An intimate interview with Deron Wagner, Founder of MTG

Charles Kirk, founder of the popular KirkReport trading website, interviewed Deron Wagner, founder of Morpheus Trading Group, for an informative Q&A session. Following is the transcript of that interview, for your weekend reading pleasure.  🙂

Q&A With Deron Wagner

Kirk:  Hi Deron. Welcome to the Q&A! We are excited to have you here so we can learn more about you and your perspectives and strategy.

Deron Wagner:  Hi Charles. Thank you for the Q&A invitation. I’m honored and pleased to be here as well.

Kirk:  When and how did your interest in the market begin?

Deron Wagner:  I knew absolutely nothing about the stock market prior to 1997. But fifteen years ago, a few years before the peak of the “dot com” frenzy, I remember picking up a newspaper and reading a blurb about an internet stock named Excite.com, a search engine that was already quite popular one year before Google commenced operations. The article was discussing how the price of Excite.com stock had more than doubled within a matter of days. Despite lacking the slightest knowledge of how the stock market worked, something in that article immediately sparked my interest to begin educating myself. After all, it didn’t take a mathematical genius to figure out the potential gains to be made on a stock that doubles, even with a tiny initial investment. Little did I know, of course, how incredibly steep the learning curve would be. Nevertheless, I persevered, initially as a part-time speculator, then a more serious “swing trader,” and eventually a full-time, professional trader years later. Lots of money was lost in those initial years, but I was merely paying tuition for the future ahead of me.

Kirk:  How did those early experiences transition into a lifetime career?

Deron Wagner:  Unlike many fund managers, I don’t come from a Wall Street brokerage background or family of traders. I did not even graduate from a university or college. However, prior to discovering the stock market, I had already started and been involved in several different businesses; being an entrepreneur was apparently in my blood. Therefore, as I learned more about the business of trading, it became apparent the stock market was perfectly suited for my desires. If successful, I figured it offered financial freedom, personal freedom, as well as the ability to work anywhere in the world (thanks to a fast-developing internet at the time).

I’ve always been a computer geek, and pretty good at most technical concepts. As such, I loved studying the application of technical analysis to the stock market. I started out as a daytrader, and was merely a nameless follower of several real-time trading “chat rooms” in the early days. I gained a basic understanding of the market in these chat rooms, but it was losing my savings, several times over, and having the will to persist, that eventually got me to where I am. I’m a big believer there’s no better teacher in the market than risking and losing one’s own capital. No matter how many books are read or seminars are attended, the theory of trading is much different than the actual psychology involved when one’s own money is on the line.

After several years of losing money, I eventually refined my own strategy, borrowing bits and pieces of knowledge from various chat rooms, and got to the point where I stopped losing money. Thereafter, it was only a matter of time (and dogged determination) until I progressed from being a break-even trader to a consistently profitable one. At that point, I partnered with another well-known trader education firm, where I moderated a respectable trading chat room. When I eventually left that firm, I had gained a bit of following from other traders. In 2002, approximately five years after making my first stock trade, I launched Morpheus Trading Group with the intention of become a capital management and trader education firm.

Kirk:  Thinking back, what would you say was the most instrumental in your development toward becoming successful in the market?

Deron Wagner:  The massive bear market of 2000 – 2002 was an incredible, pivotal learning experience. Prior to that period, I had only been involved in a massive, parabolic bull market. But when the “dot com” bubble finally burst, I very quickly learned to respect risk in a professional way (once again, compliments of the most expensive university in the world, the “school of hard knocks”). Since that time, I’ve been a rather conservative trader, at times underperforming the main stock market indexes in raging bull markets, but never again losing a devastating amount of capital. That bear market taught me the only way to make it as a professional trader over the long-term was to, first and foremost, have a focus on not losing money.

Kirk:  Most traders have a story to share of a tough lesson they had to learn early on. What is your story?

Deron Wagner:  Indeed, I’ve got numerous tough lessons learned early on. If I had to pick just one, it again dates back to the 2000 – 2002 bear market. When the plunge first began, I suffered devastating losses by failing to have strict stop losses in place. Prior to that time, every small pullback was eventually met by a rally that took the stock price back to new highs. As such, I assumed this would again be the case, but it obviously wasn’t. My stocks fell faster than a meteorite entering Earth’s atmosphere, while I shifted into “hope” mode. Eventually, I worked my way out of the mess, and learned the most valuable lesson of my career – don’t ever assume a stock can’t go any lower, just because it’s already “oversold.” While trends and patterns repeat themselves over time, markets are dynamic. Therefore, one must always be prepared for the unexpected. Always keeping firm stop losses in place is the only way to continually protect your account from the inevitable surprises the market throws at traders and investors over the years.

Kirk:  So, tell us a little about what you’re doing right now and your approach toward the market?

Deron Wagner:  Now, myself and my team write a daily ETF and stock newsletter that provides detailed picks of the leading stocks and ETFs, along with educational technical commentary, based on the winning trading strategy I’ve been developing for the past fifteen years. Additionally, I trade real capital through Morpheus Capital Limited Partnership, a small hedge fund I formed in 2004, which uses a strategy similar to what is taught in our newsletters.

Overall, our market approach is a focus on consistently outperforming the main stock market indexes over the long-term, but also while limiting drawdowns and maintaining a low month-to-month beta. This is achieved through disciplined risk management, specifically with regards to proper position sizing before each trade is entered. Furthermore, a significant part of our strategy is shifting to a full cash position when market conditions are generally not in our favor.

Kirk:  You named your firm Morpheus, I suspect after the Greek God. What was the inspiration for this?

Deron Wagner:  Thank you for assuming my company was named after a Greek God, rather than the character in the 1999 movie, The Matrix. Actually, I had not yet even seen the movie when I named my company, ha ha. Anyway, I’m a big believer in the power of positive thinking. When naming my company, I wanted a name that would make me think and dream big every time I saw my company’s name in writing. With wings on his back, Morpheus, the Greek God of Dreams, reminds me the sky is the limit.

Kirk:  How has your performance been in both at the hedge fund and in your newsletters?

Deron Wagner:  Since 2002, when Morpheus Trading Group was formed, we have tracked and reported on our website the detailed performance statistics of every stock and ETF trade listed in our daily newsletters. From inception of The Wagner Daily, through January 2012, the benchmark S&P 500 Index has generated a net cumulative gain (without compounding) of 52%. Comparatively, the picks from The Wagner Daily have accumulated a net gain of 133%. That means the newsletter has outperformed the S&P 500 by nearly 300% over the long-term, through both bull and bear markets. The average annualized gain for The Wagner Daily during this same period is 14.4% (again, without compounding). Further, this return is based on only partial utilization of the buying power of our model portfolio. As such, a trader should be able to at least double or triple those returns if they wanted to assume greater risk by utilizing full buying power with margin. Complete historical performance details of our newsletter picks are available here.

As for the performance of the hedge fund, the SEC prohibits me from publicly discussing anything about it due to the “accredited investor” rule all hedge funds must abide by.

Kirk:  Do you think most individual investors would be better off trading ETFs instead of stocks? What do you see as the potential benefits and negatives from adopting an ETF-only focused strategy?

Deron Wagner:  I think an “ETF only” approach works great for investors who prefer lower volatility in their portfolios. While they may not be as “sexy” or exciting as individual stocks, the automatic diversification afforded through buying a diverse basket of stocks (such as the portfolio of most ETFs), rather than just one stock, is ideal for those who really want to have more control of overnight risk. One will probably never wake up to find an ETF in their portfolio has jumped 50% overnight, such as occurs when the stock of an individual company gets bought out. However, there is very little risk that an ETF will ever drop by such a large margin overnight, which is what sometimes happens when your favorite company badly misses their quarterly earnings estimates.

The difference in overnight volatility is both a benefit and negative of ETF trading, depending on one’s personal comfort level with risk. As mentioned earlier, a dynamic strategy that varies the percentage exposure of both ETFs and individual stocks, based on market conditions, may be ideal for many investors.

Kirk:  I think it is clear that you think an active approach is better than a passive indexed focused buy and hold approach. Is it your view that passive approaches are no longer helpful even for individual investors? Why or why not?

Deron Wagner:  In resilient bull markets, such as what we’ve generally experienced lately, an indexed “buy and hold” approach has the benefit of ensuring net returns are comparable to the gains of the major indices. In strong uptrends, this is one way investors can ensure their portfolios do not underperform the broad market. Frankly, if one is assuming strict risk management procedures, it may sometimes be challenging to outperform the gains of an overly bullish market through an active approach.

However, the problem with a passive, indexed approach is that markets move both up and down. In substantial downward corrections, or bear markets, stocks typically go down much faster and harder than they go up. The investor utilizing a strictly indexed, “buy and hold” approach can easily give back all their previously earned gains, and then some, in one swift market correction. This is where the beauty of an actively managed approach lies.

With an actively managed approach, one is not worried about when a bull market turns into a bear, and vice versa. Reliable technical signals will usually keep them on the right side of the market, positioned to profit, or at least protect capital, regardless of market conditions. When stocks got obliterated in 2008, and the S&P 500 plunged nearly 40%, The Wagner Daily was still slightly net profitable for the year. Moreover, the actively managed portfolio assumed much less risk than a passive, indexed approach would have done in 2008.

Kirk:  I recently read your book “Trading ETFs: Gaining An Edge With Technical Analysis” which I have to say is one of the most straightforward and helpful books I’ve read about trading ETFs. I truly appreciate your no-nonsense approach. So, if we can, let’s talk now about what it seems like the three basic steps to figuring out to successfully trading ETFs. Can you tell us what those three basic steps are?

Deron Wagner:  My ETF trading strategy is based on a simple “top-down” strategy that indeed consists of three main steps.

The first step is to determine the overall trend of the broad market – up, down, or sideways. This is done through some basic trend analysis on charts of the major indices, the timeframes of which are dependent on whether a person is a daytrader, swing trader, or longer-term position trader.

The second step is to identify the industry sector indexes (including commodity and currency indexes) that are participating most strongly in the prevailing market trend. If a bull market, we would seek sector indexes showing the most relative strength to the major indices. In a bear market, we would look for indexes with the most relative weakness.

Finally, the third step is to determine which specific ETF family is performing best within that particular sector index. For example, if semiconductors were a strong index, we would compare the relative performance of all semiconductor ETFs to see which one within the sector is performing the best.

Kirk:  How do you determine the market’s trend?

Deron Wagner:  For this, I use very basic technical analysis that seeks to merely determine whether the S&P 500 and/or Nasdaq is in a dominant uptrend, downtrend, or is range-bound. The timeframe of the charts analyzed is dependent on the trader’s preferred holding period. Most of my trades are focused on an average 2 to 5 week time horizon, so I primarily use the daily chart timeframe. Longer-term investors might use a weekly chart instead. Ultra short-term traders could use an intraday hourly chart timeframe (or less).

Next, I merely look for a series of at least two consecutive “higher highs” and “higher lows” (to basically define an uptrend) or two consecutive “lower highs” and “lower lows” (to determine a downtrend). Frankly, this is just as easy as it sounds; I believe a simple strategy is always best because it is most easily followed with discipline. On the annotated chart below, taken from an uptrending period of the broad market, I have marked the point where the S&P 500 confirms a new uptrend, after breaking out above a sideways range on its daily chart (moving averages removed for visual emphasis):

Kirk:  How do you determine the indexes that are the strongest or weakest? What types of tools and scans do you run that enable you to figure this out?

Deron Wagner:  There are two basic ways to accomplish this. The first way, which is probably best for traders just starting out on my strategy, is to compose a series of “percentage change charts,” each of which compares the relative value of a particular index to the benchmark S&P 500 Index. With this type of chart, I’m not interested in actual prices; rather, I only want to see how an index has performed, relative to the broad market. Below is a recent screenshot that shows my page of various sector indexes I monitor, relative to their performance of the S&P 500. On these charts, I am comparing prices relative to the past ten days:

Just a quick glance at the screenshot taken above shows that Gold, Treasury Bonds, and the U.S. dollar (each highlighted with a pink rectangle) were exhibiting the most relative strength to the S&P 500 (as of the time of this interview). Conversely, highlighted with a blue triangle, both the Oil Service Index and Solar Energy Index are showing the most relative weakness. The former indexes may be potential buy candidates on a pullback, while the latter may be potential short sale candidates when the indexes bounce into resistance.

The other way of finding relative strength or weakness amongst various sector indexes is through the use of a quote watchlist that lists numerous indexes, sorted by their relative performance to the S&P 500. This is a better method for traders who are good with numbers, after they have gotten the gist of the method above. More details on this method are described in my book.

Kirk:  Now that you know what is strong and weak, how do you figure out which ETFs are best as a play on those sectors? This is the step I think most people have trouble with.

Deron Wagner:  Now that I’ve identified the strongest index (for going long) or weakest index (for selling short), I drill down to the third step of my “top-down” strategy to see which specific ETF family associated with the index is showing the most relative strength or weakness to its corresponding index. Depending on the popularity of the index, there could be as little as just one ETF associated with the index, or there might be as ten or more ETFs. To do so, I again use the “percentage change chart” to overlay various ETF ticker symbols against each other.

If, for example, I determine the Emerging Markets Index to be showing the most relative strength, I would then overlay the tickers of the main ETFs in that sector. The chart below, taken from an actual issue of The Wagner Daily, compares the relative performances of several different ETFs in the emerging markets sector:

Kirk:  There are a lot of ETFs out there and more are coming down the pipe. How do you figure out which ETFs are better to trade than others?

Deron Wagner:  When doing our scanning for potential plays, we first filter out any ETFs with an average daily volume of less than 100,000 shares. Although ETFs are synthetic instruments, and liquidity is therefore not a direct concern, we have found lightly-traded ETFs frequently have large bid-ask spreads we’d rather not deal with. Furthermore, there is usually a suitable, less thinly-traded ETF with a similar portfolio composition.

Beyond the average daily volume requirement, we simply choose the ETF with the most relative strength/weakness and/or chart pattern, rather than subjectively deciding which ETF group we prefer. Nevertheless, commodity, leveraged, and inverse ETFs are not created equally. For example, there are several different ETFs designed to track the price of the crude oil futures contracts, but some track more closely to the underlying commodity than others.

It’s a similar situation with leveraged and inverse “short ETFs.” Because these types of ETFs rely on a daily portfolio rebalancing of derivatives in order to arrive at their share price, they will rarely track exactly in sync with their underlying index they’re designed to follow, especially over the longer-term. As with the commodity ETFs, some ETF families track more closely to the index than others. As mentioned earlier, a “percentage change” chart that overlays the various ETFs of a particular sector with the index they’re designed to track is the quickest and easiest way to determine which ETF is the best to choose.

Kirk:  Among all of the ETFs out there, which are your favorites or, should I say, those ETFs you’ve traded the most?

Deron Wagner:  I don’t really have any “favorite” ETFs, as I try to be objective and unbiased in my trading analysis. No specific ETFs pop into my head as those I’ve traded the most, although there are periods when I will go back to trading the same ETF more frequently. This happens when I detect an ETF that has been perfectly obeying technical analysis and trending well over a period of months. This, of course, is dynamic from year to year.

Kirk:  Are there any ETFs you would avoid or not trade?

Deron Wagner:  First, I have a minimum average daily volume criteria of 100,000 shares. Unlike individual stocks, in which liquidity can greatly affect how a stock trades, all exchange traded funds are synthetic instruments. As such, the amount of average daily volume that an ETF trades is, for the most part, irrelevant. Even if a particular ETF had no buyers or sellers for several hours, the bid and ask prices would continue to move in correlation with the market value of the ETF that is derived from the prices of the underlying stocks. However, an ETF with a very low average daily volume may sometimes have slightly wider spreads between the bid and ask prices. As such, I look for ETFs that trade more than 100k shares on an average day.

Aside from the average daily volume requirement, the only other ETFs I steer clear of are those with a horrible correlation to the index they supposedly follow. One example that comes to mind is the iPath S&P 500 VIX Short-Term Futures (VXX). Although the ETF is supposed to track the S&P 500 Volatility Index ($VIX), it is designed in such a way that it consistently underperforms the actual $VIX by a huge margin over the longer term. Therefore, I would generally only consider an ETF like this for a 1 to 2 day hold time. Many of the leveraged ETFs, such as the ProShares Ultra and Direxion 3x Shares, also have a track record of considerable underperformance to the associated index when held for more than a few days. This is because they use derivatives, and their portfolio values are reset daily, unlike the actual indexes they are supposed to track.

Kirk:  What are your thoughts about trading leveraged ETFs?

Deron Wagner:  Overall, we’ve found they’re most beneficial for daytrading in a session when the broad market is trending strongly. If we identify the likelihood of a trend day in the S&P, Nasdaq, and Dow (bullish morning price action with strong volume), we will sometimes buy a leveraged ETF of the index showing the most intraday relative strength, with the intention of selling it by the close. It constitutes only a small part of our strategy, but can often add a little more “bang for the buck,” especially if the market makes a surprise at a time when we are too lightly positioned with other ETFs and stocks.

One key point is we’re frequently closing such trades the same day they’re entered. If anticipating an opening gap the next morning, we may carry it overnight, but we typically avoid holding leveraged ETFs for anything longer than a very short-term trade. This, of course, is because of the disadvantage of portfolio underperformance as the holding period increases. For taking advantage of broad market trends in intermediate or long-term holdings, the non-leveraged broad-based ETFs are probably a better bet.

Kirk:  I know your approach involves far more than the three steps already covered so let’s talk a bit about how you apply technical analysis in your trading. All traders seem to have their favorite chart setup that they always begin with. Can you share your favorite basic chart setup with us today?

Deron Wagner:  As mentioned earlier, I prefer to keep my strategy very simple, and that includes the typical chart setup. I’ve found the consistently most useful indicators to be: price (obviously), volume, and moving averages. Below is a screenshot of a typical daily chart layout used in my trading:

First, you’ll notice I prefer candlestick charts over bar or line charts, except when overlaying the prices of more than one ticker, such as in the “percentage change charts” shown earlier. On the chart above, I use volume bars that are color coded for easy reference, depending on whether corresponding price was higher or lower for the day. This enables me to quickly see whether the ETF or stock may be under institutional accumulation or distribution. The black line running through the volume bars at the bottom of the chart simply plots the average daily volume of the ticker, which again shows me unusual buying or selling interest in the ETF or stock. On daily charts, I also use the 20-day exponential moving average (the beige line), the 50-day simple moving average (the teal line), and the 200-day simple moving average (the orange line). In strongly trending markets, I also add the 10-day simple moving average, which is often the most that an ETF or stock will retrace to before resuming the dominant trend. On intraday charts, I replace the 50-day moving average with the 40-day moving average, for slightly earlier notice of pullbacks.

Kirk:  Why do you find candlestick charts more helpful than other types of charts?

Deron Wagner:  Above all, I believe the type of chart a trader relies on is purely a matter of personal preference, based on what they started learning with. For me, I initially learned technical analysis with candlestick charts, so it’s what I’m most comfortable with. If, on the other hand, I started with bar charts in the formative years of my trading, that’s probably the type of chart I’d still be using today.

Personally, I like the color coding of candlestick charts. I find I can more quickly get a feeling for dominant trend by glancing at the colors, while efficiently gauging trend conviction by looking at the length of the “wicks.”

Kirk:  What are some of your favorite candlestick patterns you try to look for?

Deron Wagner:  There are a plethora of candlestick patterns traders believe in, with varying degrees of conviction. For me, I merely view each of the patterns as an early warning sign, or a potential “heads up” for a move in a particular direction. This means I place little value on the various patterns until I actually see price confirmation the following day(s). Rarely are trade decisions based solely on a candlestick pattern.

We’ve found the bullish “hammer” candlestick frequently precedes the short-term reversal of a downtrend, but only if the downtrend has been in place for a significant length of time. The “hanging man” has the same effect of preceding the short-term reversal of an uptrend. The “doji star” pattern occurring after an extended uptrend or downtrend signals indecision, and often prompts us to tighten stops. There are many more patterns, most of which we don’t follow closely. If you want to learn about candlestick charts, I highly recommend the classic book by Steve Nisson, Japanese Candlestick Charting Techniques. (Also see this Candlestick Pattern Dictionary.)

Kirk:  How do you use moving averages in your analysis?

Deron Wagner:  I primarily use moving averages to determine ideal retracement levels at which to enter new positions. Additionally, they are used in setting stops. In strongly trending markets, such as from March to April of 2010, pullbacks to the 10-day moving average often presented the only retracement one would get in order to enter a new buy order, before the position took off again. However, most of the time, trends will not be so strong. As such, I primarily use the 20-day EMA to buy a strongly trending ETF on a pullback to that level, or to sell short in downtrending ETF that bounces to that level.

If trends are getting overheated, a touch of the 50-day MA comes into play as an ideal place to enter new buy or sell short orders. Particularly, the first touch of the 50-day MA after a strong trend tends to be a very low-risk place to enter a new position, especially on a one to two bar “undercut” of the moving average. Many institutions use program trading to automatically buy or sell on touches of the 50-day MA.

The 200-day MA is really used in a more general sense in order to determine long-term trends. Whether an ETF or stock is trading above or below the 200-day MA tells me the long-term bias of it.

Additionally, I look for crossovers of the 20 and 50-day moving averages to confirm trend reversals. If you look at my prior chart of SPY (the S&P 500 SPDR), notice that the 20-day EMA crossed up through the 50-day MA in early March, thereby confirming the reversal to an intermediate-term uptrend. Now, as of May 7, the 20-day EMA has turned back down, and is headed towards crossing below the 50-day MA. If it does, that will be a confirming indicator of an intermediate-term trend reversal to the downside.

Kirk:  Many prefer using exponential moving averages to simple moving averages. In your opinion, what is the primary benefit from using one over another?

Deron Wagner:  I actually don’t prefer one over the other, as I use both. Exponential moving averages (EMAs) more heavily weight recent price action, whereas simple moving averages (MAs) place an equal weighting on every day of the moving average period. As such, I find the EMAs tend to give a little bit more early notice of potential trend resumptions on a retracement. Since I use the 20-day EMA to gauge entry or re-entry points, I like the advance notice it provides. I’ve found strongly trending ETFs and stocks will often kiss their 20-day EMAs and resume their trends, but actually miss touching the 20-day MA.

There tends to be an argument over which moving average is better, but I don’t think it really matters too much. Both are equally effective, and the differences in price are often minimal. What’s more important is to consistently stick with whatever type of moving average one has been using, and learn how to interpret the signals provided from such.

Kirk:  How important of a role does volume play in your analysis? Is there something you look for in volume that

Deron Wagner:  Volume plays a very important role in my analysis, as it shows what is happening “under the hood,” which is often not apparent by merely looking at price, trendlines, and moving averages. Generally speaking, volume is a confirming indicator, rather than one I primarily base decisions on.

Specifically, in a long position, I want to see average to higher than average volume on the “up” days, and average to lower than average volume on the “down” days. This is a sign of a healthy pattern of institutional accumulation. Conversely, I look for higher volume selling in short positions near their highs. But after they’ve already been trending lower for a while, a higher volume day could actually be a sign of stealth buying, just as heavy volume near the highs is often a disguise of institutional selling into strength. More details on volume analysis are available in my book.

Kirk:  As an avid reader of your newsletter I cannot recall a time that you’ve shared indicators like Stochastics, MACD, RS, etc. Do you find these not helpful in your work?

Deron Wagner:  When I began the heaviest learning phase of my trading career (I never stop learning), I became aware of the incredible number of technical indicators available to traders. A sponge for knowledge, I eventually tried most of them. In doing so, I soon found myself crippled with “analysis paralysis.” Rather than focusing on buying and selling the best stocks and ETFs, I ended up spending most of my time applying a myriad of technical indicators to the charts, waiting and waiting for the “perfect” trade that never came along. Following such a path may have eventually made me a master chartist, but probably would not have helped my trading very much. Thereafter, I decided to revert back to the basics of price and volume, in the style of trading pioneer Jesse Livermore, while adding in moving averages and trendlines for good measure. While I have knowledge in all the other indicators, I personally like to keep it simple because it allows me to focus on what really moves stocks…price and volume.

Kirk:  You’re not alone in that regard Deron. Some of the best traders I know utilize very simple charts with very few indicators. Speaking of which, in your book I especially liked your recommendation to use multiple time frames for confirmation. Can you provide a recent example of how this has been helpful to you and the time frame you most like to use?

Deron Wagner:  When I was a new trader, I made the mistake of only analyzing one time frame, such as the daily chart, when doing my research. Upon taking a trade, which I thought was set up perfectly on that chart, I would often find the stock would go in the anticipated direction, but for only a short period of time before reversing direction. The problem was I was failing to take into account the power of multiple time frames.

Generally speaking, the longer the chart time frame, the more impact that trend will have on the price of the stock. For example, if a stock or ETF is in an uptrend on the daily chart, but is clearly in a downtrend on the longer-term weekly chart, the stock is going to have a difficult time moving higher over the intermediate to longer-term. However, if both the daily and weekly charts are trending in the same direction, there is a better chance of the dominant trend continuing. Therefore, I typically assess the hourly, daily, and weekly charts before entering a trade.

When the SPDR S&P Metals & Mining ETF (XME) formed a bearish “shooting star” candlestick pattern, as it neared resistance of its prior high on the daily chart, this prompted us to sell short XME, in anticipation of a move lower. However, since the long-term weekly chart showed XME in a one-year uptrend, we knew the trade should be limited to just a very short-term hold time because the power of the weekly chart would not make it easy for XME to decline in a significant way. The trade worked out well; we sold short at $57.63, then covered the position three days later, for a quick gain of 3.3 points, as XME came into support of its 20-day EMA. Two weeks later, XME had rallied back above its prior high and our original short entry point. The uptrend on the weekly chart was largely responsible for enabling the price to come back quickly.

Kirk:  From reading the newsletter, I understand chart pattern analysis plays an important role in your approach. What are some of the patterns you find most profitable in your work and that even novice traders should be able to readily recognize?

Deron Wagner:  Perhaps one of the most consistently profitable patterns is buying the “undercut” of support (for long positions) or “overcut” of resistance (for short positions). Many traders set their protective stops within just a few cents of obvious support levels, such as lows of price consolidations, prior “swing lows,” and various moving averages. When uptrending stocks and ETFs pull back to those support levels, they often will “undercut” the exact support price level by 1 to 3%, trigger traders’ sell stops, then rip back up above the support level and continue higher. With this type of setup, we like to buy the stock or ETF if it immediately snaps back into the range, above prior support, no more than 1 to 2 days after the actual “undercut.” If prices remain below the support level for more than a day or two, it may be a legitimate break of support and trend reversal, versus an “undercut” stop run that provides a buying opportunity. For the “overcut” on short entries, the opposite of all this is true.

Another pattern we like is buying the first pullback to the 20-EMA on the hourly chart, after a stock or ETF has broken out sharply. The first kiss of the 20-EMA, after a strong uptrend has taken hold, often leads to an immediate resumption of the trend. On the short side, one can also sell short a new position on the first bounce into the 20-EMA on the hourly chart, if the downtrend is new and steady.

Kirk:  Are there chart patterns you’ve found more susceptible to failure?

Deron Wagner:  Some chart patterns tend to be dynamic, where their reliability varies with market conditions. Therefore, it’s difficult to say there’s a pattern I follow that has a high degree of failure. However, over at least the past year, we’ve noticed the bearish “head and shoulders” pattern has not followed through with its anticipated downward price action very frequently. It doesn’t mean the pattern is doomed to failure; rather, the market has been so strong that bearish patterns have not followed through very frequently. Conversely, various bullish patterns, such as a “cup and handle,” rarely followed through to the upside during the bearish trend of 2008.

Kirk:  I know you draw and use trend lines quite a bit within the charts you evaluate. What’s your method for drawing those trend lines?

Deron Wagner:  The best method for drawing trend lines is kind of a grey area. Some traders prefer to connect the major anchor points at their closing prices, while other traders swear by connecting the anchor points at the intraday highs or lows of the swings. For me, I usually will connect trend line anchor points at the intraday highs or lows, as I’ve found that trends tend to conform to them more frequently. However, there will occasionally be wild price spikes on a particular day, often driven by news, that cause the trend line to be inaccurate. In this case, I will often revert to connecting the closing prices, while ignoring the one-day spike if it’s large enough of an aberration. This is what I refer to as a “dirty trend line.” Overall, I think drawing trendlines is more of an art than a science, and a bit of flexibility and common sense is required.

Kirk:  Thank you Deron for the detailed explanations regarding both your strategy and technical approach. I think many will find your comments very helpful. At this point, I would now like to move on to two very important topics: trade execution and risk management. First, on trade execution – when buying ETFs how do you determine the correct entry point?

Deron Wagner:  This question requires a rather in-depth answer that is too lengthy for the confines of this interview. Nevertheless, I’ll give it a shot at summarizing my strategy.

If the major indices are trending strongly, without a significant pullback, I prefer pullback entries into individual ETFs and stocks, rather than breakouts. I then use the 10-day MA, as well as the 20-period EMA on the hourly chart. If the market is trending, but not so strongly, I would then revert to waiting for pullbacks to the 20-day EMA instead. However, in most cases, I like to see price confirmation before buying the pullback, so I would then wait for the first rally above the previous day’s high, which often sets momentum in motion to continue the dominant trend.

In markets that are trending, but are presently on a pullback, I like to buy breakouts because odds are good the market will soon resume its dominant trend, after the correction has taken place. If an ETF or stock is so strong that it manages to break out, even as the market is pulling back, the subsequent momentum of having the broad market’s “wind on its back” will then propel the breakout much higher, reducing the odds of a failed breakout.

In markets that are choppy or range-bound, I will often trade a mix of long and short positions that are trending independently of the major indices, again focused on pullbacks to the 20-day EMA, rather than breakouts, which have a higher tendency of failure in range-bound markets. Trend reversal plays can also be effective in such markets.

Kirk:  Do you prefer buying breakouts or pullbacks? Why?

Deron Wagner:  My trading strategy involves both buying breakouts and pullbacks, depending on trend conditions of the broad market.

In an uptrend, we often limit breakout buying to those that correspond with a pullback in the broad market. If, for example, the Nasdaq has been trending higher for a month, then pulls back 2 to 3% over the course of a week, we would look to buy stocks and ETFs breaking out at that time. Because the Nasdaq would be more inclined to move higher in the near-term, there is a lower chance of the breakout failing to hold up. Conversely, if we buy a breakout after the market has been going straight up for weeks, without a pullback, there is a higher chance the breakout will fail, thereby stopping us out of the trade. In such conditions, when the market is trending higher without a pullback, we would then prefer to look for stocks and ETFs that are pulling back to key levels of support. If the broad market subsequently retraces lower, there is a better chance the stock or ETF that has already pulled back to support will hold up, and perhaps even continue to move higher.

Overall, we like breakout buying when the market has already pulled back, and pullback buying when the market has broken out and not pulled back. Counterintuitive as it may seem, we find this method puts the odds in our favor a majority of the time.

Kirk:  Earlier you talked very briefly about the importance of position sizing. So, how do you position size your trades?

Deron Wagner:  Whether or not we scale into a position depends largely on the type of technical setup we’re considering. With breakouts above solid bases of consolidation, we generally buy the entire position at once. But if it’s a pullback entry, we will often buy half the position on the initial test or “undercut” of support, then add to the position upon receiving more price confirmation, such as a rally above a short-term downtrend line or moving average.

Kirk:  Do you add to positions that have moved against you? Why or why not?

Deron Wagner:  If positions have been trending in the right direction and are showing substantial profits, we will frequently add to positions on pullbacks to support (or bounces into resistance for short positions). However, if a position has moved against us to the point of putting the trade in negative territory, we do not add to the position unless it was part of the original plan at the time of entry. An example of this would be a trade where we bought a small starter position in an “overbought” stock or ETF, with the initial intention of adding to it on a pullback to a key support level. But if we already have full position size, or if the initial intention was not to add to it, we do not add to the position.

Averaging down on a losing trade can be a very dangerous proposition. In the words of famous economist and speculator, John Maynard Keynes, “markets can remain irrational longer than you can remain solvent.” That is reason enough to not average down on a losing trade, unless it was part of an intentionally controlled, scaled-in trade.

Kirk:  Speaking of “scaling in,” can you provide an example of a recent trade you made and how the method you used to scale in and out of that position?

Deron Wagner:  Yes, we sometimes scale in and out of trades, depending on the individual setup. Generally, most of our scaled entries are done on trades that are pullback entries, whereas the trades entered with full size out of the starting gate tend to be breakouts above price consolidation. We also scale into trades that are reversals on the dominant trend, typically entering half of the position on the break of the downtrend (or uptrend) line, then entering the remaining shares on the first modest pullback that holds above new trendline support.

As for closing positions, we often scale out of winning trades by exiting half of the position into strength, as the stock or ETF nears resistance. We then keep half the remaining position with a looser stop, in order to capitalize on further profits in the event of a breakout to a new high.

One example of scaling into a trade that comes to mind is with PowerShares DB US Dollar Index Bullish Fund (UUP). On January 11, 2010 we bought our initial position of UUP, in The Wagner Daily newsletter, when it made an orderly pullback to support of its 50-day MA. We subsequently added to the position about one week later, when UUP confirmed the resumption of its developing uptrend by gapping up above its 20-day EMA and hourly downtrend line. Key support of the 50-day MA below perfectly remained intact the entire time.

Kirk:  I know in your newsletter you set price targets for your positions. Can you talk a bit about how you do that and what steps you take to figure out an appropriate target level using a recent example?

Deron Wagner:  Although our newsletter lists price targets for some of our trade setups, they are always intended to be merely a rough guideline, to give subscribers an idea of the approximate reward/risk of the trade. Frankly, we’re not big fans of giving targets all the time because strongly trending stocks and ETFs will often blow through our target prices and keep going, while positions that don’t act well will be closed well before they ever reach their targets.

When using them, targets are based on technical levels of support/resistance (trendlines, prior lows/highs, moving averages, Fibonacci, etc.). Perhaps most frequently used are the prior “swing lows” and “swing highs.”

Kirk:  For those trades that go awry, what is your stop loss method?

Deron Wagner:  First of all, an important point is we do not wait for trades to go awry before calculating our stop. Reacting after the fact is a recipe for disaster. That begin said, our stop loss method is pretty simple, as is the rest of our trading strategy. The following three steps quantify the process:

1. For trades in any of our newsletters, the maximum risk per trade is approximately 1% of the cash (not margin) value of the trading account. So, for a $50,000 account, that would equate to a $500 max risk per trade.
2. Next, we use technical analysis to determine at what price the most ideal stop level would be located. This is based primarily on support and resistance levels, specifically in the form of prior highs and lows, trendlines, and moving averages.
3. We take the max risk per trade and divide it by the number of points to the stop price. For example, if our max risk is $500 per trade, and the trade requires a 2 point stop, our full size for the position would be 250 shares ($500 / 2 points = 250 shares).

Using the above steps, one can automatically maintain a consistent risk from one trade to the next, keeping subjectivity and opinions out of the equation. While subjectivity is fine for determining which trades to enter, objectivity is preferred with all manners of risk management.

Kirk:  Have you ever utilized trailing stops based on average true range? Why or why not?

Deron Wagner:  We have experimented with stops based on ATR in the past, but ultimately did not stick with it. I know many traders such as yourselves may prefer these types of stops, and I believe they can work well because they should be designed to take advantage of exiting when volatility negatively increases.

The simple answer as to why we still set stops based on technical levels of support or resistance is that it’s the way I grew up in the business, and hence is where my comfort lies. Though I strive to learn and grow every day, I’ve also learned that jumping around with too many aspects of one’s style ultimately leads to a lack of focus on doing what works for the individual.

Kirk:  In your book (page 210) you devoted a section to “knowing when to be in SOH mode.” Can you explain what this is and how to figure out when we are in this mode?

Deron Wagner:  SOH mode is an acronym for “sitting on hands.” I once read, and now truly believe, that the most successful traders are out of the markets more than they are in the markets. 80% of a professional trader’s profits are made from 20% of their winning trades. The “80/20 rule” is known as Pareto’s Principle, and it definitely is true for our historical performance. Therefore, if odds are good that it will be challenging to find a few winning trades that will constitute that 20% of winning trades, it’s best to stay on the sidelines and wait for better opportunities to develop.

Knowing when to be in SOH mode is subjective, and largely based on intuition, which is merely the sum of all past experiences trading the market over the years. But a good example of when to be in SOH mode was going into the first week of May 2010.

After two weeks of heavy distribution (higher volume selling) in late April, I was not comfortable with the long side of the market. Conversely, the market had not actually moved lower yet, so selling short was equally risky. Therefore, going into the month of May, we were 100% in cash (in The Wagner Daily ETF portfolio). Four days later, on May 6, the major indices suffered their second worst intraday declines in history (approximately 10% at their lows of the day). Between May 6 and 7, the major indices posted closing losses of approximately 5%. The beauty is that we were fully in cash while this happened, and therefore preserved all of our hard earned profits from earlier in the year.

If signals I typically rely on are not working, or there are too many mixed signals in the market, that’s the time I tend to shift to SOH mode.

Kirk:  Well put Deron! SOH mode can be a true life saver at times.

As you know, many traders find it helpful to analyze every trade from a risk versus reward perspective. Do you do this and, if so, can you provide a recent example of how you determined the risk/reward for that particular trade?

Deron Wagner:  Yes, I always analyze the reward/risk ratio of a potential trade before entering. As a rule of thumb, I like the potential reward to be at least double the likely risk (2 to 1 reward/risk ratio). This means that, based on likely areas of price support and resistance, I like the potential profit to be at least double what I would lose if the trade did not work out and hit my protective stop.

There may be many times when I see an ETF or stock I think will move in a particular direction, but the required stop is roughly equal to the likely profit. In such a situation, I’ll simply pass on the trade. This is because trading is a numbers game. Historically, I know that only about 50 to 60% of our trades will be winners. However, if I know that my average winning trade is approximately double the size of my average losing trade, I will be consistently profitable in the end. Reward/risk ratios of only 1 to 1 should only be taken by ultra short-term traders who have a batting average consistently above 70%, which would still yield profitable results.

The best trade setups are those where the stop can be very tight, but upside potential is quite large. Trades such as those might have a reward-risk ratio of 3 to 1 or better. However, higher reward-risk ratios often have a lower chance of being a profitable trade.

As an example, we bought iShares FTSE/Xinhua China 25 Index Fund ETF (FXI) on March 26, 2010, as it pulled back to its 50-day MA on March 25, then gapped above it the following day. This enabled us to neatly set a relatively tight stop of 1.35 points, just below the 50-day MA. On the upside, we realized FXI could realistically rally 4 to 5 points if it resumed its new, intermediate-term uptrend. As it turns out, we sold the trade for a gain of nearly 3 points because it underperformed our expectations. Nevertheless, we still had a reward-risk ratio of more than 2 to 1, based on our exit point.

Kirk:  Thank you Deron for all of the interesting perspectives. As we begin to wrap things up here I would like to talk about something you wrote in you last book “Trading ETFs: Gaining An Edge With Technical Analysis.” On page 224 you wrote the following:

“I am convinced there is no direct correlation between intelligence and the ability to become a consistently profitable trader. Over the years, I’ve seen extremely intelligent doctors, lawyers, entrepreneurs, and even people with MBAs fail miserably at their trading. What’s the common denominator to all their failures? In my opinion, they all thought they were smarter than the market. They let their egos and their desire to be right dominate their trading decisions. They didn’t listen to what the market was telling them and simply react to it. My mantra, which reminds me to always keep my ego in check, is, “Trade what you see, not what you think.” I never really care about being right or wrong in my analysis, I care about making money.”

I’ve read a number of books over the years but that is one of the most powerful paragraphs ever written in a book about trading. I think any of us who have traded at a high performance level were forced to learn the lesson that we must separate our egos from our trading at all times.

So, taking this a step further, knowing that you need to do this and actually doing it is the difficult part. What suggestions would you make to people who strive to separate their egos from their decisions so they can find more success in the markets?

Deron Wagner:  I agree this is a challenging part of trading, and I am not ashamed to admit it is something I must continually focus on as well. Unlike many professions, where intelligence will usually equate to better performance and income, consistently profitable trading really has more to do with discipline to follow one’s strategy than intelligence.

For me, I eventually learned to separate my ego the hard way by losing lots of money because I stubbornly clung to my opinions in the early years. Eventually, I got through my thick brain that the market really doesn’t care, or even know, what I think about a particular ETF or stock. Rather, it operates based on supply and demand, which is fueled by greed and fear of the masses. Thereafter, I came across a Wall Street cliché to “trade what you see, not what you think.” Upon reflection, I realized this cliché should become my mantra, so I wrote it down and stuck it on my computer monitor. Now, anytime I feel myself gravitating towards sticking to my opinion, when the charts are contrary to my opinion, the mere viewing of that piece of paper reminds me that my ego must be separated from my trading actions.

Unfortunately, I think many traders cannot learn to separate their egos from their trading decisions until they’ve experienced enough pain to realize that intelligence has little to do with profitability in this business.

Kirk:  More experienced traders typically will at least try to move from a discretionary system to one that may be more mechanical. What are your thoughts about using mechanical approaches? Have you found any helpful?

Deron Wagner:  I agree that most traders eventually try to hone in on an objective, mechanical system that fits their personality. If someone has developed a mechanical system that is working for them, I certainly encourage them to continue using it. However, I personally prefer to have a mechanical system to scanning for trade setups (finding the same patterns, trends, etc.), but base on actual entry and exit points on discretion.

Human psychology has generally been the same since the beginning of time, so mechanical systems based primarily on the market-driving emotions of fear and greed work well, and will probably endure the test of time. But when it comes to details that determine precision entry and exit points, I believe the market is dynamic in such a way that what might have worked last year may not work this year. This is something a mechanical system may not be able to account for. Humans, on the other hand, have the incredible ability to pick up on subtle nuances based on years of experience in seeing the same things happen over and over, even if it’s in the back of one’s conscious memory. When one refers to a trader basing decisions on his “gut,” it’s actually the sum of all experiences and subtle observations comprising the “gut” decisions.

Kirk:  A common element I find in all successful investors and traders is that they are always working on expanding their knowledge and improving their strategies. What have you been working on lately in this regard?

Deron Wagner:  I’ve been working on ways to make my trading generally more efficient. As an entrepreneur with several successful businesses in the past, I’m no stranger to hard work and doing whatever is necessary to be a winner. Nevertheless, in the more than a decade I’ve been trading, I have also come to the conclusion that professional trading requires incredible stamina and psychological persistence. Burnout rates are very high in this business. Therefore, the more efficient I can make my trading, the smarter I can work. Working smart is about accomplishing more, while physically working less. This leads to less inherent stress and a clearer mind, which translates to more profitable trading.

Specifically, I’ve been working on determining how to be more selective in my trades to get better at “cherry picking” the trades with the best odds for profitability, while leaving the rest alone and not concerning myself over the possibility of missed opportunities. So far, it seems to be working. My average number of trades has decreased in recent months, but the bottom line has been increasing. Even better is my drawdowns and month-to-month swings have been decreasing.

Kirk:  At this point of your career who do you look up to for inspiration and guidance?

Deron Wagner:  I may be a bit unusual in this regard, but I actually try to focus on “living in a box,” at least in the professional sense. This means I try to significantly restrict the viewing and reading of other commentators, professional traders, and even the financial news media – I never watch CNBC.

The reason for “living in a box” is certainly NOT because I already know everything about trading. In fact, that is far from the truth. Nor is it an ego thing. It’s simply that I’ve learned from experience that digesting the differing market opinions of others has the negative effect of sometimes causing me to question or doubt my own analysis, which is never a good thing. Therefore, I instead stay focused on doing what I know works, while improving through own self-reflection and constructive analysis all the time.

Kirk:  Based on my own research Deron, more traders be so much better off “living in a box.” So, thinking back at your career, what were some key lessons that had the most positive influence on you?

Deron Wagner:  In the 2000 to 2002 bear market, the first one I actively participated in, my account suffered major losses because I failed to respect risk in a very deep sense. At the time, I was using mental stops, rather than physical stops, and there were occasions where I exited positions much lower than I wanted to. Up to that point, I hadn’t given much thought to physical stops because the market was so strong in the late 90’s that all one had to do with a losing trade was wait long enough for it to come back. But I soon learned the hard way that markets are very dynamic.

The good news is I eventually learned from my mistakes, and built my account back up. Thereafter, I became an avid believer in physical (mechanical) stops, which remove the emotion out of the play when volatility starts to get crazy. Since then, there have been countless instances where this policy has saved me a great deal of cash. In 2008, for example, when the main stock market indexes plunged 35 to 40%, The Wagner Daily still made a small net profit. A trader can survive through any type of market, no matter how wild and volatile, as long as disciplined stops are observed at all times. Never think a stock or ETF “just can’t go any lower” because they ultimately can go to zero (remember Enron?).

Kirk:  What are some important things that you have learned so far that would have surprised you initially if someone had told you?

Deron Wagner:  I would have been surprised if someone told me how extreme markets can move in both directions before seeing a major retracement, such as in 2000 to 2002 and 2008 (down) and the last quarter of 2011 to the present (up). Averaged over a period of 50 years or so, the markets give the impression they steadily climb higher over the long-term, but the amount of massive whipsaws along the way is sometimes staggering.

I also never would have anticipated that trading is so psychologically-driven, rather than just numbers-oriented. Understanding the human emotions of fear and greed is the key to understanding technical analysis. Fear makes markets occasionally take horrific plunges, while greed makes markets shoot for the moon at times. Chart patterns and technical analysis is really just a way of plotting those two human emotions, which haven’t really changed in thousands of years.

Kirk:  What would you recommend for those just getting started. What do you think is the best way to learn how to trade?

Deron Wagner:  Some people believe in “paper trading,” which is a way of writing down price levels where one would enter and exit a trade, as if it’s a real trade with actual capital. However, I believe it’s pretty useless because those human emotions of fear and greed, which I spoke of earlier, cause people to react much differently when real, hard-earned money is on the line. Nevertheless, this doesn’t mean a beginner should invest their life savings during the learning stages.

Perhaps the best way for a beginner to get started is to delegate a certain amount of capital to invest in a trading account, an amount that should not be too painful if all of it was lost. Then, start trading a strategy with very minimal share size. The concern in the first year or two should NOT be whether the account makes money; rather, one should just focus on losing the least amount of money possible, while still being active in the markets and taking advantage of potential opportunities. Once that part is figured out, the profits will automatically come.

Kirk:  Are there any good books or other resources that you highly recommend for individual investors?

Deron Wagner:  Reminiscences of a Stock Operator by Edwin Lefèvre is a must-read classic to teach about the importance of risk management. I’ve read that book several times, and learn something new each time. Another must-read is How To Make Money In Stocks by William O’Neill, the founder of Investor’s Business Daily, a great daily resource for traders. While certainly not a classic on the same level as the two books above, I confidently recommend my latest book, Trading ETFs: Gaining An Edge With Technical Analysis, which is targeted towards beginning to intermediate-level traders and investors. The sequel to that book, Advanced Technical Analysis of ETFs, is scheduled to be published in September of 2012.

Kirk:  What are some of your personal passions beyond the market?

Deron Wagner:  I’m glad you asked me this question, as most interviews focus only on the business. Trading is my passion, and the means to living a comfortable life, but balance in one’s personal life is crucial! I’ve met too many traders over the years that become so engrossed in trading they forget to actually enjoy the fruits of their labors. In no particular order, here’s a diverse list of personal passions that bring great happiness to my life:

• My incredibly supportive wife and two sharp boys (Bee, Ben, and Ocean)
• Traveling around the world, particularly visiting the paths least traveled
• Relaxing and meditating with a quality cigar (and a single malt scotch to boot)
• Listening to creative music (everything from Sinatra to Metallica)
• Watching independent films with a great script and low budget
• Playing poker

Having a supportive family has really helped my trading because it’s a challenging enough business without having to deal with an unsupportive family network.

Though I don’t smoke cigarettes, relaxing with a quality cigar (which I don’t inhale, like Bill Clinton) is a great way to digest the day’s market events, clear the head, and reduce my stress level.

Poker is luck in the short-term, but skill in the long-term. It’s also a battle of psychological wits, much like the stock market. Proper risk management techniques and discipline is also crucial in poker, just like trading.

Kirk:  Finally, if you had one piece of advice to share with all investors and traders, what would it be?

Deron Wagner:  Never think you’re smarter than the market because you’re not. Remember markets are driven more by emotion than logic, so even the smartest individuals do not necessarily make good traders. Always check your ego at the door because, in the words of famous British economist John Maynard Keynes, “Markets can remain irrational longer than you can remain solvent.”

Kirk:  As expected, this Q&A was terrific Deron. Thank you for spending so much time and effort to help us understand your approach and how to improve our own strategies. Thank you!

The interview above was conducted in 2010, so a few details have been edited for accuracy in the two years that have passed. Click here to get started with your risk-free subscription to The Wagner Daily ETF and stock newsletter — less than $2 per day with an annual subscription.  Also, if you enjoyed this interview, please check out KirkReport for loads of other great resources for traders and investors.