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Slide 2: COME INTO MY TRADING ROOM A Complete Guide to Trading Dr. Alexander Elder www.elder.com John Wiley & Sons, Inc. New York • Chichester • Weinheim • Brisbane • Singapore • Toronto
Slide 4: COME INTO MY TRADING ROOM A Complete Guide to Trading
Slide 5: BOOKS BY DR. ALEXANDER ELDER Trading for a Living Study Guide for Trading for a Living Rubles to Dollars: Making Money on Russia’s Exploding Financial Frontier
Slide 6: COME INTO MY TRADING ROOM A Complete Guide to Trading Dr. Alexander Elder www.elder.com John Wiley & Sons, Inc. New York • Chichester • Weinheim • Brisbane • Singapore • Toronto
Slide 7: To my campers Copyright © 2002 by Dr. Alexander Elder. All rights reserved. Published by John Wiley & Sons, Inc. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: PERMREQ@WILEY.COM. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. This title is also available in print as ISBN 0-471-22534-7. Some content that appears in the print version of this book may not be available in this electronic edition. For more information about Wiley products, visit our web site at www.Wiley.com.
Slide 8: CONTENTS Dedication Introduction HOW THIS BOOK IS ORGANIZED MALE OR FEMALE? iv 1 2 4 THE PART ONE FINANCIAL TRADING FOR BABES IN 1 Invest? Trade? Gamble? AN INTELLIGENT INVESTOR AN INTELLIGENT TRADER AN INTELLIGENT GAMBLER? 2 What Markets to Trade? STOCKS FUTURES OPTIONS 3 The First Steps THE EXTERNAL BARRIERS TO SUCCESS GETTING YOUR GEAR ANALYSIS AND TRADING WOODS 5 7 7 8 12 15 16 18 20 25 25 32 39 45 47 49 54 61 67 68 84 v PART TWO THE THREE M’S OF SUCCESSFUL TRADING 4 Mind—The Disciplined Trader SLEEPWALKING THROUGH THE MARKET A REMEDY FOR SELF-DESTRUCTIVENESS THE MATURE TRADER 5 Method—Technical Analysis BASIC CHARTING INDICATORS—FIVE BULLETS TO A CLIP
Slide 9: vi TABLE OF CONTENTS 6 Trading SYSTEM TESTING TRIPLE SCREEN UPDATE DAY-TRADING THE IMPULSE SYSTEM MARKET THERMOMETER EXITING TRADES CHOOSING WHAT TO TRADE 7 Money Management Formulas NO MATH ILLITERATES BUSINESSMAN’S RISK VS. LOSS. THE 2% SOLUTION—PROTECTION FROM SHARKS THE 6% RULE—PROTECTION FROM PIRANHAS POSITION SIZING MONEY MANAGEMENT STEPS PART THREE COME INTO MY TRADING ROOM 8 The Organized Trader TRADER’S SPREADSHEET THE EQUITY CURVE TRADING DIARY ACTION PLAN 9 Trading for a Living DISCIPLINE AND HUMILITY HAVE YOU GOT THE TIME? THE DECISION-MAKING TREE BEGINNER, SEMIPRO, PRO GOING PRO 10 Come Into My Trading Room EXCERPTS FROM THE DIARY YOUR NEXT TRADE Acknowledgments Sources Index About the Author 123 125 128 138 157 162 165 183 215 217 218 220 223 227 230 233 235 236 238 240 242 245 247 251 257 264 267 271 273 298 301 303 307 313
Slide 10: INTRODUCTION “Y ou can be free. You can live and work anywhere in the world, be independent from the routine and not answer to anybody.” With those words I began my first book, Trading for a Living. One of my great pleasures in the years since its publication has been meeting and becoming friends with people who became free thanks to successful trading. Several times a year I run a Traders’ Camp, a week of intensive classes at remote resorts. I enjoy my campers’ successes. A stockbroker became a full-time trader, closed his business, and moved to Rio to pursue a life-long interest in Latin women. A psychologist became such a successful options writer that she paid for an early retirement for her husband and moved with him to the Virgin Islands to become an expert in what she calls synchronous hammocking. A man bought a mountain in Vermont and trades from the house he built on its top. I wish all students could succeed, but it’s not that simple. How many psychiatrists does it take to change a lightbulb? Only one—but the bulb has to want to change. To succeed in trading you need several innate traits without which you shouldn’t even start. They include discipline, risk tolerance, and facility with numbers. A big fat guy who is often drunk and can’t kick a cigarette habit is unlikely to make a good trader—he lacks discipline. A nitpicker who obsesses over each dime is too tense to live with market risks. A daydreamer who cannot do simple arithmetic on the run becomes lost when prices change rapidly. In addition to discipline, risk tolerance, and ease with numbers, successful trading requires 3 M’s—Mind, Method, and Money. Mind means developing psychological rules that will keep you calm amidst the 1
Slide 11: 2 INTRODUCTION noise of the markets. Method is a system of analyzing prices and developing a decision-making tree. Money refers to money management, which means risking only a small part of your trading capital on any trade; think of the way a submarine is divided into many compartments so that it won’t sink if one section becomes flooded—you have to structure your account this way. Psychology, trading tactics, money management—you can learn these skills. How long will it take you to become a competent trader and how much will it cost? What rules do you set, what methods do you use, and how do you split your trading capital? What should you study first, second, and third? What markets should you trade, and how much money can you expect to make? If these questions interest you, you picked the right book. You can succeed in trading. It has been done before, and it’s being done right now, today, by people who started from scratch, learned to trade and are making a good living at it. The best ones make fortunes. Others fail, out of ignorance or lack of discipline. If you work through this book, ignorance will not be a problem, and you will hear me yell at you again and again, pointing you towards disciplined, responsible, professional trading. Trading is a journey of self-discovery. If you enjoy learning, if you are not scared of risk, if the rewards appeal to you, if you are prepared to put in the work, you have a great project ahead of you. You will work hard and enjoy the discoveries you’ll make along the way. I wish you success. Now let us begin. HOW THIS BOOK IS ORGANIZED Books written from the heart acquire their own direction. They develop and change in the process of being written. You start with a plan, but the book takes over, and before you know it, you’re going much farther than planned. I began writing this book three years ago on a flight to New York, returning from a Traders’ Camp in Mexico. We had more beginners than usual, many of them women. They kept asking for a book that they jokingly called Trading for Dummies. There were no dummies in our group. Those campers were smart, sharp, and motivated—but they needed to learn the rules and the tools. I figured I would write a brief
Slide 12: INTRODUCTION 3 practical introduction, call it Financial Trading for Babes in the Woods, and be done by Christmas. Three Christmases passed before I completed my project. The beginner part was easy, but I kept tunneling into the depths of trading, sharing what I learned in the nine years since Trading for a Living was published. I developed new indicators and systems. My money management became crisper, and I designed a new approach to record keeping. My work with hundreds of traders showed me how to teach people to turn their trading lives around and move from haphazard jumping in and out to a calm professional style. Take a few minutes to read how this book is organized, so that you may get full value out of it. Part One, Financial Trading for Babes in the Woods, is written primarily for those who are just becoming interested in trading. It lays out topics whose mastery is essential for success and puts up danger signs around the main pitfalls. Even experienced traders would do well to review this chapter, especially the concept of external barriers to success, which has never before been spelled out in trading literature, and the critique of the efficient market theory. Part Two, The Three M’s of Successful Trading, teaches you the three key aspects of trading—Mind, Method, and Money. Mind is your trading psychology. Method is how you go about finding trades and making entry and exit decisions. Money is how you manage your trading capital for long-term survival and success. Once we review the psychological rules, I’ll share with you my favorite analytic tools, some of which I have never before revealed. We will cover system testing, day-trading, and a new method for placing stops. The stepby-step money management strategy has never before appeared in trading literature. Part Three, Come into My Trading Room, delivers another first—a set of exact instructions for organizing your time and effort, as well as keeping good records. Proper record keeping is a hallmark of successful trading. Good records help you learn from your mistakes as well as victories. You know you should keep records, but now you’ll see exactly how to do it. By the time you work through this section, nobody can call you “a babe in the woods.” Take your time as you read this book, mark it up, return to the sections that interest you most. This volume distills 20 years of trading and teaching experience. It took three years to write, and it will probably
Slide 13: 4 INTRODUCTION take more than one reading to get its full value. Open your charting software, pull out your trading records, test all the concepts on your own data. Only testing will make these ideas your own. By the time you leave my trading room, you’ll be in a position to take your trading to a higher, more intelligent, and successful level. MALE OR FEMALE? Almost every nonfiction writer faces the dilemma—which pronoun to use. He? She? He or she? Male traders outnumber women by about twenty to one, although this ratio is rapidly becoming more balanced as more and more women come into the markets. In our Traders’ Camps, which attract the more sophisticated segment of traders, we have already moved from a great preponderance of men to a near parity with women. I find that the percentage of successful traders is higher among women. They tend to be less arrogant, and arrogance is a deadly sin in trading. The male ego—that wonderful trait that has been bringing us wars, riots, and bloodshed since time immemorial—tends to get heavily caught up in trading. A guy studies his charts, decides to buy, and now his self-esteem is involved—he has to be right! If the market goes his way, he waits to be proven even more right—bigger is better. If the market goes against him, he is tough enough to stand the pain and waits for the market to reverse and prove him right—while it grinds down his account. Women traders, on the other hand, are much more likely to ask a simple question—where’s the money? They like to take profits and focus on avoiding losses instead of trying to prove themselves right. Women are more likely to bend with the wind and go with the flow, catch trends and hop off a little earlier, booking profits. When I tell traders that keeping records is a hugely important aspect of success, women are more likely to keep them than men. If you are looking to hire a trader, all other factors being equal, I’d recommend looking for a woman. Still, there are many more male than female traders. The English language being what it is, “he” flows better than “he or she” or even jumping between the two pronouns. To make reading easier, I’ll use the masculine pronoun throughout this book. I trust you understand that no disrespect is intended toward women traders. I want to make this book easier to read for everybody, of any gender, anywhere in the world.
Slide 14: PART ONE FINANCIAL TRADING FOR BABES IN THE WOODS A re traders born or made? There is no simple answer. Both aptitude and learning are important, but in different proportions for different people. At one extreme are born geniuses who require very little learning. At the other are gamblers and dunces, whom no classes are likely to help. The rest of us are in the middle of the curve, with some aptitude but in need of education. A genius has little need for a book because he has a fantastic feel for the market. A gambler is too busy getting high on adrenaline. This book is written for the trader in the middle.
Slide 16: CHAPTER ONE INVEST? TRADE? GAMBLE? newcomer to the market faces three paths that lead into a forest full of treasures and dangers. The first path, for investors, goes through the sunniest areas. Most of those who take it come out alive, if not much richer. Another path, for traders, leads into the heart of the forest. Many travelers disappear, but those who come out look rich. The third is a shortcut that takes gamblers into the swamp. How can you tell which path is which? You must choose your way carefully because if you don’t, you’ll end up on the gamblers’ path, especially since it crosses both investors’ and traders’ trails. We’ll return to this question in the chapters on trading psychology. A AN INTELLIGENT INVESTOR Investors profit by recognizing new trends in the economy and buying into them before the majority wakes up to opportunities. A knowledgeable investor can earn huge percentage gains by holding his position without being terribly active. Back in the 1970s, I bought stock in a company called KinderCare, which ran a chain of child care centers. It tried to make them as uniform and reliable as McDonalds’ hamburgers. KinderCare catered to baby boomers who were having babies right, left, and center. Half of my friends were pregnant at that time. A major social shift was taking place in the United States, with women going to work in record numbers. Someone had to mind the babies of all those two-income families, and the stock of KinderCare soared on the crest of a new social trend. AT&T used to have a monopoly on long-distance phone calls. Then in the late 1970s a tiny brash upstart called MCI won a legal dogfight, 7
Slide 17: 8 FINANCIAL TRADING FOR BABES IN THE WOODS allowing it to compete with AT&T. The age of deregulation was upon us, and the stock of MCI—the first company into the breach—sold for $3 presenting another great opportunity to hop aboard a new trend. A few years ago I flew into New York from the Caribbean with my friend George. He became a millionaire by buying $30,000 worth of Dell stock before most people had heard of the company—and unloading it at the top three years later with the help of technical analysis. Sprawled in his first-class seat, George was perusing several investment advisories, trying to lock in on the next trend in Internet technology. How right he was! Within a year Internet stocks were flying, defying gravity. That’s the lure of investing. If you can buy a chunk of Dell at $4 a share and cash out at $80 a few years later, it is easy to fly down to a resort for a week rather than sit in front of a monitor watching every tick. What are the disadvantages? Investing requires a great deal of patience and an immense supply of self-confidence. To buy Chrysler after it was rescued from the brink of bankruptcy or Internet search engines before anyone knew what those words meant, you had to have a huge level of confidence in your ability to read the trends in society and the economy. All of us are smart after the fact; very few are smart early in the game, and only the tiniest percentage has the emotional strength to make a large bet on their vision and hold on to it. Those who can do this consistently, like Warren Buffett or Peter Lynch, are hailed as superstars. AN INTELLIGENT TRADER Traders make money by betting on short-term price swings. The idea is to buy when our reading of the market tells us prices are rising and sell when the uptrend runs out of steam. Alternatively, we can bet on a decline and sell short when our analysis points to a downtrend, covering when the downtrend starts bottoming out. The concept is simple, but implementing it is difficult. It is hard to become a good analyst, but harder to become a good trader. Beginners often assume they can make money because they’re smart, computer-literate and have a record of success in business. You can get a fast computer and even buy a backtested system from a vendor, but putting money on it is like trying to sit on a three-legged stool with two legs missing. The two other factors are psychology and money management. Balancing your mind is just as important as analyzing markets. Your personality influences your perceptions, making it a key aspect of your success or failure. Managing money in your trading account is essential
Slide 18: INVEST? TRADE? GAMBLE? 9 for surviving the inevitable drawdowns and prospering in the long run. Psychology, market analysis, and money management—you have to master all three to become a success. There are two main approaches to profiting from crowd behavior. The first is momentum trading—buy when a ripple starts running through the crowd, sending the market higher, and sell when that ripple starts losing speed. It is a challenge to identify a new trend while it’s still young. As the trend speeds up and the crowd becomes exuberant, amateurs fall in love with their positions. Professionals remain calm and monitor the trend’s speed. As soon as they find that the crowd is returning to its normal sleepiness, they take profits without waiting for a reversal. The other method is the countertrend strategy. It involves betting against the deviations and for a return to normalcy. Countertrend traders sell short when an upside breakout starts running out of speed and cover when a downtrend starts petering out. Beginners love to trade against trends (“let’s buy, this market can’t go any lower!”), but most get impaled on a price spike that fails to reverse. A man who likes peeing against the wind has no right to complain about his cleaning bills. Professionals can trade against trends only because they are ready to run at the first sign of trouble. Before you bet on a reversal, be sure your exit strategy and money management are fine-tuned. Momentum traders and countertrend traders capitalize on two opposite aspects of crowd behavior. Before you put on a trade, be sure to know whether you’re investing, momentum trading, or countertrend trading. Once you’ve entered a trade, manage it as planned! Don’t change your tactics in the midst of a trade because then you’ll contribute to the winners’ welfare fund. Amateurs keep thinking what trades to get into, while professionals spend just as much time figuring out their exits. They also focus on money management, calculating what size positions they can afford under current market conditions, whether to pyramid, when to take partial profits, and so on. They also spend a great deal of time keeping good records of their trades. The Efficient Market Theory A trader strains his mind, his soul, his entire being trying to take profits out of the market when an unsettling piece of news comes down the pike—the efficient market theory. Its main adherents are academics, who are fond of pointing out that prices reflect all available mar-
Slide 19: 10 FINANCIAL TRADING FOR BABES IN THE WOODS ket information. People buy and sell on the basis of their knowledge, and the latest price represents everything known about that market. This is a valid observation, from which the efficient market gang draws the curious conclusion that no one can beat the market. Markets know everything, they say, and trading is like playing chess against someone who knows more than you. Don’t waste your time and money—simply index your portfolio and select stocks based on volatility. What about traders who make money? The efficient market theorists say that winners are plain lucky. Most people make money at some point, before bleeding it back into the markets. What about those who keep outperforming markets year after year? Warren Buffett, one of the twentieth century’s great investors, says that investing in a market in which people believe in efficiency is like playing poker against those who believe it does not pay to look at cards. I think that the efficient market theory offers one of the truest views of the markets. I also believe it is one of the largest pieces of theoretical garbage. The theory correctly observes that markets reflect the intelligence of all crowd members; it is fatally flawed in assuming that investors and traders are rational human beings who always strive to maximize gains and minimize losses. That is a very idealized view of human nature. Most traders can be rational on a fine weekend when the markets are closed. They calmly study their charts and decide what to buy and sell, where to take profits, and when to cut losses. When the markets open on Monday, the best laid plans of mice and men get ripped up in the sweaty palms of traders. Trading and investing are partly rational and partly emotional. People often act on an impulse even if they harm themselves in the process of doing so. A winning gambler brags about his positions and misses sell signals. A fearful trader beaten up by the market becomes cautious beyond measure. As soon as his stock ticks down a bit, he sells, violating his own rules. When that stock rises, overshooting his original profit target, he can no longer stand the pain of missing the rally and buys way above his planned entry point. The stock stalls and slides, and he watches, first with hope and later frozen in horror, as it sinks like a rock. In the end, he can’t take any more pain and sells out at a loss—right near the bottom. What’s so rational about this process? The original plan to buy may have been rational, but implementing it created an emotional storm. Emotional traders do not pursue their best long-term interests. They are too busy savoring the adrenaline rush or too twisted in fear, des-
Slide 20: INVEST? TRADE? GAMBLE? 11 perate to extract their fingers from a mousetrap. Prices reflect intelligent behavior of rational investors and traders, but they also reflect screaming mass hysteria. The more active the market, the more traders are emotional. Rational individuals can become a minority, surrounded by those with sweaty palms, pounding hearts, and clouded minds. Markets are more efficient during flat trading ranges, when people are apt to use their heads. They grow less efficient during trends, when people become more emotional. It is hard to make money in flat markets because your opponents are relatively calm. Rational people make dangerous enemies. It is easier to take money from traders who are excited by a fast-moving trend because emotional behavior is more primitive and easier to predict. To be a successful trader you must keep your cool at all times and take money from aroused amateurs. People are more likely to be rational when alone, and grow more impulsive when they join crowds. A trader’s intense focus on the price of a stock, a currency, or a future pulls him into the crowd of all who trade that vehicle. As the price ticks up and down, the eyes, the heads, and the bodies of traders across the continents start moving up and down in unison. The market hypnotizes traders like a magician hypnotizes a snake, by moving his flute rhythmically up and down. The faster the price moves, the stronger the emotions. The more emotional a market, the less efficient it is, and inefficiency creates profit opportunities for calm, disciplined traders. A rational trader can make money by remaining calm and following his rules. Around him, the crowd chases rallies, hard with greed. It sells into falling markets, squealing from pain and fear. All the while, the intelligent trader follows his rules. He may use a mechanical system or act as a discretionary trader, reading his markets and putting on trades. Either way, he follows his rules rather than his gut—that is his great advantage. A mature trader pulls money through the big hole in the efficient market theory, its presumption that investors and traders are rational human beings. Most people aren’t; only winners are. What Is Price? Each trade represents a transaction between a buyer and a seller who meet face to face, by phone or on the Internet, with or without brokers. A buyer wants to buy as cheaply as possible. A seller wants to sell as expensively as possible. Both feel pressure from the crowd of
Slide 21: 12 FINANCIAL TRADING FOR BABES IN THE WOODS undecided traders that surrounds them, ready to jump in and snatch away their bargain. A trade takes place when the greediest buyer, afraid that prices will run away from him, steps up and bids a penny more. Or the most fearful seller, afraid of getting stuck with his merchandise, agrees to accept a penny less. Sometimes a fearful seller dumps his merchandise on a calm and disciplined buyer waiting for a trade to come to him. All trades reflect the behavior of the market crowd. Each price flashing on your screen represents a momentary consensus of value among market participants. Fundamental values of companies and commodities change slowly, but prices swing all over the lot because the consensus can change quickly. One of my clients used to say that prices are connected to values with a mile-long rubber band, allowing markets to swing between overvalued and undervalued levels. The normal behavior of the crowd is to mill around, make noise, and go nowhere. Once in a while a crowd becomes excited and explodes in a rally or a panic, but usually it just wastes time. Bits of news and rumors send ripples through the crowd, whose shifts leave footprints on our screens. Prices and indicators reflect changes in crowd psychology. When the market gives no clear signals to buy or sell short, many beginners start squinting at their screens, trying to recognize trading signals. A good signal jumps at you from the chart and grabs you by the face—you can’t miss it! It pays to wait for such signals instead of forcing trades when the market offers you none. Amateurs look for challenges; professionals look for easy trades. Losers get high from the action; the pros look for the best odds. Fast-moving markets give the best trading signals. When crowds are gripped by emotions, cool traders find their best opportunities to make money. When markets go flat, many successful traders withdraw, leaving the field to gamblers and brokers. Jesse Livermore, a great speculator of the twentieth century, used to say that there is time to go long, time to go short, and time to go fishing. AN INTELLIGENT GAMBLER? Most people gamble at some point in their lives. For most it provides entertainment, for some it becomes an addiction, while a few become pros and make a living at it. Gambling provides a living for a very small minority and entertainment for the masses, but a casual gambler
Slide 22: INVEST? TRADE? GAMBLE? 13 reaching for a quick buck has the same chance of success as an ice cube on a hot stove. Some famous investors like betting on horses. They include Peter Lynch, of Magellan Fund fame, and Warren Buffett, who used to publish a newsletter on handicapping. My friend Lou, to whom my first book was dedicated, spent several years on the handicapping circuit and bet on horses for a living before buying an exchange seat and approaching financial markets like a cool handicapper. Some card games, such as baccarat, are based on chance alone, whereas others, such as blackjack, involve a degree of skill that attracts intelligent people. Professionals treat gambling as a job. They keep calculating odds and act only when mathematics point in their favor. Losers, on the other hand, itch for the action and enter one game after another, switching between half-baked systems. When you gamble for entertainment, follow a set of money management rules. The first rule is to limit how much you’ll risk in any given session. On a rare occasion when a friend pulls me into a casino, I put what I am willing to lose that night into my right pocket, and stuff my winnings, if any, into the left one. I stop playing as soon as my right pocket is empty, without ever reaching into the left. Once in a while I find more money in the left pocket than I had in my right, but I certainly do not count on it. A friend who is a successful businessman enjoys the glitter of Las Vegas. Several times a year he takes $5,000 in cash and flies there for a weekend. When his bankroll runs out, he goes for a swim in the pool, enjoys a good dinner, and flies back home. He can afford to spend $5,000 on entertainment and never blows more than his initial stake. Lounging at a pool after his cash is gone, he differs from legions of compulsive gamblers who keep charging more chips on their credit cards, waiting for their “luck” to turn. A gambler with no money management is guaranteed to bust out.
Slide 24: CHAPTER TWO WHAT MARKETS TO TRADE? M any people give little thought to life’s important decisions. They stumble into them by accidents of geography, time, or chance. Where to live, where to work, what markets to trade—many of us decide on a whim, without much serious thought. No wonder so many are dissatisfied with their lives. You can choose your markets on a whim or pause to think whether to trade stocks, futures, or options. Each of those has pluses as well as minuses. Successful traders are rational people. Winners trade solely for the money, while losers get their kicks out of the excitement of the game. Where those kicks land is another question. In choosing a market to trade, keep in mind that every trading vehicle, be it a stock, a future, or an option, has to meet two criteria: liquidity and volatility. Liquidity refers to the average daily volume, compared with that of other vehicles in its group. The higher the volume, the easier it is to get in and out. You can build a profitable position in a thin stock, only to get caught in the door at the exit and suffer slippage trying to take profits. Volatility is the extent of movement in your vehicle. The more it moves, the greater the trading opportunities. For example, stocks of many utility companies are very liquid but hard to trade because of low volatility—they tend to stay in narrow price ranges. Some low-volume, low-volatility stocks may be good investments for your long-term portfolio, but not for trading. Remember that not all markets are good for trading simply because you have a strong opinion on their future direction. They also must have good volume and move well. 15
Slide 25: 16 FINANCIAL TRADING FOR BABES IN THE WOODS STOCKS A stock is a certificate of company ownership. If you buy 100 shares of a company that issued 100 million shares, you own one-millionth of that firm. You become a part owner of that business, and if other people want to own it, they will have to bid for your shares, lifting their value. When people like the prospects of a business, they bid for its shares, pushing up prices. If they don’t like the outlook, they sell their stock, depressing prices. Public companies try to push up share prices because it makes it easier for them to float more equity or sell debt. The bonuses of top executives are often tied to stock prices. Fundamental values, especially earnings, drive prices in the long run, but John Maynard Keynes, the famous economist and a canny stock picker, retorted “In the long run we’re all dead.” Markets are full of cats and dogs, stocks of unprofitable companies that at some point fly through the roof, defying gravity. Stocks of sexy new industries, such as biotechnology or the Internet, can fly on the expectations of future earnings rather than on any real operating records. Each dog has its day in the sun before reality sets in. Stocks of profitable, well-run companies may drift sideways to down. The market reflects the sum total of what every participant knows, thinks, or feels about a stock, and a declining price means large holders are selling. The essential rule in any market is “It’s OK to buy cheap, but not OK to buy down.” Don’t buy a stock that’s trending lower, even if it looks like a bargain. If you like its fundamentals, use technical analysis to confirm that the trend is up. Warren Buffett, one of the most successful investors in America, is fond of saying that when you buy a stock, you become a partner of a manic-depressive fellow he calls Mr. Market. Each day Mr. Market runs up and offers either to buy you out of business or to sell you his share. Most of the time you should ignore him because the man is psychotic, but occasionally Mr. Market becomes so terribly depressed that he offers you his share for a song—and that’s when you should buy. At other times he becomes so manic that he offers an insane price for your share—and that’s when you should sell. This idea is brilliant in its simplicity, but hard to implement. Mr. Market sweeps most of us off our feet because his mood is so contagious. Most people want to sell when Mr. Market is depressed and buy
Slide 26: WHAT MARKETS TO TRADE? 17 when he is manic. We need to keep our sanity. We need objective criteria to decide how high is too high and how low is too low. Buffett makes his decisions on the basis of fundamental analysis and a fantastic gut feel. Traders can use technical analysis. Speaking of gut feel, this is something that an investor or a trader may develop after years of successful experience. What beginners call gut feel is usually an urge to gamble, and I tell them they have no right to a gut feel. What stocks should we trade? There are more than 10,000 of them in the United States, with even more abroad. Peter Lynch, a highly successful money manager, writes that he only buys stocks in companies that are so simple that an idiot could run them—because eventually one will. But Lynch is an investor, not a trader. Stocks of many companies with little fundamental value can embark on fantastic runs, making heaps of money for bullish traders before collapsing and making just as much money for the bears. The stock market offers a wealth of choices, even after we cut out illiquid or flat stocks. You open a business newspaper, and stories of fantastic rallies and breathtaking declines leap at you from the pages. Should you jump on the bandwagon and trade stocks in the news? Have they moved too far from the gate? How do you find future leaders? Having to make so many choices stresses beginners. They spread themselves thin, jumping between stocks instead of focusing on a few and learning to trade them well. Newbies who cannot confidently trade a single stock go looking for scanning software that will let them track thousands. In addition to stocks, you can choose from their kissing cousins, mutual funds, called unit trusts in Europe. Long-term investors tend to put money into diversified funds which hold hundreds of stocks. Traders tend to focus on sector funds that let them trade specific sectors of the economy or entire countries. You pick a favorite sector or country and leave individual stock selection to the supposedly hot-shot analysts laboring at those funds. Choosing a winning stock or fund is a lot harder than listening to tips at a party or scanning headlines in a newspaper. A trader must develop a set of fundamental or technical search parameters, have the discipline to follow his system, and spread a safety net of money management under his account. We will delve into all three areas in Part 2.
Slide 27: 18 FINANCIAL TRADING FOR BABES IN THE WOODS WHERE DO I GO FROM HERE? How to Buy Stocks by Louis Engel is the best introductory book for stock investors and traders. The author died years ago, but the publisher updates the book every few years—be sure to get the latest edition. FUTURES Futures look dangerous at first—nine out of ten traders go bust in their first year. As you look closer, it becomes clear that the danger is not in futures but in the people who trade them. Futures offer traders some of the best profit opportunities, but the dangers are commensurate with rewards. Futures make it easy for gamblers to shoot themselves in the foot, or higher. A trader with good money management skills needn’t fear futures. Futures used to be called commodities, the irreducible building blocks of the economy. Old-timers used to say that a commodity was something that hurt when you dropped it on your foot—gold, sugar, wheat, crude oil. In recent decades many financial instruments began to trade like commodities—currencies, bonds, stock indexes. The term futures includes traditional commodities along with new financial instruments. A future is a contract to deliver or accept delivery of a specific quantity of a commodity by a certain date. A futures contract is binding on both buyer and seller. In options the buyer has the right but not an obligation to take delivery. If you buy a call or a put, you can walk away if you like. In futures, you have no such luxury. If the market goes against you, you have to add money to your margin or get out of your trade at a loss. Futures are stricter than options but are priced better for traders. Buying a stock makes you a part owner of a company. When you buy a futures contract you don’t own anything, but enter into a binding contract for a future purchase of merchandise, be it a carload of wheat or a sheaf of Treasury bonds. The person who sells you that contract assumes the obligation to deliver. The money you pay for a stock goes to the seller, but in futures your margin money stays with the broker as a security, ensuring you’ll accept delivery when your contract comes due. They used to call margin money honest money. While in stocks you pay interest for margin borrowing, in futures you can collect interest on your margin.
Slide 28: WHAT MARKETS TO TRADE? 19 Each futures contract has a settlement date, with different dates selling for different prices. Some professionals analyze their differences to predict reversals. Most futures traders do not wait and close out their contracts early, settling profits and losses in cash. Still, the existence of a delivery date forces people to act, providing a useful reality check. A person may sit on a losing stock for ten years, deluding himself it is only a paper loss. In futures, reality, in the form of the settlement date, always intrudes on a daydreamer. To understand how futures work, let’s compare a futures trade with a cash trade—buying or selling a quantity of a commodity outright. Let’s say it’s February and gold is trading at $400 an ounce. Your analysis indicates it is likely to rise to $420 within weeks. With $40,000 you can buy a 100-ounce gold bar from a dealer. If your analysis is correct, in a few weeks your gold will be worth $42,000. You can sell it and make a $2,000 profit, or 5 percent before commissions—nice. Now let’s see what happens if you trade futures based on the same analysis. Since it is February, April is the next delivery month for gold. One futures contract covers 100 oz. of gold, with a value of $40,000. The margin on this contract is only $1,000. In other words, you can control $40,000 worth of gold with a $1,000 deposit. If your analysis is correct and gold rallies $20 per oz., you’ll make roughly the same profit as you would have made had you bought 100 oz. of gold for cash—$2,000. Only now your profit is not 5% but 200%, since your margin was $1,000. Futures can really boost your gains! Most people, once they understand how futures work, are flooded with greed. An amateur with $40,000 calls his broker and tells him to buy 40 contracts! If his analysis is correct and gold rallies to $420, he’ll make $2,000 per contract, or $80,000. He’ll triple his money in a few weeks! If he repeats this just a few times, he’ll be a millionaire before the end of the year! Such dreams of easy money ruin gamblers. What, if anything, do they overlook? The trouble with markets is that they don’t move in straight lines. Charts are full of false breakouts, false reversals, and flat trading ranges. Gold may well rise from $400/oz. to $420/oz., but it is perfectly capable of dipping to $390 along the way. That $10 dip would have created a $1,000 paper loss for someone who bought 100 oz. of gold for cash. For a futures trader who holds a 100 oz. contract on a $1,000 margin that $10 decline represents a total wipeout. Long before he reaches that sad point, his broker will call and ask for more margin money. If
Slide 29: 20 FINANCIAL TRADING FOR BABES IN THE WOODS you have committed most of your equity to a trade, you’ll have no reserves and your broker will sell you out. Gamblers dream of fat profits, margin themselves to the hilt, and get kicked out of the game by the first wiggle that goes against them. Their long-term analysis may be right and gold may rise to its target price, but the beginner is doomed because he commits too much of his equity and has very thin reserves. Futures do not kill traders—poor money management kills traders. Futures can be very attractive for those who have strong money management skills. They promise high rates of return but demand icecold discipline. When you first approach trading, you are better off with slower-moving stocks. Once you have matured as a trader, take a look at futures. They may be right for you if you’re very disciplined. We return to the futures markets in Part 2 and look at the best ones for getting started. WHERE DO I GO FROM HERE? Winning in the Futures Markets by George Angell is the best introductory book for futures traders. (It is highly superior to all his other books.) The Futures Game by Teweles and Jones is a mini-encyclopedia that has educated generations of futures traders (be sure to get the latest edition). Economics of Futures Trading by Thomas A. Hieronymus is probably the most profound book on futures, but it’s long been out of print—try finding a used copy. OPTIONS An option is a bet that a specific stock, index, or future will reach or exceed a specific price within a specific time. Please stop and reread that sentence. Notice that the word specific occurs in it three times. You must choose the right stock, predict the extent of its move, and forecast how fast it’ll get there. You must make three choices—if you’re wrong on just one, you’ll lose money. When you buy an option, you have to jump through three hoops in a single leap. You have to be right on the stock or the future, right on its move, and right on its timing. Ever tried tossing a ball through three rings at an amusement park? This triple complexity makes buying options a deadly game. Options offer leverage—an ability to control large positions with a small outlay of cash. The entire risk of an option is limited to the price
Slide 30: WHAT MARKETS TO TRADE? 21 you pay for it. Options allow traders to make money fast when they’re right, but if the market reverses, you can walk away and owe nothing! This is the standard flow of brokerage house propaganda. It attracts hordes of small traders who cannot afford to buy stocks but want a bigger bang for their buck. What usually gets banged is the option buyer’s head. My company, Financial Trading, Inc., has been selling books to traders for years. Whenever a person comes back to buy another book, it is a sign that he is active in the markets. Many clients buy books on stocks or futures every few months or years. But when a first-time buyer orders a book on options, he never returns. Why? Does he make so much money so fast that he doesn’t need another book? Or does he wash out? Many beginners buy calls because they can’t afford stocks. Futures traders who get beat up sometimes turn to options on futures. Losers switch to options instead of dealing with their own inability to trade. Using a shortcut to weasel out of trouble instead of facing a problem never works. Successful stock and futures traders sometimes use options to reduce risks or protect profits. Serious traders buy options rarely and only in special situations, as we will see later in this book. Options are hopeless for poor people who use them as substitutes for stocks because they can’t afford the real thing. Professionals take full advantage of starry-eyed beginners crowding into options. Their bid-ask spreads are terrible. If an option is bid 75 cents, offered at a dollar, you are 25% behind the game as soon as you buy. The expression “your loss is limited to what you paid for an option” means you can lose 100%! What’s so great about losing everything? A client of mine was a market-maker on the floor of the American Stock Exchange. She came to my classes on technical analysis because she was pregnant and wanted to get off the floor and trade from home. “Options,” she said, “are a hope business. You can buy hope or sell hope. I am a professional—I sell hope. I come to the floor in the morning and find what the public wants. Then I price that hope and sell it to them.” Professionals are more likely to write options than buy them. Writing is a capital-intensive business. You need hundreds of thousands of dollars to do it right, and most successful options writers operate with millions. And even theirs is not a risk-free game. Several years ago a friend who used to be one of the nation’s top money managers landed
Slide 31: 22 FINANCIAL TRADING FOR BABES IN THE WOODS on the front page of The Wall Street Journal after he lost 20 years’ worth of profits in a single bad day of writing naked puts. There are two types of option writers. Covered writers buy a stock and write an option against it. Naked writers write calls and puts on stocks they don’t own, backing their writes with cash in their accounts. Writing naked options feels like taking money out of thin air, but a violent move can put you out of business. Writing options is a serious game, suitable only for disciplined and well-capitalized traders. Markets are like pumps that suck money out of the pockets of the poorly informed majority and pump it into the pockets of a savvy minority. People who service those pumps, such as brokers, vendors, regulators, and even janitors who sweep exchange floors, are paid from the stream of money flowing through the markets. Since markets take money from the majority, pay help, and give what’s left to the savvy minority, the majority, by definition, must lose. You can be sure that whatever the majority of traders does, believes, and says, is not worth doing, believing, and saying. You have to stand apart from the crowd in order to succeed. Smart traders look for situations where a large majority does something one way, while a small, moneyed minority goes the opposite way. In options the majority buys calls and, to a lesser degree, puts. The insiders almost exclusively write options. Professionals use their heads, while amateurs are driven by greed and fear. Options take full advantage of those feelings. Greed is the engine of option-selling propaganda. You must have heard the slogan: “Control a large block of stock with just a few dollars!” An amateur may be bullish on a $60 stock, but doesn’t have $6,000 to buy 100 shares. He buys some $70 calls with two months of life left in them for $500 each. If that stock rises to 75, those options will acquire $500 of intrinsic value, while maintaining some time value, and a speculator can double his stake in a month! The amateur buys calls and sits back to watch his money double. Strange things begin to happen. Whenever the stock rises two points, his calls go up only one, but when the stock falls or even pauses, his calls fall briskly. Instead of seeing his money double in a hurry, the amateur is soon staring at a 50% paper loss, while the clock starts ticking louder and louder. The expiration date is nearing, and even though the stock is higher than it was when he bought his calls, they are now cheaper, showing a paper loss. Should he sell and salvage some money
Slide 32: WHAT MARKETS TO TRADE? 23 or hold and wait for a rally? Even if he knows the right thing to do, he’s not going to do it. His greed does him in. He hangs on until his options expire worthless. Another great motivator for buying options is fear, especially in options on futures. A loser takes a few painful hits—his analysis was wet and money management nonexistent. He sees an attractive trade but fears losing. He hears the siren song—“unlimited gains with limited risk”—and buys options on futures. Speculators buy options like poor people buy lottery tickets. A person who buys a lottery ticket risks 100% of what he paid. Any situation where you risk 100% looks like an odd case of limited risk. Limited to 100%!?! Most speculators ignore this ominous figure. Option buyers have a dismal track record. They may make a few dollars on a few trades, but I’ve never seen anyone build equity buying options. The odds in this game are so bad that after a few trades they are sure to kick in and destroy a buyer. At the same time, options have a high entertainment value. They provide a cheap ticket to the game, an inexpensive dream, just like a lottery ticket. You need a minimum of one year of successful trading experience in stocks or futures before touching options. If you are new to the markets, do not even dream of using options in lieu of stocks. No matter how small your account, find some stocks and learn to trade them. The all-time bestseller on options, and deservedly so, is Lawrence MacMillan’s Options as a Strategic Investment. It is a veritable mini-encyclopedia that covers all aspects of options trading, better than his other book. WHERE DO I GO FROM HERE?
Slide 34: CHAPTER THREE THE FIRST STEPS rading lures us with its promise of freedom. If you know how to trade, you can live and work anywhere in the world, be independent from the routine, and not answer to anybody. Trading attracts people of above-average intelligence who enjoy games and aren’t afraid of risks. Before you rush into this exciting venture, keep in mind that in addition to your enthusiasm you will need to bring a sober understanding of the realities of trading. Trading will stress your feelings. To survive and succeed, you will need to develop a sound trading psychology. Trading will challenge your mind. To gain an edge in the markets, you will need to master good analytic methods. Trading will demand good mathematical skills. A math illiterate who can’t manage risks is guaranteed to bust out. Trading psychology, technical analysis, money management—if you learn all three, you can make it in trading. But first, let us look at the external obstacles to your success. The markets are set up to separate the maximum number of people from their money. Stealing is not permitted, but markets are heavily slanted in favor of insiders and against outsiders. Let us explore the barriers that prevent many traders from succeeding and try to lower them. T THE EXTERNAL BARRIERS TO SUCCESS An investor can start with practically nothing, buying a few thousand dollars worth of shares. If he buys and holds, his commissions and other expenses will be minor factors in his success or failure. Traders 25
Slide 35: 26 FINANCIAL TRADING FOR BABES IN THE WOODS have a harder task. Seemingly trivial expenses can break them, and the smaller the account, the greater the danger. Transaction costs can raise an impassable barrier to winning. Transaction costs?! Beginners hardly think of them, yet transaction costs are a leading cause of trader mortality. Adjusting your plans to reduce those costs gives you an advantage over the market crowd. I have a friend whose 12-year-old daughter recently came up with a brilliant idea for a new business, which she called The Guinea Pig Factory. She ran off promotional flyers on her mom’s copy machine and stuffed them into neighbors’ mailboxes. Guinea pigs, popular among kids in her neighborhood, cost $6, but she could buy them at the central market for only $4. The girl dreamed of profits when her mother, who is a trader, asked how she was going to get from the Sydney suburb where they lived to the central market and back. Someone will give me a ride, answered the girl. A child may get a free ride, but the market will not give it to you. If you buy a stock at $4 and sell it at $6, you won’t make a $2 profit. A big chunk of it will go for transaction costs. Amateurs tend to ignore them, while professionals focus on them and do everything in their power to reduce them—unless they’re collecting them from you, in which case they try to blow them up. Beginners get into their Guinea Pig Factories and cannot understand why they keep buying at 4, selling at 6, and are still losing money. A new trader is like a little lamb walking into a dark forest. He is likely to be killed, and his skin—his trading capital—divided three ways, between brokers, professional traders, and service providers. Each will try to grab a piece of that poor lamb’s skin. Don’t be that lamb—think of transaction costs. There are three kinds of them: commissions, slippage, and expenses. Commissions Commissions may appear to be a minuscule expense. Most traders neglect them, but if you add them up, you’re likely to find that your broker ends up with much of your profit. A brokerage firm may charge about $20 to buy or sell up to 5,000 shares. If you have a $20,000 account and buy 200 shares of a $100 stock, the commission of $20 comes to one-tenth of one percent. When
Slide 36: THE FIRST STEPS 27 you sell those shares and pay another commission, the cost of brokerage rises to approximately two-tenths of one percent of your equity. Trade like that once a week, and at the end of the month your broker will have earned one percent of your account, regardless of whether you made money. Keep going like that for a year, and your commission cost will rise to 12% of your equity. That’s a lot of money. Professional money managers are happy with 25% annual returns, year after year. They could not generate them if they had to pay 12% annually in commissions. But wait, it gets worse. Look at a small trader who can afford only 100 shares of a $20 stock. His purchase price is $2,000, but he pays the same $20 commission, which eats up a whopping 1 percent of his equity. When he closes that trade and pays another commission, he is 2 percent behind the game. If he trades like that once a week, by the end of the month his commissions will come to 10% of his account, more than 100% on annualized basis. The great George Soros averages 29% annual gain. He could have never accomplished that if he had to jump over a 100% commission barrier. The bigger your account, the smaller the percentage eaten by commissions and the lower your barrier to winning. Having a large account is a great advantage, but whatever your size, do not be hyperactive. Each trade and each seemingly cheap commission raise the barrier to your success. Design a system that doesn’t trade very often. I’ve met futures traders who paid $80 roundtrip commissions to fullservice brokers. That was the price of allegedly sage advice, but any disinterested professional will tell you that a futures trader who pays $80 roundtrip has no chance of winning. Why do people pay such exorbitant rates? Because the little lamb who ventures into a dark forest is so afraid of the big bad wolf, the professional trader, that he hires himself a protector to guide him, a full-service broker. Once you do the math, it becomes clear that you’re better off taking your chances on the wolf than signing up for a guaranteed skinning by your protector. There are full-service brokers whose advice is worth the money. They bring good tips, get good fills, and their commissions are not exorbitant. The catch is that they only accept very large accounts that generate a high volume of business. Bring them a million-dollar account with a history of active trading, and you may get their attention. If you have an account in five or six figures and trade only a couple of times a week, do not waste your time and money looking for false security of an expensive broker. Get a cheap, reliable, no-frills
Slide 37: 28 FINANCIAL TRADING FOR BABES IN THE WOODS broker that you can easily reach via the Internet or on the phone—and start looking for good trades. Slippage Slippage is the difference between the price at the time you placed your order and the price at which that order got filled. You may place an order to buy when a guinea pig is trading at $4, but your bill comes to $4.25. How come? Then the guinea pig goes up to $6 and you place an order to sell at the market, only to receive $5.75. Why? In our daily lives we are used to paying posted prices. Here, at the grown-up Guinea Pig Factory, they clip you for a quarter buying and another selling. It could get worse. Those quarters and halves can add up to a small fortune for a moderately active trader. Who gets that money? Slippage is one of the key sources of income for market professionals, which is why they tend to be very hush-hush about it. No stock, future, or option has a set price, but it does have two rapidly changing prices—a bid and an ask. A bid is what a buyer is offering to pay, whereas an ask is what a seller is asking. A professional is happy to accommodate an eager buyer, selling to him instantly, on the spot—at a price slightly higher than the latest trade in that market. A greedy trader who’s afraid that the bullish train is leaving the station overpays a pro who lets him have his stock right away. That pro offers a similar service to sellers. If you want to sell without waiting, afraid that prices may collapse, a professional will buy from you on the spot—at a price slightly lower than the latest trade in that market. Anxious sellers accept ridiculously low prices. Slippage depends on the emotional state of market participants. The professional who sells to buyers and buys from sellers is not a social worker. He is running a business, not a charitable operation. Slippage is the price he charges for rapid action. He has paid a high price for his spot at the crossroads of buy and sell orders, buying or leasing an exchange seat or installing expensive equipment. Some orders are slippage-proof, while others invite slippage. The three most popular types of orders are limit, market, and stop. A limit order specifies the price; that is, “Buy 100 shares of Guinea Pig Factory at $4.” If the market is quiet and you’re willing to wait, you’ll get that price. If GPF dips below $4 by the time your order hits the market, you may get it a little cheaper, but don’t count on it. If the market rises
Slide 38: THE FIRST STEPS 29 above $4, your limit order will not be filled. A limit order lets you control the price at which you buy or sell, but doesn’t guarantee you a fill. A market order lets you buy or sell immediately, at whatever price you can get at the moment. The execution is guaranteed, but not the price. If you want to buy or sell right away, this very moment, you cannot expect to get the best price—you give up control and suffer slippage. Market orders placed by anxious traders are the bread and butter of the pros. A stop order becomes a market order when the market touches that level. Suppose you buy 100 shares of Guinea Pig Factory at $4.25, expect it to rise to $7, but protect your position with a stop at $3.75. If the price slides to $3.75, your stop becomes a market order, executed as soon as possible. You’ll get out, but expect to suffer slippage in a fast-moving market. You can choose what you want to control when you place an order—the price or the time. A limit order lets you control the price, with no assurance of a fill. When you place a market order, a fill is assured, but not the price. A calm and patient trader prefers to use limit orders, since those who use market orders keep losing slivers of capital in slippage. Slippage tends to be a much bigger expense than commissions. I estimated the size of both in Trading for a Living and thought this was one of the most explosive parts of the book, but very few noticed. People in the grip of greed or fear want to trade at any price, rather than focus on their long-term financial interests. So much for the efficient market theory. There are day-trading firms promising to teach traders to take advantage of slippage by trading inside the bid-ask spreads. Their technology does not guarantee success, while commissions from active trading negate any advantage. People pay a lot of money for Level 2 quotes, but I haven’t noticed any great increase in performance among those who use them. Getting into a trade is like jumping into a fast-moving river. The opportunity as well as the danger is in the water. You are safe standing on the bank and can control where and when to jump, but getting out of the water can be more tricky. You may see a spot where you want to get out—a profit target, where you can place a limit order. You may want to let the river carry you as long as the current allows, protecting your position with a trailing stop. That may increase your profits, but it also will increase slippage.
Slide 39: 30 FINANCIAL TRADING FOR BABES IN THE WOODS Limit orders work best for entering trades. You’ll miss a trade once in a while, but there will be many others. That river has been flowing for hundreds of years. A serious trader uses limit orders to get in and to take profits, and protects his positions with stops. Anything we can do to reduce slippage goes directly to our bottom line and improves our odds of long-term success. Expenses Some expenses are unavoidable, especially in the beginning—you’ll have to buy a few books, download trading software, sign up with a data service, and so on. It is important to keep your expenses as low as possible. Amateurs have a charming habit of paying for their trading-related expenses, such as computers, subscriptions, and advisory services, with credit cards, without taking money out of their trading accounts. That protects them from seeing the true rate at which they are going downhill. Good traders add to profitable positions and reduce the size of their trades during losing streaks. We can apply the same sound principle to expenditures. Losers like to throw money at problems, while winners invest a fraction of their profits in their operations. Successful traders treat themselves to a new computer or software package only after they have enough profit to pay for it. Even the best tools can blow you out of the water. At a recent seminar in Frankfurt, a trader was excited about a powerful analytic package for which he was going to sign up the following week. It cost 2,000 marks a month (almost $1,000), but it was going to give him a tremendous analytic advantage. “How much money do you have in your trading account?” I asked. 50,000 marks. “Then you can’t afford it. This software will cost you 24,000 marks a year, and you’ll have to generate almost 50% profit simply to pay for your signals. No matter how good the software, at this rate you’ll lose money. Look for a cheaper package, something that’ll cost no more than 1,000 marks per year, or about 2% of your account.” Institutional traders get support from their managers, peers, and staff, but private traders tend to feel lonely and isolated. Vendors prey on them by promising to help lead them out of the wilderness. The more overloaded you feel, the more likely you are to listen to vendors. Nine out of ten professionals in any field, be they lawyers, auto mechanics, or doctors, are not good enough. You don’t trust an average auto mechanic
Slide 40: THE FIRST STEPS 31 or a doctor, but rather ask for referrals from friends you respect. Most private traders do not know who to ask and respond to advisors with the loudest advertisements, who are rarely the best trading experts. An advisor I’ve known for years was recently indicted by the Feds for stealing hundreds of millions of dollars from Japanese clients. Prior to that, he cultivated a reputation as one of the most prominent market experts in the United States, constantly quoted by the media. We were introduced at a conference, where people paid thousands of dollars to listen to him. He asked me what I thought of his presentation, and I said it sounded amazingly interesting but I could not understand much of it. “That’s the point,” he beamed. “If my clients believe I know something they don’t, I’ve got them for life!” I knew right away the man was dishonest, and was surprised only by the size of his loot. Some trading advice can be amazingly good. A few dollars will buy you a book that holds the experience of a lifetime. A few hundred dollars will get you a subscription to a newsletter with original and helpful advice. But gems are few and far between, while legions of hucksters prey on insecure traders. I have two rules for filtering out the worst offenders: avoid services you don’t understand and avoid expensive services. If you don’t understand an advisor, stay away from him. Trading attracts people of above-average intelligence, which probably applies to you. If you cannot understand something after an honest effort, it’s probably because the other guy is giving you double-talk. When it comes to books, I avoid those written in bad English. Language is a reflection of thought, and if a guy cannot write clearly, his thinking probably isn’t too clear either. I also avoid books with no bibliography. We all borrow from our predecessors, and an author who doesn’t acknowledge his debts is either arrogant, lazy, or both. Those are terrible traits in a trader, and if he writes like that, I don’t want his advice. And of course, I have zero respect for thieves. Book titles are not copyrighted, and in recent years a bunch of people have lifted the title of my first book, Trading for a Living, usually with slight variations. I am sure that some clown will steal the title of the book you’re now reading. Will you want to learn from a poacher who cannot think for himself? My second rule is to avoid very expensive services, be they books, advisory letters, or seminars. A $200 newsletter is likely to be a better value than a $2,000 one, and a $500 seminar a better value than a $5,000 one. Merchants of super-expensive products sell an implicit promise of “the keys to the kingdom.” Their customers are usually
Slide 41: 32 FINANCIAL TRADING FOR BABES IN THE WOODS desperate to dig out from under abysmal losses. Football players call this a “Hail Mary” play—when a losing team in the last seconds of the game desperately tosses the ball forward, hoping to score. They’ve already lost the game on skill, and now try to come back in a single desperate gamble. When a trader who lost more than half of his account buys a $3,000 trading system, he is doing the same thing. Helpful advisors tend to be modest, and price their services accordingly. An obscene price is a marketing gimmick that conveys a subliminal message that the service is magic. There is no magic—no one can deliver on that promise. A relatively inexpensive service is a bargain when it’s good, and a cheap loss when it isn’t. Someone once asked Sigmund Freud what he thought the best attitude for a patient was. “Benign skepticism,” answered the great psychiatrist, and that’s good advice for financial traders. Maintain an attitude of healthy skepticism. If you find something you don’t understand, try it again, and if you still do not get it, it is probably not worth having. Run, do not walk, from those who offer to sell you the keys to the kingdom. Keep your expenses low and remember, any information you receive becomes valuable to you only after you’ve tested it on your data, making it your own. GETTING YOUR GEAR A successful trader is like a fish swimming upstream, against the current. Commissions, slippage, and expenses keep pushing you back. You must make enough money to overshoot these three barriers before making a dime. There is no shame in deciding trading is too hard and walking away, just as there is no shame in being unable to dance or play the piano. Many beginners jump in without thinking and get financially and emotionally hurt. It is a great game, but if you leave, better do it early. If you decide to trade, read on, because in the following sections we will look into psychology, trading tactics, and money management. But first, we must talk about the practical aspects of trading—how to open an account, choose a computer, and start collecting data. Size Matters Making or losing money in the market depends in part on how much you put into your account. Two people can take identical trades, but one
Slide 42: THE FIRST STEPS 33 will grow equity, while the other will bust out. How could this be if they buy and sell the same quantity of the same stock at the same time? Suppose we meet and decide to pass an hour tossing a coin, playing heads-or-tails—heads you win, tails you lose. Each of us will bring $5 to the game and bet 25 cents on each flip. As long as we use a fair coin, by the end of the hour we will be about even, each with about $5. What happens if we play the same game and use the same coin, only now you start with $5, while I bring only $1? You’ll probably end up taking my money. You are likely to win because your capital provides greater staying power. It would take a string of 20 losses to bankrupt you, while for me a string of just 4 losses would be fatal. Four losses in a row are much more likely than 20. The trouble with a small account is that it has no reserves to survive even a short run of losing trades. Winning trades are always interlaced with losers, and a short losing streak wipes out small traders. Most beginners start out with too little money. There is plenty of noise in the markets—random moves that defy trading systems. A small trader who runs into a noisy period has no safety cushion. His longterm analysis may be brilliant, but the market will do him in, because he does not have the staying power to ride out a losing streak. Back in 1980, as a greenhorn amateur, I walked into a Chase bank around the corner and drew a $5,000 cash advance against my credit card. I needed that princely sum to meet a margin call in my depleted trading account. A beady-eyed cashier called the manager, who demanded my thumbprint on the receipt. The transaction felt dirty, but I got the money—which I proceeded to lose within a few months. My system was correct, but the market noise was killing me. It wasn’t until I got my trading account into a comfortable high five figures that I started making money. I wish someone had explained the concept of size to me in those days. Trading a small account is like flying an airplane at treetop level. You have no room to maneuver, no time to think. The slightest slip of attention, a piece of bad luck, a freaky branch sticking out into the air—you crash and burn. The higher you fly, the more time you have to find your way out of trouble. Flying at a low altitude is tough enough for experts, but deadly for beginners. A trader needs to gain altitude, get more equity, and buy some space for maneuvers. A person with a large account who bets a small fraction on any given trade can stay calm. A person with a small account grows tense
Slide 43: 34 FINANCIAL TRADING FOR BABES IN THE WOODS knowing that any single trade can either boost or damage his account. As the stress rises, the capacity to reason goes down. I saw the best example of how money can twist a player’s mind while teaching my oldest daughter to play backgammon. She was about eight at the time but very determined and bright. After a few months of practice she began beating me. Then I suggested we play for money— a penny a point, which in our scoring meant a maximum of 32 cents per game. She kept beating me, and I kept raising the stakes. By the time we reached 10 cents a point she started losing and soon gave back every last penny. Why could she beat me playing for little or no money but lost when the stakes increased? Because for me $3.20 was pocket change, but for the kid it was real money. Thinking about it made her a little more tense and she played slightly below her peak level— enough to fall behind. A trader with a small account is so preoccupied with money that it impairs his ability to think, play, and win. Other beginners bring too much money to the game, and that is not good either. A beginner with too much capital goes chasing after too many rabbits, becomes careless, loses track of his positions, and ends up losing money. How much should you have in your trading account when you start? Remember, we are talking about trading capital. It doesn’t include your savings, long-term investments, retirement funds, house equity, or Christmas club. We only count the money that you want to spin in the markets, aiming to achieve a higher rate of return than you can get from Treasury bills. Do not even dream of starting with less than $20,000. That is the barest minimum, but $50,000 provides a much safer flying altitude. It allows you to diversify and practice sensible money management. At the same time, I do not suggest starting with more than $100,000. Too much money in a trading account makes a beginner lose focus and leads to sloppy trading. Professionals can use a lot more, but beginners should stay below $100,000 while learning to trade. Learn to fly a single-engine plane before moving up to a twin-engine model. A successful trader needs to get into the habit of being careful with money. Beginners sometimes ask me what to do if they have only $10,000 or $5,000. I urge them to study the markets and paper-trade, while getting a second job to accumulate capital. Start trading with a decentsized account. You’re going into battle, your capital is your sword, and
Slide 44: THE FIRST STEPS 35 you need a weapon that’s long enough to give you a chance in combat with well-armed opponents. Hardware and Software Thinking about my first purchases of trading technology is pure nostalgia. I walked into a drugstore in Florida and bought a pocket calculator. A year later I acquired a programmable calculator with a tiny engine that pulled magnetic memory cards through its slot. Then I bought my first computer. It had two floppy drives—one for the program, the other for the data diskette. I upgraded it from 48K to 64K RAM (that’s kilobytes, not megabytes!), and it was a rocket. My first modem collected data at a brisk 300 baud, later upgraded to a sizzling 1,200. When hard drives became available, I bought myself a 10-MB unit (they also had a 20-MB model, but who needed such a monster?). There was only one good program for technical analysis, and it cost $1,900. Today, I can buy a hundred times more powerful software for a tenth of that price. Does every trader need a computer? My friend Lou Taylor did all his research on scraps of paper. I used to offer him computers, but to no avail. Most traders, including myself, would be lost without a computer. It expands our reach and speeds up research. Just keep in mind that computers do not guarantee profits. Technology helps, but does not guarantee victory. A poor driver will crash the best car. To become a computerized trader, you must choose a computer, trading software, and a source of data. Trading programs tend to be undemanding and run well on older, slower machines. A good program for technical analysis must download the data, plot daily, weekly, and possibly intraday charts, and offer a multitude of indicators. A good program should allow you to add your own indicators to the system and let you scan lists of securities according to your parameters. The list of programs for traders keeps growing, so that by the time you read this book any review will be out of date. My company keeps updating our brief software guide, which we send out as a public service. To request a current copy, please contact us at the address that appears in the back of this book. A striking development in recent years is the wealth of resources for traders available on the Internet. Today you can analyze markets with-
Slide 45: 36 FINANCIAL TRADING FOR BABES IN THE WOODS out buying any software—just go to a website, key in your stocks or futures, select the indicators, and click your mouse. Some websites are free, while others are subscription-based. With all those websites, why buy technical analysis software? For the same reason that in a city like New York, with its good public transportation system, some of us own cars. Clients often ask me how to add some new indicator to their favorite website. When you travel by bus, you cannot ask the driver to take your favorite route. Can you program your own indicator into a website and scan charts with it, posting green dots for buy signals and red dots for sell signals? When you find a website that can do it, you may no longer need software. Until that time, those of us who are serious about research will continue to buy technical analysis software. You can get a top-notch program for a few hundred dollars. A historical database with a year’s worth of updates will cost a couple of hundred more. If you have a tiny account, however, use free websites. Always try to push your expenses down to the smallest possible percentage of your account. Data Signing up with a data service appears simple, but raises several questions that go to the heart of trading. How many markets should you follow? How far back should you go in your research? Do you need real-time data? Answering these questions takes you deep into the trading enterprise and forces you to review your decision-making process. How Many Markets Should You Follow? Beginners make the common mistake of trying to follow too many markets at once. Some look for software to scan thousands of stocks and quickly bog down. Serious beginners should pick no more than two or three dozen stocks and track them day in and day out. You need to get to know them, develop a feel for how they move. Do you know when your companies release their earnings? Do you know their highest and lowest prices for the past year? The more you know about a stock, the more confidence you have and the fewer surprises can jump out at you. Many professionals focus on just a few stocks, or even on a single one. Which stocks should you track? Begin by choosing two or three currently hot industries. Technology, Internet, telecommunications, and biotechnology industries are in the forefront of the market at the time
Slide 46: THE FIRST STEPS 37 of this writing, but the list is likely to change. It always does. Pick half a dozen leading stocks in each of those industries and follow them daily. That’s where you’ll find the highest volumes, the steadiest trends, the crispest reversals. Several months later, after you get to know your stocks and make some money, you may be ready to add another industry group and pick its top six stocks. Remember, the depth of your research is much more important than its breadth. You can make more money from a handful of familiar stocks. The choice is easier for futures traders—there are only about three dozen futures, in six or seven groups. Beginners should stay away from the most volatile markets. Take grains, for instance. You should analyze corn, wheat, and soybeans, but trade only corn because it tends to be the slowest and quietest of the group. Learn to ride a bicycle with training wheels before starting to race. When it comes to tropicals, analyze all, but trade only sugar—a big, liquid, and reasonably volatile market, leaving aside coffee and cocoa, which can move as fast as the S&P. Needless to say, a beginner has no business with stock index futures, whose nickname on the floor is “rockets.” You may graduate to them in a couple of years, but at this stage, if you have an opinion on the stock market, trade SPDRs or QQQs, exchange-traded market indexes. How Far Back Should You Go in Your Research? A daily chart on a computer screen will comfortably show five or six months of history. You’ll see less with candlesticks (see p. 72), which take up more space. Daily charts alone aren’t enough, and you need weekly charts with at least two years worth of history. Learning history prepares you for the future, and it could be helpful to glance at a 10-year chart and see whether that market is high or low in the long-term scheme of things. Charts spanning 20 or more years are especially useful for futures traders. Futures, unlike stocks, have natural floors and ceilings. Those levels are not rigid, but before you buy or sell, try to find out whether you’re closer to the floor or the ceiling. The floor price of futures is their cost of production. When a market falls below that level, producers start quitting, supply falls, and prices rise. If there is a glut of sugar and its price on the world markets falls below what it costs to grow the stuff, major producers are going to start shutting down their operations. There are exceptions, such as when a desperately poor country sells commodities on the world markets to earn hard currency, while paying domestic workers with devalued
Slide 47: 38 FINANCIAL TRADING FOR BABES IN THE WOODS local money. The price can dip below the cost of production, but it cannot stay there for long. The ceiling for most commodities is the cost of substitution. One commodity can replace another if the price is right. For example, with a rise in the price of corn, a major animal feed, it may be cheaper to feed animals wheat. As more farmers switch and reduce corn purchases, they take away the fuel that raised corn prices. A market in the grip of hysteria may briefly rise above its ceiling, but cannot stay there for long. Its return to the normal range provides profit opportunities for savvy traders. Learning from history can help you keep calm when others are losing their heads. Futures contracts expire every few months, making long-term charts difficult to analyze. When it comes to dailies, we look at the currently active month, but what about the weeklies? Here we have to use continuous contracts, mathematical devices that splice several contract months. It pays to download two data series—the currently active contract, going back about six months, and the continuous contract going back at least two years. Analyze weekly charts using continuous data, and switch to the front month to study daily charts. Do You Need Real-Time Data? Real-time data flows to your screen tick by tick, as prices change in the markets. A live screen is one of the most captivating sights on Earth, right up there with nude co-ed volleyball or a chain collision on an expressway. Watching your stock dance in front of your face can help you find the best spots for buying and selling—or make you forget reality and swim in adrenaline. Will live data improve your trading? The answer is “yes” for a few, “maybe” for some, and “no” for most. Having a live screen on your desk, says a trader friend, is like sitting in front of a one-armed bandit. You invariably end up feeding it quarters. Trading with live charts looks deceptively easy, while in fact it is one of the fastest games on the planet. Buy at 10:05 A.M., watch the price rise a few ticks, and take a couple of hundred dollars off the table by 10:15. Repeat several times a day, and go home at 4 with thousands of dollars and no open positions. Sleep like a baby and return in the morning. Trouble is, you need perfect reflexes to do that. If you pause to think, delay taking a profit, or quibble accepting a loss, you’re dead. Most successful day-traders are men in their early 20s. I’ve met very few successful day-traders over 30. There are exceptions, of course—a friend
Slide 48: THE FIRST STEPS 39 in her 70s is a fantastic day-trader, but she is an exception who confirms the rule. This game requires lightning-fast reflexes, as well as a certain thoughtless capacity to jump, that few of us preserve past the age of 30. Beginners do not need live data because they have to put all their attention into learning to trade with daily and weekly charts. Once you start pulling money out of the markets, it might be a good idea to apply your new skills to intraday charts. When longer-term charts give you a buy or a sell signal, use live data not to day-trade but to dance into or out of positions. Once you decide to use live data, make sure it’s real and not delayed. Most exchanges charge monthly fees for real-time data, while the Internet is full of websites offering free data, delayed by 20 minutes. That delay does not interfere with the entertainment value, but trading with it is suicidal. If you need real-time data, be sure to get the best. ANALYSIS AND TRADING Markets generate vast volumes of information: annual and quarterly reports, earnings estimates, corporate insiders’ reports, industry group studies, technology forecasts, weekly, daily, and intraday charts, technical indicators, trading volume, opinions in chat rooms, the neverending discussion circles on the Internet. With so much data, you soon realize your analysis can never be complete. Some traders who have lost money fall into paralysis from analysis. They develop a quaint notion that if they analyze more data, they’ll stop losing and become winners. You can recognize them by their beautiful charts and shelves crammed with stock reports. They will show you indicator signals in the middle of any chart, but when you ask them what they will do at the right edge, they only mumble because they do not trade. Analysts are paid to be right; traders are paid to be profitable. Those are two different goals, calling for different temperaments. Institutions tend to separate traders and analysts into different departments. Private traders have no such luxury. Analysis quickly reaches the point of diminishing returns. The goal is not to be complete but to develop a decision-making process and back it up with money management. You need to develop several analytic screens to reduce a huge volume of market information to a manageable size.
Slide 49: 40 FINANCIAL TRADING FOR BABES IN THE WOODS Fundamental Analysis Fundamental analysts predict price movements on the basis of supply and demand. In stocks, they study supply and demand for company products. In futures they research supply and demand for commodities. Has a company announced a new technological breakthrough? An expansion abroad? A new strategic partnership? A new chief executive? Anything that happens to the business can influence the supply of its products and their costs. Almost everything that happens in society can influence the demand. Fundamental analysis is hard because the importance of different factors changes with the passage of time. For example, during an economic expansion, fundamental analysts are likely to focus on growth rates, but during a recession, on the safety of dividends. A dividend may seem like a quaint relic in a go-go bull market, but when the chips are down the ultimate test of a stock is how much income it generates. A fundamental analyst must keep an eye on the crowd, as it shifts its attention from market share to technological innovation to whatever else preoccupies it at the moment. Fundamental analysts study values, but the relationship between values and prices is not direct. It’s that mile-long rubber band all over again. The job of a fundamental analyst in the futures markets isn’t much easier. How do you read the actions of the Federal Reserve, with its great power over interest rates and the economy? How do you analyze weather reports during the critical growing seasons in the grain markets? How do you estimate carryover stocks and weather prospects in the Southern versus the Northern Hemispheres which are six months apart in their weather cycles? You can spend a lifetime learning the fundamentals, or you can look for capable people who sell their research. Fundamental analysis is much more narrow than technical. A moving average works similarly in soybeans and IBM, on weekly, daily, and intraday charts. MACD-Histogram flashes similar messages in Treasury bonds and Intel. Should we forget about the fundamentals and concentrate on technicals? Many traders take the path of least resistance, but I think this is a mistake. Fundamental factors are very important to a long-term trader who wants to ride major trends for several months or years. If the fundamentals are bullish, we should favor the long side of the market, and
Slide 50: THE FIRST STEPS 41 if bearish, the short side. Fundamental analysis is less relevant to a short-term trader or a day-trader. You do not have to become an expert in the fundamental analysis of every stock and commodity. There are very intelligent people who specialize in that, and they publish their research. Many of them also bang their heads against the walls, unable to understand why, if they know so much about their markets, they cannot make money trading. If we can take our ideas from fundamental analysts but filter them through technical screens, we’ll be miles of head of those who analyze only fundamentals or technicals. Bullish fundamentals must be confirmed by rising technical indicators; otherwise they are suspect. Bearish fundamentals must be confirmed by falling technical indicators. When fundamentals and technicals are in gear, a savvy trader can have a field day. The main book on the fundamental analysis of stocks is Security Analysis by Graham and Dodd. Both authors are long dead, but the book is being kept up-to-date by their disciples. If you decide to study it, make sure to get the latest edition. Warren Buffett, a student of Graham, became one of the richest men in the world. There is an easy-to-read book that explains his approach to fundamental analysis—The Buffett Way by Robert G. Hagstrom. The best review of futures fundamentals is in The Futures Game by Teweles and Jones. This classic volume is being revised and updated every 10 years or so (be sure to get the latest edition). It has a section on the fundamentals of every futures market. Whether you trade soybeans or Swiss francs, you can quickly read up on the key factors driving that market. WHERE DO I GO FROM HERE? Technical Analysis Financial markets run on a two-party system—bulls and bears. Bulls push prices up, bears push them down, while charts show us their footprints. Technical analysts study charts to find where one group overpowers the other. They look for repetitive price patterns, trying to recognize uptrends or downtrends in their early stages and generate buy or sell signals. The role of technical analysis on Wall Street has changed over the years. It was very popular in the early part of the twentieth century,
Slide 51: 42 FINANCIAL TRADING FOR BABES IN THE WOODS ushered in by Charles Dow, the founder of The Wall Street Journal and the originator of the Dow averages. Several prominent analysts, such as Roger Babson, predicted and identified the 1929 top. Then came a quarter century of exile, when institutional analysts had to hide their charts if they wanted to keep their jobs. Technical analysis has become hugely popular since the 1980s. Easy access to personal computers has put technical software within easy reach of traders. The stock market has become increasingly short-term oriented in recent years. Gone are the days of “buy-and-hold” when people bought “good stocks” for the long run, put them away, and collected dividends. The pace of economic change is increasing, and stocks are moving faster and faster. New industries emerge, old ones sink, and many stocks have become more volatile than commodities. Technical analysis is well suited for those fast-paced changes. There are two main types of technical analysis: classical and computerized. Classical analysis is based solely on the study of charts, without using anything more complex than a pencil and ruler. Classical technicians look for uptrends and downtrends, support and resistance zones, as well as repetitive patterns, such as triangles and rectangles. It is an easy field to enter, but its main drawback is subjectivity. When a classical technician feels bullish, his ruler tends to inch up, and when he feels bearish, that ruler tends to slide down. Modern technical analysis relies on computerized indicators whose signals are much more objective. The two main types are trendfollowing indicators and oscillators. Trend-following indicators, such as moving averages, Directional System, and MACD (moving average convergence-divergence), help identify trends. Oscillators, such as Stochastic, Force Index, and Relative Strength Index (RSI) help identify reversals. It is important to select several indicators from both groups, set their parameters, and stay with them. Amateurs often misuse technical analysis by looking for indicators that show them what they want to see. The main tool of technical analysis is neither the pencil nor the computer, but the organ that every analyst is supposed to have between his ears—the brain. Still, if two technicians are at the same level of development, the one with a computer has an advantage. Technical analysis is partly a science and partly an art—partly objective and partly subjective. It relies on computerized methods, but it tracks crowd psychology, which can never be fully objective. The best model for technical analysis is a public opinion poll. Pollsters use scientific methods but need psychological flair to design questions and
Slide 52: THE FIRST STEPS 43 select polling techniques. Price patterns on our computer screens reveal crowd behavior. Technical analysis is applied social psychology, the craft of analyzing mass behavior for profit. Many beginners, overwhelmed by the sheer volume of data, fall into the trap of automatic trading systems. Their vendors claim to have backtested the best technical tools and put them together into winning systems. Whenever an excited beginner tells me he is planning to buy an automatic system, I ask him what he does for a living and what would happen if I came to compete with him after buying an automatic decision-making system in his field. People want to believe in magic, and if that magic can also save them from working and thinking, they gladly pay good money for it. Successful trading is based on the 3 M’s—Mind, Method, Money. Technical analysis, no matter how clever, is responsible for only onethird of your success. You also need to have sound trading psychology and proper money management, as you’ll see later in this book. WHERE DO I GO FROM HERE? Technical Analysis of Stock Trends by Edwards and Magee, written in the first half of the twentieth century, is considered the definitive book on classical charting. Get any edition after 1955, because that was the last major revision of the book. Technical Analysis of the Financial Markets by John Murphy offers the most thorough review of modern as well as classical technical analysis. My first book, Trading for a Living, has large sections on both classical and modern technical analysis. When to Buy and Sell The secret of trading is that there is no secret. There is no magic password to profits. Beginners keep looking for a gimmick, and plenty of crafty vendors sell them. In truth, trading is about work—and a bit of flair. It is no different from any other field of human endeavor. Whether you do surgery, teach calculus, or fly an airplane, it all boils down to knowing the rules, having the discipline, putting in the work, and having a bit of flair. An intelligent trader pays attention to fundamentals. He is aware of the key forces in the economy. He spends most of his analytic time on technical analysis, working to identify trends and reversals. Later in this book we will review key technical tools and put together a trading plan.
Slide 53: 44 FINANCIAL TRADING FOR BABES IN THE WOODS Markets keep changing, and flexibility is the name of the game. A brilliant programmer told me recently that he kept losing money but whoever was buying off of his stops must have been profitable because his stops kept nailing the bottoms of declines. I asked why he didn’t start placing his buy orders where he now placed stops. He wouldn’t do it because he was too rigid, and for him buy orders were buy orders and stops were stops. A high level of education can be a handicap in trading. Brian Monieson, a noted Chicago trader, once said in an interview, “I have a Ph.D. in mathematics and a background in cybernetics, but I was able to overcome those disadvantages and make money.” Many professional people are preoccupied with being right. Engineers believe that everything can be calculated, and doctors believe that if they run enough tests, they’ll come up with the right diagnosis and treatment. Curing a patient involves a lot more than precision. It is a running joke how many doctors and lawyers lose money in the markets. Why? Certainly not for lack of intelligence, but for lack of humility and flexibility. Markets operate in an atmosphere of uncertainty. Trading signals are clear in the middle of the chart, but as you get closer to the right edge, you find yourself in what John Keegan, the great military historian, called “the fog of war.” There is no certainty, only odds. Here you have two goals—to make money and to learn. Win or lose, you have to gain knowledge from a trade in order to be a better trader tomorrow. Scan your fundamental information, read technical signals, implement your rules of money management and risk control. Now you are ready to pull the trigger. Go!
Slide 54: PART TWO THE THREE M’S OF SUCCESSFUL TRADING B uy low, sell high. Short high, cover low. Traders are like surfers, trying to catch good waves, only their beach is rocky, not sandy. Professionals wait for opportunities but amateurs jump in, driven by emotions—they keep buying strength and selling weakness, bleeding their equity into the markets. Buy low, sell high sounds like a simple rule, but greed and fear can override the best intentions. A professional waits for familiar patterns to emerge from the market. He may notice a new trend with rising momentum, indicating higher prices ahead. Or he may detect the feebleness of momentum during a rally, indicating weakness. Once he recognizes a pattern, he puts on a trade. He has a clear notion of how he’ll get in, where he’ll take profits, and where he’ll accept a loss if the market turns against him. A trade is a bet on a price change, but there is a paradox. Each price reflects the latest consensus of value of market participants. Putting on a trade challenges that consensus. A buyer disagrees with the collective wisdom by saying the market is underpriced. A seller disagrees with the wisdom of the entire group, believing the market is overpriced. Both the buyer and the seller expect the consensus to change, but meanwhile they defy the market. That market includes some of the most brilliant minds and some of the deepest pockets on Earth. Arguing with this group is dangerous business, and it has to be done very cautiously. An intelligent trader looks for holes in the efficient market theory. He scans the market for brief periods of inefficiency. When the crowd is gripped by greed, the newcomers jump in and load up on stocks.
Slide 55: 46 THE THREE M’S OF SUCCESSFUL TRADING When falling prices squeeze the fingers of thousands of buyers, they dump their holdings in a panic, disregarding fundamental values. Those episodes of emotional behavior dilute the cold efficiency of the market, creating opportunities for disciplined traders. When markets are calm and efficient, trading becomes a crapshoot, with commissions and slippage worsening the odds. Crowd mentality changes slowly, and price patterns recur, albeit with variations. Emotional swings provide trading opportunities, while efficient markets chop up and down, offering no edge to traders, only piling up their costs. Technical analysis tools will work for you only if you have the discipline to wait for patterns to emerge. Professionals trade only when markets offer them special advantages. According to chaos theory, many processes—the flow of water in a river, the movement of clouds in the sky, the changes of prices in the cotton markets—are chaotic, with transient islands of order, called fractals. Those fractals look similar from any distance, whether through a telescope or a microscope. The coast of Maine looks just as jagged from a space shuttle as it does when you drop down on your hands and knees and look at it through a magnifying glass. In most financial markets, the long-term weekly charts and the short-term 5-minute charts look so similar, you cannot tell them apart without markings. Engineers have realized that they can achieve better control over many processes if they accept them as chaotic and try to capitalize on temporary fractals, the islands of order. That’s exactly what a good trader does. He recognizes the market as chaotic and unpredictable much of the time, but expects to find islands of order. He trains himself to buy and sell without quibbling when he finds those patterns. Successful trading depends on the 3 M’s—Mind, Method, and Money. Beginners focus on analysis, but professionals operate in a threedimensional space. They are aware of trading psychology—their own feelings and the mass psychology of the markets. Each trader needs to have a method for choosing specific stocks, options, or futures as well as firm rules for pulling the trigger—deciding when to buy and sell. Money refers to how you manage your trading capital. Mind, Method, Money—trading psychology, trading method, and money management—people sometimes ask me which of the three is more important. It is like asking which leg of a three-legged stool is the most important. Take them away one at a time and then try to sit down. In Part 2 we focus on those three foundations of market success.
Slide 56: CHAPTER FOUR MIND— THE DISCIPLINED TRADER* T raders come to the markets with great expectations, but few make profits and most wash out. The industry hides good statistics from the public, while promoting its Big Lie that money lost by losers goes to winners. In fact, winners collect only a fraction of the money lost by losers. The bulk of losses goes to the trading industry as the cost of doing business—commissions, slippage, and expenses—by both winners and losers. A successful trader must hop over several high hurdles—and keep hopping. Being better than average is not good enough—you have to be head and shoulders above the crowd. You can win only if you have both knowledge and discipline. Most amateurs come to the markets with half-baked trading plans, clueless about psychology or money management. Most get hurt and quit after a few painful hits. Others find more cash and return to trading. We do not have to call people who keep dropping money in the markets losers because they do get something in return. What they get is fantastic entertainment value. Markets are the most entertaining places on the face of the Earth. They are like a card game, a chess game, and a horse race all rolled into one. The game goes on at all hours—you can always find action. An acquaintance of mine had a terrible home life. He avoided his wife by staying late in the office, but the building closed on weekends, pushing him into the bosom of his family. By Sunday mornings he could take no more “family togetherness” and escaped to the basement of his house. There he had set up a trading apparatus, using the equipment loaned to him by another loser in exchange for a share of future *Thanks to Mark Douglas, the title of whose book I borrowed to name this chapter. 47
Slide 57: 48 THE THREE M’S OF SUCCESSFUL TRADING profits. What can you trade on a Sunday morning in suburban Boston? It turned out that the gold markets were open in the Middle East. My acquaintance used to turn on his quote screen, get on the phone (this was in the pre-Internet days), and trade gold in Abu Dhabi! He never asked himself what his edge was over local traders. What has he got, sitting in a bucolic suburb of Boston, that they haven’t got in Abu Dhabi? Why should locals send him money? Every professional knows his edge, but ask an amateur and he’ll draw a blank. A person who doesn’t know his edge does not have it and will lose money. Warren Buffett, one of the richest investors on Earth, says that when you sit down to a game of poker, you must know within 15 minutes who is going to supply the winnings, and if you don’t know the answer, that person is you. My Boston buddy wound up losing his house in a bankruptcy, which put a whole new spin on his marital problems, even though he no longer traded gold in Abu Dhabi. Many people, whether rich or poor, feel trapped and bored. As Henry David Thoreau wrote almost two centuries ago, “The mass of men lead lives of quiet desperation.” We wake up in the same bed each morning, eat the same breakfast, and drive to work down the same road. We see the same dull faces in the office and shuffle papers on our old desks. We drive home, watch the same dumb shows on TV, have a beer, and go to sleep in the same bed. We repeat this routine day after day, month after month, year after year. It feels like a life sentence without parole. What is there to look forward to? Perhaps a brief vacation next year? We’ll buy a package deal, fly to Paris, get on a bus with the rest of the group, and spend 15 minutes in front of the Triumphal Arch and half an hour going up the Eiffel Tower. Then back home, back to the old routine. Most people live in a deep invisible groove—no need to think, make decisions, feel the raw edge of life. The routine does feel comfortable—but deathly boring. Even amusements stop being fun. How many Hollywood movies can you watch on a weekend until they all become a blur? How many trips to Disneyland can you take before all the rides in plastic soap dishes feel like one endless ride to nowhere? To quote Thoreau again, “A stereotyped but unconscious despair is concealed even under what are called games and amusements of mankind. There is no play in them.” And then you open a trading account and punch in an order to buy 500 shares of Intel. Anyone with a few thousand dollars can escape the routine and find excitement in the markets.
Slide 58: MIND—THE DISCIPLINED TRADER 49 Suddenly, the world is in living color! Intel ticks up half a point— you check quotes, run out for a newspaper, and tune in for the latest updates. If you have a computer at work, you set up a little quote window to keep an eye on your stock. Before the Internet, people used to buy pocket FM receivers for market quotes and hide them in halfopen desk drawers. Their antennae, sticking out of desks of middleaged men, looked like beams of light shining into prison cells. Intel is up a point! Should you sell and take profits? Buy more and double up? Your heart is pounding—you feel alive! Now it’s up three points. You multiply that by the number of shares you have and realize that your profits after just a few hours are close to your weekly salary. You start calculating percentage returns—if you continue trading like that for the rest of the year, what a fortune you’ll have by Christmas! Suddenly you raise your eyes from the calculator to see that Intel has dropped two points. Your stomach is tied in a knot, your face pushes into the screen, you hunch over, compressing your lungs, reducing the flow of blood to the brain, which is a terrible position for making decisions. You are flooded with anxiety, like a trapped animal. You are hurting—but you are alive! Trading is the most exciting activity that a person can do with their clothes on. Trouble is, you cannot feel excited and make money at the same time. Think of a casino, where amateurs celebrate over free drinks, while professional card-counters coldly play game after game, folding most of the time, and pressing their advantage when the card count gives them a slight edge over the house. To be a successful trader, you have to develop iron discipline (Mind), acquire an edge over the markets (Method), and control risks in your trading account (Money). SLEEPWALKING THROUGH THE MARKETS There is only one rational reason to trade—to make money. Money attracts us to the markets, but in the excitement of the new game we often lose sight of that goal. We start trading for entertainment, as an escape, to show off in front of our family and friends, and so on. Once a trader loses his focus on money, his goose is cooked. It is easy to feel cool, calm, and collected reading a book or looking at your charts on a weekend. It’s easy to be rational when the markets are closed—but what happens after 30 minutes in front of a live screen? Does your pulse begin to race? Do upticks and downticks hypnotize you? Traders get an adrenaline rush from the market, and
Slide 59: 50 THE THREE M’S OF SUCCESSFUL TRADING the excitement clouds their judgment. Calm resolutions made on a weekend fly out the window during rallies or declines. “This time is different . . . It’s an exception . . . I won’t put in a stop now, the market is too volatile” are the giveaway phrases of emotional traders. Many intelligent people sleepwalk through the markets. Their eyes are open, but their minds are shut. They are driven by emotions and keep repeating their mistakes. It is OK to make mistakes but not OK to repeat them. When you make a mistake for the first time, it shows that you are alive, searching, experimenting. Repeating a mistake is a neurotic symptom. Losers come in all genders, ages, and colors, but several stock phrases give them away. Let us review some of the common excuses. If you recognize yourself, use that as a sign to start learning a new approach to the markets. Blame the Broker A trader hears his broker’s voice at the most important and tense moments—when placing buy or sell orders or requesting information that may lead to an order. The broker is close to the market, and many of us assume that he knows more than we do. We try to read our broker’s voice and figure out whether he approves or disapproves of our actions. Is listening to your broker’s voice a part of your trading system? Does it say to buy when the weekly moving average is up, daily Force Index is down, and the broker sounds enthused? Or does it simply say to buy when such and such indicators reach such and such parameters? Trying to read your broker’s voice is a sign of insecurity, a common state for beginners. Markets are huge and volatile, and their rallies and declines can feel overpowering. Frightened people look for someone strong and wise to lead them out of the wilderness. Can your broker lead you? Probably not, but if you lose money, you’ll have a great excuse—it was your broker who put you into that stupid trade. A lawyer who was shopping for an expert witness recently called me. His client, a university professor, had shorted Dell at 20 several years ago, before the splits, after his broker told him it “could not go any higher.” That stock became the darling of the bull market, went through the roof, and a year later the professor covered at 80, wiping out his million-dollar account, which represented his life savings. That
Slide 60: MIND—THE DISCIPLINED TRADER 51 man was smart enough to earn a Ph.D. and save a million dollars but emotional enough to follow his broker while his life savings were doing a slow burn. Few people sue their brokers, but almost all beginners blame them. Traders’ feelings towards brokers are similar to patients’ feelings towards psychoanalysts. A patient lies on the couch, and the analyst’s voice, emerging at important moments, seems to carry deeper psychological truths than the patient could have possibly discovered himself. In reality, a good broker is a craftsman who can sometimes help you get better fills and dig up information you requested. He is your helper—not your advisor. Looking to a broker for guidance is a sign of insecurity, which is not conducive to trading success. Most people start trading more actively after switching to electronic brokers. Low commissions are a factor, but the psychological change is more important. People are less self-conscious when they don’t have to deal with a live person. All of us occasionally make stupid trades, and electronic brokers allow us to make them in private. We are less ashamed hitting a key than calling a broker. Some traders manage to transfer their anxieties and fears onto electronic brokers. They complain that electronic brokers do not do what they want, such as accept certain types of orders. Why don’t you transfer your account, I ask—and see fear in their faces. It is the fear of change, of upsetting the cart. To be a successful trader, you must accept total responsibility for your decisions and actions. Blame the Guru A beginner entering the markets soon finds himself surrounded by a colorful crowd of gurus—experts who sell trading advice. Most charge fees, but some give advice for free to drum up business for their brokerage firms. Gurus publish newsletters, are quoted in the media, and many would kill to get on TV. Masses are hungry for clarity, and gurus are there to feed that hunger. Most are failed traders, but being a guru is not that easy. Their mortality rate is high, and few stay around for more than two years. The novelty wears off, customers do not renew subscriptions, and a guru finds it easier to earn a living selling aluminum siding than drawing trendlines. My chapter on the guru business in Trading for a Living drew more howls and threats than any other in that book.
Slide 61: 52 THE THREE M’S OF SUCCESSFUL TRADING Traders go through three stages in their attitudes towards gurus. In the beginning, they drink in their advice, expecting to make money from it. At the second stage, traders start avoiding gurus like the plague, viewing them as distractions from their own decision-making process. Finally, some successful traders start paying attention to a few gurus who alert them to new opportunities. Some losing traders go looking for a trainer, a teacher, or a therapist. Very few people are experts in both psychology and trading. I’ve met several gurus who couldn’t trade their way out of a paper bag but claimed that their alleged expertise in psychology qualified them to train traders. Stop for a moment and compare this to sex therapy. If I had a sexual problem, I might see a psychiatrist, a psychologist, a sex therapist, or even a pastoral counselor, but I would never go to a Catholic priest, even if I were Catholic. That priest has no practical knowledge of the problem—and if he does, you want to run, not walk away. A teacher who does not trade is highly suspect. Traders go through several stages in their attitudes towards tips. Beginners love them, those who are more serious insist on doing their own homework, while advanced traders may listen to tips but always drop them into their own trading systems to see whether that advice will hold up. Whenever I hear a trading tip, I run it through my own computerized screens. The decision to buy, go short, or stand aside is mine alone, with an average yield of one tip accepted out of every 20 heard. Tips draw my attention to opportunities I might have overlooked, but there are no shortcuts to sweating your own trades. A greenhorn who has gotten burned may ask for a guru’s track record. Years ago I used to publish a newsletter and noticed how frighteningly easy it was for gurus to massage and slant their records, even if they were tracked by independent rating services. I’ve never met a trader who took all the recommendations of his guru, even if he paid him a lot of money. If a guru has 200 subscribers, they’ll choose different recommendations, trade them differently, and most will lose money, each in his own way. There is a rule in the advisory business: “If you make forecasts for a living, make a lot of them.” Gurus offer convenient excuses to sleepwalking traders who need a scapegoat for their losses. Whether or not you listen to a guru, you’re 100% responsible for the outcome of your trades. The next time you get a hot tip, drop it into your trading system to see whether it gives you a buy or sell signal. You are responsible for the consequences of taking or rejecting advice.
Slide 62: MIND—THE DISCIPLINED TRADER 53 Blame the Unexpected News It is easy to feel angry and hurt when a sudden piece of bad news blows a hole in your stock. You buy something, it goes up, bad news hits the market, and your stock collapses. The market did it to you, you say? The news may have been sudden, but you are responsible for handling any challenges. Most company news is released on a regular schedule. If you trade a certain stock, you should know well in advance when that company releases its earnings and be prepared for any market reaction to the news. Lighten up on your position if unsure about the impact of a coming announcement. If you trade bonds, currencies, or stock index futures, you must know when the key economic statistics are released and how the leading indicators or the unemployment rate can impact your market. It may be wise to tighten your stops or reduce the size of your trade in advance of an important news release. What about a truly unexpected piece of news—a president gets shot, a noted analyst comes out with a bearish earnings forecast, and so on? You must research your market and know what happened after similar events in the past; you have to do your homework before the event hits you. Having this knowledge allows you to act without delay. For example, the stock market’s reaction to an assault on a president has always been a sharp hiccup to the downside, followed by a complete retracement, so a sensible thing to do is buy the break. Your trading plan must include the possibility of a sharp adverse move caused by sudden events. You must have your stop in place, and the size of your trade must be such that you cannot get financially hurt in the case of a reversal. There are many risks waiting to spring on a trader—you alone are responsible for damage control. Wishful Thinking When the pain grows bit by bit, the natural tendency is to do nothing and wait for an improvement. A sleepwalking trader gives his losing trades “more time to work out,” while they slowly destroy his account. A sleepwalker hopes and dreams. He sits on a loss and says, “This stock is coming back; it always did.” Winners accept occasional losses, take them, and move on. Losers postpone taking losses. An amateur puts on a trade the way a kid buys a lottery ticket. He waits for the wheel of fortune to decide whether he wins or loses. Professionals, to
Slide 63: 54 THE THREE M’S OF SUCCESSFUL TRADING the contrary, have ironclad plans for getting out, either with a profit or a small loss. One of the key differences between professionals and amateurs is their planning for exits. A sleepwalking trader buys at 35 and puts in a stop at 32. The stock sinks to 33, and he says, “I’ll give it a little more room.” He moves his stop down to 30. That is a fatal mistake—he has breached his discipline and violated his own plan. You may move stops only one way—in the direction of your trade. Stops are like a ratchet on a sailboat, designed to take the slack out of your sails. If you start giving your trade “more room to breathe,” that extra slack will swing around and hurt you. When the market rewards traders for breaking their rules, it sets up an even deeper trap in their next trade. The best time to make decisions is before you enter a trade. Your money is not at risk, and you can weigh profit targets and loss parameters. Once you’re in a trade, you begin to form an attachment to it. The market hypnotizes you and lures you into emotional decisions. This is why you must write down your exit plan and follow it. Turning a losing trade into an “investment” is a common disease among small private traders, but some institutional traders also suffer from it. Disasters at banks and major financial firms occur when poorly supervised traders lose money in short-term trades and stick them into long-term accounts, hoping that time will bail them out. If you are losing in the beginning, you’ll lose in the end. Do not put off the hour of reckoning. The first loss is the best loss—this is the rule of those of us who trade with our eyes open. A REMEDY FOR SELF-DESTRUCTIVENESS People who like to complain about their bad luck are often experts in looking for trouble and snatching defeat from the jaws of victory. A friend in the construction business used to have a driver who dreamed of buying his own truck and working for himself. He saved money for years and finally paid cash for a huge brand-new truck. He quit his job, got gloriously drunk, and at the end of the day rolled his uninsured truck down an embankment—it was totaled, and the driver came back asking for his old job. Tragedy? Drama? Or fear of freedom and an unconscious wish for a safe job with a steady paycheck? Why do intelligent people with a track record of success keep losing money on one harebrained trade after another, stumbling from calamity to catastrophe? Ignorance? Bad luck? Or a hidden desire to fail?
Slide 64: MIND—THE DISCIPLINED TRADER 55 Many people have a self-destructive streak. My experience as a psychiatrist has convinced me that most people who complain about severe problems are in fact sabotaging themselves. I cannot change a patient’s external reality, but whenever I cure one of self-sabotage, he quickly resolves his external problems. Self-destructiveness is such a pervasive human trait because civilization is built on controlling aggression. As we grow up, we are trained to control aggression against others—behave, do not push, be nice. Our aggression has to go somewhere, and many turn it against themselves, the only unprotected target. We turn our anger inward and learn to sabotage ourselves. Little wonder so many of us grow up fearful, inhibited, and shy. Society has several defenses against the extremes of self-sabotage. The police will talk a potential suicide down from the roof, and the medical board will take the scalpel away from an accident-prone surgeon, but no one will stop a self-defeating trader. He can run amok in the financial markets, inflicting wounds on himself, while brokers and other traders gladly take his money. Financial markets lack protective controls against self-sabotage. Are you sabotaging yourself? The only way to find out is to keep good records, especially a Trader’s Journal and an equity curve, shown later in this book. The angle of your equity curve is an objective indicator of your behavior. If it slopes up, with few downticks, you’re doing well. If it points down, it shows you’re not in gear with the markets and possibly in a self-sabotage mode. When you observe that, reduce the size of your trades and spend more time with your Trader’s Journal figuring out what you’re doing. You need to become a self-aware trader. Keep good records, learn from past mistakes, and do better in the future. Traders who lose money tend to feel ashamed. A bad loss feels like a nasty comment— most people just want to cover up, walk away, and never be seen again. Hiding doesn’t solve anything. Use the pain of a loss to turn yourself into a disciplined winner. Losers Anonymous Years ago I had an insight that changed my trading life forever. Back in those days my equity used to swing up and down like a yo-yo. I knew enough about markets to profit from many trades but couldn’t hold on to my gains and grow equity. The insight that eventually got
Slide 65: 56 THE THREE M’S OF SUCCESSFUL TRADING me off the roller coaster came from a chance visit to a meeting of Alcoholics Anonymous. One late afternoon I accompanied a friend to an AA meeting at a local YMCA. Suddenly, the meeting gripped me. I felt as if the people in the room were talking about my trading! All I had to do was substitute the word loss for the word alcohol. People at the AA meeting talked about how alcohol controlled their lives, and my trading in those days was driven by losses—fearing them and trying to trade my way out. My emotions followed a jagged equity curve—elation at the highs and cold clammy fear at the lows, with fingers trembling above the speed dial button. Back in those days I had a busy psychiatric practice and saw my share of alcoholics. I began to notice similarities between them and losing traders. Losers approached markets the way alcoholics walked into bars. They entered with pleasant expectations, but left with mean headaches, hangovers, and loss of control. Drinking and trading lure people across the line from pleasure to self-destructiveness. Alcoholics and losers live with their eyes closed—both are in the grip of an addiction. Every alcoholic I saw in my office wanted to argue about his diagnosis. To avoid wasting time, I used to suggest a simple test. I’d tell alcoholics to keep on drinking as usual for the next week, but write down every drink, and bring that record to our next appointment. Not a single alcoholic could keep that diary for more than a few days because looking in a mirror reduced the pleasure of impulsive behavior. Today when I tell losing traders to keep a diary of their trades, many become annoyed. Good records are a sign of self-awareness and discipline. Poor or absent records are a sign of impulsive trading. Show me a trader with good records, and I’ll show you a good trader. Alcoholics and losers do not think about the past or the future, and focus only on the present—the sensation of alcohol pouring down the gullet or the market pulsing on the screen. An active alcoholic is in denial; he doesn’t want to know about the depth of his abyss, the severity of his problem, or the harm he is causing himself and others. The only thing that can pierce an alcoholic’s denial is the pain of hitting what AA calls “rock bottom.” It is each individual’s private version of hell—a life-threatening illness, a rejection by family, a job loss, or another catastrophic event. The unbearable pain of hitting rock bottom punctures the alcoholic’s denial and forces him to face a stark choice: he can self-destruct or turn his life around.
Slide 66: MIND—THE DISCIPLINED TRADER 57 AA is a nonprofit voluntary organization whose only purpose is to help alcoholics stay sober. It doesn’t ask for donations, advertise, lobby, or take part in any public actions. It has no paid therapists; members help each other at meetings led by long-term members. AA has a system of sponsorships whereby older members sponsor and support newer ones. An alcoholic who joins AA goes through what is called a 12-Step program. Each step is a stage of personal growth and recovery. The method is so effective that people recovering from other addictive behaviors have begun to use it. The first step is the most important for traders. It looks easy, but is extremely hard to take. Many alcoholics can’t take it, drop out of AA, and go on to destroy their lives. The first step consists of standing up at a meeting, facing a room full of recovering alcoholics, and admitting that alcohol is stronger than you. This is hard because if alcohol is stronger than you, you cannot touch it again. Once you take the first step, you are committed to a struggle for sobriety. Alcohol is such a powerful drug that AA recommends planning to live without it one day at a time. A recovering alcoholic does not plan to be sober a year or five years from now. He has a simpler goal—go to bed sober tonight. Eventually those days of sobriety add up to years. The entire system of AA meetings and sponsorships is geared toward the goal of sobriety one day at a time. AA aims to change not only the behavior but the personality in order to reinforce sobriety. AA members call some people “sober drunks.” It sounds like a contradiction in terms. If a person is sober, how can he be a drunk? Sobriety alone is not enough. A person who has not changed his thinking is just one step away from sliding back into drinking under stress or out of boredom. An alcoholic has to change his way of being and feeling to recover from alcoholism. I never had a problem with alcohol, but my psychiatric experience had taught me to respect AA for its success with alcoholics. It was not a popular view. Each patient who went to AA reduced the profession’s income, but that never bothered me. After my first AA meeting I realized that if millions of alcoholics could recover by following the program, then traders could stop losing, regain balance, and become winners by applying the principles of AA. How can we translate the lessons of AA into the language of trading? A losing trader is in denial. His equity is shrinking, but he continues to jump into trades without analyzing what is going wrong. He keeps
Slide 67: 58 THE THREE M’S OF SUCCESSFUL TRADING switching between markets the way an alcoholic switches between whiskey and cheap wine. An amateur whose mind isn’t strong enough to accept a small loss will eventually take the mother of all losses. A gaping hole in a trading account hurts self-esteem. A single huge loss or a series of bad losses smash a trader against his rock bottom. Most beginners collapse and wash out. The lifetime of an average speculator is measured in months, not years. Those who survive fall into two groups. Some return to their old ways, just like alcoholics crawl into a bar after surviving a bout of delirium. They toss more money into their accounts and become customers of vendors who sell magical trading systems. They continue to gamble, only now their hands shake from anxiety and fear when they try to pull the trigger. A minority of traders that hit rock bottom decide to change. Recovery is a slow and solitary process. Charles Mackay, the author of one of the best books on crowd psychology, wrote almost two centuries ago that men go mad in crowds, but come to their senses slowly, and one by one. I wish we had an organization for recovering traders, the way recovering alcoholics have AA. We don’t because trading is so competitive. Members of AA strive for sobriety together, but a meeting of recovering traders could easily be poisoned by envy and showing off. Markets are such cutthroat places that we don’t form mutual support groups or find sponsors. Some opportunists hold themselves out as traders’ coaches, but most make me shudder at their sharkiness. If we had a traders’ organization, I’d call it Losers Anonymous (LA). The name is blunt, but that’s fine. After all, Alcoholics Anonymous does not call itself Drinkers Anonymous. A harsh name helps traders face their impulsivity and selfsabotage. Since we do not have LA, you’ll have to walk on the road to recovery alone. I wrote this book to help you along the way. Businessman’s Risk vs. Loss Years ago, when I began my recovery from losing, each morning I held what I called a Losers Anonymous meeting for one. I’d come into the office, turn on my quote screen, and while it was warming up I’d say, “Good morning, my name is Alex, and I am a loser. I have it in me to do serious damage to my account. I’ve done it before. My only goal for today is to go home without a loss.” When the screen was up, I’d begin trading, following the plan written down the night before while the markets were closed.
Slide 68: MIND—THE DISCIPLINED TRADER 59 I can immediately hear an objection—what do you mean, go home without a loss? It is impossible to make money every day. What happens if you buy something, and it goes straight down—in other words, you’ve bought the top tick of the day? What if you sell something short and it immediately rallies? We must draw a clear line between a loss and a businessman’s risk. A businessman’s risk is a small dip in equity. A loss goes through that limit. As a trader, I am in the business of trading and must take normal business risks, but I cannot afford losses. Imagine you’re not trading but running a fruit and vegetable stand. You take a risk each time you buy a crate of tomatoes. If your customers do not buy them, that crate will rot on you. That’s a normal business risk—you expect to sell most of your inventory, but some fruit and vegetables will spoil. As long as you buy carefully, keeping the unsold spoiled fruit to a small percentage of your daily volume, your business stays profitable. Imagine that a wholesaler brings a tractor-trailer full of exotic fruit to your stand and tries to sell you the entire load. He says that you can earn more in the next two days than you made in the previous six months. It sounds great—but what if your customers don’t buy that exotic fruit? A rotting tractor-trailer load can hurt your business and endanger its survival. It’s no longer a businessman’s risk—it’s a loss. Money management rules draw a straight line between a businessman’s risk and a loss, as you will see later in this book. Some traders have argued that my AA approach is too negative. A young woman in Singapore told me she believed in positive thinking and thought of herself as a winner. She could afford to be positive because discipline was imposed on her from the outside, by the manager of the bank for which she traded. Another winner who argued with me was a lady from Texas in her seventies, a wildly successful trader of stock index futures. She was very religious and viewed herself as a steward of money. Each morning she got up early and prayed long and hard. Then she drove to the office and traded the living daylights out of the S&P. The minute a trade went against her, she’d cut and run—because the money belonged to the Lord and wasn’t hers to lose. She kept her losses small and accumulated profits. I thought that our approaches had a lot in common. Both of us had principles outside the market preventing us from losing money. Markets are the most permissive places in the world. You may do any-
Slide 69: 60 THE THREE M’S OF SUCCESSFUL TRADING thing you like, as long as you have enough equity to put on a trade. It’s easy to get caught in the excitement, which is why you need rules. I rely on the principles of AA, another trader relies on her religious feelings, and you may choose something else. Just make sure you have a set of principles that clearly tells you what you may or may not do in the markets. Sober in Battle Most traders open accounts with money earned in business or the professions. Many bring a personal track record of success and expect to do well in the markets. If we can run a hotel, perform eye surgery, or try cases in court, we can surely find our way between the high, the low, and the close! But the markets, which seem so simple at first, keep humbling us. Little blood gets spilled in trading, but the money, the lifeblood of the markets, has a major impact on the quality and the length of our lives. Recently, a friend who writes a stock market advisory showed me a stack of letters from his subscribers. The one that caught my eye came from a man who made enough money trading to pay for a kidney transplant. It saved his life, but I thought of what happened to legions of others who also had big needs but traded poorly and lost money. Trading is a battle. When you pick up your weapon and put your life on the line, would you rather be drunk or sober? You have to prepare yourself, choose your fight, go in when you are ready, and quit after you’ve done what you’ve planned. A man who is cool and sober calmly picks his fights. He enters and leaves when he chooses and not when some bully throws him a challenge. A disciplined player chooses his own game out of hundreds available. He doesn’t have to chase every rabbit like a dog with its tongue hanging out—he lays an ambush for his game and lets it come to him. Most amateurs won’t admit they are trading for entertainment. A common cover story is that they’re in the markets to make money. In reality, most traders get tremendous thrills tossing money at half-baked ideas. Trading financial markets is more respectable than betting on ponies, but the kicks are just as good. I tell my horse-playing friends to imagine going to a race where you can place bets after the horses are out of the gate and take your money
Slide 70: MIND—THE DISCIPLINED TRADER 61 off the table before the race ends. Trading is a fantastic game, but its temptations are very intense. THE MATURE TRADER Successful traders are sharp, curious, and unassuming people. Most have been through losing periods. They graduated from the school of hard knocks, and that experience helped smooth their rough edges. Successful traders are self-assured but never arrogant. People who survive in the markets remain alert. They trust their skills and trading methods, but keep their eyes and ears open for new developments. Confident and attentive, calm and flexible, successful traders are fun to be with. Successful traders are often unconventional people, and some are very eccentric. When they mix with others, they often break social rules. The markets are set up for the majority to lose money, and a small group of winners marches to a different drummer, in and out of the markets. Markets consist of huge crowds of people watching the same trading vehicles, mesmerized by upticks and downticks. Think of a crowd at a concert or in a movie theater. When the show begins, the crowd gets emotionally in gear and develops an amorphous but powerful mass mind, laughing or weeping together. A mass mind also emerges in the markets, only here it is more malignant. Instead of laughing or weeping, the crowd seeks each trader’s private psychological weakness and hits him in that spot. Markets seduce greedy traders into buying positions that are too large for their accounts and then destroy them with a reaction they cannot afford to sit out. They shake fearful traders out of winning trades with brief countertrend spikes before embarking on runaway moves. Lazy traders are the favorite victims of the market, which keeps throwing new tricks at the unprepared. Whatever your psychological flaws and fears, whatever your inner demons, whatever your hidden weaknesses and obsessions, the market will seek them out, find them, and use them against you, like a skilled wrestler uses his opponent’s own weight to toss him to the ground. Successful traders have outgrown or overcome their inner demons. Instead of being tossed by the markets, they maintain their own balance and scan for chinks in the crowd’s armor, so that they can toss the market for a change. They may appear eccentric, but when it comes to trading they are much healthier than the crowd.
Slide 71: 62 THE THREE M’S OF SUCCESSFUL TRADING Being a trader is a journey of self-discovery. Trade long enough, and you will face all your psychological handicaps—anxiety, greed, fear, anger, and sloth. Remember, you’re not in the markets for psychotherapy; self-discovery is a byproduct, not the goal of trading. The primary goal of a successful trader is to accumulate equity. Healthy trading boils down to two questions you need to ask in every trade: “What is my profit target?” and “How will I protect my capital?” A good trader accepts full responsibility for the outcome of every trade. You cannot blame others for taking your money. You have to improve your trading plans and methods of money management. It will take time, and it will take discipline. Discipline A friend of mine used to have a dog-training business. Occasionally a prospective client would call her and say, “I want to train my dog to come when called, but I do not want to train it to sit or lie down.” And she’d answer, “Training a dog to come off-leash is one of the hardest things to teach; you must do a lot of obedience training first. What you’re saying sounds like, ‘I want my dog be a neurosurgeon, but I do not want it to go to high school.’” Many new traders expect to sit in front of their screens and make easy money day-trading. They skip high school and head straight for neurosurgery. Discipline is necessary for success in most endeavors, but especially in the markets because they have no external controls. You have to watch yourself because no one else will, except for the margin clerk. You may put on the stupidest and self-destructive trades, but as long as you have enough money in your account, no one will stop you. No one will say hold on, wait, think what you’re doing! Your broker will repeat your order to confirm he got it right. Once your order hits the market, other traders will scramble for the privilege of taking your money. Most fields of human endeavor have rules, yardsticks, and professional bodies to enforce discipline. No matter how independent you feel, there is always some agency looking over your shoulder. If a doctor in private practice starts writing too many prescriptions for painkillers, he’ll soon hear from the health department. Markets impose no restrictions, as long as you have enough equity. Adding to losing positions is similar to overprescribing narcotics, but nobody will stop you. As a matter of fact, other market participants want you to be undisci-
Slide 72: MIND—THE DISCIPLINED TRADER 63 plined and impulsive. That makes it easier for them to get your money. Your defense against self-destructiveness is discipline. You have to set up your own rules and follow them in order to prevent self-sabotage. Discipline means designing, testing, and following your trading system. It means learning to enter and exit in response to predefined signals rather than jumping in and out on a whim. It means doing the right thing, not the easy thing. And the first challenge on the road to disciplined trading involves setting up a record-keeping system. Record-Keeping Good traders keep good records. They keep them not just for their accountants but as tools of learning and discipline. If you do not have good records, how can you measure your performance, rate your progress, and learn from your mistakes? Those who do not learn from the past are doomed to repeat it. When you decide to become a trader, you sign up for an expensive course. By the time you figure out the game, its cost may equal that of a college education, only most students never graduate—they drop out and get nothing for their money except for memories of a few wild rides. Whenever you decide to improve your performance in any area of life, record keeping helps. If you want to become a better runner, keeping records of your speeds is essential for designing better workouts. If money is a problem, keeping and reviewing records of all expenditures is certain to uncover wasteful tendencies. Keeping scrupulous records turns a spotlight on a problem and allows you to improve. Becoming a good trader means taking several courses—psychology, technical analysis, and money management. Each course requires its own set of records. You’ll have to score high on all three in order to graduate. Your first essential record is a spreadsheet of all your trades. You have to keep track of entries and exits, slippage and commissions, as well as profits and losses. Chapter 5, “Method—Technical Analysis” on trading channels will teach you to rate the quality of every trade, allowing you to compare performance across different markets and conditions. Another essential record shows the balance in your account at the end of each month. Plot it on a chart, creating an equity curve whose angle will tell you whether you are in gear with the market. The goal is a steady uptrend, punctuated by shallow declines. If your curve slopes down, it shows you’re not in tune with the markets and must
Slide 73: 64 THE THREE M’S OF SUCCESSFUL TRADING reduce the size of your trades. A jagged equity curve tends to be a sign of impulsive trading. Your trading diary is the third essential record. Whenever you enter a trade, print out the charts that prompted you to buy or sell. Paste them on the left page of a large notebook and write a few words explaining why you bought or sold, stating your profit objective and a stop. When you close out that trade, print out the charts again, paste them on the right page and write what you’ve learned from the completed trade. These records are essential for all traders, and we will return to them later in Chapter 8, “The Organized Trader.” A shoebox crammed with confirmation slips does not qualify as a record-keeping system. Too many records? Not enough time? Want to skip high school and dive into neurosurgery? Traders fail because of impatience and lack of discipline. Good records set you apart from the market crowd and put you on the road to success. Training for Battle How much training you need depends on the job you want. If you want to be a janitor, an hour of training might do. Just learn to attach a mop to the right end of the broomstick and find a pail without holes. If, on the other hand, you want to fly an airplane or do surgery, you’ll have to learn a great deal more. Trading is closer to flying a plane than to mopping a floor, meaning you’ll need to invest a lot of time and energy in mastering this craft. Society mandates extensive training for pilots and doctors because their errors are so deadly. As a trader, you are free to be financially deadly to yourself—society does not care, because your loss is someone else’s gain. Flying and medicine have standards and yardsticks, as well as professional bodies to enforce them. In trading, you have to set up your own rules and be your own enforcer. Pilots and doctors learn from instructors who impose discipline on them through tests and evaluations. Private traders have no external system for learning, testing, or discipline. Our job is hard because we must learn on our own, develop discipline, and test ourselves again and again in the markets. When we look at training for pilots and doctors, three features stand out. They are the gradual assumption of responsibility, constant evalu-
Slide 74: MIND—THE DISCIPLINED TRADER 65 ations, and training until actions become automatic. Let us see whether we can apply them to trading. 1. The Gradual Assumption of Responsibility A flying school doesn’t put a beginner into a pilot’s seat on his first day. A medical student is lucky if he is allowed to take a patient’s temperature on his first day in the hospital. His superiors double-check him before he can advance to the next, slightly higher level of responsibility. How does this compare to the education of a new trader? There is nothing gradual about it. Most people start out on an impulse, after hearing a hot tip or a rumor of someone making money. A beginner has some cash burning a hole in his pocket. He gets a broker’s name out of a newspaper, FedExes him a check, and enters his first trade. Now he is starting to learn! When do they close this market? What is a gap opening? How come the market is up and my stock is down? A “sink or swim” approach does not work in complex enterprises, such as flying or trading. It is exciting to jump in, but excitement is not what good traders are after. If you do not have a specific trading plan, you’re better off taking your money to Vegas. The outcome will be the same, but at least there they’ll throw in some free drinks. If you are serious about learning to trade, start with a relatively small account and set a goal of learning to trade rather than making a lot of money in a hurry. Keep a trading diary and put a performance grade on every trade. 2. Constant Evaluations and Ratings The progress of a flying cadet or a medical student is measured by hundreds of tests. Teachers constantly rate knowledge, skills, and decision-making ability. A student with good results is given more responsibility, but if his performance slips, he has to study more and take more tests. Do traders go through a similar process? As long as you have money in your account, you can make impulsive trades, trying to weasel your way out of a hole. You can throw confirmation slips into a shoebox, and give them to your accountant at tax time. No one can force you to look at your test results, unless you do it yourself. The market tests us all the time, but only a few pay attention. It gives a performance grade to every trade and posts those ratings, but few
Slide 75: 66 THE THREE M’S OF SUCCESSFUL TRADING people know where to look them up. Another highly objective test is our equity curve. If you trade several markets, you can take this test in every one of them, as well as in your account as a whole. Do most of us take this test? No. Pilots and doctors must answer to their licensing bodies, but traders sneak out of class because no one takes attendance and their internal discipline is weak. Meanwhile, tests are a key part of trading discipline, essential for your victory in the markets. Keeping and reviewing records, as outlined later in this book, puts you a mile ahead of undisciplined competitors. 3. Training until Actions Become Automatic During one of my finals in medical school I was sent to examine a patient in a half-empty room. Suddenly I heard a noise from behind the curtain. I looked, and there was another patient—dying. “No pulse,” I yelled to another student, and together we put the man on the floor. I began pumping his chest, while the other fellow gave him mouth to mouth, one forced breath for four chest pumps. Neither of us could run for help, but someone opened the door and saw us. A reanimation team raced in, zapped the man with a defibrillator and pulled him out. I never had to revive anyone before, but it worked the first time because I had five years of training. When the time came to act, I didn’t have to think. The point of training is to make actions automatic, allowing us to concentrate on strategy. What will you do if your stock jumps five points in your favor? Five points against you? What if your future goes limit up? Limit down? If you have to stop and think while you’re in a trade, you’re dead. You need to spend time preparing trading plans and deciding in advance what you will do when the market does any imaginable thing. Play those scenarios in your head, use your computer, and get yourself to the point where you do not have to ruminate about what to do if the market jumps. The mature trader arrives at a stage where most trading actions have become nearly automatic. This gives you the freedom to think about strategy. You think about what you want to achieve, and less about tactics of how to achieve it. To reach that point, you need to trade for a long time. The longer you trade and the more trades you put on, the more you’ll learn. Trade a small size while learning and put on many trades. Remember, the first item on the agenda for a beginner is to learn how to trade, not to make money. Once you’ve learned to trade, money will follow.
Slide 76: CHAPTER FIVE METHOD— TECHNICAL ANALYSIS W ill this stock rise or fall? Should you go long or short? Traders reach for a multitude of tools to find answers to these questions. Many tie themselves into knots trying to choose between pattern recognition, computerized indicators, artificial intelligence, or even astrology for some desperate souls. No one can learn all the analytic methods, just as no one can master every field of medicine. A physician cannot become a specialist in heart surgery, obstetrics, and psychiatry. No trader can know everything about the markets. You have to find a niche that attracts you and specialize in it. Markets emit huge volumes of information. Our tools help organize these flows into a manageable form. It is important to select analytic tools and techniques that make sense to you, put them together into a coherent system, and focus on money management. When we make our trading decisions at the right edge of the chart, we deal with probabilities, not certainties. If you want certainty, go to the middle of the chart and try to find a broker who will accept your orders. This chapter on technical analysis shows how one trader goes about analyzing markets. Use it as a model for choosing your favorite tools, rather than following it slavishly. Test any method you like on your own data because only personal testing will convert information into knowledge and make these methods your own. Many concepts in this book are illustrated with charts. I selected them from a broad range of markets—stocks as well as futures. Technical analysis is a universal language, even though the accents differ. You can apply what you’ve learned from the chart of IBM to silver or Japanese yen. I trade mostly in the United States, but have used the same methods in Germany, 67
Slide 77: 68 THE THREE M’S OF SUCCESSFUL TRADING Russia, Singapore, and Australia. Knowing the language of technical analysis enables you to read any market in the world. Analysis is hard, but trading is much harder. Charts reflect what has happened. Indicators reveal the balance of power between bulls and bears. Analysis is not an end in itself, unless you get a job as an analyst for a company. Our job as traders is to make decisions to buy, sell, or stand aside on the basis of our analysis. After reviewing each chart, you need to go to its hard right edge and decide whether to bet on bulls, bet on bears, or stand aside. You must follow up chart analysis by establishing profit targets, setting stops, and applying money management rules. BASIC CHARTING A trade is a bet on a price change. You can make money buying low and selling high or shorting high and covering low. Prices are central to our enterprise, yet few traders stop to think what prices are. What exactly are we trying to analyze? Financial markets consist of huge crowds of people who meet on the floor of an exchange, on the phone, or via the Internet. We can divide them into three groups: buyers, sellers, and undecided traders. Buyers want to buy as cheaply as possible. Sellers want to sell as expensively as possible. They could take forever to negotiate, but feel pressure from undecided traders. They have to act quickly, before some undecided trader makes up his mind, jumps into the game, and takes away their bargain. Undecided traders are the force that speeds up trading. They are true market participants, as long as they watch the market and have the money to trade it. Each deal is struck in the midst of the market crowd, putting pressure on both buyers and sellers. This is why each trade represents the current emotional state of the entire market crowd. Price is a consensus of value of all market participants expressed in action at the moment of the trade. Many traders have no clear idea what they are trying to analyze. Balance sheets of companies? Pronouncements of the Federal Reserve? Weather reports from soybean-growing states? The cosmic vibrations of Gann theory? Every chart serves as an ongoing poll of the market. Each tick represents a momentary consensus of value of all market participants. High and low prices, the height of every bar, the angle of every trendline, the duration of every pattern reflect aspects of crowd behavior. Recognizing these patterns can help us decide when to bet on bulls or bears.
Slide 78: METHOD—TECHNICAL ANALYSIS 69 During an election campaign pollsters call thousands of people asking how they’ll vote. Well-designed polls have predictive value, which is why politicians pay for them. Financial markets run on a two-party system—bulls and bears, with a huge silent majority of undecided traders who may throw their weight to either party. Technical analysis is a poll of market participants. If bulls are on top, we should cover shorts and go long. If bears are stronger, we should go short. If an election is too close to call, a wise trader stands aside. Standing aside is a legitimate market position and the only one in which you can’t lose money. Individual behavior is difficult to predict. Crowds are much more primitive and their behavior more repetitive and predictable. Our job is not to argue with the crowd, telling it what’s rational or irrational. We need to identify crowd behavior and decide how likely it is to continue. If the trend is up and we find that the crowd is growing more optimistic, we should trade that market from the long side. When we find that the crowd is becoming less optimistic, it is time to sell. If the crowd seems confused, we should stand aside and wait for the market to make up its mind. The Meaning of Prices Highs and lows, opening and closing prices, intraday swings and weekly ranges reflect crowd behavior. Our charts, indicators, and technical tools are windows into the mass psychology of the markets. You have to be clear about what you are studying if you want to get closer to the truth. Many market participants have backgrounds in science and engineering and are often tempted to apply the principles of physics. For example, they may try to filter out the noise of a trading range to obtain a clear signal of a trend. Those methods can help, but they cannot be converted into automatic trading systems because the markets are not physical processes. They are reflections of crowd psychology, which follows different, less precise laws. In physics, if you calculate everything, you’ll predict where a process will take you. Not so in the markets, where a crowd can always throw you a curve. Here you have to act within this atmosphere of uncertainty, which is why you must protect yourself with good money management. The Open The opening price, the first price of the day, is marked on a bar chart by a tick pointing to the left. An opening price reflects the influx of overnight orders. Who placed those orders? A dentist who read a tip in a magazine after dinner, a teacher whose broker touted a trade but who needed his wife’s permission to buy, a financial officer of a slow-moving
Slide 79: 70 THE THREE M’S OF SUCCESSFUL TRADING institution who sat in a meeting all day waiting for his idea to be approved by a committee. They are the people who place orders before the open. Opening prices reflect opinions of less informed market participants. When outsiders buy or sell, who takes the opposite side of their trades? Market professionals step in to help, only they do not run a charity. If floor traders see more buy orders coming in, they open the market higher, forcing outsiders to overpay. The pros go short, so that the slightest dip makes them money. If the crowd is fearful before the opening and sell orders predominate, the floor opens the market very low. They acquire their goods on the cheap, so that the slightest bounce earns them short-term profits. The opening price establishes the first balance of the day between outsiders and insiders, amateurs and professionals. If you are a short-term trader, pay attention to the opening range—the high and the low of the first 15 to 30 minutes of trading. Most opening ranges are followed by breakouts, which are important because they show who is taking control of the market. Several intraday trading systems are based on following opening range breakouts. One of the best opportunities to enter a trade occurs when the market gaps at the open in the direction opposite your intended trade. Suppose you analyze a market at night and your system tells you to buy a stock. A piece of bad news hits the market overnight, sell orders come in, and that stock opens sharply lower. Once prices stabilize within the opening range, if you are still bullish and that range is above your planned stop-loss point, place your buy order a few ticks above the high of the opening range, with a stop below. You may pick up good merchandise on sale! The High Why do prices go up? The standard answer—more buyers than sellers—makes no sense because for every trade there is a buyer and a seller. The market goes up when buyers have more money and are more enthusiastic than sellers. Buyers make money when prices go up. Each uptick adds to their profits. They feel flushed with success, keep buying, call friends and tell them to buy—this thing is going up! Eventually, prices rise to a level where bulls have no more money to spare and some start taking profits. Bears see the market as overpriced and hit it with sales. The market stalls, turns, and begins to fall, leaving behind the high point of the day. That point marks the greatest power of bulls for that day. The high of every bar reflects the maximum power of bulls during that bar. It shows how high bulls could lift the market during that time period. The high of a daily bar reflects the maximum power of bulls during that
Slide 80: METHOD—TECHNICAL ANALYSIS 71 day, the high of a weekly bar shows the maximum power of bulls during that week, and the high of a five-minute bar shows their maximum power in those five minutes. The Low Bears make money when prices fall, with each downtick making money for short sellers. As prices slide, bulls become more and more skittish. They cut back their buying and step aside, figuring they’ll be able to pick up what they want cheaper at a later time. When buyers pull in their horns, it becomes easier for bears to push prices lower, and the decline continues. It takes money to sell stocks short, and a fall in prices slows down when bears start running low on money. Bullish bargain hunters appear on the scene. Experienced traders recognize what’s happening and start covering shorts and going long. Prices rally from their lows, leaving behind the low mark—the lowest tick of the day. The low point of each bar reflects the maximum power of bears during that bar. The lowest point of a daily bar reflects the maximum power of bears during that day, the low point of a weekly bar shows the maximum power of bears during that week, and the low of a five-minute bar shows the maximum power of bears during those five minutes. Several years ago I designed an indicator, called Elder-ray, for tracking the relative power of bulls and bears by measuring how far the high and the low of each bar get away from the average price. The Close The closing price is marked on a bar chart by a tick pointing to the right. It reflects the final consensus of value for the day. This is the price at which most people look in their daily newspapers. It is especially important in the futures markets, because the settlement of trading accounts depends on it. Professional traders monitor markets throughout the day. Early in the day they take advantage of opening prices, selling high openings and buying low openings, and then unwinding those positions. Their normal mode of operations is to fade—trade against—market extremes and for the return to normalcy. When prices reach a new high and stall, professionals sell, nudging the market down. When prices stabilize after a fall, they buy, helping the market rally. The waves of buying and selling by amateurs that hit the market at the opening usually subside as the day goes on. Outsiders have done what they planned to do, and near the closing time the market is dominated by professional traders.
Slide 81: 72 THE THREE M’S OF SUCCESSFUL TRADING Closing prices reflect the opinions of professionals. Look at any chart, and you’ll see how often the opening and closing ticks are at the opposite ends of a price bar. This is because amateurs and professionals tend to be on the opposite sides of trades. Candlesticks and Point and Figure Bar charts are most widely used for tracking prices, but there are other methods. Candlestick charts became popular in the West in the 1990s. Each candle represents a day of trading with a body and two wicks, one above and another below. The body reflects the spread between the opening and closing prices. The tip of the upper wick reaches the highest price of the day and the lower wick the lowest price of the day. Candlestick chartists believe that the relationship between the opening and closing prices is the most important piece of daily data. If prices close higher than they opened, the body of the candle is white, but if prices close lower, the body is black. The height of a candle body and the length of its wicks reflect the battles between bulls and bears. Those patterns, as well as patterns formed by several neighboring candles, provide useful insights into the power struggle in the markets and can help us decide whether to go long or short. The trouble with candles is they are too fat. I can glance at a computer screen with a bar chart and see five to six months of daily data, without squeezing the scale. Put a candlestick chart in the same space, and you’ll be lucky to get two months of data on the screen. Ultimately, a candlestick chart doesn’t reveal anything more than a bar chart. If you draw a normal bar chart and pay attention to the relationships of opening and closing prices, augmenting that with several technical indicators, you’ll be able to read the markets just as well and perhaps better. Candlestick charts are useful for some but not all traders. If you like them, use them. If not, focus on your bar charts and don’t worry about missing something essential. Point and figure (P&F) charts are based solely on prices, ignoring volume. They differ from bar and candlestick charts by having no horizontal time scale. When markets become inactive, P&F charts stop drawing because they add a new column of X’s and O’s only when prices change beyond a certain trigger point. P&F charts make congestion areas stand out, helping traders find support and resistance and providing targets for reversals and profit taking. P&F charts are much older than bar charts. Professionals in the pits sometimes scribble them on the backs of their trading decks.
Slide 82: METHOD—TECHNICAL ANALYSIS 73 Choosing a chart is a matter of personal choice. Pick the one that feels most comfortable. I prefer bar charts but know many serious traders who like P&F charts or candlestick charts. The Reality of the Chart Price ticks coalesce into bars, and bars into patterns, as the crowd writes its emotional diary on the screen. Successful traders learn to recognize a few patterns and trade them. They wait for a familiar pattern to emerge like fishermen wait for a nibble at a riverbank where they fished many times in the past. Many amateurs jump from one stock to another, but professionals tend to trade the same markets for years. They learn their intended catch’s personality, its habits and quirks. When professionals see a short-term bottom in a familiar stock, they recognize a bargain and buy. Their buying checks the decline and pushes the stock up. When prices rise, the pros reduce their buying, but amateurs rush in, sucked in by the good news. When markets become overvalued, professionals start unloading their inventory. Their selling checks the rise and pushes the market down. Amateurs become spooked and start dumping their holdings, accelerating the decline. Once weak holders have been shaken out, prices slide to the level where professionals see a bottom, and the cycle repeats. That cycle is not mathematically perfect, which is why mechanical systems tend not to work. Using technical indicators requires judgment. Before we review specific chart patterns, let us agree on the basic definitions: An uptrend is a pattern in which most rallies reach a higher point than the preceding rally; most declines stop at a higher level than the preceding decline. A downtrend is a pattern in which most declines fall to a lower point than the preceding decline; most rallies rise to a lower level than the preceding rally. An uptrendline is a line connecting two or more adjacent bottoms, slanting upwards; if we draw a line parallel to it across the tops, we’ll have a trading channel. A downtrendline is a line connecting two or more adjacent tops, slanting down; one can draw a parallel line across the bottoms, marking a trading channel. Support is marked by a horizontal line connecting two or more adjacent bottoms. One can often draw a parallel line across the tops, marking a trading range.
Slide 83: 74 THE THREE M’S OF SUCCESSFUL TRADING Resistance is marked by a horizontal line connecting two or more adjacent tops. One can often draw a parallel line below, across the bottoms, to mark a trading range. Tops and Bottoms The tops of rallies mark the areas of the maximum power of bulls. They would love to lift prices even higher and make more money, but that’s where they get overpowered by bears. The bottoms of declines, on the other hand, are the areas of maximum power of bears. They would love to push prices even lower and profit from short positions, but they get overpowered by bulls. Use a computer or a ruler to draw a line, connecting nearby tops. If it slants up, it shows that bulls are becoming stronger, which is a good thing to know if you plan to trade from the long side. If that line slants down, it shows that bulls are becoming weaker, and buying is not such a good idea. Trendlines applied to market bottoms help visualize changes in the power of bears. When a line connecting two nearby bottoms slants down, it shows that bears are growing stronger, and short selling is a good option. If that line slants up, however, it shows that bears are becoming weaker. When the lines connecting the tops and the lines connecting the bottoms are close to horizontal, the market is locked in a trading range. We can either wait for a breakout or trade short-term swings within that range. Uptrendlines and Downtrendlines Prices often appear to travel along invisible roads. When peaks rise higher at each successive rally, prices are in an uptrend. When bottoms keep falling lower and lower, prices are in a downtrend. We can identify uptrends by drawing trendlines connecting the bottoms of declines. We use bottoms to identify an uptrend because the peaks of rallies tend to be expansive, uneven affairs during uptrends. The declines tend to be more orderly, and when you connect them with a trendline, you get a truer picture of that uptrend. We identify downtrends by drawing trendlines across the peaks of rallies. Each new low in a downtrend tends to be lower than the preceding low, but the panic among weak holders can make bottoms irregularly sharp. Drawing a downtrendline across the tops of rallies paints a more correct picture of that downtrend. The most important feature of a trendline is the direction of its slope. When it rises, the bulls are in control, and when it declines, the bears are
Slide 84: METHOD—TECHNICAL ANALYSIS 75 in charge. The longer the trendline and the more points of contact it has with prices, the more valid it is. The angle of a trendline reflects the emotional temperature of the crowd. Quiet, shallow trends can last a long time. As trends accelerate, trendlines have to be redrawn, making them steeper. When they rise or fall at 60° or more, their breaks tend to lead to major reversals. This sometimes happens near the tail ends of runaway moves. Figure 5.1 Trendlines; Kangaroo Tails Draw uptrendlines across the bottoms to mark uptrends. Draw downtrendlines across the tops to mark downtrends. Notice that prices can briefly penetrate a trendline without breaking the trend. Observe that prices seem attached to their trendlines with rubber bands that extend only so far in any given trend. You want to establish positions in the direction of the slope of a trendline, entering reasonably close to it. By the time the trend reaches a new high or low, that swing away from the trendline is getting old—there is not much life left in the old dog. At the right edge of this chart the trend is down and the swing has fallen as far below its trendline as any since May. If you are short, it is time to start thinking of taking profits. Notice several bars that stick out of the tight weave of prices at the bottoms in May, November, and April, as well as the latest top in May. Those are kangaroo tails, which tend to mark turning points. The market tests a new high or a new low with a bar that is much taller than the preceding and following bars, and then recoils from that price extreme. You can recognize a tail during the bar that follows, and trade against it.
Slide 85: 76 THE THREE M’S OF SUCCESSFUL TRADING You can plot these lines using a ruler or a computer. It is better to draw trendlines as well as support and resistance lines across the edges of congestion areas instead of price extremes. Congestion areas reflect crowd behavior, while the extreme points show only the panic among the weakest crowd members. Tails—The Kangaroo Pattern Trends take a long time to form, but tails are created in just a few days. They provide valuable insights into market psychology, mark reversal areas, and point to trading opportunities. A tail is a one-day spike in the direction of a trend, followed by a reversal. It takes a minimum of three bars to create a tail—relatively narrow bars in the beginning and at the end, with an extremely wide bar in the middle. That middle bar is the tail, but you won’t know for sure until the following day, when a bar has sharply narrowed back at the base, letting the tail hang out. A tail sticks out from a tight weave of prices—you can’t miss it. A kangaroo, unlike a horse or a dog, propels itself by pushing with its tail. You can always tell which way a kangaroo is going to jump—opposite its tail. When the tail points north, the kangaroo jumps south, and when the tail points south, it jumps north. Market tails tend to occur at turning points in the markets, which recoil from them like kangaroos recoil from their tails. A tail does not forecast the extent of a move, but the first jump usually lasts a few days, offering a trading opportunity. You can do well by recognizing tails and trading against them. Before you trade any pattern, you must understand what it tells you about the market. Why do markets jump away from their tails? Exchanges are owned by members who profit from volume rather than trends. Markets fluctuate, looking for price levels that will bring the highest volume of orders. Members do not know where those levels are, but they keep probing higher and lower. A tail shows that the market has tested a certain price level and rejected it. If a market stabs down and recoils, it shows that lower prices do not attract volume. The natural thing for the market to do next is rally and test higher levels to see whether higher prices will bring more volume. If the market stabs higher and recoils, leaving a tail pointing upward, it shows that higher prices do not attract volume. The members are likely to sell the market down in order to find whether lower prices will attract volume. Tails work because the owners of the market are looking to maximize income. Whenever you see a very tall bar (several times the average for recent months) shooting in the direction of the existing trend, be alert to the possibility of a tail. If the following day the market traces a very narrow bar
Slide 86: METHOD—TECHNICAL ANALYSIS 77 at the base of the tall bar, it completes a tail. Be ready to put on a position, trading against that tail, before the close. When a market hangs down a tail, go long in the vicinity of the base of that tail. Once long, place a protective stop approximately half-way down the tail. If the market starts chewing its tail, run without delay. The targets for profit taking on these long positions are best established by using moving averages and channels (see “Indicators—Five Bullets to a Clip,” page 84). When a market puts up a tail, go short in the area of the base of that tail. Once short, place a protective stop approximately half-way up the tail. If the market starts rallying up its tail, it is time to run; do not wait for the entire tail to be chewed up. Establish profit-taking targets using moving averages and channels. You can trade against tails in any timeframe. Daily charts are most common, but you can also trade them on intraday or weekly charts. The magnitude of a move depends on its timeframe. A tail on a weekly chart will generate a much bigger move than a tail on a five-minute chart. Support, Resistance, and False Breakouts When most traders and investors buy and sell, they make an emotional as well as a financial commitment to their trade. Their emotions can propel market trends or send them into reversals. The longer a market trades at a certain level, the more people buy and sell. Suppose a stock falls from 80 and trades near 70 for several weeks, until many believe that it has found support and reached its bottom. What happens if heavy selling comes in and shoves that stock down to 60? Smart longs will run fast, banging out at 69 or 68. Others will sit through the entire painful decline. If losers haven’t given up near 60 and are still alive when the market trades back towards 70, their pain will prompt them to jump at a chance to “get out even.” Their selling is likely to cap a rally, at least temporarily. Their painful memories are the reason why the areas that served as support on the way down become resistance on the way up, and vice versa. Regret is another psychological force behind support and resistance. If a stock trades at 80 for a while and then rallies to 95, those who did not buy it near 80 feel as if they missed the train. If that stock sinks back near 80, traders who regret a missed opportunity will return to buy in force. Support and resistance can remain active for months or even years because investors have long memories. When prices return to their old levels, some jump at the opportunity to add to their positions while others see a chance to get out.
Slide 87: 78 THE THREE M’S OF SUCCESSFUL TRADING Whenever you work with a chart, draw support and resistance lines across recent tops and bottoms. Expect a trend to slow down in those areas, and use them to enter positions or take profits. Keep in mind that support and resistance are flexible—they are like a ranch wire fence rather than a glass wall. A glass wall is rigid and shatters when broken, but a herd of bulls can push against a wire fence, shove their muzzles through it, and it will lean but stand. Markets have many false breakouts below support and above resistance, with prices returning into their range after a brief violation. A false upside breakout occurs when the market rises above resistance and sucks in buyers before reversing and falling. A false downside breakout occurs when prices fall below support, attracting more bears just before a rally. False breakouts provide professionals with some of the best trading opportunities. They are similar to tails, only tails have a single wide bar, whereas false breakouts can have several bars, none of them especially tall. What causes false breakouts and how do you trade them? At the end of a long rise the market hits resistance, stops, and starts churning. The professionals know there are many more buy orders above the resistance level. Some were placed by traders looking to buy a new breakout, and others are protective stops placed by those who went short on the way up. The pros are the first to know where people have stops because they are the ones holding the orders. A false breakout occurs when the pros organize a fishing expedition to run stops. For example, when a stock is slightly below its resistance at 60, the floor may start loading up on longs near 58.85. As sellers pull back, the market roars above 60, setting off buy stops. The floor starts selling into that rush, unloading longs as prices touch 60.50. When they see that public buy orders are drying up, they sell short and prices tank back below 60. That’s when your charts show a false breakout above 60. S&P 500 futures are notorious for false breakouts. Day after day this market exceeds its previous day’s high or falls below its previous day’s low by a few ticks (a tick is the minimum price change permitted by the exchange where an instrument is traded). This is one of the reasons the S&P is a difficult market to trade, but it attracts beginners like flies. The floor has a field day slapping them. Some of the best trading opportunities occur after false breakouts. When prices fall back into the range after a false upside breakout, you have extra confidence to trade short. Use the top of the false breakout as your stoploss point. Once prices rally back into their range after a false downside breakout, you have extra confidence to trade long. Use the bottom of that false breakout for your stop-loss point.
Slide 88: METHOD—TECHNICAL ANALYSIS 79 Figure 5.2 Support, Resistance, and False Breakouts In September CIEN reached a peak below 140, then attacked that level in October and rallied above 150, only to sink below the old peak a few days later. Some poor guy actually bought above 150—he really needed that stock! The false upside breakout marked the end of the bull market. The bear market established a bottom just near 65 in December, but in January some desperate sellers dumped enough stock to briefly push CIEN near 60. At the right edge of the chart prices are rallying above the level of their old bottom. The bear trap has slammed shut, with a 50% rally in just one month. Such signals are much easier to recognize using technical indicators, to be discussed later. If you have an open position, defend yourself against false breakouts by reducing your trading size and placing wider stops. Be ready to reposition if stopped out of your trade. There are many advantages to risking just a small fraction of your account on any trade. It allows you to be more flexible with stops. When the volatility is high, consider protecting a long position by buying a put or a short position by buying a call. Finally, if you get stopped out on a false breakout, don’t be shy about getting back into a trade. Beginners tend to make a single stab at a position and stay out if they are stopped out. Professionals, on the other hand, will attempt several entries before nailing down the trade they want.
Slide 89: 80 THE THREE M’S OF SUCCESSFUL TRADING C D A B Figure 5.3 Double Tops and Bottoms; Volume Double Tops and Bottoms Bulls make money when the market rises. There are always a few who take profits on the way up, but new bulls come in and the rally continues. Every rally reaches a point where enough bulls look at it and say—this is very nice, and it may get even nicer, but I’d rather have cash. Rallies top out after enough wealthy bulls take their profits, while the money from new bulls is not enough to replace what was taken out. When the market heads down from its peak, savvy bulls, the ones who’ve cashed out early, are the most relaxed group. Other bulls who are still long, especially if they came in late, feel trapped. Their profits are melting away and turning into losses. Should they hold or sell? If enough moneyed bulls decide the decline is being overdone, they’ll step in and buy. As the rally resumes, more bulls come in. Now prices approach the level of their old top, and that’s where you can expect sell orders to hit the market. Many traders who got caught in the previous decline swear to get out if the market gives them a second chance. As the market rises toward its previous peak, the main question is whether it will it rise to a new high or form a double top and turn down. Technical indicators can be of great help in answering this question. When they rise to a new high, they tell you to hold, and when they form bear-
Slide 90: METHOD—TECHNICAL ANALYSIS 81 Callaway Golf (ELY) reached its high of 27.18 in March, at point A, and struggled again near that level, to 26.95 in April, at point B. A few days after it recoiled from B, the double top became clearly visible. Many indicators (which we will review later) traced bearish divergences at that time. In June the stock collapsed, as the aged founder of the company, the inventor of the famous Big Bertha golf club, became ill and died. In a fairly typical emotional reaction, people dumped their stock without stopping to think whether the demise of an individual would ruin a large, well-established company. Such declines feed on themselves, as lower prices scare more people into selling. Notice a fantastic spike of volume, which reflected mass panic. The low at point C looks like a kangaroo tail, although not in its most classical form. Prices rallied above 17 at point D in what is called “a dead cat bounce,” not out of any great bullishness but simply as a reaction to the decline. At the right edge of the chart ELY is grinding down towards its recent bottom on low volume. If it recoils from that level, it’ll establish a double bottom. This is a fairly typical pattern—a crash, followed by a dead cat bounce, followed by a slow decline into the second bottom. Once prices rally from the second low, they are likely to usher in a sustainable rise. ish divergences (see “Indicators—Five Bullets to a Clip,” page 84), they tell you to take profits at the second top. A mirror image of this situation occurs at market bottoms. The market falls to a new low at which enough smart bears start covering shorts and the market rallies. Once that rally peters out and prices start sinking again, all eyes are on the previous low—will it hold? If bears are strong and bulls skittish, prices will break below the first low, and the downtrend will continue. If bears are weak and bulls are strong, the decline will stop in the vicinity of the old low, creating a double bottom. Technical indicators help decipher which of the two is more likely to happen. Triangles A triangle is a congestion area, a pause when winners take profits and new trend followers get aboard, while their opponents trade against the preceding trend. It is like a train station. The train stops to let passengers off and pick up new ones, but there is always a chance this is the last stop on the line and it may turn back. The upper boundary of a triangle shows where sellers overpower buyers and prevent the market from rising. The lower boundary shows where buyers overpower sellers and prevent the market from falling. As the two start to converge, you know a breakout is coming. As a general rule, the
Slide 91: 82 THE THREE M’S OF SUCCESSFUL TRADING trend that preceded the triangle deserves the benefit of the doubt. The angles between triangle walls reflect the balance of power between bulls and bears and hint at the likely direction of a breakout. An ascending triangle has a flat upper boundary and a rising lower boundary. The flat upper line shows that bears have drawn a line in the sand and sell whenever the market comes to it. They must be a pretty D A C E B Figure 5.4 Triangles, Pennants, and Rectangles Charts patterns are the footprints of bulls and bears. Patterns A and D are called pennants—a tight weave of prices that follows a sharp move up or down its flagpole. When a pennant flies in the direction of the trend (A), it is usually followed by a sharp reversal. When it flies against the preceding trend (D), it is a consolidation pattern and the trend usually continues. Place your entry orders accordingly, above or below a pennant’s boundary. Pattern B is a symmetrical triangle and pattern C is an ascending triangle. Breakouts from triangles tend to follow the trends that preceded them, especially when triangles are compact, consisting of only a few bars. Pattern E is a rectangle; notice how bulls and bears push against the rectangle walls, creating brief false breakouts—do not jump in too early. When prices decisively break out of a rectangle, the reversal is complete. At the right edge of the chart, prices are below a rectangle that provides severe overhead resistance; the price is like a drowning man under an ice floe. The trend is down, with rallies presenting shorting opportunities.
Slide 92: METHOD—TECHNICAL ANALYSIS 83 powerful group, calmly waiting for prices to come to them before unloading. At the same time buyers are becoming more aggressive. They snap up merchandise and keep raising the floor under the market. On what party should you bet? Nobody knows who’ll win the election, but savvy traders tend to place buy orders slightly above the upper line of an ascending triangle. Since sellers are on the defensive, if the attacking bulls succeed, the breakout is likely to be steep. This is the logic of buying upside breakouts from ascending triangles. A descending triangle has a flat lower boundary and a declining upper boundary. The horizontal lower line shows that bulls are pretty determined, calmly waiting to buy at a certain level. At the same time, sellers are becoming more aggressive. They keep selling at lower and lower levels, pushing the market closer to the line drawn by buyers. As a trader, which way will you bet—on the bulls or the bears? Experienced traders tend to place their orders to sell short slightly below the lower line of a descending triangle. Let buyers defend that line, but if bulls collapse after a long defense, a break is likely to be sharp. This is the logic of shorting downside breakouts from descending triangles. A symmetrical triangle shows that both bulls and bears are equally confident. Bulls keep paying up, and bears keep selling lower. Neither group is backing off, and their fight must be resolved before prices reach the tip of the triangle. The breakout is likely to go in the direction of the trend that preceded the triangle. Volume Each unit of volume represents the actions of two individuals— a buyer and a seller. It can be measured by several numbers: shares, contracts, or dollars that have changed hands. Volume is usually plotted as a histogram below prices. It provides important clues about the actions of bulls and bears. Rising volume tends to confirm trends, and falling volume brings them into question. Volume reflects the level of pain among market participants. At each tick in every trade, one person is winning and the other losing. Markets can move only if enough new losers enter the game to supply profits to winners. If the market is falling, it takes a very courageous or reckless bull to step in and buy, but without him there is no increase in volume. When the trend is up, it takes a very brave or reckless bear to step in and sell. Rising volume shows that losers are continuing to come in, allowing the trend to continue. When losers start abandoning the market, volume falls, and the trend runs out of steam. Volume gives traders several useful clues.
Slide 93: 84 THE THREE M’S OF SUCCESSFUL TRADING A one-day splash of uncommonly high volume often marks the beginning of a trend when it accompanies a breakout from a trading range. A similar splash tends to mark the end of a trend if it occurs during a wellestablished move. Exceedingly high volume, three or more times above average, identifies market hysteria. That is when nervous bulls finally decide that the uptrend is for real and rush in to buy or nervous bears become convinced that the decline has no bottom and jump in to sell short. Divergences between price and volume tend to occur at turning points. When prices rise to a new high but volume shrinks, it shows that the uptrend attracts less interest. When prices fall to a new low and volume falls, it shows that lower prices attract little interest and an upside reversal is likely. Price is more important than volume, but good traders always analyze volume to gauge the degree of crowd involvement. For a more objective rating of volume use an indicator called Force Index (see next section). Changes in volume detected by Force Index give important messages to traders. INDICATORS—FIVE BULLETS TO A CLIP I had a friend who drove a tank in World War ll, fighting his way from Stalingrad to Vienna. He maintained his tank with only three tools—a big hammer, a big screwdriver, and the Russian version of “f... you.” He won the war with a few simple tools, and we can apply his lessons to the dangerous environment of the markets. An amateur tries to grab a bit of money here and there. He uses one technique today and another tomorrow. His mind is scattered and he keeps losing, enriching only his broker and floor traders. A new hunter walks into the woods with a load of fancy gear on his back but soon discovers that most of it only slows him down. An experienced woodsman travels light. A beginner shoots at anything that moves, including his own shadow. An old hunter knows exactly what prey he is after and brings only a few bullets. Simplicity and discipline go hand in hand. To be a successful trader, choose a small number of markets, select a few tools, and learn to use them well. If you follow five stocks, your research will be deeper and results better than if you follow 50. If you use five indicators, you’ll get more mileage out of them than out of 25. You can always expand later, once you make steady profits. The indicators we are about to discuss represent the choice of one trader. I call this approach “five bullets to a clip.” An old army rifle used to take five bullets, and I analyze markets using no more than five indicators.
Slide 94: METHOD—TECHNICAL ANALYSIS 85 If five do not help, 10 will not do any better because there probably is no trade. I offer you this list as a starting point for selecting your own bullets. Pay attention to the general principle of selecting indicators from different groups to focus on different aspects of crowd behavior. The key idea is to select a few core tools that fit your style of analysis and trading. The tools we are about to review—moving averages, envelopes, MACD, MACD-Histogram, and Force Index—are the building blocks of a trading system described in the following chapter. There is no magic indicator; they all have advantages and disadvantages. It is important to be aware of both because then we can combine several indicators into a system to take advantage of their strengths, while their disadvantages cancel each other out. Choice of Tools Markets can confound traders. They often run in two directions at once— up on the weekly charts and down on the dailies. A market can reverse without sending you an e-mail about its change of plans. A sleepy stock can get so hot that it burns through stops, while a formerly hot stock becomes so cold it freezes your capital along with your fingers. Trading is a complex, nontrivial game. Markets consist of huge crowds of people, and technical analysis is applied social psychology. We must select several tools to identify different aspects of market behavior. Before using any indicator, we must understand how it is constructed and what it measures. We must test it on historical data and learn how it performs under different conditions. Once you start testing an indicator, expect to adjust its settings, turning it into a personal trading tool as reliable and familiar as an old wrench. Toolboxes vs. Black Boxes I keep seeing ads in traders’ magazines that show computers with $100 bills coming out of their disk drives. I’d love to get a hold of one of those models. The only ones I could find have the direction of money reversed. Computers can chew up cash, but pulling it out of them takes a lot of hard work. Those ads sell black boxes—computerized trading systems. Some clown has programmed a bunch of trading rules, put them on a copy-protected diskette or a CD, and now sells you a tool with a great track record. Feed it market data, and it will spit out an answer—when to buy or sell! If you believe this magic, wait until you meet Santa Claus. A fantastic track record of a canned system is meaningless because it comes from fitting the rules to old data. Any computer can tell you which rules worked in the past. Black-box programs self-destruct as soon as the
Slide 95: 86 THE THREE M’S OF SUCCESSFUL TRADING markets change, even if they include self-optimization. Black boxes appeal to beginners who derive a false sense of security from them. A good software package is a toolbox—a collection of tools for analyzing markets and making your own decisions. A toolbox can download data, draw charts, and plot indicators, as well as any trading signals you care to program. It provides charting and analytic tools but leaves you to make your own trading decisions. The heart of any toolbox is its collection of indicators—tools for identifying trends and reversals behind the noise of raw data. Good toolboxes allow you to modify indicators and even design your own. Indicators are objective; you may argue about the trend, but when an indicator is up, it’s up, and when it is down, it’s down. Keep in mind that indicators are derived from prices. The more complicated they are, the farther they are from prices and the farther away from reality. Prices are primary, indicators are secondary, and simple indicators work best. Trend-Following Indicators and Oscillators Learning to use indicators is like learning a foreign language. You have to immerse yourself in them, make typical beginners’ mistakes, and keep practicing until you rise to the level of proficiency and competence. Good technical indicators are simple tools that perform well when market conditions change. They are robust, that is, relatively immune to parameter changes. If an indicator gives great signals using a 17-day window but bombs when you try a 15-day window, then it’s probably useless. Good indicators give useful signals at a broad range of settings. We can divide all technical indicators into three major groups: trend-following, oscillators, and miscellaneous. Whenever we use an indicator, we must know to which group it belongs. Each group has its advantages and disadvantages. Trend-following indicators include moving averages, MACD (moving average convergence-divergence), Directional System, and others. Big trends mean big money, and these indicators help us stay long in uptrends and short in downtrends. They have built-in inertia that allows them to lock onto a trend and ride it. That same inertia causes them to lag at turning points. Their advantages and disadvantages are the flip sides of each other, and you cannot have one without the other. Oscillators include Force Index, Rate of Change, and Stochastic, among others. They help catch turning points by showing when markets are overbought (too high and ready to fall) or oversold (too low and ready to
Slide 96: METHOD—TECHNICAL ANALYSIS 87 rise). Oscillators work great in trading ranges, where they catch upturns and downturns. Taking their signals when prices are relatively flat is like going to a cash machine—you always get something, although not very much. Their downside is that they give premature sell signals in uptrends and buy signals in downtrends. Miscellaneous indicators, such as Bullish Consensus, Commitments of Traders, and New High–New Low Index, gauge the current mood of the market. They show whether the overall bullishness or bearishness is rising or falling. Indicators from different groups often contradict one another. For example, when markets rise, trend-following indicators turn up, telling us to buy. At the same time, oscillators become overbought and start flashing sell signals. The opposite occurs in downtrends, when trend-following indicators turn down, giving sell signals, while oscillators become oversold, flashing buy signals. Which should we follow? The answers are easy in the middle of a chart, but much harder at the right edge, where we must make our trading decisions. Some beginners close their eyes to complexity, choose a single indicator, and stick to it until the market whacks them from an unexpected direction. Others create a homemade opinion poll; they take a battery of indicators and average their signals. This is a meaningless exercise because its outcome depends on what indicators you include in your poll; change the selection and you’ll change the outcome. The Triple Screen trading system, described below, overcomes the problem of conflicting indicators by linking them with different timeframes. Time—The Factor of Five A computer screen can comfortably show about 120 bars in an open-high-low-close format. What if you display a monthly chart, each of whose bars represents one month? You’ll see 10 years worth of history at a glance, your stock’s big picture. You can display a weekly chart and review its rallies and declines for the past two years. A daily chart will show you the action for the past few months. How about an hourly chart, each of whose bars represents one hour of trading? It will let you zoom in on the past few days and pick up short-term trends. Want to get even closer? How about a 10-minute chart, each of whose bars represents 10 minutes of market action? Looking at all these charts, you quickly notice that markets can move in different directions at the same time. You may see an upmove on the weekly chart, while the dailies are breaking down. An hourly chart may be sagging, while a 10-minute chart is rallying. Which trend to follow?
Slide 97: 88 THE THREE M’S OF SUCCESSFUL TRADING Most beginners look at only one timeframe, usually daily. The trouble is that a new trend, erupting from another timeframe, often hurts traders who do not look beyond their noses. Another serious problem is that looking at the daily chart puts you on par with thousands of other traders who also look at it. What’s your advantage, what’s your edge? Markets are so complex that we must always analyze them in more than one timeframe. The Factor of Five, first described in Trading for a Living, links all timeframes. Every timeframe is related to the next higher and the next lower by the factor of five. There are almost five (4.3 to be exact) weeks to a month, five days to a week, and close to five hours in many trading days. We can break an hour into 10-minute segments and those into 2-minute bars. The key principle of Triple Screen, which we will review later, is to choose your favorite timeframe and then immediately go up to the timeframe one order of magnitude higher. There we make a strategic decision to go long or short. We return to our favorite timeframe to make tactical decisions about where to enter, exit, place a profit target and a stop. Adding the dimension of time to our analysis gives us an edge over the competition. Use at least two, but not more than three, timeframes because adding more only clutters up the decision-making process. If you are day-trading with 30- and five-minute charts, then a weekly chart is essentially irrelevant. If you are trading market swings using a weekly and a daily, then the wiggles of a five-minute chart are no more than noise. Choose your favorite timeframe, add the timeframe one order of magnitude higher, and start your analysis at that point. Moving Averages Moving averages (MAs) are among the oldest, simplest, and most useful tools for traders. They help identify trends and find areas for entering trades. We plot them as lines on price charts, each of whose points reflects the latest average price. What is the reality behind the moving averages, and what do they measure? Each price is a momentary consensus of value among market participants, a snapshot of the market crowd at the moment of a trade. What if you show me a snapshot of your friend and ask whether he is an optimist or a pessimist, a bull or a bear? It is hard to tell from a single photo. If you take his snapshot from the same position for 10 days in a row and bring them to a lab, you can get a composite photo. When 10 pictures are super-
Slide 98: METHOD—TECHNICAL ANALYSIS 89 imposed upon one another, the typical features stand out, while the atypical fade away. If you start updating that composite each day, you’ll have a moving average of your friend’s mood. If you lay a string of composite photos side by side, it will be clear whether your friend is becoming happier or sadder. A moving average is a composite photograph of the market. It adds new prices as they occur and drops old ones. A rising moving average shows that the crowd is becoming more optimistic—bullish. A falling moving average shows that the crowd is becoming more pessimistic— bearish. A moving average responds not only to the data but to how we construct it. We must make several decisions to help separate the message of our moving average from the construction noise. First, we need to decide what data we’ll use. We need to select the width of our time window— wider for catching longer trends, narrower for catching minor ones. Finally, we need to choose the type of moving average. What Data to Average? Traders who rely on daily and weekly charts usually apply moving averages to closing prices. This makes sense, because they reflect the final consensus of value, the most important price of the day. The closing price of a five-minute or an hourly bar has no such special meaning. Day-traders are better off averaging not closing prices, but an average price of each bar. For example, they can average Open + High + Low + Close of each bar, divided by four, or High + Low + Close divided by three. We can apply moving averages to indicators, such as Force Index (see below). A raw Force Index reflects price changes and volume for the day. Averaging produces a smoother plot and reveals a longer-term trend of Force Index. How Long a Moving Average? Moving averages help identify trends. A rising MA encourages you to maintain longs, whereas a falling MA tells you to hold shorts. The wider the time window, the smoother is a moving average. That benefit has a cost. The longer a moving average, the slower it responds to trend changes. The shorter a moving average, the better it tracks prices, but the more subject it is to whipsaws, temporary deviations from the main trend. If you make your moving average very long, it will miss important reversals by a wide margin. Shorter MAs are more sensitive
Slide 99: 90 THE THREE M’S OF SUCCESSFUL TRADING to trend changes, but those shorter than 10 bars defeat the purpose of a trend-following tool. At the time I wrote Trading for a Living, I was using 13-bar MAs, but in recent years I switched to longer moving averages to catch more important trends and avoid whipsaws. To analyze weekly charts, start with a 26-week moving average, representing half a year’s worth of data. Try to shorten that number and see whether you can do it without sacrificing the smoothness of your MA. On the daily charts, start with a 22-day MA, reflecting roughly the number of trading days in a month, and see whether you can make it shorter. Whatever length you decide to use, be sure to test it on your own data. If you track just a handful of markets, you’ll have enough time to try different lengths of moving averages until you get smoothly flowing lines. The width of any indicator time window is best expressed in bars rather than days. The computer doesn’t know whether you are analyzing daily, monthly, or hourly charts; it sees only bars. Whatever we say about a daily MA applies to the weekly or the monthly. It’s better to call it a 22-bar MA rather than a 22-day MA. Mathematically savvy traders can look into using adaptive moving averages whose length changes in response to market conditions, as advocated by John Ehlers, Tushar Chande, and Perry Kaufman. Ehlers’ latest book, Rocket Science for Traders, delves into adapting all indicators to current market conditions. What Type of Moving Average? A simple MA adds up prices in its time window and divides the sum by the width of that window. For example, for a 10-day simple MA of closing prices, add up closing prices for the past 10 days and divide the sum by 10. The trouble with a simple MA is that each price affects it twice—when it comes in and when it drops out. A high new value pushes up the moving average, giving a buy signal. This is good; we want our MAs to respond to new prices. The trouble is that 10 days later, when that high number drops from the window, the MA also drops, giving a sell signal. This is ridiculous because if we shorten a simple MA by one day, we’ll get that sell signal a day sooner, and if we lengthen it by a day, we’ll get it a day later. We can engineer our own signals by fiddling with the length of a simple MA! An exponential moving average (EMA) overcomes this problem. It reacts only to incoming prices, to which it assigns more weight. It does not drop old prices from its time window, but slowly squeezes them out with the passage of time.
Slide 100: METHOD—TECHNICAL ANALYSIS 91 EMA = Ptoday where K N Ptoday EMA yesterday = • K + EMA yesterday • (1 − K) 2 N+1 = the number of days in the EMA (selected by trader) = today’s price = the EMA of yesterday Few people calculate indicators by hand these days—computers do it faster and more accurately. If we decide to look at a 22-bar EMA of closing prices, K = 2/(22 + 1) = 2 / 23 = 0.087. Multiply the latest closing price by that figure, multiply yesterday’s EMA by 0.913 (i.e., 1 − 0.087), add the two, and arrive at today’s EMA. Traders sometimes ask where to get an EMA in the beginning. Begin by calculating a 22-bar simple MA and then switch to the EMA. Most indicators require you to have one or two months of data before they start giving meaningful signals. Trading Signals The most important message of a moving average is the direction of its slope. When the EMA rises, it shows that the crowd is becoming more optimistic and bullish, which is a good time to be long. When it falls, it shows that the crowd is becoming more pessimistic and bearish. It is a good time to be short. When a moving average points up, trade that market from the long side. When a moving average points down, trade that market from the short side. As a trader, you have three options: go long, go short, or stand aside. A moving average takes away one of those. When it points up, it prohibits you from shorting and tells you to go long or stand aside. When it points down, it prohibits you from buying and tells you to look only for shorts or stay out. When an EMA starts jerking up and down, it indicates a vacillating, trendless market; it is better to stop using trend-following methods. Continue to monitor the EMA, but take its signals at a discount until a new trend emerges. The only time when it is OK to override the message of a moving average is when trying to pick a bottom after a bullish divergence between MACD-Histogram (described below) and price. If you do that, be sure to use tight stops. If you succeed, bank your profits but do not think that the rules of the game have changed. A trader who thinks he is above the rules becomes careless and loses money. Enter long positions in the vicinity of a rising MA. Enter short positions in the vicinity of a falling MA. Use MA to differentiate between “value trades” and
Slide 101: 92 THE THREE M’S OF SUCCESSFUL TRADING Figure 5.5 Moving Average—Major Trend An exponential moving average is slow but steady, like a directional indicator on a steamroller. EMA works in all timeframes but shines on the weeklies, where it helps you stay with the major trend no matter how hard it tries to shake you off. Trading in the direction of a weekly moving average should help you get ahead of many traders. You can position yourself in the direction of the EMA and hold, or else trade in and out, using daily charts. This 26-week EMA has tracked the entire glorious bull market in YHOO, from its obscure beginnings, to the breathtaking $250 peak, and back into the doghouse. If you wake up in the morning, look at the weekly EMA, and trade in its direction, you will not be in too bad a shape! There are no perfect indicators, and an EMA has its share of difficulties when markets go flat. When the EMA starts to quiver, as it did in 1999, it is time to stand aside or trade short term, not counting on a major trend. Notice the three tails in YHOO (and the fourth, not as pure as the first three). Every time there was a tail, the price got halved within weeks. At the right edge of the chart prices are flat and EMA is declining. Prices are closer to the bottom than they are to the top, but there is no rush to buy. Let the EMA flatten out and tick up before positioning for a new major bull move.
Slide 102: METHOD—TECHNICAL ANALYSIS 93 “greater fool theory trades.” Most uptrends are punctuated by declines, when prices return to the EMA. When we buy near the moving average, we buy value and can place a tight stop slightly below the EMA. If the rally resumes, we’ll make money, but if the market turns against us, the loss will be small. Buying near the EMA helps maximize gains and minimize risks. E F C A B D Value Value Figure 5.6 Value Trades and Greater Fool Theory Trades When you buy near a rising moving average, you buy value (points D and F). Waiting for such opportunities requires patience, but it is infinitely safer than chasing rallies. Those who buy high above the EMA pay above value, hoping to meet a greater fool who will pay them even more. Anxious traders who buy near the tops (points C and E) get shaken out, or else they tensely wait to get out at breakeven. Many stocks and futures have typical behavior patterns, and you should try to identify them and use them. At the time of this writing, EBAY likes to have kangaroo tails (A, B, C, and E). The C tail had the most classical shape, but others worked also. Knowing what pattern to expect helps you recognize it a little sooner when it appears. At the right edge of the chart the EMA has stopped rising and begun to flutter. The bull move is over. If you are a trend trader, it is time to move over to other, trending stocks. Keep an eye on EBAY, waiting for a new trend to emerge.
Slide 103: 94 THE THREE M’S OF SUCCESSFUL TRADING If we buy high above the EMA, our actions say, “I am a fool, I am overpaying, but I hope to meet a greater fool down the road who’ll pay me even more.” Betting on the greater fool theory is a poor idea. There are very few fools in the markets. Financial markets do not attract foolish people, and counting on them is a losing proposition. There are times when wild rallies in high-flying stocks seem to vindicate the greater fool theory. Stocks with no assets or earnings can fly on hot air. A value trader who feels he is missing those spectacular moves has a choice. He can stick to his method, soberly saying, “Can’t catch them all.” Or he may decide, “When living with the wolves, howl like a wolf” and start buying upside breakouts. If you do that, remember, you are now engaged in greater fool theory trading and the only asset separating you from the manic crowd is your risk control—your stops and money management. The same rules apply to shorting in downtrends. When you go short on a rally to the EMA, you are selling value—before the market reverses and starts destroying value again. A greater fool theorist shorts far below the EMA—the farther away, the greater the fool. Use a system of dual moving averages to identify trends and enter positions. You may select an EMA that tracks your market well, but it moves so explosively that prices never react back to that EMA, denying you a chance to put on a value trade. To solve this problem, you can add a second moving average. Use the longer EMA to indicate the trend, and the shorter to find entry points. Suppose you find that a 22-day EMA does a good job identifying trends in your market. Plot it, but then divide its length in half and plot an 11-day EMA on the same screen in a different color. Continue to use the 22-day EMA to identify bull and bear moves, but use pullbacks to the shorter EMA to identify entry points. Moving averages help identify trends and decide whether to trade long or short. They help mark value areas for entering trades. To find exit points, we turn to our next tool, channels on moving averages. Channels Markets are manic-depressive beasts. They rise in powerful rallies, only to collapse in breathtaking declines. A stock catches the public’s fancy, shoots up 20 points one day, and then slides 24 points down the next. What drives those moves? Fundamental values change slowly, but waves of greed, fear, optimism, and despair drive prices up and down.
Slide 104: METHOD—TECHNICAL ANALYSIS 95 How can you tell when a market has reached an undervalued or overvalued level, a zone for buying or selling? Market technicians can use channels to find those levels. A channel, or an envelope, consists of two lines, one above and one below a moving average. There are two main types of channels: straight envelopes and standard deviation channels, also known as Bollinger bands. In Bollinger bands the spread between the upper and lower lines keeps changing in response to volatility. When volatility rises, Bollinger bands spread wide, but when markets become sleepy, those bands start squeezing the moving average. This feature makes them useful for options traders since volatility drives options prices. In a nutshell, when Bollinger bands become narrow, volatility is low, and options should be bought. When they swing far apart, volatility is high, and options should be sold or written. Traders of stocks and futures are better off with straight channels or envelopes. They keep a steady distance from a moving average, providing steadier price targets. Draw both lines a certain percentage above or below the EMA. If you use dual moving averages, draw channel lines parallel to the longer one. A moving average reflects the average consensus of value, but what is the meaning of a channel? The upper channel line reflects the power of bulls to push prices above the average consensus of value. It marks the normal limit of market optimism. The lower channel line reflects the power of bears to push prices below the average consensus of value. It marks the normal limit of market pessimism. A well-drawn channel helps diagnose mania and depression. Most software programs draw channels according to this formula: Upper channel line = EMA + EMA Lower channel line = EMA − EMA • • Channel coefficient Channel coefficient A well-drawn channel contains the bulk of prices, with only a few extremes poking out. Adjust the coefficient until the channel contains approximately 95 percent of all prices for the past several months. Mathematicians call this the second standard deviation channel. Most software packages make this adjustment very easy. Find proper channel coefficients for any market by trial and error. Keep adjusting them until the channel holds approximately 95% of all data, with only the highest tops and the lowest bottoms sticking out. Drawing a channel is like trying on a shirt. Choose the size in which the entire body fits comfortably, with only the wrists and the neck poking out.
Slide 105: 96 THE THREE M’S OF SUCCESSFUL TRADING Different trading vehicles and timeframes require different channel widths. Volatile markets require wider channels and higher coefficients. The longer the timeframe, the wider the channel; weekly channels tend to be twice as wide as dailies. Stocks tend to require wider channels than futures. A good time to review and adjust channels in futures is when an old contract nears expiration and you switch to the new front month. A channel drawn in an uptrend tends to fit the peaks. Rallies in a bull market are much stronger than declines, and bottoms seldom reach the lower channel line. In a downtrend, a channel tends to track bottoms, while the tops are too limp to rise to the upper channel line. It is unnecessary to draw two separate channels, one for the tops and the other for the bottoms; just follow the dominant crowd. In a flat market expect both tops and bottoms to touch their channel lines. When we are bullish, we want to buy value near the rising EMA and take profits when the market becomes overvalued—at or above the upper channel line. When bearish, we want to go short near the falling EMA and cover when the market becomes undervalued—at or below the lower channel line. K I G E B F C A D H J Figure 5.7 Channels for Profit Taking When the EMA rises, it identifies an uptrend. It is a good idea to buy near that EMA or slightly higher or lower, depending on the stock’s recent behavior. At point A, EMA stands at 35, while the low point of the bar reaches 33—a
Slide 106: METHOD—TECHNICAL ANALYSIS 97 If you buy near a rising moving average, take profits in the vicinity of the upper channel line. If you sell short near a falling moving average, cover in the vicinity of the lower channel line. Channels catch swings above and below value but not major trends. Those swings can be very rewarding. If you can catch a move from the EMA to the channel line in bond futures, you’ll make about $2,000 in profit on a $2,000 margin. If you can do this a few times a year, you’ll find yourself far ahead of many professionals. A beginner who sells his position near the upper channel line may regret it several weeks later. In a bull market, what looks overvalued today may look like a bargain the next month. Professionals do not let such feelings bother them. They are trading, not investing. They know it’s easy to be smart looking at old charts, but hard to make decisions at the right edge. They have a system, and they follow it. When prices blow out of a channel but then return to the moving average, trade in the direction of the slope of that MA, with a profit target near the channel line. Prices break out of channels only during the strongest trends. After they pull back, they often retest the extremes of those break2-point downside penetration. At point C, the price low penetrates the EMA by 1 point, at D by 2.25, at F by 4, at point H by 0.75, and at J by 4. Those short-term bottoms keep alternating between shallow and deep—an important piece of intelligence when you try to decide where to place your buy order. If the latest penetration was shallow, expect the next one to be deep, and vice versa, and place your buy orders accordingly. The place to sell stocks purchased near the EMA is at the upper channel line. Looking back, it is easy to see that buy-and-hold would have worked even better in TARO, but the future is not nearly as clear at the right edge of the chart. Buying value near the EMA and taking profits above value, near the upper channel line, is safer and more reliable. Stock bought at A can be sold at B, bought again at C or D and sold at E, and so on. A trader can grade his performance, based on the percentage of the channel he takes in profits on any given trade. For example, at the right edge of the chart, the upper channel line stands at 97 and the lower at 69, making the channel 28 points high. An A trader should get the minimum of 30% or 8.4 points out of the next trade, a B trader 20% or 5.6 points, and a C trader 10% or 2.8 points. At the right edge of the chart, prices are hitting the upper channel line. It is time to take profits on stocks purchased in area J, near the EMA, and wait for a pullback.
Slide 107: 98 THE THREE M’S OF SUCCESSFUL TRADING outs. A breakout from a channel gives us confidence to trade again in its direction. Prices occasionally take off on wild runaway trends. They break out of a channel and stay out for a long time, without pulling back to their EMA. When you recognize such a powerful move, you have a choice: stand aside or switch to a system for trading impulse moves. Professional traders, once they find a technique that works for them, tend to stay with it. They’d rather miss a trade than change to an unfamiliar style. If a moving average is essentially flat, go long at the lower channel line, sell short at the upper channel line, and take profits when prices return to their moving average. The upper channel line marks an overbought zone. If the market is relatively flat on long-term charts, rallies to the upper channel line then provide shorting opportunities, whereas declines to the lower channel line provide buying opportunities. Professionals tend to trade against deviations and for the return to normalcy. Amateurs think that every breakout will be followed by a massive runaway move. Once in a rare while the amateurs are right, but in the long run it pays to bet like the pros. They use channels to find when the market has outrun itself and where it is likely to reverse. How to Grade Your Performance Imagine two friends taking a college course. Both have similar abilities and backgrounds, but one takes a test each week, while the other waits for a final. All other factors being equal, which of them is likely to get a higher grade on the exam? The one who waited or the one who took weekly tests? Most educational systems test students at regular intervals. Testing prompts people to fill the gaps in their knowledge. Students who take tests throughout the year tend to do better on their finals. Frequent tests help improve performance. Markets keep testing us, only most traders don’t bother to look up their grades. They gloat over profits or trash confirmation slips for losing trades. Neither bragging nor beating yourself makes you a better trader. The market grades every trade and posts results on a wall, only most traders have no clue where to look. Some count money, but that’s a very crude measure, which does not compare performance in different markets at different prices. You may take more money from a sloppy trade in a big expensive market than from an elegant entry and exit in a difficult narrow market. Which of them reveals a higher level of skill? Money is important but it doesn’t always provide the best measure of success.
Slide 108: METHOD—TECHNICAL ANALYSIS 99 Channels help us grade the quality of our trades. When you enter a trade, measure the height of the channel from the upper to the lower line. If you use daily charts to find trades, measure the daily channel; if you use a 10-minute chart, measure the channel on a 10minute chart; and so on. When you exit that trade, calculate the number of points you’ve taken as a percentage of the channel. That is your performance grade. If a stock is trading at 80 with a 10% channel, then the upper channel line is at 88 and the lower at 72. Suppose you buy that stock at 80 and sell it at 84. If you take 4 points out of the 16-point channel, then your grade is 4⁄16 or 25%. Where does that place you on the rating curve? Any trade where you take 30% or more out of a channel earns you an A. If you take between 20 and 30%, your grade is a solid B. If you grab between 10 and 20%, you earn a C. You get a D by taking less than 10% out of a channel or running a loss. Good traders keep good records. Your first essential record is a spreadsheet of all your trades (we’ll review this in Chapter 8, “The Organized Trader”). Add two columns to your spreadsheet. Use the first to record the height of the channel when you enter the trade. Use the second to calculate what percentage of that channel you’ve grabbed exiting that trade. Keep monitoring your grades to see whether your performance is improving or deteriorating, steady or erratic. Back in college, professors used to grade you. Now you can use channels to find out your grades and become a better trader. What Markets to Trade? Channels can help us decide which stocks or futures to trade and which to leave alone. A stock may have great fundamentals or beautiful technical signals, but measure its channel before you put on a trade. It’ll show you whether the swings are wide enough to be worth trading. You may look at a volatile stock whose channel height is 30 points. If you are an A trader, you should be able to get 30%, or 9 points, out of a trade. That will be more than enough to pay commissions, cover slippage, and leave you with profits. On the other hand, if you look at an inexpensive stock whose channel is only 5 points high, then an A trader would be shooting for a paltry 1.5-point gain. That would leave you with next to nothing after commissions and slippage—leave that stock alone, no matter how good it looks. What if your performance slips a bit or the market throws you a curve? What if you earn only a C and take only 10% out of a channel? The first
Slide 109: 100 THE THREE M’S OF SUCCESSFUL TRADING stock, with its 30-point channel, will return 3 points profit—enough to make some money after expenses. The stock with a 5-point channel will return only half a point, and commissions and slippage may push you into negative territory! Beginners are often seduced by low-priced stocks with strong technical patterns. They cannot understand why they keep losing money. When there is no room for the stock to swing, a trader can’t win. A good technical analyst who was slowly losing money called me for a consultation. When I asked him to fax me his charts, he showed $10 and $15 stocks whose channels were only $2 to $4 tall. There was simply no room for price swings, while commissions, slippage, and expenses continued to chip away at his equity. If you’re going to support yourself by fishing, find a channel where the fish are big enough. Once you become interested in a new stock, draw a channel to see whether it’s wide enough to trade. We like to think of ourselves as A traders and all-around A people, but what if you pull only a C trade? If you take only 10 percent out of this channel, will it be worth trading? Beginning traders should leave alone any stock whose channel is narrower than 10 points, meaning that a C trader can take one point out of it. A few traders said to me it was OK to trade stocks with narrrow channels, as long as one increased trading size. They think that trading 10,000 shares in a three-point channel is the same as trading 1,000 shares in a 30-point channel, but it is not, because the ratio of slippage to channel is much higher in narrow channels, raising the external barrier to victory. Low-priced stocks with slender channels can make good investments. Think of Peter Lynch, a famous money manager, looking for his elusive 10-bagger, a stock that goes up 10-fold. A $5 stock is much more likely to rise to $50 than an $80 stock to rally to $800. But those are investments, not trades. As a trader, you are looking to take advantage of short-term swings. That is why you should not waste your energy on any stock whose channel is narrow. The Rewards of Day-Trading Day-trading seems deceptively easy, and beginners flock to it like moths to a flame. Amateurs look at intraday charts and see strong rallies and steep declines. It looks like the money is there for the picking by any sharp-witted individual with a computer, a modem, and a live data feed. Day-trading firms make fortunes in commissions. They promote day-trading because they need to replace the great majority of customers who flame out. The firms hide customer statistics from the public, but in the year 2000 state regulators in Massachusetts subpoenaed records which showed that after 6 months only 16% of day-traders made money.
Slide 110: METHOD—TECHNICAL ANALYSIS 101 There is an old Russian saying: “your elbow is near, yet you can’t bite it.” Try it now—stretch your neck, bend your arm, go for it. So near, yet so far. It’s the same with day-trading—the money is right in front of your face, yet you keep missing it by a few ticks. Why do so many people lose so much money day-trading? There is simply not enough height in intraday channels to make profits. Using channels to select trades sends a powerful message to day-traders. Look at a few popular actively traded stocks—YHOO, AMZN, and AOL are in the forefront of public attention on the day I write this. The figures are likely to change by the time you read this book, but today I get the following numbers for channel heights on their daily and five-minute charts: Daily channel AOL AMZN YHOO 20 21 54 A-level trader (30%) 6 6.3 16.2 C-level trader (10%) 2 2.1 5.4 Fiveminute channel 3 3 7 A-level trader (30%) 0.9 0.9 2.1 C-level trader (10%) 0.3 0.3 0.7 A swing trader who uses daily charts to buy and hold for a few days can do very well in these active stocks. He can really clean up if he is an A-level trader, but even if he is a C trader, taking 10% out of a channel, he can stay afloat while he’s learning. A person who day-trades the same stocks must be a straight-A trader in order to survive. Anything less, and he’ll be eaten alive by slippage, commissions, and expenses. I can hear a howl of protests from the crowd of vendors who make a good living from day-trading—brokers, software dealers, system sellers, etc. They can roll out their examples of successful day-traders, as if that proves anything! Brilliant day-traders do exist, and I am friends with a handful of them myself. Sadly, it’s a very small handful. The chances of becoming a successful day-trader are very low because the channels on intraday charts are not high enough. You must be a straight-A trader to make money out of those minute swings. The slightest distraction, a bit of market noise, a slight slip of performance, and another day-trader bites the dust. Day-trading provides fantastic entertainment value. Recreational athletes expect to pay for their sport rather than make money from it.
Slide 111: 102 THE THREE M’S OF SUCCESSFUL TRADING Recreational day-traders who expect to make money are deluding themselves into believing that they will reach their elbow with their teeth. Maybe tomorrow . . . . MACD-Histogram MACD stands for Moving Average Convergence-Divergence. This indicator was developed by Gerald Appel, who combined three moving averages into two MACD lines. We can enhance MACD by plotting it as a histogram, reflecting the distance between those lines. It helps identify trends and rate the power of bulls and bears. It is one of the best tools in technical analysis for catching reversals. Before we use any indicator, we must understand how it is constructed and what it measures. As noted before, each price represents a momentary consensus of value of market participants. A moving average shows us the average consensus of value during a selected period of time. A fast moving average reflects the average consensus during a short period of time, and a slow moving average during a longer period of time. MACDHistogram measures changes in consensus by tracking the spread between fast and slow moving averages. Appel used three exponential moving averages to create MACD: 1. Calculate a 12-day EMA of closing prices. 2. Calculate a 26-day EMA of closing prices. 3. Subtract the 26-day EMA from the 12-day EMA—this is the fast or MACD line. 4. Calculate a 9-day EMA of the fast line—this is the slow or signal line. The values of 12, 26, and 9 have become standard numbers, used as defaults in most software packages. My testing shows that changing these values has little impact on MACD signals, unless you go way out on a limb and seriously distort their relationships by more than doubling one but not the others. If you track several markets and do not have the time to customize your indicators, you can accept the default values of MACD. If you follow only a few markets, it makes sense to experiment with higher and lower MACD values to find those that more closely track turning points in your stocks or futures. If your software doesn’t include MACD, you may use two EMAs (for example, 12-day and 26-day) in lieu of the fast and slow MACD lines. Then apply the MACD-Histogram formula, on the next page, to the spread between those two averages.
Slide 112: METHOD—TECHNICAL ANALYSIS 103 sell buy buy sell buy sell buy Figure 5.8 MACD Lines Entry and exit signals are rarely symmetrical. The indicator that gives you good entry signals is usually not the best indicator for exits; some other tool will do a better job. MACD lines give entry signals when the fast line crosses the slow line. If the fast line crosses above, it gives a signal to go long. When it crosses below, it gives a signal to sell short. Waiting for a crossover in the opposite direction to close out a position is not a good idea because by that time a lion’s share of profits will have evaporated. Can you find a trading system in this chart? MACD lines tell you to enter at the crossover, but how will you decide when to exit? What tools can you use to find out when a market surge is starting to fade and hop off with profit? At the right edge of the chart MACD lines are in a buy mode, with a fast line above the slow and both rising. Prices are hovering above the EMA—an overvalued level. Buying at the right edge would mean taking a “greater fool theory” trade. Placing a buy order in the vicinity of the rising EMA would allow us to buy value. The fast line of MACD reflects a short-term consensus of value, while the slow signal line reflects a longer-term consensus. When the fast line rises above the slow line, it shows that market participants are becoming more bullish. When bulls are becoming stronger, it is a good time to get long. When the fast line of MACD falls below the slow line, it shows that market participants are becoming bearish. When bears become stronger, it is a good
Slide 113: 104 THE THREE M’S OF SUCCESSFUL TRADING time to get short. MACD lines follow trends, and their crossovers mark trend reversals. Like all trend-following indicators, they work best when markets are moving but lead to whipsaws during choppy periods. We can make MACD more useful by converting it into MACD-Histogram. MACD-Histogram = Fast MACD line − Slow signal line MACD-Histogram measures the spread between short-term and longterm moving averages and plots it as a histogram. It reflects the difference between short-term and long-term consensus of value. Some software packages include MACD lines but not MACD-Histogram. In that case, run MACD lines, return to the menu and run an indicator called spread (or similar), which should measure the spread between the two lines and plot it as a histogram. When you look at MACD lines, their spread may appear tiny, but MACDHistogram rescales it to fit the screen. The slope of MACD-Histogram shows whether bulls or bears are growing stronger. That slope is defined by the B A C Figure 5.9 MACD-Histogram A very powerful signal of MACD-Histogram, which occurs only once or twice per year on a daily chart, is a divergence between the indicator peaks or bottoms and price extremes. In area A the Euro grinds down to a low of
Slide 114: METHOD—TECHNICAL ANALYSIS 105 relationship between the two latest bars. When the bars of MACD-Histogram rise (like the pattern of letters g-G), they show that the crowd is becoming bullish—it is a good time to be long. When the slope of MACD-Histogram declines (like in letters Q-q), it shows that the crowd is becoming bearish— it is a good time to be short. Markets run on a two-party system—the bulls and the bears. When MACD-Histogram rises, it shows that bulls are becoming stronger, and when it declines, it shows that bears are becoming stronger. MACD-Histogram helps you bet on the winning party and sell short the opposition. The Strongest Signal MACD-Histogram gives two types of signals. One is ordinary, and we see it at every bar—it is the slope of MACDHistogram. An uptick of MACD-Histogram shows that bulls are stronger than they were at the previous bar, and a downtick shows that bears are gaining. Those upticks and downticks provide minor buy and sell signals, but we shouldn’t read too much into them. Markets do not move in 84 cents and MACD-Histogram confirms that low by tracing its own bottom, A. Prices rally into area B, and a strong rally of MACD-Histogram confirms its strength. It rises to a new multi-month high, showing that bulls are becoming stronger below the surface of the bear market. Prices trace a double top in area B. The second top of MACD-Histogram in that area is a little lower than the first, warning of the imminent resumption of the downtrend. So far, the indicator and prices are in gear, but from this point they diverge. In area C prices crash to a new bear market low, while MACD-Histogram stops just below its centerline, creating a more shallow bottom than during its previous decline. When it ticks up from that low, it completes the bullish divergence and shows that bears have run out of steam and bulls are taking over. When two or three diverse technical tools flash the same message, they confirm one another. Notice that prices have traced a false downside breakout in area C. That breakout has cleaned out stops placed by bulls and sucked in the most rabid bears who shorted. Premature bulls have been shaken out, late bears have been trapped, and the upside reversal is complete. Those trapped bears will have to cover shorts when they can no longer stand the pain, adding fuel to the rally. At the right edge of the chart prices are shooting higher from a bullish divergence. This powerful pattern usually propels prices for weeks if not months.
Slide 115: 106 THE THREE M’S OF SUCCESSFUL TRADING straight lines, and it’s normal for MACD-Histogram to keep ticking up and down. The other signal occurs rarely, only a couple of times per year on the daily charts of most markets, but it’s worth waiting for because it is the strongest signal in technical analysis. That signal is a divergence between the peaks and bottoms of price and MACD-Histogram. A divergence occurs when the trend of price highs and lows goes one way and the trend of tops and bottoms in MACD-Histogram goes the opposite way. Those patterns take several weeks or even more than a month to develop on the daily charts. A bullish divergence occurs when prices trace a bottom, rally, and then sink to a new low. At the same time MACD-Histogram traces a different pattern. When it rallies from its first bottom, that rally lifts it above the zero line, “breaking the back of the bear.” When prices sink to a new low, MACD-Histogram declines to a more shallow bottom. At that point, prices are lower, but the bottom of MACD-Histogram is higher, showing that bears are weaker and the downtrend is ready for a reversal. MACDHistogram gives a buy signal when it ticks up from its second bottom. Occasionally, the second bottom is followed by a third. This is why traders must use stops and proper money management. There are no certainties in the markets, only probabilities. Even a reliable pattern such as a divergence of MACD-Histogram fails occasionally, which is why we must exit if prices fall below their second bottom. We must preserve our trading capital and reenter when MACD-Histogram ticks up from its third bottom, as long as it is higher than the first. A bearish divergence occurs when prices rise to a new high, decline, and then rise to a higher peak. MACD-Histogram gives the first sign of trouble when it breaks below its zero line during the decline from its first peak. When prices reach a higher high, MACD-Histogram rises to a much lower high. It shows that bulls are weaker, and prices are rising simply out of inertia and are ready to reverse. The Hound of the Baskervilles MACD-Histogram offers traders what x-rays offer doctors, showing the strength or weakness of the bone below the surface of the skin. Bulls or bears may appear powerful when prices reach a new extreme, but a divergence of MACD-Histogram shows that the dominant party is becoming weak and prices are ready to reverse. Go long when MACD-Histogram traces a bullish divergence, that is, when prices fall to a new low while the indicator ticks up from a more shallow low. Get long after MACD-Histogram ticks up from its second bottom.
Slide 116: METHOD—TECHNICAL ANALYSIS 107 A bottom that is more shallow than the preceding one shows that bears have grown weaker, and the uptick tells us that bulls are taking over. Place a protective stop below the latest bottom. Rallies from bullish divergences tend to be very powerful, but you must always use protection in case a signal does not work out. An aggressive trader can make that stop “stop-and reverse,” meaning that if stopped out of a long position, he will reverse and go short. When a super-strong signal doesn’t pan out, it shows that something is fundamentally changing below the surface of the market. If you buy on the strongest signal in technical analysis and then your stop gets hit, it means that bears are especially strong, making it worthwhile to sell short. Reversing positions from long to short is usually not the best idea, but the failure of a divergence of MACD-Histogram is an exception. I call this a Hound of the Baskervilles signal, after a story by Sir Arthur Conan Doyle. Sherlock Holmes was called to investigate a murder on a country estate. His clue came from the fact that the family dog did not bark while the crime was being committed. That indicated the dog knew the criminal, and the murder was an inside job. Sherlock Holmes received his signal not from the action but from the lack of expected action. When a divergence of MACD-Histogram fails to produce a reversal, it gives a Hound of the Baskervilles signal. Go short when the MACD-Histogram traces a bearish divergence, that is, when prices rise to a new high but the indicator ticks down from a lower peak. When the crowd gets on its hind legs and roars, it is tempting to throw caution to the wind, close our eyes, and buy. When the crowd becomes manic, it is hard to remain cool, but an intelligent trader looks for MACD-Histogram divergences. If prices rally, decline, and then rally to a higher level, but MACD-Histogram rallies, falls below its zero line, breaking the back of the bull, and rallies again, but to a lower level, it creates a bearish divergence. It shows that bulls have grown weaker, the stock is rising out of inertia, and as soon as that inertia runs out, the stock is likely to collapse. MACD-Histogram flashes a signal to go short when it ticks down from its second peak. Once short, place a stop above the latest rally peak. Placing stops when shorting near the tops is notoriously difficult because of high volatility. Trading smaller positions allows you to place wider stops. Divergences between MACD-Histogram and prices on the daily charts are almost always worth trading. Divergences on the weekly charts usually mark transitions between bull and bear markets.
Slide 117: 108 THE THREE M’S OF SUCCESSFUL TRADING A C D B E Figure 5.10 The Hound of the Baskervilles Signal Heating oil, along with the rest of the oil complex, ran up to an historic high in November 2000. Then the demand shrunk, new supplies entered the market, bullish mania was broken, and oil began to slide. In December, it fell to 85 cents (point A), with MACD-Histogram tracing a new massive low, which When MACD-Histogram reaches a new multi-month peak, it indicates that bulls are extremely strong, and the corresponding price peak is likely to be retested or exceeded. When MACD-Histogram falls to a new multimonth low, it shows that bears are extremely strong, and the corresponding price low is likely to be retested or exceeded. When MACD-Histogram rises to a new record peak, it shows a terrific splash of bullish enthusiasm. Even if bulls pause to catch their breath, the upside inertia is so strong that the rally is likely to resume after a pause. When MACD-Histogram drops to a new low, it shows that bears are extremely strong. Even if bulls manage to stage a rally, the sheer downside inertia is likely to drive the market to retest or exceed its low. MACD-Histogram works like headlights on a car—it lights up a stretch of the road ahead. It doesn’t show you the entire way home, but lets you see far enough so that driving at a normal speed you can prepare for the twists and turns ahead.
Slide 118: METHOD—TECHNICAL ANALYSIS 109 indicated that bears were extremely strong. There was a brief reflex rally to the EMA, while the indicator turned positive (breaking the back of the bear) and then declined to a more shallow low (point B). At that time prices traced out a kangaroo tail, reaching down to 75 cents, and turned up. That bullish divergence, combined with a tail, gave a buy signal. Remember, no matter how strong the signal, a serious trader needs to use stops. Heating oil resumed its decline and gave a Hound of the Baskervilles sell signal when prices violated their bottom B in area C. It paid to switch to the short side then because heating oil eventually slid below 68. A violation of a bullish divergence of MACD-Histogram is a prime example of the Hound of the Baskervilles signal. The underlying fundamentals must be extremely strong to violate a divergence, and one is well advised to trade in the direction of the break after the stop is hit. If you have the discipline to use stops and reverse after a divergence is violated, you are not going to be afraid the next time you see a divergence. After seeing a new bullish divergence D-E you’ll put on a trade again, using the same principles and rules. At the right edge of the chart a minor bullish divergence is taking shape. Prices have briefly violated their March-April lows and rallied, completing a false downside breakout and giving a bullish signal. The EMA has stopped declining and gone flat. From here, heating oil should be traded from the long side, with a stop below the recent low. Force Index Force Index is an oscillator developed by this author and first described in Trading for a Living. The decision to reveal Force Index was one of the hardest in writing that book. I felt reluctant to disclose my private weapon but remembered how resentful I used to feel while reading books by authors who wrote, in so many words, “Now, of course, you wouldn’t expect me to tell you everything,” I decided I would write either everything or nothing, and describe Force Index. The disclosure did me no harm. Force Index continues to work for me as well as it did before. Very few software companies have included it in their systems, and its behavior on my charts hasn’t changed. This reminds me of a good friend with whom I served on a ship. He was the biggest smuggler I ever met, but he never hid anything far away. Sometimes he’d put the contraband right on his desk, under the noses of customs officers. Leaving a secret in the open can be the best way of hiding it.
Slide 119: 110 THE THREE M’S OF SUCCESSFUL TRADING Force Index helps identify turning points in any market by tying together three essential pieces of information—the direction of price movement, its extent, and volume. Price represents the consensus of value among market participants. Volume reflects their level of commitment, financial as well as emotional. Price reflects what people think, and volume what they feel. Force Index links mass opinion with mass emotion by asking three questions: Is the price going up or down? How big is the change? How much volume did it take to move the price? It is very useful to measure the force of a move because strong moves are more likely to continue than weak ones. Divergences between peaks and bottoms of prices and Force Index help nail important turning points. Spikes of Force Index identify zones of mass hysteria, where trends become exhausted. Here is the Force Index formula: Force Index = (Close today − Close yesterday) • Volumetoday If the market closes higher today than yesterday, Force Index is positive, and if it closes lower, Force Index is negative. The greater the spread between today’s and yesterday’s closes, the greater the force. The higher the volume, the more forceful the move. Force Index is greater when the market moves far on high volume and lesser when the market moves a short distance on thin volume. When the market closes unchanged, Force Index equals zero. Smooth Is Better We can plot Force Index as a histogram, with positive readings above the zero line and negative readings below. The raw Force Index looks very jagged, up one day, down the next. It works better if we smooth it with an exponential moving average and plot it as a line. If we smooth Force Index with a long-term EMA of 13 days or longer, it will measure long-term shifts in the balance of power between bulls and bears. To help pinpoint entries and exits, we should smooth Force Index with a very short moving average, such as a two-day EMA. When the trend of our stock or future is up and the two-day EMA of Force Index declines below zero, it gives a buy signal. When the trend is down and the two-day EMA of Force Index rallies above zero, it gives a sell signal. The key to using a short-term Force Index is to combine it with a trendfollowing indicator. For example, when the 22-day EMA of price is up and the two-day EMA of Force Index becomes negative, it reveals a short-term splash of bearishness within an uptrend, a buying opportunity. Once long,
Slide 120: METHOD—TECHNICAL ANALYSIS 111 S B H S Tail D A C Figure 5.11 Force Index—Two-Day EMA Spikes of a short-term, two-bar Force Index mark areas where trends exhaust themselves. The downward spike in area A showed that the move from 56 to 43 was at its end. Curiously enough, it was immediately followed by an upward spike in area B. This pattern of two adjacent spikes, pointing in opposite directions, shows a great deal of confusion in the markets and is usually followed by a period of flat prices. GE remained flat for almost two months following those two opposing spikes. Technical patterns confirm one another when they give similar messages. The downward spike in area C showed that the downtrend was becoming exhausted. That bullish signal was followed by a bullish divergence between prices and Force Index, which traced a series of higher bottoms while prices tried to grind lower. For fans of classical charting, there was a “reverse head-and-shoulders” pattern. Finally, there was a kangaroo tail at the very low. It looks as if GE keeps ringing a bell and telling us that the decline is over, it is ready to go up! In area D, half-way through the rise from 37 to 53, Force Index starts tracing a bearish divergence, warning that bulls are losing power. When the EMA follows this up by turning down in May, the bullish game is over. It is the last good chance to take profits and position short. At the right edge of the chart the EMA is down and prices have just fallen to a new low, but Force Index is starting to trace a bullish divergence. It tells you to tighten stops on short positions.
Slide 121: 112 THE THREE M’S OF SUCCESSFUL TRADING you have several exit strategies. If you’re very short-term oriented, sell the day after Force Index turns positive, but if your time horizon is wider, hold until prices hit their channel line or the EMA turns flat. When the 22-day EMA of prices is down, and the two-day EMA of Force Index rallies above zero, it reveals a short-term splash of bullishness within a downtrend, a shorting opportunity. If you’re very short-term oriented, grab a quick profit and cover the day after Force Index turns negative. If your time horizon is wider, use the lower channel wall for the profit target. When the two-day EMA of Force Index spikes up or down, exceeding its normal peaks or lows by several times, it identifies an exhaustion move— a signal to take profits on existing positions. When the trend is up and the two-day EMA of Force Index traces a sharp upward spike, eight or more times above its normal height for the past two months, it marks a buying panic. The bulls are afraid of missing the train and bears feel trapped and cover shorts at any cost. Such spikes tend to occur during end-stages of bull moves. They tell you it is a good time to take profits on long positions. Prices often rally to retest the spike day’s high. By then the spirit is gone from the rally and other indicators start developing bearish divergences, warning of a trend reversal. When the two-day EMA of Force Index traces a sharp downward spike during a downtrend, four or more times deeper than normal for the past two months, it marks an hysterical stage of the downmove. It identifies a selling panic among the bulls, who are dumping their holdings at any price to get out. Such spikes tend to occur at the end-stages of bear moves. They tell you that it’s a good time to take profits on short positions. Prices sometimes retest the spike day’s low, but by then most indicators are developing bullish divergences and an upside reversal is coming. Spikes are somewhat similar to the kangaroo tails we discussed earlier (see “The Reality of the Chart” on page 73). The difference between them is that tails are purely price-based, while Force Index reflects volume as well as prices. Tails and spikes identify panics among the weakest players. Once they get flushed out, the trend is ready to reverse. A Reversal Is Coming Trend reversals do not have to come as a surprise; divergences between Force Index and price usually precede them. If the market is trying to rally, but the peaks in Force Index are becoming lower, it is a sign of weakness among the bulls. If a stock or a future is trying to decline, but the bottoms in Force Index are becoming more shallow, it is a sign of weakness among the bears.
Slide 122: METHOD—TECHNICAL ANALYSIS 113 A Tail B C Figure 5.12 Force Index—13-Day EMA A longer-term Force Index, smoothed with a 13-day EMA, identifies longerterm shifts of power between bulls and bears. When it is below zero, bears are in control, and when it is above that line, the bulls are in charge. Divergences between the peaks of this indicator and price peaks precede market tops, whereas divergences between their lows precede important bottoms. In area A, Force Index traces a lower peak during the final price peak. It reveals that bulls are weak and a top is likely. A few days later, the EMA ticks down, confirming that a new downtrend has begun. A mirror image of this pattern occurs in area B, where we see a lower closing price, a higher bottom of Force Index, and a few days later an uptick of the EMA, auguring an important rally. Notice also the double bottom in that area—a kangaroo tail, followed by a retest of the lows. This is one of many examples of patterns and indicators reinforcing each other. In area C Force Index traces a bearish divergence and warns you that the bull move is over. A few days later the EMA ticks down, and it’s all downhill from there. The market keeps sending you messages—all you have to do is listen. At the right edge of the chart the market is declining, confirmed by the falling EMA. Force Index is starting to trace a bullish divergence; it is time to tighten stops on short positions.
Slide 123: 114 THE THREE M’S OF SUCCESSFUL TRADING A divergence between an EMA of Force Index and price shows that the trend is ready to reverse. Divergences between the patterns of peaks or bottoms of Force Index and prices show that the trend is becoming weaker. The power of this message depends on the length of the EMA with which we smooth our Force Index. If we use a very short EMA of Force Index, such as two days, its divergences help pinpoint the ends of shortterm trends lasting a week or so. If we use a 13-day or longer EMA of Force Index, we can identify the ends of longer-term moves that last months. If the trend is up and you are long, take profits when the two-day EMA of Force Index traces a bearish divergence—a lower peak in the indicator during a higher price in the market. If you are short, take profits when the two-day EMA of Force Index traces a bullish divergence—a higher bottom in the indicator during a lower price in the market. Take your profits and monitor the market from the sidelines. It is cheaper to exit and reenter than sit through a countertrend move. It is essential to combine Force Index with trend-following indicators. If you use this oscillator alone, it will lead to overtrading because it is so sensitive. In that case, only your broker will make money. The signals of a short-term oscillator must be filtered using a long-term trend-following indicator. This is the key principle of the Triple Screen trading system. The Fifth Bullet A clip for an old army rifle held only five bullets. Going into action with such a weapon forced one to take good aim instead of shooting wildly. This is a good attitude for trading the markets. By now, we have selected four bullets—exponential moving averages, channels, MACD-Histogram, and Force Index. A moving average and MACD are trend-following indicators. Channels, Force Index, and MACDHistogram are oscillators. What fifth bullet shall we pick? To help you choose your fifth bullet, we’ll review several more tools. Feel free to range beyond this menu, but make sure to understand how each indicator is constructed and what it measures. Test your indicators to develop confidence in their signals. In Trading for a Living I described more than a dozen technical indicators. There are dozens more in other books on technical analysis. Quality and the depth of understanding are more important than quantity. A drowning amateur, grasping at straws, keeps adding indicators. A mature trader selects a few effective tools, learns to use them well, and focuses on system development and money management.
Slide 124: METHOD—TECHNICAL ANALYSIS 115 There are no magic bullets in the markets. There is no perfect or ultimate indicator. A trader who becomes preoccupied with indicators quickly reaches the point of diminishing returns. Your choice of analytic tools depends on your trading style. The idea is to select your tools and quickly move on to where the real money is—system development and risk management. Elder-ray Elder-ray is an indicator developed by this author and named for its similarity to x-rays. It shows the structure of bullish and bearish power below the surface of the markets. Elder-ray combines a trendfollowing moving average with two oscillators to show when to enter and exit long or short positions. Most software developers fail to include Elder-ray in their packages, but you can do it yourself with minimal programming. To plot Elder-ray, divide your computer screen into three horizontal panels. Plot a chart of the stock you plan to analyze in the top panel and add an exponential moving average. The second and third panels will contain Bull Power and Bear Power, plotted as histograms. Here are the Elder-ray formulae: Bull Power = High − EMA Bear Power = Low − EMA A moving average reflects the average consensus of value. The high of each bar reflects the maximum power of bulls during that bar. The low of each bar marks the maximum power of bears during that bar. Elder-ray works by comparing the power of bulls and bears during each bar with the average consensus of value. Bull Power reflects the maximum power of bulls relative to the average consensus, and Bear Power the maximum power of bears relative to that consensus. We plot Bull Power in the second windowpane as a histogram. Its height reflects the distance between the top of the price bar and the EMA—the maximum power of bulls. We plot Bear Power in the third windowpane. Its depth reflects the distance between the low of the price bar and the EMA—the maximum power of bears. When the high of a bar is above the EMA, Bull Power is positive. When the entire bar sinks below the EMA, which happens during severe declines, Bull Power becomes negative. When the low of a bar is below the EMA, Bear Power is negative. When the entire bar rises above the EMA, which happens during wild rallies, Bear Power becomes positive.
Slide 125: 116 THE THREE M’S OF SUCCESSFUL TRADING The slope of a moving average identifies the current trend of the market. When it rises, it shows that the crowd is becoming more bullish; it is a good time to be long. When it falls, it shows that the crowd is becoming more bearish; it is a good time to be short. Prices keep getting away from a moving average but snap back to it, as if pulled by a rubber band. Bull Power and Bear Power show the length of that rubber band. Knowing the A bull power B C D E bear power Figure 5.13 Elder-ray “Buy low, sell high” sounds good, but traders and investors seem to have been more comfortable buying Lucent above 70 than below 7. Perhaps they are not as rational as the efficient market theorists would like us to believe? Elder-ray gives rational traders a glimpse into what is going on below the surface of the market. When the trend, identified by the 22-day EMA, is down and bulls are under water, the rallies back to the surface mark shorting opportunities (arrows A and B). Prices draw a kangaroo tail in area C, and a sharp rally follows. A rise from 5.50 to 11.50 is nothing to sneeze at; cheaper stocks tend to have bigger percentage gains. In area D, Lucent slides to a new low, but Bear Power traces a more shallow bottom, completing a bullish divergence. That false downside breakout traps bears. As the rally accelerates, Bear power becomes positive and each dip of Bear power back to its zero line marks a buying opportunity (area E).
Slide 126: METHOD—TECHNICAL ANALYSIS 117 normal height of Bull or Bear Power reveals how far prices are likely to get away from their moving average before returning. Elder-ray offers one of the best insights into where to take profits—at a distance away from the moving average that equals the average Bull Power or Bear Power. Elder-ray gives buy signals in uptrends when Bear Power turns negative and then ticks up. A negative Bear Power means that the bar is straddling the EMA, with its low below the average consensus of value. Waiting for Bear Power to turn negative forces you to buy value rather than chase runaway moves. The actual buy signal is given by an uptick of Bear Power, which shows that bears are starting to lose their grip and the uptrend is about to resume. Take profits at the upper channel line or when a trendfollowing indicator stops rising. Profits may be greater if you ride the uptrend to its conclusion, but taking profits at the upper channel line is more reliable. Elder-ray gives shorting signals in downtrends when Bull Power turns positive and then ticks down. We can identify the downtrend by a declining daily or weekly EMA. A positive Bull Power shows that the bar is straddling the EMA, with its high above the average consensus of value. Waiting for Bull Power to turn positive before shorting forces you to sell at or above value instead of chasing waterfall declines. The actual shorting signal is given by a downtick of Bull Power, which shows that bulls are starting to slip and the downtrend is about to resume. Once short, take profits at the lower channel line or when the trend-following indicator stops falling, depending on your style. You can make more money by holding on for the duration of the downtrend, but it is easier to achieve steady results by taking profits at the lower channel line. A beginning trader is better off learning to catch short swings, while leaving long-term trend trading for a later stage of development. Stochastic This oscillator identifies overbought and oversold conditions, helping us buy low or sell high. Just as important, it helps avoid buying at high prices or shorting at low prices. This indicator was popularized by George Lane decades ago and is now included in most software packages. Stochastic measures the capacity of bulls to close prices near the top of the recent trading range and the capacity of bears to close them near the bottom. It ties the high of the range, representing the maximum power of bulls, with the low, representing the maximum power of bears, and with closing prices, the final balance in the markets, representing the actions of smart money.
Slide 127: 118 THE THREE M’S OF SUCCESSFUL TRADING Bulls may push prices higher during the day, or bears may push them lower, but Stochastic measures their performance at closing time—the crucial money-counting time in the markets. If bulls lift prices during the day but cannot close them near the high of the recent range, Stochastic turns down, identifying weakness and giving a sell signal. If bears push prices down during the day but cannot close them near the lows, Stochastic turns up, identifying strength and giving a buy signal. There are two types of Stochastic: Fast and Slow. Both consist of two lines: the fast line, called %K, and the slow line, called %D. We construct Fast Stochastic in two steps and Slow Stochastic in three steps: 1. Obtain %K, the fast line. %K = where Close today = Lown = Highn = n = Close today − Low n High n − Low n • 100 today’s close the lowest low for the selected number of bars the highest high for the selected number of bars the number of bars for Stochastic (selected by the trader) We have to choose the number of days, or bars, over which to calculate Stochastic—the value of n. If we use a low number, below 10, Stochastic will focus on the recent bars and flag minor turning points. If we choose a wider window, Stochastic will look at more data and flag major turns, missing minor ones. How wide should we make the Stochastic window? Since we use oscillators to catch reversals, short-term windows are better; we should reserve longer time windows for trend-following indicators. Five or seven days are a good starting point, but consider testing longer parameters to find the ones that work best in your market. 2. Obtain %D, the slow line. We obtain %D by smoothing the fast line %K over a number of bars that is shorter than %K. For example, if we decide to plot a five-day Stochastic, we will use the value of five for the %K formula, above, and three bars for the %D formula, below: %D = Three -bar sum of Close today − Low n Three -bar sum of (High n − Low n ) ( ) • 100
Slide 128: METHOD—TECHNICAL ANALYSIS 119 Fast Stochastic is very sensitive to price changes, making its lines appear jagged. It pays to add one more step and convert it into a smoother Slow Stochastic. Of course, a computer does this all automatically. 3. Convert Fast Stochastic into Slow Stochastic. The slow line of Fast Stochastic becomes the fast line of Slow Stochastic. Repeat step 2, above, to obtain the slow line %D of Slow Stochastic. Stochastic is designed to oscillate between 0 and 100. Low levels mark oversold markets, and high levels mark overbought markets. Overbought means too high, ready to turn down. Oversold means too low, ready to turn up. Draw horizontal reference lines at levels that have marked previous tops and bottoms, starting with 15 near the lows and 85 near the highs. Look for buying opportunities when Stochastic nears its lower reference line. Look for selling opportunities when Stochastic nears its upper reference line. Buying when Stochastic is low is emotionally hard because markets usually look terrible near bottoms, which is precisely the right time to buy. When Stochastic rallies to its upper reference line, it tells you to start looking for selling opportunities. This also goes against the grain emotionally. When Stochastic rallies to a top, the market often looks fantastic, which is a good time to sell. We should not use Stochastic alone, in a mechanical manner. When a strong uptrend takes off, Stochastic quickly becomes overbought and starts flashing sell signals. In a powerful bear market, Stochastic becomes oversold and flashes premature buy signals. This indicator works well only if you use it with a trend-following indicator and take only those Stochastic signals that point in the direction of the main trend. Should a trader wait for Stochastic to turn up to recognize a buy signal? Should he wait for it to turn down to recognize a sell signal? Not really, because by the time Stochastic turns, a new move is usually under way. If you are looking for an opportunity to enter, the mere fact of Stochastic reaching an extreme gives you a signal. Go long when Stochastic traces a bullish divergence, that is, when prices fall to a new low but the indicator makes a more shallow low. Go short when Stochastic traces a bearish divergence, that is, when prices rise to a new high but the indicator ticks down from a lower peak than during the previous rally. In an ideal buying situation, the first Stochastic low is below and the second above the lower reference line. The best sell signals occur when the first top of Stochastic is above and the second below the upper reference line.
Slide 129: 120 THE THREE M’S OF SUCCESSFUL TRADING A B C D EF G H I Figure 5.14 Stochastic It may feel good to buy when prices are high and it brings relief to sell when prices fall, but Stochastic helps you do the right thing—buy low and sell high. When it declines to its lower reference line, it tells you the market is oversold and gives a signal to buy (points B, C, and F). Whether you buy or not, low Stochastic prevents you from shorting when it falls to low levels. When Stochastic rises to its upper reference line, it gives a sell signal (points A, D, G, and H). A sell signal may be premature in a strong uptrend, but whether you take it or not, one thing is clear—it is too late to buy. Stochastic helps you avoid chasing trends. Divergences give the strongest signals. At point E, Exxon rises to a double top, while Stochastic traces a lower top—a bearish divergence, a strong sell signal. A powerful rally begins in March, but by May there is a bearish divergence—a sign that the party is coming to an end. There is one more chance to sell and go short when a triple bearish divergence appears at point I—it is all downhill from there. At the right edge of the chart XOM is declining, confirmed by the falling EMA. Stochastic is trying to trace a bullish divergence, but the second bottom is almost as low as the first; the bears are very strong, and the decline is likely to continue.
Slide 130: METHOD—TECHNICAL ANALYSIS 121 Do not buy when Stochastic is above its upper reference line and do not sell short when it is below its lower reference line. These “no go” rules are probably the most useful messages of Stochastic. Moving averages are better than Stochastic at identifying trends, MACD-Histogram is better at identifying reversals, channels are better at identifying profit targets, and Force Index is sharper at catching entry and exit points. The trouble with them is that they give action signals most of the time. Stochastic identifies danger zones, just like a line of red flags on a ski slope marks unsafe areas for skiers. It says “no go” just when you feel tempted to chase a trend. Ready to Hunt? Your choice of indicators depends on personal preferences, just like selecting a car. Be sure to combine trend-following indicators, which identify trends, with oscillators, which identify reversals. In addition to the indicators described above, you may want to take a look at the Directional indicator, which does a good job of signaling trends. It consists of several components, one of which, ADX, helps identify new bull markets. Williams %R is an oscillator similar to Stochastic, especially useful for showing when to pyramid winning positions. Relative Strength Index (RSI) is an oscillator based entirely on closing prices. It helps track the behavior of market professionals who tend to dominate markets at closing time. All of them are described in Trading for a Living. Keep in mind that no single indicator can guarantee you victory in the trading game. Trend-following indicators, such as moving averages, catch trends but produce whipsaws in trading ranges. Oscillators identify tops and bottoms during trading ranges but flash premature countertrend signals when the markets begin to run. Trading signals are easy to recognize in the middle of the chart, but hard to see at the right edge. There is no magic indicator. All indicators are building blocks of trading systems. A good system uses several tools, combining them so that their negative features filter each other out, while their positive features remain undisturbed.
Slide 132: CHAPTER SIX TRADING B eginners become emotional when they trade, but if you want to survive and succeed, you must develop discipline. The moment you become aware of feeling fear or joy, use that as a signal to tighten your discipline and follow your system. You developed that system when the markets were closed and you felt calm. Now it gives you your only chance of survival and success in the markets. The idea of an automatic trading system is fundamentally flawed. If those systems could work, then the smartest guy with the biggest computer would have cornered the market long ago. Automatic systems do not work because the market is not a mechanical or electronic entity that follows the laws of physics. It is a huge crowd of people acting in accordance with the imperfect laws of mass psychology. Physics and mathematics can help, but trading decisions must take psychology into account. When you talk with a pro, one of the first questions he’ll ask—or not even ask because he’ll know the answer from a few of your comments—is whether you are a discretionary trader or a system trader. A discretionary trader takes in market information and analyzes it using several technical tools. He is likely to shift and apply somewhat different tools to different markets at different times. His decision-making tree has many branches, and he follows them at different times as market conditions change. All branches are connected to the sturdy trunk of his decision-making tree, an inviolate set of rules for risk control. A system trader develops a mechanical set of rules for entering and exiting trades. He backtests them and puts them on autopilot. At that point, an amateur and a pro go in opposite directions. An amateur, frightened by the market, feels relieved that a system, either his own 123
Slide 133: 124 THE THREE M’S OF SUCCESSFUL TRADING or bought from someone else, will free him from worry. Market conditions always change and all systems self-destruct, which is why every amateur with a mechanical system must lose money in the end. A pro who puts his system on autopilot continues to monitor it like a hawk. He knows the difference between a normal drawdown period and a time when a system deteriorates and has to be shelved and replaced. A professional system trader can afford to use a mechanical system precisely because he is capable of discretionary trading! In my experience, system traders tend to achieve more consistent results, but the best and most successful traders use the discretionary approach. The choice depends on your temperament rather than a cold business decision. Some people feel attracted to system trading, others to discretionary trading. Much of what you read in this book deals with discretionary trading. All of these components can be used in systematic trading. This book is written to help both types of traders. A trading system is an action plan for the market, but no plan can anticipate everything. A degree of judgment is always required, even with the best and most reliable plans. Think of any other plan or system in your life. For example, you probably have a system for taking your car out of the garage. You need to open the garage door, start the car, warm up the engine, and pull the car out into the street without bumping into walls, running over tricycles, or getting hit by passing trucks. You have a system in the sense that you perform the same actions each time in the same sequence, not thinking of the routine but paying attention to what is important—watching out for dangers, such as kids on bicycles, or freshly fallen snow, or a neighbor crossing the sidewalk. When you detect an obstacle, you deviate from your system, and return to it after the situation returns to normal. You would not try to design a complete system, which would include dealing with the snow, and the bicyclists, and the neighbors because that system would be too complex and still could never be complete—a neighbor could come into your car’s path from another angle. A system automates routine actions and allows you to exercise discretion when needed. And that’s what you need in the markets—a system for finding trades, setting stops, establishing profit targets—all the while paying attention to a heavy truck headed toward you in the shape of a Federal Reserve announcement or a kid on a tricycle in the form of a disappointing earnings report. Many beginners set themselves the impossible
Slide 134: TRADING 125 task of designing or buying a complete trading system, which is just as impossible as a complete system for pulling your car out of the garage. I have two friends who earn a good living testing systems for traders. Both are expert programmers. One of them laughed as he told me how he gets at least one phone call a week from yet another amateur who thinks he has discovered the Holy Grail. He wants his automatic set of rules backtested to find the best parameters, and his only concern is that the programmer should not steal his secret! I asked my friend how many profitable automatic systems he found during several years of backtesting. Not one. Not one? Doesn’t he get discouraged doing this kind of work? Well, what keeps him going is that he has a handful of steady clients who are successful professional traders. They bring him snippets of trading methods for testing. They may test their parameters for placing stops, the length of MACD, and so on. Then they use their own judgment to bind those snippets into a decision-making tree. An intelligent trading system includes components that have been backtested, but the trader retains control over his actions. He has several inviolate rules, mostly having to do with risk control and money management, but allows himself latitude in combining those components to reach trading decisions. An intelligent trading system is an action plan for entering and exiting markets that spells out several specific functions, such as finding trades or protecting capital. Most actions, such as entries, exits, and adjusting stops, can be partly but not fully automated. Thinking is a hard job; a mechanical trading system tempts you by promising you won’t have to think any more, but that’s a false promise. To be a successful trader you need to use your judgment. A trading system is a style of trading, not an automatic turnkey operation. SYSTEM TESTING You must test each indicator, rule, and method before including them in your trading system. Many traders do this by dumping historical data into testing software and obtaining a printout of their system’s parameters. The profit-loss ratio, the biggest and the smallest profit or loss, the average profit and loss, the longest winning and losing streaks, the average profit, and the average or the maximum drawdowns give the appearance of objectivity and solidity.
Slide 135: 126 THE THREE M’S OF SUCCESSFUL TRADING Those printouts provide a false sense of security. You may have a very nice printout, but what if the system delivers five losses in a row, while you trade real money? Nothing in your testing has prepared you for that, but it happens all the time. You grit your teeth and put on another trade. Another loss. Your drawdown is getting deeper. Will you put on the next trade? Suddenly, an impressive printout looks like a very thin reed on which to hang your future, while your account is being whittled away. The attraction of electronic testing is such that there is now a small cottage industry of programmers who test systems for a fee. Some traders spend months, if not years, learning to use testing software. A loser who cannot admit he’s afraid to trade has a wonderful excuse that he is learning new software. He’s like a swimmer who is afraid of water and keeps himself busy ironing his swimsuit. Only one kind of system testing makes sense. It is slow, it is timeconsuming, and it does not lend itself to testing a hundred markets at once, but it’s the only method that prepares you for trading. It consists of going through historical data one day at a time, scrupulously writing down your trading signals for the day ahead, then clicking your chart forward and recording the trades and signals for the next day. Begin by downloading your stock or futures data for a minimum of two years. Swing to the left side of the file, without looking at what happened next. Open your technical analysis program and a spreadsheet. The two most important keys for traders on a computer are Alt and Tab because they let you switch between two programs. Open two windows in your analytic program—one for your long-term chart with its indicators, the other for the short-term chart. Open a spreadsheet, write down your system’s rules at the top of the page and create columns for the date, entry date and price, and the exit date and price. Turn to the weekly chart and note its signal, if any. If it gives you a buy or sell signal, go to the daily chart ending on the same date to see whether it gives you a buy or a sell signal as well. If it does, record the order you have to place in your spreadsheet. Now return to the daily chart and click one day forward. See whether your buy or sell order was triggered. If so, return to the spreadsheet and record the result. Track your trade day by day, calculating stops and deciding where to take profits. Follow this process throughout your entire data file, advancing a week at a time on the weekly chart, a day at a time on the daily chart. At every click write down your system’s signals and your actions.
Slide 136: TRADING 127 As you click forward, one day at a time, the market history will slowly unfold and challenge you. You click and a buy signal comes into view. Will you take it? Record your decision in a spreadsheet. Will you take profits at a set target, on a sell signal, or on the basis of price action? You are doing much more than testing a set of rigid rules. Moving ahead day by day, you develop your decision-making skills. This one-bar-at-a-time forward testing is vastly superior to what you get from backtesting software. How will you deal with gap openings when prices open above your buy level or below your stop? What about limit moves in futures? Should the system be adjusted, changed, or scrapped? Clicking forward one day at a time gets you as close to the real experience of trading as you can ever get without putting on a trade. It puts you in touch with the raw edge of the market, which you can never experience through an orderly printout from a professional system tester. Manual testing will improve your ability to think, recognize events, and act in the foggy environment of the market. Your trading plans must include certain absolute rules, most of them concerning money management. As long as you stay within those rules, you have much freedom in trading the markets. Your growing levels of knowledge, maturity, judgment, and skill are much more important assets than any computerized testing. Paper Trading Paper trading means recording your decision to trade and tracking it as if it were a real trade, only without money. Most of those who paper trade have lost their nerve after getting beat up by the markets. Some people alternate between real trades and paper trades and cannot understand why they seem to make money on paper but lose whenever they put on a real trade. This happens for two reasons. First, people tend to be less emotional with paper. Good decisions are easier to make when your money is not on the line. Second, good trades often look murky at entry time. The easy-looking ones are more likely to lead to problems. A nervous beginner jumps into obvious-looking trades but paper trades the more promising ones. It goes without saying that hopping between real trading and paper trading is sheer nonsense. You either do one or the other. There is only one good reason to paper trade—to test your discipline.
Slide 137: 128 THE THREE M’S OF SUCCESSFUL TRADING If you can download your data at the end of each day, do your homework, write down your orders for the day ahead, watch the opening and record your entries, and then track your market each day, adjusting your profit targets and stops—if you can do all of this for several months in a row, recording your actions, without skipping a day— then you probably have the discipline to trade that market. Someone who is in it for entertainment will not be able to paper trade this way because it requires work. To paper trade your system, download your data at the end of each day. Apply your tools and techniques, reach trading decisions, calculate stops and profit targets, and write them down for tomorrow. Do not place your orders with a broker, but check whether they would have been triggered and write down those fills. Enter paper trades in your spreadsheet and your trading diary (see Chapter 8, “The Organized Trader”). If you have the willpower to repeat this process daily for several months, then you have the discipline for successful trading with real money. Still, there is no substitute for trading with real money, because it engages emotions more than any paper trade. It is better to learn by putting on very small real trades than paper trades. TRIPLE SCREEN UPDATE One of the most pleasant encounters that occur several times each year is when a trader comes up to me at some conference and tells me how he started trading for a living after studying my book or participating in a Camp. At that point, he may be living and trading on a mountaintop, and as often as not he owns the mountaintop. I noticed long ago that half-way through our conversation these people become slightly apologetic. They tell me they use Triple Screen, but not exactly the way I taught it. They may have modified an indicator, added another screen, substituted a tool, and so forth. Whenever I hear that, I know I am talking to a winner. First of all, I tell them they owe their success primarily to themselves. I did not teach them any differently than the dozens of others in the same class. Winners have the discipline to take what is offered and use it to succeed. Second, I see their apology for having changed some aspects of my system as an indication of their winning attitude. To benefit from a system, you must test its parameters and fine-tune them until that system becomes your own, even though originally it was developed by someone else. Winning takes discipline, discipline comes from confi-
Slide 138: TRADING 129 dence, and the only system in which you can have confidence is the one you have tested on your own data and adapted to your own style. I developed the Triple Screen trading system in the mid-1980s and first presented it to the public in 1986 in an article in Futures magazine. I updated it in Trading for a Living and several videos. Here I will review it, focusing on recent enhancements. What is a trading system? What’s the difference between a method, a system, and a technique? A method is a general philosophy of trading. For example; trade with the trend, buy when the trend is up, and sell after it tops out. Or—buy undervalued markets, go long near historical support levels, and sell after resistance zones have been reached. A system is a set of rules for implementing a method. For example, if our method is to follow trends, then the system may buy when a multi-week moving average turns up and sell when a daily moving average turns down (get in slow, get out fast). Or—buy when the weekly MACDHistogram ticks up and sell after it ticks down. A technique is a specific rule for entering or exiting trades. For example, when a system gives a buy signal, the technique could be to buy when prices exceed the high of the previous day or if prices make a new low during the day but close near the high. The method of Triple Screen is to analyze markets in several timeframes and use both the trend-following indicators and oscillators. We make a strategic decision to trade long or short using trend-following indicators on long-term charts. We make tactical decisions to enter or exit using oscillators on shorter-term charts. The original method has not changed, but the system—the exact choice of indicators—has evolved over the years, as have the techniques. Triple Screen examines each potential trade using three screens or tests. Each screen uses a different timeframe and indicators. These screens filter out many trades that seem attractive at first. Triple Screen promotes a careful and cautious approach to trading. Conflicting Indicators Technical indicators help identify trends or turns more objectively than chart patterns. Just keep in mind that when you change indicator parameters, you influence their signals. Be careful not to fiddle with indicators until they tell you what you want to hear.
Slide 139: 130 THE THREE M’S OF SUCCESSFUL TRADING We can divide all indicators into three major groups: Trend-following indicators help identify trends. Moving averages, MACD lines, Directional system, and others rise when the markets are rising, decline when markets fall, and go flat when markets enter trading ranges. Oscillators help catch turning points by identifying overbought and oversold conditions. Envelopes or channels, Force Index, Stochastic, Elder-ray, and others show when rallies or declines outrun themselves and are ready to reverse. Miscellaneous indicators help gauge the mood of the market crowd. Bullish Consensus, Commitments of Traders, New High–New Low Index, and others reflect the general levels of bullishness or bearishness in the market. Different groups of indicators often give conflicting signals. Trendfollowing indicators may turn up, telling us to buy, while oscillators become overbought, telling us to sell. Trend-following indicators may turn down, giving sell signals, while oscillators become oversold, giving buy signals. It is easy to fall into the trap of wishful thinking and start following those indicators whose message you like. A trader must set up a system that takes all groups of indicators into account and handles their contradictions. Conflicting Timeframes An indicator can call an uptrend and a downtrend in the same stock on the same day. How can this be? A moving average may rise on a weekly chart, giving a buy signal, but fall on a daily chart, giving a sell signal. It may rally on an hourly chart, telling us to go long, but sink on a 10minute chart, telling us to short. Which of those signals should we take? Amateurs reach for the obvious. They grab a single timeframe, most often daily, apply their indicators and ignore other timeframes. This works only until a major move swells up from the weeklies or a sharp spike erupts from the hourly charts and flips their trade upside down. Whoever said that ignorance was bliss was not a trader. People who have lost money with daily charts often imagine they could do better by speeding things up and using live data. If you cannot make money with dailies, a live screen will only help you lose faster. Screens hypnotize losers, but a determined one can get even closer to the market by renting a seat and going to trade on the floor. Pretty soon a margin clerk for the clearing house notices that the new trader’s
Slide 140: TRADING 131 equity has dropped below limit. He sends a runner into the pit who taps that person on the shoulder. The loser steps out and is never seen again—he has “tapped out.” The problem with losers is not that their data is too slow, but their decision-making process is a mess. To resolve the problem of conflicting timeframes, you should not get your face closer to the market, but push yourself further away, take a broad look at what’s happening, make a strategic decision to be a bull or a bear, and only then return closer to the market and look for entry and exit points. That’s what Triple Screen is all about. What is long term and what is short term? Triple Screen avoids rigid definitions by focusing instead on the relationships between timeframes. It requires you to begin by choosing your favorite timeframe, which it calls intermediate. If you like to work with daily charts, your intermediate timeframe is daily. If you are a day-trader and like fiveminute charts, then your intermediate timeframe is the five-minute chart, and so on. Triple Screen defines the long term by multiplying the intermediate timeframe by five (see “Time—The Factor of Five,” page 87). If your intermediate timeframe is daily, then your long-term timeframe is weekly. If your intermediate timeframe is five minutes, then your long-term is half-hourly, and so forth. Choose your favorite timeframe, call it intermediate, and immediately move up one order of magnitude to a long-term chart. Make your strategic decision there, and return to the intermediate chart to look for entries and exits. The key principle of Triple Screen is to begin your analysis by stepping back from the markets and looking at the big picture for strategic decisions. Use a long-term chart to decide whether you are bullish or bearish, and then return closer to the market to make tactical choices about entries and exits. The Principles of Triple Screen Triple Screen resolves contradictions between indicators and timeframes. It reaches strategic decisions on long-term charts, using trendfollowing indicators—this is the first screen. It proceeds to make tactical decisions about entries and exits on the intermediate charts, using oscillators—this is the second screen. It offers several methods for placing buy and sell orders—this is the third screen, which we may implement using either intermediate- or short-term charts.
Slide 141: 132 THE THREE M’S OF SUCCESSFUL TRADING Begin by choosing your favorite timeframe, the one with whose charts you like to work, and call it intermediate. Multiply its length by five to find your long-term timeframe. Apply trend-following indicators to long-term charts to reach a strategic decision to go long, short, or stand aside. Standing aside is a legitimate position. If the long-term chart is bullish or bearish, return to the intermediate charts and use oscillators to look for entry and exit points in the direction of the longterm trend. Set stops and profit targets before switching to short-term charts, if available, to fine-tune entries and exits. SCREEN ONE Choose your favorite timeframe and call it intermediate. Multiply it by five to find the long-term timeframe. Let’s say you prefer to work with daily charts. In that case, move immediately one level higher, to the weekly chart. Do not permit yourself to peek at the dailies because this may color your analysis of weekly charts. If you are a day-trader, you might choose a 10-minute chart as your favorite, call it intermediate, and then immediately move up to the hourly chart, approximately five times longer. Rounding off is not a problem; technical analysis is a craft, not an exact science. If you are a long-term investor, you might choose a weekly chart as your favorite and then go up to the monthly. Apply trend-following indicators to the long-term chart and make a strategic decision to trade long, short, or stand aside. The original version of Triple Screen used the slope of weekly MACD-Histogram as its weekly trend-following indicator. It was very sensitive and gave many buy and sell signals. I now prefer to use the slope of a weekly exponential moving average as my main trend-following indicator on longterm charts. When the weekly EMA rises, it confirms a bull move and tells us to go long or stand aside. When it falls, it identifies a bear move and tells us to go short or stand aside. I use a 26-week EMA, which represents half a year of trading. You can test several different lengths to see which tracks your market best, as you would with any indicator. I continue to plot weekly MACD-Histogram. When both EMA and MACD-Histogram are in gear, they confirm a dynamic trend and encourage you to trade larger positions. Divergences between weekly MACD-Histogram and prices are the strongest signals in technical analysis, which override the message of the EMA.
Slide 142: TRADING 133 A B Figure 6.1 Triple Screen—Weekly Chart Gaming stocks tend to do well in a weak economy—gambling appeals to people down on their luck. In 2000 and 2001, as the broad stock market was declining, gaming stocks put in a stellar performance. Alliance Gaming, for instance, rallied from below 2 to over 40, with very few pullbacks. How could Triple Screen help us benefit from this performance? The pattern between points A and B is called a saucer bottom, a slow drawn-out minimal decline and just as minimal a rise on hardly any volume. Still, during that time ALLY had managed to put in a bullish divergence of MACD-Histogram, a hugely powerful signal that is rarely seen on weekly charts. It traced a low in area A, but could not even push below zero at the bottom of the saucer. The first vertical arrow marks the point where MACD-Histogram starts trending higher. A few weeks later the weekly EMA also turns up, and at that point, with both weekly indicators trending up, ALLY becomes a screaming buy. It is time to switch to the daily charts and look for buying opportunities. The second vertical arrow marks another period when both the EMA and MACD-Histogram are in gear to the upside, and then the stock doubles in a few weeks. The clean, steady uptrend of the weekly EMA keeps telling us to trade ALLY only from the long side. At the right edge of the chart, the weekly EMA keeps trending higher, but wildly volatile price action shows that the easy portion of the uptrend is over. MACD-Histogram is moving opposite the EMA, warning of high volatility ahead. The relatively easy money is off the table.
Slide 143: 134 THE THREE M’S OF SUCCESSFUL TRADING SCREEN TWO Return to the intermediate chart and use oscillators to look for trading opportunities in the direction of the long-term trend. When the weekly trend is up, wait for daily oscillators to fall, giving buy signals. Buying dips is safer than buying the crests of waves. If an oscillator gives a sell signal while the weekly trend is up, you may use it to take profits on long positions but not to sell short. Figure 6.2 Triple Screen—Daily Chart The uptrend on the weekly chart keeps telling us to trade ALLY from the long side or stand aside. With the daily EMA also rising, we have several options. We may buy when prices pull back to their rising daily EMA, or when short-term Force Index dips below zero. The upper channel line provides a logical profit-taking target. An experienced trader can pyramid his position, adding to it whenever a new buy signal appears and only tightening stops instead of exiting at the upper channel. That channel keeps getting wider as prices rise—from 10 points wide in April to 16 in July. At the right edge of the chart, the alternating spikes of Force Index warn traders that the days of relatively easy money are over. The market has become hysterical, and the likelihood of trend continuation is low. Better bank your winnings and go look for another stock in another group that is rising or falling quietly, not yet discovered by the market crowd.
Slide 144: TRADING 135 When the weekly trend is down, look for daily oscillators to rise, giving sell signals. Shorting during upwaves is safer than selling new lows. When daily oscillators give buy signals, you may use them to take profits on shorts but not to buy. The choice of oscillators depends on your trading style. For conservative traders, choose a relatively slow oscillator, such as daily MACD-Histogram or Stochastic, for the second screen. When the weekly trend is up, look for daily MACD-Histogram to fall below zero and tick up, or for Stochastic to fall to its lower reference line, giving a buy signal. Reverse these rules for shorting in bear markets. When trendfollowing indicators point down on the weekly charts, but daily MACDHistogram ticks down from above its zero line, or Stochastic rallies to its upper reference line, they give sell signals. A conservative approach works best during early stages of major moves, when markets gather speed slowly. As the trend accelerates, pullbacks become more shallow. To hop aboard a fast-running trend, you need faster oscillators. For active traders, use the two-day EMA of Force Index (or longer, if that’s what your research suggests for your market). When the weekly trend is up and daily Force Index falls below zero, it flags a buying opportunity. Reverse these rules for shorting in bear markets. When the weekly trend is down and the two-day EMA of Force Index rallies above zero, it points to shorting opportunities. Many other indicators can work with Triple Screen. The first screen can also use Directional System or trendlines. The second screen can use Momentum, Relative Strength Index, Elder-ray, and others. The second screen is where we set profit targets and stops and make a go–no go decision about every trade after weighing the level of risk against the potential gain. Set the stops. A stop is a safety net, which limits the damage from any bad trade. You have to structure your trading in such a way that no single bad loss, or a nasty series of losses, can damage your account. Stops are essential for success, but many traders shun them. Beginners complain about getting whipsawed, stopped out of trades that eventually would have made them money. Some say that putting in a stop means asking for trouble because no matter where you put it, it will be hit.
Slide 145: 136 THE THREE M’S OF SUCCESSFUL TRADING First of all, you need to place stops where they are not likely to be hit, outside of the range of market noise (see SafeZone on page 173). Second, an occasional whipsaw is the price of long-term safety. No matter how great your analytic skills, stops are always necessary. You should move stops only one way—in the direction of the trade. When a trade starts moving in your favor, move your stop to a breakeven level. As the move persists, continue to move your stop, protecting some of your paper profit. A professional trader never lets a profit turn into a loss. A stop may never expose more than 2% of your equity to the risk of loss (see Chapter 7, “Money Management Formulas”). If Triple Screen flags a trade but you realize that a logical stop would risk more than 2% of your equity, skip that trade. Set profit targets. Profit targets are flexible and depend on your goals and capital. If you are a well-capitalized, long-term-oriented trader, you may build up a large position at an early stage of a bull market, repeatedly taking buy signals from the daily charts, as long as the weekly trend is up. Take your profits after the weekly EMA turns flat. The reverse applies to downtrends. Another option is to take profits whenever prices on the daily charts hit their channel line. If you go long, sell when prices hit the upper channel line and look to reposition on the next pullback to the daily moving average. If you go short, cover when prices fall to their lower channel line and look to reposition short on the next rally to the EMA. A short-term-oriented trader can use the signals of a two-day EMA of Force Index to exit trades. If you buy in an uptrend when the twoday EMA of Force Index turns negative, sell when it turns positive. If you go short in a downtrend after the two-day EMA of Force Index turns positive, cover when it turns negative. Beginners often approach markets like a lottery—buy a ticket and sit in front of the TV to find out whether you have won. You will know that you are becoming a professional when you start spending almost as much time thinking about exits as looking for entries. SCREEN THREE The third screen helps us pinpoint entry points. Live data can help savvy traders but hurt beginners who may slip into day-trading.
Slide 146: TRADING 137 Use an intraday breakout or pullback to enter trades without realtime data. When the first two screens give you a buy signal (the weekly is up, but the daily is down), place a buy order at the high of the previous day or a tick higher. A tick is the smallest price fluctuation permitted in any market. We expect the major uptrend to reassert itself and catch a breakout in its direction. Place a buy order, good for one day only. If prices break out above the previous day’s high, you will be stopped in automatically. You do not have to watch prices intraday, just give your order to a broker. When the first two screens tell you to sell short (the weekly is down, but the daily is up), place a sell order at the previous day’s low or a tick lower. We expect the downtrend to reassert itself, and try to catch the downside breakout. If prices break below the previous day’s low, they will trigger your entry. Daily ranges can be very wide, and placing an order to buy at the top can be expensive. Another option is to buy below the market. If you are trying to buy a pullback to the EMA, calculate where that EMA is likely to be tomorrow and place your order at that level. Alternatively, use the SafeZone indicator (see page 173) to find how far the market is likely to dip below its previous day’s low and place your order at that level. Reverse these approaches for shorting in downtrends. The advantage of buying upside breakouts is that you follow an impulse move. The disadvantage is that you buy high and your stop is far away. The advantage of bottom fishing is that you get your goods on sale and your stop is closer. The disadvantage is the risk of getting caught in a downside reversal. A “breakout entry” is more reliable, but profits are smaller; a “bottom-fishing entry” is riskier, but the profits are greater. Make sure to test both methods in your markets. Use real-time data, if available, for entering trades. When the first two screens give you a buy signal (the weekly is up, but the daily is down), use live data to get long. You could follow a breakout from the opening range, when prices rally above the high of the first 15 to 30 minutes of trading, or apply technical analysis to intraday charts and finesse your entry. When trying to short, you may enter on a downside breakout from the opening range. You could also monitor the market intraday and use technical analysis to enter into a short trade, using live charts. The techniques for finding buy and sell signals on real-time charts are the same as on daily charts, only their speed is much higher. If you use
Slide 147: 138 THE THREE M’S OF SUCCESSFUL TRADING weeklies and dailies to get in, use them also to get out. Once a live chart gives an entry signal, avoid the temptation to exit using intraday data. Do not forget that you entered that trade on the basis of weekly and daily charts, expecting to hold for several days. Do not be distracted by the intraday chop if you are trading swings that last several days. DAY-TRADING Day-trading means entering and exiting trades on the same day. Watching money flow from the screen into your account is extremely appealing. Surely we are smart enough to use modern technology to outrun slow-moving folks who follow their stocks through the newspapers. Every partial truth contains a dangerous lie. Day-trading can bring profits to professionals, but it is also a common last stop for losers who blow what little is left of their accounts. Day-trading offers advantages and disadvantages, while placing extreme demands on its practitioners. Day-trading offers one of the markets’ greatest challenges, but it is amazing how little literature on it exists. There are several “daytrading for dummies” types of books, a few get-rich-quick jobs, but not a single definitive volume on day-trading. Bad day-traders write bad books and good day-traders are too action-oriented to sit down to write. A good day-trader is a street-smart person with fast reflexes. He is quick, confident, and flexible. Successful day-traders are so focused on the immediate results that they do not make good writers. I hope one of them will rise to the challenge of writing a book, but in the meantime, here are a few notes, even though each of them deserves its own chapter in a thick book on day-trading. The late 1990s saw an explosion of interest in day-trading. Even housewives and students were pulled in by the bull market and the easy reach of the Internet. Brokers advertise for more people to come in to day-trade, knowing full well most will bust out. The advantages of day-trading include: Trading opportunities are more frequent. If you can trade with daily charts, you’ll see similar trades more often on intraday charts. You can cut losses very quickly. There is no overnight risk if a major piece of news hits your market after the close.
Slide 148: TRADING 139 The disadvantages of day-trading include: You miss longer-term swings and trends. Profits are smaller because intraday swings are shorter. Expenses are higher because of more frequent commissions and slippage. Day-trading is a very expensive game, which is why vendors love it. Day-trading makes several hard demands on its practitioners: You must act instantly—if you stop to think, you’re dead. With daily charts you have the luxury of time, but intraday charts demand immediate action. Day-trading chews up a great deal of time. You have to ask yourself whether the hourly pay is better in longer-term trading. Day-trading plays into people’s gambling tendencies. If there are any gaps in your discipline, day-trading will find them fast. There are three main groups of day-traders: floor traders, institutional traders, and private traders. They have different agendas and use different tools. Imagine three persons coming to the beach—one goes for a swim, another stretches in the sun, and the third goes jogging and runs head on into a tree. Floor traders and institutional traders tend to do better than private traders. Let us see what we can learn from them. Lessons from Floor Traders Floor traders stand in the pit, trading with each other, but more often against the public. They scalp, spread, and take directional trades. Scalping is based on the fact that there are two prices for any stock or future. One is a bid—what the pros are offering to pay. The other is an ask—what the pros are willing to sell for. You may bid below the market, but as a friend said, “You can’t excite the market with a flaccid bid.” When in a hurry, you buy at the ask and pay what sellers demand. If you want to sell, you may place a limit order above the market or “hit the bid” and accept what buyers are willing to pay. For example, the last trade in gold was at 308.30, but now it is quoted as 308.20 bid, 308.40 ask. This means there are willing buyers at 308.20, while sellers are asking for 308.40. When a market order to buy comes into the pit, a floor trader goes short by selling at 308.40. The outsider has paid the ask price, and the floor trader is now short
Slide 149: 140 THE THREE M’S OF SUCCESSFUL TRADING and needs to buy. When a market order to sell comes to the floor, he buys at 308.20, and pockets 20 cents profit. Floor traders pay no commissions, only clearing costs, and can afford to trade even for single ticks. They stand on their feet all day, yelling to all passersby that they want to buy a tick below the market and sell a tick above. It is the highest paid form of manual labor. This is a simplified example. The reality is less orderly, as floor traders try to widen the spread and make more than one or two ticks. They compete with one another, shouting, jumping, and getting into each other’s faces. It helps to be tall and muscular and have a big voice. You get stabbed with pencils and splattered with saliva. There is a story about a floor trader who died of a heart attack on the floor but remained upright, squeezed in by the crowd. A floor trader can get stuck if he buys a tick below the market but the market falls by two ticks, and puts him underwater. Half of all floor traders disappear in their first year. One of the Chicago exchanges puts red circular badges on the chest of new traders, making them look like shooting targets. Lest you start feeling sorry for floor traders, keep in mind that many of them make a very good living and some make a great deal of money from hitting you for a tick or more on every trade. Before electronic trading became a serious threat, seats on some exchanges sold for a million dollars. Floor traders also get involved in spreading—buying and selling related markets when their relationships get out of line. Spread traders tend to be more cautious and better capitalized than scalpers. Finally, some of the wealthiest floor traders get involved in directional trading. They put on trades that last days or weeks, closer to the timeframe of public traders. What lessons can we learn from the floor? If you are a position trader, you should use limit orders whenever possible. Buy and sell at specified prices, and don’t let the floor scalp you. Put those fellows on a diet. Another lesson is to stay away from scalping. When a crowd of athletic young men starts fighting for ticks, jumping, salivating, and screaming, you have no business reaching into that crowd to grab a few ticks for yourself because they’ll take off your fingers. If you day-trade away from the floor, forget about scalping. Look for the longer-term daytrades, where the competition tapers off a bit. Go to the middle ground between scalpers who chase ticks and position traders with their end-of-the-day charts. Try to find one or two trades a day, longer than scalping but shorter than position trades.
Slide 150: TRADING 141 Lessons from Institutional Day-Traders Institutional traders work for banks, brokerage houses, and similar firms. A company may have more than a hundred traders sitting behind rows of expensive equipment. Maintaining each seat costs several thousand dollars a month, not counting salaries and bonuses. Each institutional trader narrowly focuses on a single market. One may trade only two-year Treasury notes, another only five-year notes, and so on. Institutional traders generate paper-thin returns on huge volumes of capital. A friend of mine who trades bonds for a leading investment bank in New York has access to essentially unlimited capital during the day, but his overnight positions are capped at $250 million. His standard deviation, the amount he usually wins or loses in a trading day, is $180,000. This is 0.072% of his overnight limit, and only about 0.010% of his intraday size. His profits appear large until you express them as a percentage of his account and ask yourself what you would earn if you traded as well as him. Suppose your account is $250,000 or one-thousandth of his $250 million. If you could match my friend’s percentage gains, you’d earn $180 on overnight trades and $25 at the end of a busy day-trading session. That would hardly cover your costs! Why do institutions do it? The big boys benefit from economies of scale, but the main reason they stay in the game is to keep themselves visible to potential customers. Their main income comes from commissions and spreads on customer orders. Institutional traders accept paper-thin returns to maintain a presence in the market, which gives them first dibs on lucrative customer business. They work to maintain visibility, and as long as they do not lose money, they’re happy. The main thing we can learn from institutional traders is their rigid system of discipline, with managers forcing them to cut losses. A private trader has no manager, which is why he needs to design and implement a strict system of money management rules. Institutional traders benefit from focusing on a single market, unlike private traders who may jump from cocoa today to IBM tomorrow. It pays to choose just a few trading vehicles and learn them well. Institutions are busy scalping, and a private trader is better off keeping out of this area to avoid getting trampled. If you see a trade that offers only a few ticks, it is safer to pass it up because the institutions can barge in at any moment. The longer your timeframe, the less competition you have from them.