and throw it up on YouTube.

I can't tell you how much of a difference it has made. 

Over the last month or so, my trading has improved exponentially. Lately I feel confident, strong and knowledgeable in all aspects of life. Because of this my trading and investing performance has improved greatly, which means money in the bank for me, the ultimate goal of any investor.

So be healthy. Be happy. Exercise. Eat well. If you are a newer investor, don't fall into the trap of becoming "over-educated." It's easy to do in this fast-paced world, so put yourself first. Don't become consumed by the chase of the almighty dollar. Benjamin Franklin said that the only things that are certain in this world are death and taxes. I disagree - I think there are three things: death, taxes, and the existence of the stock market. It will be here tomorrow if you need to take a break and go to the gym or go for a jog, so go do it. You'll be surprised how much being healthy and happy will benefit your investing performance.

Paper Trading - Don't Give Yourself a Paper Cut

Hey guys and girls! Sorry it's been a while since I posted. I've been insanely busy with reading, studying and trying to get my daytrading game in order. This business is extremely time consuming and difficult!

I wanted to talk quickly about something I think is vitally important to anyone who aspires to be a professional trader or even a successful long term investor: paper trading.

What is paper trading? Well, it's trading on paper. It's trading with imaginary money. The reason people do it is that it allows them to learn without losing huge amounts of money during the learning process.  I have read several trading books recently, and almost every single one points out that many traders, during their first two years of trading, will spend upwards of $50,000 just learning how to become profitable. While I'm sure this is a true statistic, it's completely unacceptable for me. I don't plan on spending that much. In fact, I don't even plan on spending $10,000. Instead, lately I've been meticulously paper trading, and paper trading everything so that I can build some serious statistics. I have spoken to several professional traders now about the value of paper trading, and they all had pretty much the same opinion: they don't like it. Most of them don't like it because they feel that it removes the emotional aspect from trading which is an incredibly significant factor when trading with real money. While I agree with them, all of them also agreed with my theory that if you can be honest with yourself about what you would really do if you were trading with real money, paper trading can be incredibly valuable.

The key is to be honest with yourself. I document everything. I document what time I bought (to the second), the exact price I could have bought at (based on level 2 bid and ask prices which are the prices you would actually be filled at if you were to buy or sell with real money), the reason for the purchase, what my setup was, what my stop price is, my reward to risk ratio, the number of shares (considering how many I could safely buy based on my true account value), and my targets. I treat these trades exactly as if they were real trades. Most importantly, I document every single mistake and meticulously pick it apart to understand why the trade failed. I even consider commission and ECN fees, and account for market slippage (having an order in at one price but being filled at another).

By doing this I have found that even though I am making mistakes while paper trading, I am starting to see some patterns emerge that I can work to correct. Sure, I could do this with real money, but is it worth it? I am trying to cut down my tuition cost at daytrading university. To keep my head in the game, I am also still making real trades, but only if I am very confident in the setup and have thoroughly backtested it to understand not only how profitable it can be, but how probable it is that the trade will be successful.

Unfortunately if you're an aspiring professional trader, you are going to lose money. It doesn't matter how good you are. You need to be well-funded and you need to be willing to accept the fact that you could bust your account a couple times, even if your account is $10,000, $25,000 or $50,000. You can, however, reduce the likelihood that you will completely bust your account and help yourself to learn while preserving your capital for as long as possible by paper trading and being honest with yourself about your trades. If you are switching from real trading to paper trading because you're having trouble, you should expect to lose money in your paper portfolio too. If you switch from trading with real money to paper trading and suddenly your trading profits go through the roof, you are lying to yourself. As hard as it is to accept this, you need to take a step back and evaluate how useful trading on paper is really going to be for you. In my experience, some people can do it and some people can't. Most people cheat, but if you don't cheat, it can be incredibly valuable.

If you really want to prove your worth and make sure that you're being honest, operate on a system of full disclosure like I do. I post all my trades on public forums for two reasons: first, so that others may benefit from my mistakes and hopefully save themselves some money, and secondly so that I can't lie. I have several professional traders who evaluate these trades on a weekly basis and will call my bluff if they catch me lying. To me it's not worth it to lie. If you're going to paper trade, be honest with yourself, because if you're not you're only hurting yourself. If you find that you're becoming too comfortable with paper trading, take a couple real trades and lose some real money. It's a great teacher. Remember, it is only after you've lost everything that you're free to do anything.

Click these links if you'd like to follow my paper trades and/or my real trades with full disclosure, and please feel free to ask me questions in the comments section here or on the Tradervue website!

Before and After - Backtesting Your Intuition

Hello inter-friends!

So one of the things I have been having a little bit of trouble with in my daily trading is having the confidence to actually pull the trigger and execute my plan. When I first started daytrading seriously, I overtraded a lot the very first week and I lost a pretty large chunk of change. It was enough to make me sit back and ask myself whether this daytrading stuff was really for me. After that happened I took almost an entire week off to just watch the markets and watch the trades that others were executing, the idea being to give myself some perspective and to affirm that I did in fact know what I was doing, I just needed to settle down and focus. Since that time I have been much more cautious about the setups I play and whether they are strong setups or not, but lately I've actually been a little too cautious. Specifically, I've fallen into a problem called paralysis by analysis, which basically means that I over-analyze all of my setups and constantly wait for more and more confirmation that they are working correctly and by the time I am confident enough to enter, it's too late. This is a dangerous problem to have because what ends up happening is that by the time you've finally confirmed your setup is working, if you enter the trade there's a good chance that your risk is much, much higher now and that the trade will turn around on you.

Now, I make it a habit to send an email once a week to the person who is in charge of the team of traders I work with. In the email I'll include a list of charts that I'm watching for the week and I'll ask for his input on the charts. Does he think the setups are strong, am I missing anything that could make my risk higher, are they high-probability setups, has he played these stocks in the past and had notable results? These are the questions I'm asking and the feedback I'm looking for. I almost always get a response back saying the charts look great, but lately what I've found is that even though I have confirmation from someone who's been doing this for 10-15 years, I still find myself hesitating a bit too long and missing a lot of opportunities. To combat this, I decided to be systematic about it and analyze all of the charts I've sent for the last two weeks for a before and after status. That's what this post is about.

Each of these charts are stocks that I have been watching for the past couple weeks. The vertical line on the "after" chart for each stock indicates the day that I made the call, so I can see how accurate the call was by following what the stock did the day after the vertical line. I am hoping that by going back and reviewing these charts, I will find either a) that a high percentage of my calls were correct and that I should just be more confident and trust my gut, or b) that many of the setups are failing and I should reevaluate what I look for when I seek out stocks to trade. To make it persuasive, I will also include the amount of money I missed out on making by not taking some of these setups, based on a $5,000 position which is usually about the size that I play. At the end, I'll total it all up and hopefully smack myself in the face with the realization that if I had just been a little more confident, I could have made a lot more than I have over the past couple weeks. I haven't even done this myself yet, other than to take the screenshots of the charts, so I don't know at this point what the results will be, but let's find out:

The following are charts I started watching the week of 3/23/12. The comments on the "before" charts are questions I was asking the person I sent the charts to (click to enlarge):

ACOR before:

ACOR after:

Conclusion: This stock hasn't really done anything. I am still watching for a break of the $27.50-$27.75 area. $0 opportunity missed.

AMRN before:

AMRN after:

Conclusion: This was a short call, meaning I thought the stock would go down. The next day it did. Assuming a drop from $11.92 to $11.60 this would have been a 2.7% gain. $137.93 opportunity missed.

BRP before:

 BRP after:

Conclusion: This trade never developed. It gapped down the following day so the potential break of the flag never happened. $0 opportunity missed.

CKEC before:

 CKEC after:

Conclusion: I should have taken this trade the next day. It was another short call that dropped from $12.52 to $12.20, a 2.6% gain. $131.15 opportunity missed.

CVO before:

 CVO after:

Conclusion: This trade was another which gapped down and never developed. Looking at my question on the "before" chart, however, there's something interesting to learn here: increasing volume on a downtrend is a really bad sign. This actually should have been a short call in which case, had I played it the next day I would have taken a $4.02 to $3.11 gain, 29.2%, or $1463.02. This was an incorrect call but also a huge missed opportunity. 

GMAN before:

 GMAN after:

Conclusion: I absolutely should have traded this. The gap up the day after I called it was actually due to earnings, so it would have been lucky had I bought it the day before at $15.50 where my call was, however, I definitely should have bought at the first opportunity on the following day. I remember watching this and thinking "it can't possibly go any higher" over and over again, just watching opportunities pass me by. Had I taken the trade like I planned, I could have taken $17.15 to $19.69, or a 14.8% gain. $740.52 missed opportunity. Furthermore, this could have easily netted me over $1,000 since I would almost certainly have held part of the position for one or two more days after such a large gain on the first day. It was a huge mistake to not play this trade.

HCKT before:

 HCKT after:

Conclusion: This is another one that I definitely should have played. Following the day I made the call the stock broke out of the formation just like I expected and ran from $4.80 to $5.25, a 9.4% gain. $470.00 missed opportunity.

MATR before:

 MATR after:

Conclusion: This play was a potential short. However, generally speaking when a potential short goes sideways it gives it the potential to run higher. That is exactly what happened in this situation, so while the original call never developed, I should have kept this on my watch list a little more closely since when it broke the flag at $8.15 it ran to $8.75, which would have yielded a 7.36% gain. $368.10 missed opportunity.

MYRG before:

 MYRG after:

Conclusion:  This setup did not develop like I expected it to. However, it should be noted that the stock is now "basing" meaning it has hit the bottom and is going sideways. Usually this means that it is about to make a small correction, in this case the breakout would be above the blue line (the 50 day moving average, which I'll talk about in other posts eventually), and could be a potential run from $18.30 to $19.00, or a 3.83% gain. I am keeping this one on my watch list.

PATH before:

 PATH after:

Conclusion: PATH was supposed to be a swing play, meaning I would buy it and hold it for multiple days rather than what I usually do which is buy and sell the same day. At the time I called this stock I was still waiting for a proper entry (some indication that it was turning around). That never happened, but now we see another opportunity in it, possibly above $3.85 for a run to $5.00. This is a huge gain, 29.87%, for only 15 to 20 cents risk, or $1493.51 on a $5,000 trade. I am keeping this one on my watch list for that opportunity.

PWAV before:

 PWAV after:

Conclusion: I should have taken this trade. It worked just like I'd planned, opening low, taking out the previous day's high at $2.35 and then running to $2.58. This would have been a 9.79% gain. $489.36 missed opportunity.

SCVL before:

 SCVL after:

 Conclusion: This play was similar to GMAN, in that it had a nice setup and then an earnings release the next day. Many times I do this: scan for earnings releases and then filter those releases to charts that have strong setups, that way I have a great setup as well as an emotional catalyst to push the price of the stock. I realize now that I should have played this, even after the price gapped up as you see on the chart, because like GMAN it was a huge gainer. It did exactly what I expected it to but I thought it couldn't go any higher because it had already gapped so high. Seeing both GMAN and SCVL do this as well as many other trades that have taken place in our chat room over the last couple weeks, I am starting to learn that this is pretty standard. A large gap on an earnings release is common if the release is good, and they can sometimes run 20, 30 or even 50 percent in one day. This would have been a run from $29.19 to $32.24, or 10.45%. $522.44 missed opportunity.

I have several more of these charts including some that I started watching on 3/27/12, but after reviewing these and seeing the results I think I know what my conclusions are, and they are what I suspected: I need to trust my gut. Had I played each of these stocks as I had planned, I would have finished the last two weeks with a profit of $4322.52. Furthermore, since I made some other trades last week that netted me some $200-300 gains, and since I generally cap my losses around $130, even if I made 20 trades during the week all of these trades took place in and 50% of them failed, I still would have netted over $3,000 in profit during that week alone! This also doesn't even count all the trades that the rest of my team makes which occasionally I take as well.

This is why paralysis of analysis is such a dangerous problem to have. Not only does it prevent you from making huge profits if you're good at what you do, but it can end up costing you money when you try to enter setups too late. For next week and going forward, I am going to use this shocking number, over $4,300 in missed profits, to convince myself that I need to follow my instincts and take the trades I have studied hard to understand. As I work through this problem I expect to see some of these profits materialize in my account, which I hope will continue to build my confidence so I can continue to improve. If you are trading and having trouble, or you constantly find yourself looking back and saying "Man, I was so right! If only..." then try backtesting your intuition like I've done here. Chances are that you know what you're doing, and you will get results similar to mine that will help motivate you to trust your gut.