A note from fellow contributor Tim Melvin caught my attention Thursday. He pointed out that discount brokerages reported a surge in new accounts in October, as well as a notable spike in trading activity. I was skeptical at first, but it appears this is right on target, pointing to greater trading frequency by small retail players.

This is absolutely nuts, because October triggered the highest-risk market conditions we've seen in several decades. To me, these numbers expose a disturbing trend that doesn't bode well for this class of investors. Simply stated, many of the little guys who lost their shirts in the market crash are now trying to trade their way out of the big black hole.

Add in the unhealthy element of seduction that comes from watching 400-, 500- and even 700-point swings in the Dow Industrials. This is the type of phenomenon that puts dollar signs into the starry eyes of underskilled folks who have no clue about the significant danger in trading through historic volatility.

The consequences of this activity for the public investor are frightening. Consider the extensive damage already done to their long- and short-term accounts during the financial crisis. Rather than raising cash and waiting for a better stock market, they're risking speculative capital and core wealth trying to game an environment that's essentially ungameable.

We know there's just one outcome for this malignant behavior. Public wealth destruction is being magnified well above the percentage losses of the major indices, or popular funds that "couldn't go down" during the selloff. Sadly, this damage will reduce the pool of capital available to lift the market when it's finally time for a bona fide recovery.

PowerShares QQQ Trust (QQQQ)
Click here for larger image.
Source: eSignal

I've become a total gadfly in the Daily Swing Trade, my TSC newsletter, pleading with subscribers to hold cash defensively and not throw it away on phantom momentum. The latest trap was set last week after the market printed a string of nominal recovery highs and then broke down in two wide range selloff days.

Look at the five sessions after the huge Oct. 28 rally. The market posted three new highs during that period, sucking in retail players expecting to cash in on another big up day. Sadly, it's a strategy that worked well during the bull market, but not any longer. Momentum faded after each high and buyers were trapped when the market turned south.

It's likely the majority of public investors opened trades in those five bars, while smarter folks took profits from long positions picked up deep in the big rally bar. Same old story, isn't it? The crowd sat out the historic session, waiting for their "buy signal," which came when the evening news told the world what a great day it was on Wall Street.

However, most of the upside had already been posted by that time. Note how the five sessions got dismantled by the first selloff day, which dropped prices down to the close of the big rally bar. This efficient bear trap practically ensures that by the time retail players tossed in the towel, their accounts were in far worse shape than a month ago.

I have four pieces of cautionary advice for my at-home brethren. Listen up, because it's no longer a question of whether you want to take real money out of the market, or just add a few bucks to the weekly shopping budget. These remedial steps must be taken if you want to survive long enough to take advantage of the real opportunity.
  1. Wait for the Market Volatility Index (VIX) to drop below 40 and stay there for a week. Massive price swings require equally massive stop losses, which rarely justify the intended positions. Your only alternative is to stand aside and do nothing, no matter how much it hurts to watch others playing those big rallies and selloffs.
  2. Forget overnight positions until the index futures stop gapping 2% or more every morning. These price jolts are great news when you're on the right side of the trade, but total devastation if you're on the wrong side. And guess what? You're not smart enough to predict overnight direction from day to day. Neither am I.
  3. End your love affair with popular stocks that made you money during the last bull market. In November 2008, these are the issues that will trigger the most painful and unexpected reversals, which happen right after you're absolutely convinced your position is the right play. The bottom line: They see you coming, sucker.
  4. Get control of the time element in your market strategy. You're getting killed because you have no patience and forgot how to sit on your hands when your trading edge isn't in play. Realistically, it could be months before the market works for you again. Would you rather wait it out and survive, or stay busy and get crushed?


Know What You Own: Farley mentioned brokerages. These include Charles Schwab (SCHW), TD Ameritrade (AMTD), E-Trade (ETFC), Merrill Lynch (MER), TradeStation (TRAD), Nomura Holdings (NMR) and SEI Investments (SEIC).

At the time of publication, Farley had no positoins in the stocks mentioned, although holdings can change at any time.

Farley is also the author of The Daily Swing Trade, a premium product that outlines his charts and analysis. Farley has also been featured in Barron's, SmartMoney, Tech Week, Active Trader, MoneyCentral, Technical Investor, Bridge Trader and Online Investor. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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