Thursday, May 15, 2008
10 Questions For Brian Shannon
Brian's book is an excellent resource because he is such a great instructor. Unlike many books on trading written by traders who frankly have a difficult time explaining their methods, Brian shows his skills by breaking down relatively complex ideas in a straightforward manner. Ultimately this makes his book particularly good for traders who are just starting out on the learning curve and those who've found other trading books too complex or difficult to implement in the real world.
After reading his book, I sent Brian 10 questions so that you can at least get some idea of what is covered there and whether you think it may be something worthwhile to check out on your own.
10 Questions For Brian Shannon
Kirk: What was your main goal from writing the book? In the book you say admit to being reluctant to write it because "you are still learning and honing your methods" something I can also identify with.
Shannon: My main goal was to help the reader better understand how and why prices change so they can find a strategy which fits their individual objectives. I wanted to provide a resource for traders which allowed them to better understand market structure and then use that as a starting point to identify and manage low risk/ high profit potential trades. The idea for the book came about as a result of the many questions I receive from readers of my blog. Even with 16 years of full time trading experience, the reluctance to write the book comes from readers expectations which may be too high. No one truly masters the market, there is always a way to do better. I know that you are a golfer and am sure that you have yet to attain the "perfect round", Tiger Woods might even say he is still seeking it.
Kirk: Why do you think trend following is the "lowest-stress way" to profit from the markets consistently?
Shannon: I am a big believer in the phrase that "a trend, once established, is more likely to continue than it is to reverse." Trends tend to persist much longer than most people expect. It seems that anytime an uptrend or a downtrend pauses there is someone calling it a top or a bottom, occasionally they get it right, but most of the time the market will continue along the path of least resistance.
Kirk: According to you, "Technical analysis is not about memorizing patterns - it is rather about understanding the motivations of participants so you can anticipate their next moves." Where do traders frequently go wrong in their analysis?
Shannon: I think they tend to take technical analysis too literally. Just as you cannot expect to profit from buying stocks with a single fundamental valuation tool (such as buying stocks with a P/E of 15, or any other number), you cannot expect a technical pattern to work all the time. There is a definite cyclical flow of capital through markets, sectors and stocks, recognizing those flows with technical analysis is a starting point for a trader to identify potential trade scenarios. There are many technical traders who spend an inordinate amount of time seeking out the perfect pattern or indicator, but in the end there has to be flexibility and an openness to admitting your analysis may be flawed. Technical analysis is referred to as "an art, not a science" and just as no two people see a masterpiece of artwork exactly the same, the interpretation of price action will be influenced by subjective biases. In the end it is only price which pays us and our final buy and sell decisions should be weighted towards price action first.
Kirk: You've said the goal is to "time the trade so that your account is exposed to minimum financial downside and the greatest potential profit." How do traders learn how to do this?
Shannon: By obsessively managing risk and being selective about what you trade and when you trade. To me it is about understanding who is in control (buyers or sellers) and then objectively assessing the potential for risk versus reward. The very definition of an uptrend (higher highs and higher lows) assures us that the sum of rallies will be greater than the sum of declines in an uptrending stock and the opposite is true for a stock in a downtrend, so the simple math tells us that trend trading provides greater odds of profits. Of course, you have to enter the trends at the correct time (which multiple timeframes allow us to do with better accuracy) and be willing to exit with a small loss if the market does not agree with your analysis.
Kirk: The book focuses some time on the four stages - accumulation, markup, distribution, & decline - a stock (or market) can be classified. Why is it so important for us to know?
Shannon: Because it breaks the market down into simple logical structure. Stock can be trending higher or lower or they will be range bound. By identifying which stage the vehicle we are trading is in we can start with the odds in our favor and avoid tying our money up in stagnant positions.
Kirk: Ultimately you think that price action is the most important indicator above all else? Why is this?
Shannon: Because price is the only true representation of value. Many people claim that "XYZ is under/over valued." The only value which matters is price, if you need to liquidate, that is the value, period. Your models may tell you that it should be worth something else, but what if your model is flawed? In the end the only thing that pays us is price so that is where I focus the majority of my attention.
Kirk: In the book you recommend that investors, swing traders, and daytraders utilize a minimum of three time frames before you commit capital to a trade. Why is using at least three time frames so important and, more importantly, which one ultimately takes priority over the others when push comes to shove?
Shannon: I like to use a longer timeframe to identify the primary trend, intermediate term timeframe to plan the trade and short term timeframe for entry and management of the open position. Looking at price action on multiple timeframes allows us to be more precise in our entries and exits which ultimately leads to greater profitability. The timeframe which takes priority for me is the shorter term timeframes. The longer term trends are nothing more than the sum of the shorter term trends, therefore the short term trends lead the longer term trends. With commissions as cheap as they are, I can always get back into a trade if I reconsider my actions.
Kirk: One of my favorite quotes from your book is the following: "Our job as traders is to objectively observe the supply and demand imbalances in the issues we are trading while we take advantage of the trends that are created by these imbalances. Leave the reasons for the journalists and academics to debate while we go about our business of harvesting profits from the markets. Listen to the market!" As you know, it is a natural instinct for all of us to look for explanations to market and stock behavior and quite a few investors think that the market should be rational at all times when it seldom really is. How did you learn how to stop looking for neat rational explanations as a trader?
Shannon: Early in my career I realized that the market doesn't care about my opinions and that stocks don't always do what it appears they should do. As we know, the market is a discounting mechanism which looks forward, a lot of times the "reasons" for a move are revealed after the fact. I have always liked the phrase that "news and surprises follow the direction of the trend."
Kirk: Can you provide a quick explanation to your 1:3 risk/reward ratio analysis?
Shannon: Sure. First, its not "mine." The concept is that when you identify a trade situation you want to make sure that the potential for reward appears to be at least three times greater than your perceived risk, that way even if you have only 50% win/loss ratio you will still come out ahead. The key words there are "potential" and "perceived". Again, as technical analysis is more art than science, there is a great deal of subjectivity when it comes to measuring the potential in a trade. In essence, a risk/reward ratio is "garbage in, garbage out" meaning that it will only be as good as our analysis and then how disciplined we are in implementing our plans. The risk/reward should be based on actual trading levels where the stock has previously shown support or resistance, not on random percentages or other methods. Risk management is actually one of the longer chapters in the book.
Kirk: The final chapter of your book "putting it all together" was my favorite because it basically provides readers with nice overview of how you manage your work. Thinking back, how has your routine changed and improved over the years?
Shannon: I am a lot more methodical in everything I do in the markets. I have become more anticipatory but always wait for price confirmation before I will take action. Early on in my career I would react to what has already moved and find that I was consistently late to a trade. Planning for all potential outcomes in advance will never eliminate losses, but it does reduce the chance that emotions be allowed to influence my thinking and emotional decisions are usually costly.