There is no sure thing. But after trading everything from stocks on the screen to futures on the floor, I’ve come to believe that the most simple and effective way to put the odds on your side when allocating assets is to follow what I believe is the golden rule: Don’t fight the tape.

Deciding whether a stock is “overvalued” or “undervalued” is totally subjective. Price, on the other hand, never lies. The tape is the tape and determining weather a security is strong or weak is easily visible to even the uneducated naked eye. When a market is strong, you might not want to invest in it, but I think you’re a major fool to stand in its path.

If you’re interested in fighting the market — friend, you’re going to lose. The market has an unlimited supply of capital and patience. We don’t. We harbor these fantasies that, now that we’ve bought our 500 shares, XYZ is likely to bottom out and rebound to all-time highs. Certainly my few thousand shares aren’t going to affect the price of IHOP Corporation (IHP), and even big players like Kirk Kerkorian — who lost a quick $300 million on a position in super-weak General Motors (GM) — can’t influence a market before it reverts to the laws of supply and demand. Unless you’re prepared to take a company private and have unlimited resources, the market can outbox you with one hand tied behind its back.

Of course, “the tape” refers to price action, which should be of dear concern even to those who evaluate a company’s fundamentals. While you can follow a company’s earnings or underlying economics, at the end of the day, it’s the stock we actually trade. And, yes, satellite radio has potential and I love Howard Stern, but that hasn’t stopped Sirius Satellite Radio (SIRI) and XM Satellite Radio (XMSR) from dropping up to 20% over the last six months. And, while the sector could easily stage a formidable rebound, for my money, I’d wait to see some sign of strength before fighting a persistent trend toward lower prices. If XM is worth $37, why not at least wait until it can trade at $22.50 first? Why do people insist on betting on the old, sickly horse instead of the young, strong stallion?

And that’s where my money goes. Opinions are unlimited but trading capital isn’t. The disciplined player only puts money into those few high-probability trades in which the odds are on his side. Fighting the tape is always an inherently low-probability trade.

Take, for example, the Dow Jones Transportation Average, which we profiled back in 2003. In recent months, the Transports have become major market leaders, driven by massive gains in stocks such as FedEx (FDX), Norfolk Southern (NSC) and even airlines like AMR (AMR).

Maybe you own the sector and maybe you don’t. You might think the gains will continue or that the real money has already been made. Regardless of your outlook for future prices, any rational person has to respect the fact that — for now — the Transports are strong. So don’t fight the tape. As long as the price action climbs higher, shorting them, which one could easily do with a security such as iShares Dow Jones Transportation Average (IYT), is lunacy. It’s a perfect example of a low-probability trade.

And perhaps this is the high for Transports. But if you’re bearish on them, I’d say wait until at least you see some signs of weakness before putting dollars on the line by shorting the stocks. For example, as we pointed out recently, you didn’t need to short Nasdaq at 5000 in order to make money on its decline. You could have easily waited until the first big break before initiating short positions and still come out with a grand profit in due course.

Bizarrely, it’s human nature to fight the tape even on a much shorter time horizon. Armed with a freshly funded E*Trade (ET) account, we naturally become hell-bent on standing in front of a moving freight train just to see if it bothers to stop. (Hint: It doesn’t.)

So with XYZ down four points within the first 10 minutes of trading, why am I instinctively drawn into the fantasy of buying a few hundred shares at the market and hoping to sell a point or two higher by the time “Morning Call” turns into “Power Lunch”? My experience is that, if you want to make trades, that’s by far your best approach. If you want to make money, that eagerness to stand in the market’s path is downright insane.

For one thing, as we always point out, playing for the short-term swings — a point here, a quarter point there — is by definition a loser’s game. What inevitably happens is that, because you’ve clipped your winning trades at such insignificant amounts, even a few big losers wipe out all the wins. The only winner in these “scalper” type of accounts is the broker, who, of course, earns his commission on every trade.

Moreover, what’s inherently problematic about this approach is that, by stepping into a stock that’s suffered a recent and large decline, you’re fighting the tape, trying to catch a falling knife that literally hasn’t stopped. And when you look at the sustained fall taken recently by stocks such as Mills (MLS) and PXRE Group (PXT), one is reminded of the danger of the “it’ll-bounce-back” mentality. Those who bought the weakness hoping for a quick two-point pop were likely stuck with losers that dropped 50% or more in a matter of weeks. Again, no strategy is perfect, but on average, you generally have less of them when you focus on following the tape, not fighting it.

– Originally on Mar 27, 2006 by Jonathan Hoenig

The gambling system, which dates back to a London gaming house in the late 1700s, is completely irrational, yet incredibly seductive. The thinking: If you keep doubling your losing bets, eventually a winning trade will make up for the losses. Like making a deal with the devil, the Martingale system will always comes back to haunt you — and often more quickly than you might expect. (For a more detailed history of the Martingale, I’d recommend Nicholas Dunbar’s wonderful book, “Inventing Money.”)

Unlike Jim Cramer or Arch Crawford, I don’t give out a list of stock picks each week. My philosophy is that trading technique, not security selection, is what ultimately determines success. We of the Tradecraft prefer not to give a man a fish so that he may eat for a day, but to teach a man to fish so that he may eat everyday.

So instead of a list of this week’s “hot stocks,” I’ll give you a piece of advice you can use for the rest of your life: Don’t use the Martingale. It simply doesn’t work.

Sure, you might win once in a while with the Martingale — perhaps enough to keep you interested in the strategy. But eventually, you’ll lose it all, in a very quick and undignified fashion. Take it from somebody who has tried it — the Martingale will kill you. It has to kill you. Why? The strategy is inherently flawed. It’s designed to have you increase your bet at exactly the wrong time.

The smartest thing an investor can do is trade with the trend. The Martingale forces investors to be antitrend, fighting the market rather than following it. That’s a recipe for failure.

While each roll of the casino dice is an independent event, stock prices have a tendency to follow a trend. As we’ve pointed out from the beginning, a trade can’t be good for the “long haul” without first being good for the “short haul” as well.

But the Martingale forces you to trade against the trend, which in my book stacks the deck against you from the start. And although moving with the market is a lot more difficult than doubling down, a pro-trend strategy works over time because it will inherently focus you on the most promising, high-probability ideas.

While good traders never know exactly how the market might move, they’re always aware of the relative risk of their positions. That’s another major problem with the Martingale system: It prompts you to increase your position size at exactly the wrong time.

As we often point out, trading isn’t about avoiding risk, but managing it. And when your account shrinks, prudence dictates your position size must shrink as well. Yet the Martingale system has you increasing your bets with every losing trade. It is exactly the wrong move.

The reality of using the Martingale is that you’ll often lose several bets in a row, leaving you without the cash — or the nerve — to double on the next bet. Even for the biggest of bank accounts, that’s a sucker’s trade you should avoid making.

A final flaw with the Martingale is that it offers limited profits. Very limited profits. Because the system mandates you sell every position at the first sign of a profit, you are, in effect, cutting your winners and letting your losers run.

The point of trading isn’t to make trades all day, but to get into good positions and ride them out. The notion of a lot of small winning trades may be appealing, but the real gravy is made on catching a big trend and sticking with it for as long as possible.

The Martingale is a trading style that’s designed for failure. So stop searching for stock tips and start focusing on technique. No matter how skilled a stock picker you think you may be, what you buy will never be as important as how you buy it.

– Originally on Nov 18, 2002 by Jonathan Hoenig

The country isn’t just patriotic — it’s bullish. From Joe Sixpack to Joe Battipaglia, most people aren’t questioning a rebound, but just waiting for it to occur. As we often point out, two sides make a market. Many investors feel as if the worst is over, while others expect more downside to come.

While I am not a roaring bear, I am a realist. And besides rising or falling, the third scenario for stocks — one it seems bulls and bears alike have completely forgotten about — is that the market might go absolutely nowhere for quite some time.

Most financial planners, market analysts and mutual-fund companies like to harp on the idea that the market returns about 10% a year. And while it’s true that the long-term average return on stocks has been approximately 10%, to suggest that an average year sees the market up 10% isn’t just misleading, but just plain wrong. Indeed, as we first pointed out a few months back, there have been long periods of time where the market has done absolutely squat.

For example, in 1903, the Dow traded at 42, only to hit a lower low of 41 some 29 years later. In 1959, the Dow hit 685, not too far from where it traded in 1974, some 15 years later. And if this all sounds like ancient history, keep in mind that the late 1990s have now joined this notorious roster of dead-money periods for equities. At 1500, the Nasdaq trades back where it first crossed in July of 1997, and even the much-celebrated Standard & Poor’s 500 index funds have gone nowhere for three years.

The only reason to invest in anything is to make money. The point isn’t to be right, but profitable. So as the talking heads, most of whom have been unflappingly bullish for the past 18 months, fall all over themselves to pound the table for what a steal the market is at these levels, let’s revisit some basic high-school mathematics. Because if you’re still holding stocks for “the long haul,” it might be nice to have a sense of just how long the long haul really is.

There’s plenty of evidence to suggest that most people were, in fact, buying stocks sometime near March 10, 2000, when the Nasdaq hit its all-time high of 5132. The largest-ever cash inflows into equity mutual funds came during the first quarter of 2000, with the lion’s share, over $55 billion, coming in February. So for argument’s sake, let’s assume that most investors, either individually or through mutual funds, ended up buying the high — not necessarily the highs of their own stocks, but around the top of the overall market.

The unfortunate reality is that stocks tend to fall a lot faster than they rise. And once they’ve fallen, mathematics really begins to work against you. Consider: When a stock falls from $100 to $50, it registers a 50% decline. But getting back to “even” would require a 100% increase. And if you think it’s unlikely that a stock can double in today’s tough economic climate, a 100% rebound is a pittance compared to the gains needed to revive some of the washed-up favorites of the Nasdaq 100. So as tough as it might be to hear, the frustrating truth is that even a substantial rally might not make it worthwhile to keep the faith, especially compared to taking the tax loss and moving on to some better-performing ideas.

Take the case of Oracle (ORCL), just one of the stocks that white-shoe Goldman Sachs identified as a “core holding” back when the market was near its peak.

At its current price of $12.25, Oracle would need to rise approximately 233% to achieve the $40.81 it traded for on March 10, 2000. Assuming an annual return of 10%, as the long haulers often do, it will take Oracle approximately 13 years to make it — and that doesn’t even factor in inflation.

Or Lucent Technologies (LU), which PaineWebber analyst and regular Wall $treet Week elf Mary Farrell recommended in a March 12, 2000, speech ironically titled, “The Bull Market Continues: Outlook for 2000 and Beyond.” At $5.75 a share, Lucent needs to rise roughly 1,010% to get back to its March 2000 levels. Assuming the 10% return, and you’re talking about 25 years. Factor in 3% inflation and it’s more like 36 years. By that time, Ms. Farrell will be well over 90 years old. Makes you wonder how much Lucent is stuffed in her retirement portfolio.

Back in March of 2000, Morgan Stanley called DoubleClick (DCLK) an Outperform, reiterating a price target of $150 in an enthusiastic research report titled, “The Right Thing to Do.” At its current price of approximately $6 a share, the stock needs to rise 2,421% to reach that lofty goal. At 10% a year, it will take over 34 years. Factor in inflation at 3%, and the stock should hit Morgan Stanley’s price target sometime in 2050.

And while Merrill Lynch’s Henry Blodget quietly dropped coverage of CMGI (CMGI) last June, at one point he had slapped a (split-adjusted) $150 price target on the stock, which I’ll admit it kissed not long after. At current levels, however, the stock needs to rise 11,365% to revisit its March 11, 2000, close. Assuming the 10% return, it will take approximately 50 years before inflation, and factoring in a 3% rate, 72 years after. I guess while the visibility for next year isn’t too great, it’s crystal clear 288 quarters from now.

The math isn’t much less depressing for more established names. AOL Time Warner (AOL) needs to rise 81% to reach its March 11, 2000, price, while both Cisco Systems (CSCO) and Sun Microsystems (SUNW) need to gain approximately 441%.

With the market down so sharply as of late, and still plenty of money on the sidelines, it’s very possible we could see some major rallies in stocks at some point. Cisco, for example, could easily get back to its early summer highs of around $20 a share, which would represent over a 50% increase from current levels. That would constitute a massive return by any standard, so if you’re overweight in tech, I wouldn’t dump my entire position in one trade. As we’ve discussed in the past, effective trading isn’t black or white, but shades of gray.

But revisiting Cisco’s glory days of March 2000, when it traded at $80? That’s a 534% move, so don’t hold your breath. After all, if Cisco ever did rally back to within hailing distance of that high, most people would sell. Wouldn’t you? And in the final analysis, that is precisely what will keep it from getting back to $80.

– Originally on Sep 28, 2001 by Jonathan Hoenig

Patience is always a virtue, but in trading it’s a requirement. Despite the fact that traders are often thought to be constantly jumping in and out of stocks, the real money is made by holding on for the big moves. In trading as in life, good things come to those who wait.

So although I am a trader, I want to play the major moves. Short-term fluctuations are fodder for the talking heads, but trying to constantly scalp a half point out of a news headline is usually more trouble (read: risk) than it’s worth. My own results improved substantially once I stopped making big bets on small movements and focused on the converse. Small bets on big movements make much more sense.

The point is this: You want to take chunks out of the market, not bite-sized pieces. It may feel great to grab a quick kill now and then, but the real money is made on the big moves. The weekend moves. The moves that happen when you least expect them and probably aren’t even paying attention.

Take a look at some of the best-performing stocks over the past 52 weeks, and you’ll find that the majority didn’t generate their stellar performance overnight. It took time. When stocks move, they move in trends and it often takes traders weeks or months to build a substantial position. Despite some intermittent negative press, for instance, Abercrombie & Fitch (ANF) has climbed 336% over the past 52 weeks. You could probably have done alright by jumping in and out of the specialty retailer’s stock, but the big profits were made by getting in early and hanging on. Even if you had missed buying at the absolute bottom, you could have ridden at least part of the stock’s rise over the past year and done very well.

I’m certainly not espousing a strategy of buy and hope. If you’re long and wrong XYZ, cutting your losses is just part of the game. But just like children who need their space, you’ve got to let a winner be a winner. As long as a stock is acting right…it stays. Most of the trades I make involve taking losses, not cashing in winners. With the exception of a few well-placed buys, a winning position doesn’t need that much encouragement.

Indeed, 95% of trading is watching. So if you buy XYZ at 50 and it goes to 55, hold on! The big money is made while you sit on your hands and wait, not by popping Xanax while glued to the screen frantically hoping Cisco Systems (CSCO) ticks a quarter point higher.

The problem with traditional day trading (that is, entering and exiting a position during the same trading session), isn’t that the market is so impossible to predict over the short term. It’s that it is very difficult to make any real money over the short term unless you are trading inordinately large positions. And we know how well that turns out.

Positions grow large, they don’t start out that way. And even if you are extremely well-capitalized or are using leverage, the risk of making large short-term bets just isn’t worth it.

Additionally, it messes with your mind. No matter how good your analysis, every day can’t be a winning day. Irregular income is part of dealing with the markets — its one of the reasons we trade noncorrelated asset classes. Yet most people trading short term take huge risks just because they feel compelled to have a winning trade — at all costs. Either I win on this trade, or I’m taking the whole ship down with me. Egos like this will risk $10,000 to make $100, and you don’t need a Harvard MBA to know that over a long period of time, the math just doesn’t add up.

The last thing I’ll say about short-term trading is that it involves too many decisions. Let’s say you buy XYZ at $50 and it goes to $55. Now you’ve got a winner, so you sell out for a quick profit only to see the stock spike to $60. Yikes! Not wanting to miss any more of the move, you buy it back at $60, double down at $55, and puke the positions entirely when it again touches $50. You aren’t playing the market, the market is playing you.

If you like XYZ at $50, buy it at $50. But buy it because you think it’s going to $100, not $55. Rome wasn’t built in a day, and neither are profitable core positions. Taxes, commissions and the bid-ask spread are often cited as the reasons so many individuals lose money trying to trade short term. But the real reason is that the big money is made on the big moves, and big moves take time.

There is one good reason to trade short term and that’s to hedge an existing position. What the heck is hedging? We’ll discuss some basics to get you started, one week from today.

– Originally on Jun 07, 2001 by Jonathan Hoenig

Markets aren’t chaotic. Just as the seasons follow a series of predictable trends, so do market psychology and stock prices. Stocks are like everything else in the world: They move in trends, and trends tend to persist.

We are all looking for an edge. Low commissions and superior trade execution can only do so much. I have found that the biggest advantage you can have in the market is to trade with the trend. It’s the economic equivalent of having the wind in your sails.

In my experience, good traders seldom have strong opinions about the future, because they are humble enough to know their opinions don’t mean squat. The future will unfold no matter what any of us think about it. What most fundamental investors and message-board devotees fail to realize is that it isn’t our job to hypothesize how a stock should or could act. What matters is how a stock is acting at the time of our analysis.

That’s why good traders leave their egos at the door. They don’t want to be “right.” They just want to be profitable. Good traders don’t talk about the market, but listen to it.

And the reason they listen is this: Trends in the market tend to persist. So as a rule, I want to buy strength, simply because strong stocks tend to stay strong. “Strength” of course, refers solely to price action, and not to anything fundamental occurring within the company.

It’s a philosophy that belies one of the biggest misconceptions you hear on Wall Street — that past performance is no indication of future performance. Au contraire! In fact, recent past performance tends to be an excellent indicator of near-term future performance. It’s only long-term past performance, especially the type that’s so frequently quoted by the mutual-fund companies as a reason for investing in stocks, that offers no guidance to the future.

For example, just because Microsoft (MSFT) led the market during the early 1990s is no indication that it will ever do so again. Xerox’s (XRX) performance during the go-go 1960s was no indication of the hardships that would befall the company 30 years later.

But near-term past performance is quite a different matter. Think of it this way: That it was sunny three weeks ago doesn’t tell you anything about today’s weather. But if it was sunny in the morning, you might reasonably expect a sunny afternoon, too.

That isn’t the way most investors think — or they wouldn’t insist on buying so much recently marked-down merchandise. Watch the Ameritrade Online Investor Index, where the most popular online buy is usually the previous day’s fallen star.

Another telling piece of evidence: Last year bonds and other fixed-income investments dramatically outperformed equities. But while inflows to bond mutual funds have picked up, the average mutual-fund investor is still unquestionably long stock, hoping that those “bargains” will rebound. I take that as a pretty good indicator that the next big bull market will most likely be in bonds.

I want to be long stocks that are strong now, because long-term performance starts out as short-term performance. When a stock begins moving in one direction, the law of inertia alone is often enough to suggest the trend will continue. It’s far more likely a strong stock will get stronger than that a weak stock will turn around just because I bought a few thousand shares. But most people would rather buy weak stocks in the hope that they’ll become strong again, rather than strong stocks that most likely will get even stronger.

So then, you might ask, where can one find strong stocks? In fact, you can find a list easily. Many of my best trading ideas come from the 52-week high/low list, probably the most important and least understood weapon in the investment arsenal. Stocks making 52-week highs are, by definition, strong stocks — just the type that tend to get stronger.

This type of trading takes confidence. Unconfident traders are afraid to buy stocks at new highs because they are certain that, with their dumb luck, XYZ is going to plummet as soon as they buy. They’d much prefer to buy a dip (read: a dog), snag a perceived bargain and hope for a rebound.

But when a stock is making a new 52-week high, it’s holding up a big sign that says “liquidity needed.” That’s the time a trader wants to step in and add liquidity, simply because what we fear to be “the top” is probably just a top. So I buy high — and sell higher — because when you buy a stock making a 52-week high you are inherently buying a strong stock.

There’s also such a thing as too much confidence, and it’s embodied in that shopworn proposition, “Buy low, sell high.” Overconfident traders buy technically weak stocks languishing at multimonth lows because they seem cheap. They believe things are about to turn around because they have a hunch, or saw a research report, or watched a demo of a new product. It isn’t our job to pass judgment on how things should be valued, merely to respect how they are valued. Stocks at 52-week lows are there for a reason. Let them be.

I don’t fight the tape. I don’t need to prove I’m right. While the world often seems chaotic, it moves in trends, most of which tend to persist longer than we’d ever expect. And in buying strong stocks, traders are following the trend instead of fighting it.

– Originally on Feb 15, 2001 by Jonathan Hoenig