I decided to write a 5-part series (this is part 2 of 5) on the common misconceptions that really need to stop being promoted. Keep in mind, these are all my humble opinions, but after 16 years of trading and studying market history, one really begins to notice what works and what doesn’t.

Common Misconception #2 – Dollar Cost Averaging

Paul Tudor Jones is one of the greatest traders in market history. Why? Because he’s consistently profitable. The best “anything” in the world are the best because they perform at a consistent, superior level for long periods of time. Michael Jordan isn’t considered the best basketball player ever because he scored 30 points ONCE in a game. It’s because he averaged 30 points per game over his ENTIRE career.

Jones keeps a sign above his desk that says: “Losers Average Losers.” What he means by this is don’t add to your positions when they are showing you a loss. He goes on to say: “If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in.”

Unfortunately, many investors are constantly advised to “Dollar Cost Average.” In other words, buy more shares at a lower price to lower your overall average cost. If you are doing this: JUST STOP! Why? Because all you’re doing is being a “loser” and ensuring mediocre results. Essentially, you are putting good money after bad. All it takes is averaging down on one Enron, Bear Stearns, or Worldcom (stocks which at the time were considered “Blue Chips”) to ruin your portfolio and possibly end your trading career. I’d rather listen to a “winner” and cut my losses.

Follow me on Twitter @jfahmy
Follow me on StockTwits @jfahmy

1) I am finding very few quality setups. Many of the stocks I got stopped out of recently have traded lower, and most of the stocks on my watch list have failed to breakout…all these observations make me cautious for now.

2) When I tweeted these thoughts earlier, many people responded: “You’re in the wrong stocks.” I realize that a few stocks such as $AAPL $GOOG $BIDU $PCLN $LULU $AMZN $GMCR are acting well, but the leadership seems to be narrowing.

3) The narrow leadership reminds me of Sept/Oct 2007 when the market was being driven higher by 3 stocks: $AAPL $GOOG and $RIMM. I’m not saying that we are topping here, but I would prefer to see more “broad-based” participation. In addition, most of the big cap stocks mentioned above are getting “later-stage” in their moves and are extended from proper buy points. Keep in mind that I look for the best “low-risk, quality setups” that I can find.

4) The debt ceiling issue is not a factor in my stock trading. Why? Because after it’s done, the media will find something else to scare us. Remember Egypt, Greece, Libya, the earthquake in Japan, all the nuclear waste that was headed our way, Italy, Greece again, etc. That’s why I pay attention to the price action of stocks and ignore the news.

5) I always keep an open mind and realize that my analysis can be wrong. Therefore, I constantly maintain a watch list of quality stocks. If they begin to act better, I will be ready to pounce on the long side. For now, I remain in 100% cash. If I’m wrong, I’m not worried because I can always get back in.

I suggest being a little defensive and trading lighter-than-normal positions until conditions improve. Keep in mind that I trade with an EXTREMELY defensive posture and I use tighter stops than most traders. I live by the Paul Tudor Jones quote: “Play great defense, not great offense.” Although the major averages are holding up well, my trading instincts are telling me to be defensive for now.

$AAPL $AMZN $BIDU $DIA $GMCR $GOOG $IWM $LULU $PCLN $QQQ $RIMM $SPY

Follow me on Twitter @jfahmy
Follow me on StockTwits @jfahmy

So, I decided to change my approach. My new strategy would be to trade stocks ahead of key events, take advantage of any run anticipating the “rumor,” and sell the stock PRIOR to the “news.” Key events include earnings releases, shareholder meetings, analyst meetings, user conferences, and sometimes even economic reports. This theory obviously doesn’t work all the time, but it works consistently enough that I have added it to my arsenal of trading strategies.

A real-time example of this happened over the past 4 trading days. I bought $NFLX last Tuesday morning (4/19/11) and sold it Monday afternoon (4/25/11) prior to its earnings release (after Monday’s close). I made approximately 20 points on the trade. Here are some keys to this strategy:

1) DO YOUR HOMEWORK. Find out the EXACT date of the earnings/event. That’s the easy part.

2) CHOOSE STOCKS that are liquid, widely followed, and preferably highly shorted. For example, stocks such as $AAPL $NFLX $PCLN tend to run ahead of earnings reports, and if it’s a highly-shorted stock such as $OPEN $LULU $DECK, the shorts tend to cover prior to earnings.

3) FIND A LOW-RISK ENTRY POINT for your trade. This isn’t so easy as it took me years of trading to work on getting better entry points. In general, it helps to trade around strong technical support areas.

4) HAVE A LOSS CUTTING STRATEGY. No matter what your reasoning is for making a trade, ALWAYS USE STOPS! For example, I got into $NFLX around 233, my stop loss was 228, and my target was 250-255 (a 4R trade). If the trade didn’t work, I wasn’t going to force it or be stubborn about it. I was simply going to sell the stock. As Paul Tudor Jones says: “Play great defense, not great offense.”

5) STICK TO YOUR PLAN AND DON’T GET MARRIED TO THE TRADE. Whether the stock hits your target, your stop, or somewhere in between, don’t risk holding over the event. Simply move on with no regrets. In other words, if $NFLX goes up 30 points after its earnings, I don’t care! Too many times, technical traders start reading fundamental news to justify why they should hold over earnings. JUST MOVE ON TO THE NEXT ONE WITH NO REGRETS AND NO EMOTIONS!

One final point: This is one of many strategies that I use to trade AHEAD of earnings. Sometimes, I will hold a position OVER earnings, but I will save that topic for a future blog post. Again, the above strategies don’t work all time, but they are consistent enough to consider using as a trader.

Follow me on Twitter @jfahmy
Follow me on StockTwits @jfahmy

I especially think of this quote when trading stocks over earnings reports. Jones says “never trade in situations where you don’t have control. For example, I don’t risk significant amounts of money in front of key reports, since that is gambling, not trading.” Although Jones was mainly referring to his futures positions, this advice can also be applied to stocks or any other trading instruments. (This strategy does not really apply to long-term investors who are holding positions over several quarters of earnings or longer).

Since we are just starting earnings season, I want to discuss a strategy that I find fairly successful when trading stocks around news releases. It involves “buying the rumor and selling the news.” In other words, I find that many stocks “run” into their earnings dates and tend to “sell off” after the release, especially if the stock has made decent gains in anticipation of the news. Therefore, part of my research during earnings season is to find out EXACT earnings dates and to try and take advantage of possible moves prior to those dates. One thing to keep in mind is that I am not blindly buying stocks a week or two before earnings. My strategy begins with sound fundamental companies and combines buying them near strong technical areas.

Here’s a real-time example: $BIDU closed Monday (10/11) at 99.74. The company reports earnings around 10/26 (they should post the exact date soon). I think you could buy it here and use $95 as your stop with a possibility of the stock running to 110-115 prior to its earnings release. By the way, this is NOT a recommendation! I am simply trying to give an example of 1) starting with a strong fundamental company 2) buying it near a decent support area and 3) trading it in anticipation of a potential run into its earnings release. If you trade this idea, PLEASE USE A STOP and protect your portfolio if the stock turns against you.

There are situations where I will hold a stock over earnings. For example, I like to find “sleeper” companies that are not widely followed by analysts. In other words, I would never play $MSFT over their earnings because 400 analysts follow them and their estimates are in a fairly tight range. I prefer finding companies with a few analysts covering them, thus making upside surprises more likely. One VERY important note: When I do hold a stock over earnings, I keep a “smaller than normal” position size. Again, I’m just “playing defense” and not concerned with missing potential upside. If you are adamant about holding a stock over earnings because you have done your research and you are 100% convinced that they will beat estimates, my best advice would be to hold a position that will allow you to “sleep at night” in case the stock gaps down 10-20%.

In summary: Do your due diligence, find out the earnings dates of the stocks you are trading, try and take advantage of “run-ups” into earnings, and if you decide to hold over earnings, keep your position sizes small. Remember: “PLAY DEFENSE!”

Follow me on Twitter @jfahmy

I’m sure most people’s immediate thought is: “What am I supposed to do? How am I going to make money unless I trade?” Here are a few responses:

1) I respect if you work for a prop trading firm and HAVE TO trade. Just keep in mind that trading the market doesn’t automatically mean you will make money! If you HAVE TO trade because it’s your job, my best advice is to keep positions small until market conditions improve.

2) Define yourself! I am a swing trader looking for high probability situations in a healthy market. If there are none, then I don’t trade…PERIOD! Again, I’m not going to agonize and kill myself over pennies when there are dollars to be made later.

3) The key in corrective markets is not to make money, but to protect your capital. As Paul Tudor Jones says: “Play great defense, not great offense.”

4) “Wait until as many factors as possible are in your favor before making a trade. It’s the patience that makes the money.” — Jesse Livermore

As most of you know, I’m not a big fan of predictions because ALL of them (including mine) are useless. I also realize that I could be wrong and conditions could improve quickly (which is why I do my homework EVERY night). Right now, that work is telling me that the market will continue to move 2 steps forward and 3 steps back until we truly bottom.

One last note, the true response to the question above is: Do post analysis of your work and look at your P+L over the past 6 or 7 weeks. If you made money during this choppy time, then you have proven you can successfully trade in these types of environments. If you lost money, you are better off protecting your capital and sitting out until conditions improve.

Follow me on Twitter @jfahmy

2) Stocks are forming bases right now, but they need more time to set up properly. PATIENCE is so important right now!

3) I wouldn’t be surprised to see the market chop around through July. By chop, I mean 1 day up and 2 days down, followed by 2 days up and 1 day down. Again, nothing “sustainable” to the upside.

4) If you insist on trading, keep position sizes small and take quick profits. If you are not comfortable trading that way, then don’t trade.

5) The key in corrective markets is not to make money, but to protect your capital. As Paul Tudor Jones says: “Play great defense, not great offense.”

6) I don’t think we will have another big leg down, but I’m not ruling it out either. (How’s that for hedging myself?)

7) Keep in mind that cash is a position and there is nothing wrong with doing nothing.

8) I do like how many leaders found support near their 20-day moving averages on Wednesday. Examples include: $BIDU $DECK $CRM $APKT $NFLX $AKAM $CMG. Unfortunately, everyone is watching the same 10-15 stocks and this could be a crowded trade. I like these names but I would prefer to see MORE stocks setup.

9) “Wait until as many factors as possible are in your favor before making a trade. It’s the patience that makes the money.” — Jesse Livermore

Please tune into my show “The Next Big Move” this Sunday night at 8PM EST on StockTwitsTV (http://www.stocktwits.tv/). I will be discussing these thoughts in more detail and comparing the current market to a possible 1997 scenario.

Follow me on Twitter @jfahmy

Here’s my response:

1) Take a Ritalin and relax! What’s the big hurry to trade??? Wait patiently for a healthier environment. One day doesn’t change anything!

2) The four signs that I like to see in a strong market are still non-existent. Stocks setting up, institutional accumulation, high bearish sentiment, and the NASDAQ Composite above its 50-day moving average. Still 0 for 4.

3) I wouldn’t be surprised to see some form of a rally over the next few days. My guess is that it will come on light volume as we are heading into a long weekend and most of the big boys will be in the Hamptons.

4) I am keeping a list of stocks “holding up well” but I don’t feel comfortable sharing that list because we are not in a healthy environment. Once again, breakouts and sloppy bases have low probabilities of working out, especially in corrective markets.

5) People keep asking me: “How can you sit in cash and not make money?” First, making money in these market conditions is very challenging. Second, my goal is not to “make money” but rather to “protect” my client’s capital. As Paul Tudor Jones says: “Play great defense, not great offense.”

Keep in mind that we will have some great winners coming out of this correction, but right now: THE MARKET NEEDS TIME!!! If you insist on trading, I highly recommend keeping your positions light. My better advice is to remain on the sidelines. That’s my position right now: 100% cash. Did you take your Ritalin yet?

Follow me on Twitter @jfahmy