ASIA PACIFIC’S PREEMINENT TRADING MAGAZINE
www.traders-journal.com VOLUME 2 ISSUE 2
When to Quit
Your Day Job
SG$8.80 / A$13.80 / HK$68 / RM$19.80
Dr Van Tharp on worrying The Emotional Dynamics of Trading How Exercise can Help Keep Systems Simple Interview with Hank Pruden
Trading Tools: MACD Wyckoff Options Wyckoff Buy/Sell Tests The Measure Rule Forecasted Moving Averages
ISSN 1793-2149
MICA (P) 352/05/2005
CONTENTS 6
FROM THE EDITOR TECHNICAL ANALYSIS
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Forecasted Moving Averages: Creating Leading Indicators Through Intermarket Analysis Darrell Jobman, author of several trading books as well as trading courses for both the Chicago Mercantile Exchange and the Chicago Board of Trade, explains how moving averages can be tailored to provide leading indicators
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Goodman’s Swing Count System - Part Two M. Duane Archer, experienced commodity futures and forex trader, explains in greater detail the Goodman’s Swing Count System
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Wyckoff’s Buy/Sell Tests applied to the Malaysian Stock Market and Dow Jones Index Hank Pruden, a speculator and an educator and Fred Tam, author and stock and futures market analyst, explain the use of the Wyckoff’s Buy/Sell Tests
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Moving Average Convergence Divergence – Part Two Jason Sidney, Managing Director of Market Insight Pty Ltd, explains some practical applications of the popular MACD indicator
TRADING TOOLS 27
CBOT® Liquidity Data Bank (LDB®) Mark Haraburda, a Director of Market Data Products with the Chicago Board of Trade, explains how the CBOT’s enhanced volume data offers buy and sell data segmented by customer type
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BOOKS FOR TRADERS
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SLIPSIDE INTERVIEW
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Interview with Hank Pruden
PSYCHOLOGY 36
Exercise Stuart McPhee, trader, author and editor of the Traders’ Journal, explains how traders can prepare their minds for top performance through physical exercise
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Our (Not So) Good Friend Harry Hindsight Gary Norden explains the dangers of the various biases especially that of hindsight bias
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How We Worry Ourselves Out of Profits Dr. Van K. Tharp, author and professional trading coach, explains the powerful force of worry and how it can sabotage our trading
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The Emotional Dynamics of Trading Martin Kemp, an experienced and qualified facilitator/coach, explains some of the different emotions traders experience and what we can do to combat them
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When To Quit Your Day Job Jim Wyckoff, financial journalist and technical analyst, details some very important issues to consider before making the leap to trading full time
TRADING SYSTEM DEVELOPMENT 54
Keep Systems Simple Price Headley, the founder of BigTrends.com, explains how traders should not try and complicate their trading systems
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Option Trading Using the Wyckoff Trading Range Brent Leonard, options trader and technical analyst, explains how we can use options more effectively during different market stages
CHARTING 51
The Measure Rule Thomas Bulkowski, author and private investor, explains how to use the measure rule to predict a price target after the breakout from a chart pattern
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ECONOMIC CALENDAR
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UPCOMING EVENTS
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FROM THE EDITOR To Research and Educate
The Trader’s Journal is published by DPR International Pte Ltd EDITORIAL
[email protected] Managing Editor : Dickson Yap
[email protected] Editor : Stuart McPhee
[email protected] Consulting Editor Joe DiNapoli Contributing Writers Brent Leonard Darrell Jobman Dr Van Tharp Fred Tam Gary Norden Hank Pruden Jason Sidney Jim Wyckoff M. Duane Archer Mark Haraburda Martin Kemp Price Headley Stuart McPhee Thomas Bulkowski SINGAPORE 24 Raffles Place, Clifford Centre #27-06 Singapore 048621 Tel : (65) 9788 8141 Fax : (65) 6312 8091 Advertising :
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[email protected] AUSTRALIA P O Box 4026, Ringwood Vic 3134 Australia Tel : (613) 8802 0593 Fax : (613) 9870 1738 Advertising:
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[email protected] WEBSITE www.traders-journal.com copyright@2005-2006 DPR International Pte Ltd. All rights reserved. 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, or otherwise, without the prior written permission of the copyright holder. 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 authors and the publisher are not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. In commodity trading, as in stock, and mutual fund trading, there can be no assurance of profit. Losses can and do occur. As with any investment, you should carefully consider your suitability to trade and your ability to bear the financial risk of losing your entire investment. It should not be assured that the methods, techniques, or indicators presented in this magazine will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples in this magazine are for educational purposes only. This is not a solicitation for any order to buy and sell. The information contained herein has been obtained from sources believed to be reliable, but cannot be guaranteed as to accuracy of completeness, and is subject to change without notice. The risk of using any trading method rests with the user.
“Certain key beliefs, which have nothing to do with the market, will still undermine your success in the markets. Those are your beliefs about yourself.” Dr Van Tharp.
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elcome back to the latest issue of the Trader’s Journal. We continue to receive comments from people all over the world about our publication and are confident that each Issue is only going to get better. What a powerful message Dr Van Tharp has for us above. There are some vital items which have nothing to do with the market, that can still have a drastic influence on whether we will be successful or not. At the end of the day, our success depends on ourselves and clearly being STUART MCPHEE self-confident is a large part of that. Here at the Trader’s Journal, our primary goal is to educate you. You are not going to be confident at something unless you are competent doing it. We want to help you develop your competence. We are very fortunate to have the calibre of people who contribute to our publication, and as always, to help you along the path of trading well, we have compiled a number of quality articles written by leading educators, authors and traders for our latest Issue. Renowned professional trading coach and author, Dr Van Tharp has written how worrying can sabotage our trading activities. He writes that both a biological component and a psychological component of stress impair human performance. It is the physiological arousal that causes people to narrow their focus and put more energy into what they are doing. He argues that it might help you run faster or fight more aggressively, but it does not help you invest more successfully. Further on the mindset front, Martin Kemp, an experienced and qualified facilitator/ coach, explains some of the different emotions traders can experience and what we can do to combat them. Furthermore, Jim Wyckoff, who is a financial journalist and technical analyst, details some very important issues to consider before making the leap to trading full time. In the technical analysis area, we have patterns expert Thomas Bulkowski explain how to use the measure rule to predict a price target after the breakout from a chart pattern. Jason Sidney also provides a more in depth look at the popular indicator, the Moving Average Convergence Divergence (MACD). We have an interesting interview with Hank Pruden who is a professor in the School of Business at Golden Gate University in San Francisco, California. He firmly believes that in knowledge, there is power. He believes those seeking to master technical analysis need to attain basic knowledge and practical skills of the field before risking their assets. He also believes that successful traders need to develop a triple threat skill set – these are systems building, pattern recognition, and mental state management. Again, we have been able to gather a highly qualified group of contributors to the Trader’s Journal and all of them make a valuable contribution to enable us to continue to provide you a healthy balance of material. We are always very grateful for their contributions. Again, I am very excited to be introducing this, the latest issue of the Trader’s Journal and I trust it will become a vital part of your education and your personal development into a successful trader. Let me leave you with a thought from Dr Van Tharp below, who again stresses the importance of yourself in the whole equation. When we start trading, we never think that we are going to be such a large part of our own success. We concentrate on other things like what software we are going to use and which indicators to consider. Those who are able to, from an early stage, focus on the right areas to trading well like your own mindset will have a far greater chance of success. In an environment where success is difficult enough to achieve as it is, why not do everything you can to increase those chances? I hope you enjoy this issue of the Trader’s Journal.
“You are the most important factor in your trading and investing. Doesn’t it make sense to spend a little time analyzing yourself?” Dr Van Tharp.
Stuart McPhee Editor
TECHNICAL ANALYSIS
DARRELL JOBMAN
Forecasted Moving Averages:
Creating Leading Indicators Through Intermarket Analysis Darrell Jobman, author of several trading books as well as trading courses for both the Chicago Mercantile Exchange and the Chicago Board of Trade, explains how moving averages can be tailored to provide leading indicators
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hen you review all of the technical indicators available to traders in today’s analytical software, moving averages are still one of the most popular and widely-used indicators to help identify market trends. Moving averages form the basis of many single-market, trend-following trading strategies, ranging from the popular 4-9-18-day moving average “crossover” approach to the widely followed 50-day and 200-day simple moving averages used to highlight the underlying trend direction of broad market indexes and individual stocks.
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Notice, for example, how the moving average lags behind the market at major turning points on Figure 1, a chart of daily prices of the U.S. Dollar Index futures contract with its actual 10-day simple moving average. This lag is the Achilles’ heel of moving averages. Technical analysts have spent years on research in a futile effort to eliminate this lag while still retaining the beneficial “smoothing” effects of moving averages. As a result, numerous types of moving averages have been devised, each with its own mathematical construction and effectiveness at discerning the underlying market trend and ability to minimize the lag effect. Figure 1 - Daily prices of the 30 Year U.S. Treasury Bonds with its actual 10-day simple moving average. Source: VantagePoint Intermarket Analysis Software (www.TraderTech.com)
Moving averages, calculated according to precise mathematical formulae, are an objective (quantitative) way to ascertain the current trend direction of a market and develop expectations about its future direction. Moving averages filter out the random “noise” in past price data by “smoothing” or “averaging” out the fluctuations in price movement.
ware. “Depending on the market’s price movement and the type and size of moving average used, this lag effect can be substantial, causing the difference between trading success and failure in today’s highly volatile, global financial markets.”
Complexity Doesn’t Help Moving averages are often incorporated into more complex technical indicators, such as moving average crossover strategies, to improve their effectiveness. One such approach involves two simple moving averages of different lengths, such as a 5-day and a 10-day average. When the short moving average value is greater than the long moving average value, the under-
Lagging Behind However, traditional moving averages have one very serious deficiency: They are a ‘”lagging” technical indicator. By virtue of their mathematical construction (averaging prices over a number of prior periods), they have to rely on past prices that have already occurred so tend to lag behind the current market price. “Making trades based upon the analysis of moving averages typically results in getting into and out of the market late when you compare the points at which the market’s price actually makes a top or bottom and when it changes trend direction,” points out Lou Mendelsohn, developer of VantagePoint Intermarket Analysis soft-
Figure 2 - Chart of daily prices of the U.S. Dollar Index with its actual 5-day and 10day simple moving averages. Source: VantagePoint Intermarket Analysis Software (www.TraderTech.com) VOLUME 2 ISSUE 2
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TECHNICAL ANALYSIS lying trend is assumed to be up. When the short moving average value is less than the long moving average value, the trend is assumed to be down. The chart of the New York light crude oil futures contract provides an example of how the shorter 5-day moving average is more responsive to current price action than the longer 10-day simple moving average (see Figure 2), but both still lag behind the market at major turning points. An inherent assumption behind moving averages is that once a trend is underway, it tends to persist. Therefore, until the long moving average is penetrated by the short moving average in the direction opposite from the prevailing trend, an uptrend is assumed to remain intact. Traditional moving average crossover strategies are effective at identifying the current market direction in strongly trending markets. In non-trending, sideways markets, however, and even in trending markets when very short moving averages may be overly sensitive to abrupt price fluctuations, these approaches are subject to whipsaws. This results in erroneous trading signals at market tops and bottoms. So, while traders can make money in trending markets using moving averages, it is the choppy markets, increasingly more common today, that can cause substantial trading losses. Various crossover strategies have been created in a further effort to overcome this deficiency. One popular approach compares an actual price, such as the daily close, with a moving average value. Other commonly-used approaches attempt to minimize whipsaws and filter out faulty signals by using bands surrounding the moving averages, using three or more moving averages, or combining moving averages with other single-market technical indicators for additional confirmation. With today’s unprecedented intraday and interday market volatility, caused in no small measure by the globali-
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zation of the markets and resulting effects of related markets on one another, traders can no longer rely solely on single-market lagging indicators such as moving averages. Knowing that a market made a top or bottom several days ago is no longer an effective way to make trading decisions, if it ever was. Even a one-day lag in today’s fast-paced, globally interconnected markets is too long to wait for this information. “It is imperative that traders adopt an intermarket perspective and incorporate intermarket data into their current trading strategies, so they can develop effective leading indicators that correspond to how today’s global financial markets really exist,” Mendelsohn contends.
New Way to Forecast The purpose of technical analysis is to identify the underlying market trend and forecast (or at the very least extrapolate) its future course for the purpose of making profitable trading decisions. Therefore, it seems logical that this goal could best be achieved through applying leading indicators that use both single-market and intermarket data, rather than by continuing to rely upon trend-following indicators such as traditional moving averages that are computed solely on past single-market data. Theoretically, a predicted moving average value for a future date, if it were 100% accurate, would have, by definition, no lag whatsoever. Since this is impossible, something else must be done to bring this widely-used trendfollowing indicator into the 21st century of trend forecasting. One innovative solution to this dilemma transforms moving averages into a leading indicator by using both single-market and intermarket price, volume and open interest futures data as inputs into the design of neural networks, which are then trained to make short-term forecasts of moving averages.
“Neural networks are a mathematical technology from the field of artificial intelligence and can be trained to find reoccurring patterns and relationships within both single-market and intermarket data that can be applied to market forecasting,” Mendelsohn explains. “These forecasted moving averages are then incorporated into predictive moving average crossover strategies that identify market trend direction of individual financial markets with very high accuracy.” For instance, to forecast the short-term trend direction of 30-year U.S. Treasury bond futures for the next several days, neural networks can be trained on past single-market data on the 30year U.S. Treasury bond itself, in addition to intermarket data from various related markets. Sophisticated software can be used to analyze related markets to forecast several moving averages of different lengths and of different forecast time horizons on 30-year Treasury bond futures. This could include a 5day average for two days in the future and a 10-day average for four days in the future. The related markets would include the 10-year U.S. Treasury notes, U.S. Dollar Index, Euro FX, Comex Gold Index, S&P 500 Index, Japanese Yen, Eurodollar, Bridge/CRB Index and New York light crude oil. Figure 3 shows a crossover of a predicted 10-day simple moving average for four days in the future with today’s actual 10-day moving average for 30year T-bond futures. Notice that the predicted moving average, because it is forecasted in advance, does not lag behind the market, while the actual 10-day average lags behind both the market and the predicted average. Each day as the neural networks are updated with the most recent singlemarket and intermarket data, new moving average forecasts are made, and the difference in value between each predicted and actual moving average of the same length is determined.
TECHNICAL ANALYSIS traditional price charts or can be identified by single-market trend-following indicators that lag the market. Admittedly, it is impossible to create leading trend forecasting indicators that can forecast future market direction with 100% accuracy. This elusive Holy Grail is the financial market equivalent of a desert mirage. In reality, no more than 80%-85% predictive accuracy can ever be achieved, given the randomness and unpredictable events that are inherent in today’s globally interdependent financial markets, as well as due to the daunting task of creating effective forecasting tools that can stay current with rapidly evolving, complex financial markets. Figure 3 - Chart of daily prices of the Australian Dollar / Japanese Yen Forex pair with a 10-day predicted and actual moving average crossover. This charts shows that the market has moved over 600 pips total for the three moves depicted. 600 pips equals about $6900. Source: VantagePoint Intermarket Analysis Software (www.TraderTech.com)
Crossover Signals That Pay Off In this simple example, when the predicted moving average crosses the actual moving average from above to below (the difference goes from positive to negative), the market trend is expected to turn down within the forecast time horizon. When the difference reaches a maximum negative value and starts to narrow (indicating that the downward trend is beginning to lose strength), this is an early warning that the market is poised to make a bottom and turn up. Rather than wait for the crossover itself to occur, trading decisions can be based on a narrowing in the difference. For instance, when the difference reaches a maximum negative value and starts to narrow, you can act on this information in a number of ways depending on your account size, risk propensity, trading style and objectives. Mendelsohn cites just three possible scenarios that can be pursued (assuming that you are in a short position): • If the difference reaches a maximum negative value and nar-
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rows by even a small amount, you can close out your short position and stand aside. Then you can wait for the difference to narrow further before going long. • If the difference reaches a maximum negative value and narrows by even a small amount, you can tighten your stop and stay in your short position until the next day. • If the difference reaches a maximum negative value and narrows by a minimal amount, you can close out your short position and go long. This strategy is the most aggressive of the three because it involves reversing positions at the earliest indication that the current market trend is expected to make a bottom and change direction.
No Financial Crystal Ball By employing leading indicators, using both single-market and intermarket data such as forecasted moving averages, early warnings of imminent changes in trend direction become apparent days before they show up on
As the futures and equities markets become even more intertwined and more traders incorporate intermarket analysis into their trading strategies, powerful leading indicators, such as the predictive moving average crossover strategies that expand upon the concepts of popular trend-following indicators, are a must for serious traders. These indicators will allow traders to seize trading opportunities based on predictive information derived from the hidden relationships and complex patterns among related global markets. Darrell Jobman is an acknowledged authority on the financial markets and has been writing about them for over 35 years. Mr. Jobman is the Senior Market Analyst for www.TradingEducation.com. He has authored and/or edited six books including The Handbook of Technical Analysis as well as trading courses for both the Chicago Mercantile Exchange and the Chicago Board of Trade.
TECHNICAL ANALYSIS MICHAEL DUANE ARCHER
Goodman’s Swing Count System - Part Two M. Duane Archer, experienced commodity futures and forex trader, explains in greater detail the Goodman’s Swing Count System
Diagram 1-5: The Markets are Recursive
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ow we can begin to informally define SIX of the SEVEN CONCEPTS in THE RULE that Mr. Goodman used to construct GCSC. What had been neglected by previous theorists, users, writers and purveyors of THE RULE was this: The 50% point is indeed an equilibrium point. As such, the equilibrium must ‘give way’ BUT EITHER SIDE (buyers or sellers) in either a downtrend or an uptrend may prevail at any given matrix or price level. Goodman realized both the possibilities for a REVERSAL (as in the case of the completed measured move) and a PRICE SURGE. A price surge would be the equivalent to the sellers (in an uptrend) and the buyers (in a downtrend) winning the tug of war within a matrix. In price action this means prices
Diagram 1-6: Price Surge - The FIRST Concept
would fall or rise to at least the beginning point of the initial swing! In other words - the measured move is not a done deal - the 50% retracement (Diagram 1-1a) could also become a ‘V’ or inverted ‘V’ as in the next diagram. The 50% retracement is not a reversal point (necessarily) but should be considered as a ‘point of interest’ where prices may be more likely than randomly to decide whether to continue or reverse. It may not sound like much, but it is a major discovery. Clearly price surges are implicit in THE RULE. But they are not visible on a chart unless you are looking for them and unless you are considering the 50% retracement as a ‘point of interest’ and not necessarily a reversal. In fact, most practitioners perceive a price surge as a failure of THE RULE! VOLUME 2 ISSUE 2
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TECHNICAL ANALYSIS Even more importantly, Goodman discovered the implications of THE RULE occurring simultaneously at all price levels. I remember EXACTLY the day and place when Charlie showed me this one - it hit me as truly a grand revelation on the markets! Here you are: The initial (primary) trend and secondary (reaction trend) as well as reversals (measured moves) and surges are relative to price matrix context. What is one thing in one price matrix may well be its opposite in a higher (or lower) matrix. (It’s true - Elliot Wave Theory contains the same concept. But with GCSC you can tell BEFORE (in many instances) which it is. In Elliot you can only tell AFTER. GCSC is a predictive system, while Elliot - grand and elegant as it is - is primarily a descriptive system.)
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All Price Matrices (levels) - in theory - are part of a larger price matrix, All Price Matrices composed of smaller price matrices Of course there is the practical limitation of the smallest possible fluctuation. Besides Reversals and Surges GCSC matrix concepts include Domination and Generation. Clearly prices do not always seem to find any kind of equilibrium at the 50% retracement price area. Or, so it may seem. This leads to the third Grand discovery: The extent a price swing overshoots or undershoots its ideal 50% retracement that price value will be ‘made up’ on the next price swing within the matrix.
Diagram 1-7: THE RULE at Multiple Levels (Matrices) of Operation - The SECOND Concept
Diagram 1-8: Examples of Compensation within a Matrix - The THIRD Concept
Diagram 1-9 Carry Over - The FOURTH Concept
Diagram 1-10: Cancellation - The FIFTH Concept
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Diagram 1-11: Meaning of the Brackets Revealed
Diagram 1-12: Intersections - The SIXTH Concept
Now THIS is the trading rule that can make you rich! For example, if prices fall only 40% of the initial trend and reverse, the measured move will actually be either 90% or 110% of the measured move point and value of the primary (initial swing in the matrix. The 10% difference - GCSC holds - MUST be made up eventually. This is the concept of Compensation. Furthermore: If the difference is not fully made up in the final price swing of a matrix the cumulative ‘miss’ value will carry over through each price subsequent price matrix until it does. This is the concept of Carry Over. A ‘carryover’ table is used to add and subtract cumulative carry over values until they cancel. When no Carry Over remains, the price matrix is said to have ‘cleared’ or ‘cancelled’. This is the GCSC concept of Cancellation. Cancellation is critical to finding GCSC support and resistance points and other chart ‘hot spots’ where something much less than random is likely to occur. The exact method for these important concepts is more fully described in this article, Part 2. We can now get an early glimpse of what the strange brackets on Charlie’s charts were all about. Charlie had even more ideas: The importance of a ‘hot spot’ in relationship to its likelihood of being an important point of support or resistance, reversal or continuation, increased when two or more price matrices cancel at the same price or same price area. This is the key concept of In-
tersection. There is no analogous concept in Elliot, the most common ‘competitor’ to GSCS. Intersection makes GSCS much more objective and testable than other swing systems. This article has covered micro formations. Charlie also had compiled a dozen or so extremely valuable macro formations - combinations of micros. I encourage the reader to examine some charts and find simple areas of the intersection of two (or three) matrices. You will see at once that these points are GOLDEN to the trader. If I had, after 30 years of studying the markets one idea to impart it would be to show you an example of a GSCS intersection in 2 or 3 matrices. Remember, Carry Over is to the same or NEXT larger price matrix. The above are examples of Independent Intersections. That is, each price level Carry Over calculation is kept separate from the others and ‘tallied’ at the end of each matrix. Charlie had also developed (much less precisely) a concept of Dependent Intersections but it is quite complex, beyond the scope of this article and worth of further codification into software at a future date. Michael Duane Archer has been an active commodity futures and FOREX trader for over thirty years. Mike has also worked in various registered advisory capacities, notably as a CTA (Commodity Trading Advisor) and as an Investment Advisor. He is currently CEO of CommTools, Inc., a corporation focusing on nonlinear solutions to trend forecasting, with a special emphasis on cellular automata models. He can be reached at
[email protected] or via his website www.fxpraxis.com VOLUME 2 ISSUE 2
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TECHNICAL ANALYSIS
Wyckoff’s Buy/ Sell Tests HANK PRUDEN
FRED THAM
applied to the Malaysian Stock Market and Dow Jones Index
Hank Pruden, a speculator and an educator and Fred Tam, author and stock and futures market analyst, explain the use of the Wyckoff’s Buy/ Sell Tests
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yckoff is a name with celebrity status in the world of Technical Analysis and Trading. Richard D. Wyckoff worked in New York City, U.S.A. during the ‘golden age’ for technical analysis that existed during the early decades of the 20th Century. Wyckoff was a contemporary of Edwin Lefevré who wrote ‘The Reminiscences of A Stock Operator’. The Wyckoff Method is essentially a codicil of the best practices reported in ‘The Reminiscences of A Stock Operator’. Like Lefevré, Wyckoff was a keen observer and reporter who codified the best practices of the celebrated stock and commodity operators of that era. The
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TECHNICAL ANALYSIS Basic Buying Tests or Nine Basic Selling Tests.
The Nine Classic Buy/Sell Tests of the Wyckoff Method
results of Richard Wyckoff ’s effort became known as the Wyckoff Method of Technical Analysis and Stock Speculation. Wyckoff is a practical, straight forward bar chart and point-and-figure chart pattern recognition method that, since the founding of the Wyckoff and Associates educational enterprise in the early 1930s, has stood the test of time. Around 1985, after ten years of trial-and-error with a variety of technical analysis systems and approaches, the Wyckoff Method became the mainstay of The Graduate Certificate in Technical Market Analysis at Golden Gate University in San Francisco, U.S.A. During the past two decades, dozens of Golden Gate graduates have successfully applied the Wyckoff Method to futures, equities, fixed income and foreign exchange markets using a range of time frames. Then in 2002 Mr. David Penn, in a ‘Technical Analysis of Stocks and Commodities’ magazine article, named Richard D. Wyckoff as one of the five ‘Titans of Technical Analysis’. The Wyckoff Method is a school of thought in technical market analysis that necessitates judgment. Although the Wyckoff Method is not a mechanical system per se, nevertheless high reward/low risk opportunities can be routinely and systematically based on what Wyckoff identified as the Nine
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The classic set of ‘Nine Buying Tests’ and ‘Nine Selling Tests’ were designed to diagnose significant reversal formations. The ‘Nine Classic Buying Tests’ define the emergence of a new bull trend (see Table 1). A new bull trend emerges out of a base that forms after a significant price decline. The ‘Nine Selling Tests’ help define the onset of a bear trend out of top formation following a significant advance (see Table #2). These nine classic tests of Wyckoff are logical, time-tested, and reliable. Each test represents a principle of the Wyckoff Method. As the reader approaches this case of ‘Nine Classic Buying Tests’, he/she ought to keep in mind the following admonitions from the ‘Reminiscences of a Stock Operator’: “The average ticker hound – or, as they used to call
Application of the 9 Wyckoff Buying Tests: Commerz-Weekly, 1997-1999. (see Figure 1) Wyckoff Test:
Commentary:
#1, Downside price objective accomplished?
Yes. The distribution top formed during the 1997 created a point-and-figure (horizontal) chart count that gave downside price projections that were met in the vicinity of the 1997-98 market lows.
#2, Preliminary support, selling climax, secondary?
Yes. This sequence of price-and-volume actions signaled that the downtrend from 1997 had been stopped. Note the high volume on the early ‘big money’ buying during mid-to-late 1997. The sharp price rise on expanded volume during early 1998 indicated heavy demand overcoming weakening supply. This bullish action was confirmed on the subsequent secondary test that occurred in late 1998. Although price fell below the level of the previous selling climax low, the volume was demonstrably less. Then at the very end of 1998 prices rallied off the bottom on a relative increase in volume… a bullish sign!
#3, Activity bullish (volume increases on rallies and decreases on reactions)?
Yes. Noted expansions in volume during late 1998 and into 1999 as compared to the earlier lower level of volume while prices drifted lower in 1998.
#4, Downward stride broken (i.e., supply line penetrated)?
Yes. Downward sloping supply-line S-S was penetrated in early 1998 (note how the old supply S-S switched from acting as resistance to becoming support as price drifted lower during 1998).
#5, Higher supports?
Yes. A series of ascending lows were registered during late 1998 and early 1999.
#6, Higher tops?
Yes. A series of advancing price peaks were registered during late 1998 and early 1999.
#7, Stock stronger than the market?
Yes. Relative to the group which Commerz represented.
#8, Base forming (horizontal price line)?
Yes. A complex inverse-head-and-shoulders bullish reversal formation is/was discernable under the dashed horizontal price resistance line.
#9, Estimated upside profit potential is at least three times the loss if protective stop is hit?
Yes. If purchase was made on the pullback to the neckline of the inverse H+S pattern after the high volume advance during second quarter 1999, then the price stop below support would have been Y and the price objective > risk ratio equal to 3 > 1.
him, tapeworm – goes wrong, I suspect, as much from overspecialization as from anything else. It means a highly expensive inelasticity. After all, the game of speculation isn’t all mathematics or set rules, however rigid the main laws may be. Even in my tape reading something enters that is more than mere arithmetic. There is what I call the behavior of a stock, actions that enable you to judge whether or not it is going to proceed in accordance with the precedents that your observation has noted. If a stock doesn’t act right don’t touch it; because, being unable to tell precisely what is wrong, you cannot tell which way it is going. No diagnosis, no prognosis. No prognosis, no profit. This experience has been the experience of so many traders so many times that I can give this rule: In a narrow market, when prices are not getting anywhere to speak of but move within a narrow range, there is no sense in trying to anticipate what the next big movement is going to be – up or down. The thing to do is to watch the market, read the tape to VOLUME 2 ISSUE 2
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TECHNICAL ANALYSIS determine the limits of the get-nowhere prices, and make up your mind that you will not take an interest until the price breaks through the limit in either direction. A speculator must concern himself with making money out of the market and not with insisting that the tape must agree with him. Therefore, the thing to determine is the speculative line of least resistance at the moment of trading; and what he should wait for is the moment when that line defines itself, because that is his signal to get busy.”
Examples: Commerz and Apland Point #3 on the charts identifies the juncture when all Nine Wyckoff Buying Tests or Selling Tests were passed. The passage of all nine tests confirmed that an up trending or markup phase had begun or a down trending/markdown phase had begun (see Figure 1). The passage of all Nine Tests determined that the speculative line of least resistance was to the upside or to the downside. “Commerz upside price objectives: The original 1996-97 base generated a count to the upside that was exceeded in 1999-2000. It appears that another accumulation base formed during 2001-2003. A count taken along that 3.40 base line generated 5.1
points for an upside target range of 7.5 to 8.5. (Note that before taking the count, the point and figure chart for Commerz was adjusted so that no less than two entries appeared in any column).” The Commerz point-and-figure chart is not included in this article.
Wyckoff Looks to the Future Malaysian Stock Index The Malaysian Composite Index remains in a bull market trend. The upside price target from the inverse head-and shoulders bottom of 1998-1999 at about the 530 level gives 1250 (the count from the very low was reached around the 1000 level, then the correction set in). A re-accumulation count at the 770 level during 2000-2004 confirms the original upside count with a target objective of 1280. OBV clearly supports the continuation of the bull market. Also the recent pattern of ascending bottoms (like ascending triangle) is bullish and may hint of a resumption of the advance soon. This can be seen in Figure 3.
Wyckoff ‘Stepping Stone Count’ confirms DJIA 14,400 When the DJIA broke out above the top of its 8month trading range in November 2005, a unique
Application of the 9 Wyckoff Selling Tests: Apland-Weekly, 1999-2000 (see Figure 2)
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Wyckoff Test:
Commentary:
#1, Upside price objective accomplished?
Yes. The price objective generated during the previous accumulation was reached around the price highs of year 2000.
#2, Activity bearish (volume decreases on rallies and increases on reactions)?
Yes. The dominances of sell side volume over demand were evident during the third quarter of 1999 and the first quarter of the year 2000.
#3, Preliminary supply, buying climax?
Yes. High volume stopping of the uptrend (reversals in price) were registered in 1999. The buying climax at the price peak was particularly pronounced.
#4, Average or stock weaker than market (i.e., more responsive on rallies and sluggish on rallies)?
Yes. Weaker than the relevant group.
#5, Upward stride broken (i.e., support line penetrated)?
Yes. Demand line D-D was definitively penetrated during the final quarter of 1999.
#6, Lower tops?
Yes. A series of triple descending price peaks from the high to the top of the pullback rally in the third quarter of 2000.
#7, Lower supports?
Yes. Lower supports registered immediately after the buying climax and upon the breaking of horizontal support line MM.
#8, Crown forming (lateral move)?
Yes. A large, classical pattern of distribution that was characterized by descending price peaks took place over almost four quarters during 1999-2000 between 2.0 price and 1.2 price.
#9, Estimated profit is at least three times the indicated risk for stop order placement?
Yes. With a ‘Short Sale’ at the pull back of 1.2 and a profit potential 1.1, and a stop loss order placed at 1.5, the reward-risk ratio was a comfortable 3.67.
VOLUME 2 ISSUE 2
and powerful market-timing principle was at work. The Wyckoff Method’s concept of the ‘Stepping Stone Confirming Count’ states that when sufficient point-and-figure count has been collected during a lateral consolidation pattern to project an upward price target equal to what had been generated during the original base of accumulation, then an immediate resumption of the upward bull market trend would begin. Both the base and the re-accumulation counts are measured horizontally on point-and-figure charts. Figure 1 – Commerz Weekly Chart
Figure 2 – Apland Weekly Chart
Figure 3 – Malaysian Stock Index
The behavior of the DJIA during 2005 was a case study in support of the Wyckoff Method’s ‘Stepping Stone Confirming Count’ concept. During the sideways market from March to November 2005, the DJIA was creating a substantial figure chart count. Then, just when this re-accumulation count became sufficient to confirm the original upward price objective of 14,400, taken from the 2002-03 inverse-head-and-shoulders bottom, the bull market uptrend resumed. The ‘Stepping Stone Confirming Count’ price projection to DJIA 14,000 -14,450 is shown on the 50point figure chart of the DJIA, seen in Figure 4. The counting of this reaccumulation started at the Wyckoff ‘Last Point of Support Following a Sign of Strength’ which occurred at the 10,500 price level in November 2005. Counting backward from right to left along the 10,500 level until the beginning of the rectangular price formation in March 2005 revealed an accumulation of 79 boxes. Thus 79 at 50 points per box produced a total count of 3,950 points potential. When this reaccumulation build up of 3,950 points was added to the bottom of the rectangular consolidation (DJIA 10,050) and added to the count line itself (DJIA 10,500) an upward price target zone of 14,000-14,450 ensued. Since the original 2002-03 base of accumulation had and upside projection to DJIA 14,400, this zone of re-accuVOLUME 2 ISSUE 2
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TECHNICAL ANALYSIS mulation reached a spot in November 2005 where the points collected during 2005 created a projection (14,450) that matched, hence confirmed, the original upward objective of 14,400. Then suddenly in a unique and almost mysterious fashion, the DJIA adhered to the ‘Stepping Stone Confirming Count’s timing rule’ by immediately breaking upward out of the trading range. Hank Pruden is a speculator and an educator. He is a professor of business in the School of Business at Golden Gate University in San Francisco, California where he has been teaching for 20 years. Hank is more than a theoretician; having actively traded his own account for the Figure 4 – DJIA past 20 years he has placed real equity at risk based upon the theories he teaches. roving ambassador of education for IFTA. His personal involvement in the market ensures that what he teaches is practical for the trader, and not just abstract Fred Tam, MPHIL, MSTA, CFTe, ACCA, is a well-known stock academic theory. and futures market analyst, author, columnist and public speaker among the Malaysian investing public. He is the He is also the Executive Director of the Institute of Technical author of three popular books on the Malaysian stock and Market Analysis (ITMA). At Golden Gate he developed futures markets and a regular columnist for the Malaysian the accredited courses in technical market analysis in 1976. Since then the curriculum has expanded to include Business magazine, Nanyang Siang Pau and New Straits advanced topics in technical analysis and trading. In his Times from 1989 - 2004. courses Hank emphasizes the psychology of trading and Since 1980, he has conducted numerous professional courses as well as the use of technical analysis methods. He has published extensively in both areas. and seminars in association with the Malaysian Institute of Management (MIM), the Research Institute of Investment Hank has mentored individual and institutional traders in Analysts of Malaysia, the Kuala Lumpur Commodity the field of technical analysis for many years. He is presently Exchange, the Kuala Lumpur Stock Exchange, Malaysian on the Board of Directors of the Technical Securities Analysts Investors Association, University of Malaya, Universiti Putra Association of San Francisco and is past president of that association. Malaysia, Multimedia University, Chartered Institute of Management Accountants, several major stock broking Hank was also on the Board of Directors of the MTA and has firms in Malaysia and the Singapore Remisiers Association. served as vice chair, Americas with IFTA. For eleven years He was the main organizer and a speaker at the ‘Market Hank was the editor of The Market Technicians Association East 1995’, the 1st World Technical Analysis Conference held Journal, the premier publication of technical analysts. From in Kuala Lumpur. He holds a Master of Philosophy (Finance) 1982 to 1993 he was a member of the Board of Trustees of Golden Gate University. from Multimedia University, Malaysia, is a member of the Technical Analysts Society of Singapore, a Full Member Hank completed his Ph.D. (with honors), at Lundquist of the Society of Technical Analysts, United Kingdom, is College of Business, University of Oregon. He also holds a Certified Financial Technician from the International an MBA from the Haas School of Business, University of Federation of Technical Analysts, USA and is a Certified California, Berkeley and a Bachelor’s of Science degree Accountant from the U.K. Mr. Tam is a full-time trader and from, California State University, Chico. conducts his own comprehensive technical analysis course Professor Pruden, was a visiting professor/visiting scholar “The F-1 Trader Stock/futures Course” in Kuala Lumpur, at Euromed-Marseille Ecole de Management, Marseille, Malaysia. He can be contacted at
[email protected]. France in 2004-2005. While in France, Hank acted as a Website: www.picapital.com.my.
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VOLUME 2 ISSUE 2
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TECHNICAL ANALYSIS
JASON SIDNEY
Moving Average Convergence Divergence Jason Sidney, Managing Director of Market Insight Pty Ltd, explains some practical applications of the popular MACD indicator 24
VOLUME 2 ISSUE 2
– Part Two
I
n the first part of this article we discussed how MACD was calculated and then began to discuss the various methods we can use to interpret this indicator. Continuing on from this and using the same charts we used in the first part of this article. It was established the default settings for the MACD indicator was 12, 26 and 9 exponential moving average and increasing the time frames using the Fibonacci number series to 13, 34, and 8 had the effect of smoothing the indicator and gave less false signals. It was mentioned that the buy signal from the MACD indicator occurs when the fast MACD line rises above the slow signal line and
line of the histogram the overall up or down trend is strong and likely to continue. During this trend the averages will often cross above and below each other, but as long as both averages are still holding above or below the zero line of the histogram the trend overall is still strong and likely to continue. It’s not until both the averages cross through the zero line of the histogram that indicator would suggest that the overall trend is over. Confirmation of a break of trendline would usually have occurred by this stage, and can be valuable information when trying to let your profits run in a trade or for people who try to trade or capture intermediate moves.
Figure 1 – Hang Seng Index
that ideally the buy signal generated by the averages should be occurring below the histogram, and sell signal from the averages should occur above the histogram. While this won’t always be the case, if it does we then have the option to use another interesting aspect to this indicator to help back up and confirm the buy or sell signal the indicator has generated. To confirm the buy and sell signal from the MACD averages simply wait for both averages to cross through the zero line of the histogram. By doing this it will add further weight to the significance of the buy or sell signal and give you a second chance to open a position usually still in the early stages of the new emerging trend.
method has been in identifying the last three major moves on this index and how increasing the time to 13, 34 and 8 resulted in no false signals being generated from the indicator using this method. Taking this concept now even further, it was previously established that as long as both of the MACD averages remain above or below the zero
Expanding further on this idea now, if it’s agreed that when both the MACD averages remain above or below the zero line of the histogram we are looking at a strong trend in that direction that is likely to continue, we can then use this information to suggest what the market is likely to do when it approaches key levels of support or resistance. This concept now
A close study of the chart of the Hang Seng shows both averages crossing through the zero line of the histogram not too long after each break of the trendline, allowing users of this method to identify major reversal points and to open positions still in the early stages of the new emerging trend. Also note how reliable this Figure 2 – Hang Seng Index VOLUME 2 ISSUE 2
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TECHNICAL ANALYSIS tion, putting anyone using this method on red alert for a possible major reversal in trend. Also notice how divergence was clearly seen before both the buy signals outlined in this article and before the break of the falling trendline previously shown on this chart. Looking now at the now at the right hand side of the chart and the current uptrend being shown. Divergence can be seen appearing only on the MACD averages which is of less significance than it would be if it had occurred on both the MACD averages and the histogram. Figure 3 – Hang Seng Index
changes the idea of MACD being a lagging indicator and now suggests a method of how MACD could be used as a leading indicator to forecast how markets will handle key levels of support or resistance when they get to them. Taking another look at the first chart of the Hang Seng Index you can see looking at the very right hand side of the chart a very clear horizontal level of resistance. This is the position the Hang Seng was in at the time the first part of this article was originally published. Looking now at the MACD indicator, at the time the Hang Seng was approaching this key level of horizontal resistance both the MACD averages were above the zero line of the histogram suggesting the underlying uptrend was still strong and likely to continue. Referring now to the second updated chart, this is exactly what the Hang Seng index went on to do, later using this level as support before continuing higher making higher peaks and higher and at the time of writing is still holding above its rising trendline with both MACD averages still holding above the zero line of the histogram
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suggesting a strong underlying trend that’s likely to continue. The other method that can be used to make MACD more of a leading indicator is known as Divergence. Divergence occurs when the chart does one thing and the indicator does the complete opposite. An example of divergence would occur if the chart makes a lower trough but the indicator makes a higher trough or if the chart were to make a higher peak but the indicator shows a lower peak. Both of these situations would suggest the underlying trend is loosing momentum in its current direction and nearly always occurs before the break of the trendline or the buy or sell signals outlined in this article. Divergence will sometimes occur on the MACD averages but also on the MACD Histogram, but it will always be more significant when it occurs on both the MACD averages and the histogram. Looking again at the Hang Seng Index we can see two major lows occurring on this index, with two very good examples of divergence occurring on both the MACD averages and the histogram. This suggested the downtrend was loosing momentum in this direc-
Based on a previous chart in this article we can also see the uptrend is still holding above its rising trendline with both MACD averages remaining above the zero line of the histogram suggesting the underling trend is still intact and likely to continue. Should things change with the Hang Seng Index we could then confirm the possibility of a major reversal by looking for both the sell signals outlined in this article followed by the break of its rising trendline to confirm the reversal. Until this time, based on the methods outlined here in this article you would still consider the underlying trend to be strong and likely to continue. Jason Sidney is the managing director of Market Insight Pty Ltd. Market Insight is an educational company that teaches analysis techniques for financial markets. Market Insight Pty Ltd produces a free newsletter that promotes these techniques and how they are applied to financial markets. To subscribe to this newsletter, simply visit the Market Insight website. Jason can be contacted at
[email protected] or via his website www.marketinsight.com.
TRADING TOOLS MARK HARABURDA
CBOT® Liquidity Data Bank (LDB®) Mark Haraburda, a Director of Market Data Products with the Chicago Board of Trade, explains how the CBOT’s enhanced volume data offers buy and sell data segmented by customer type Introduction Volume data is valuable market information but can it be enhanced to become even more useful? Before I discuss that question, let’s first describe normal volume data as we understand it and use it today. As you read along keep this in mind...what if volume data was segmented into different categories, which were made up of different customer types and you could even see the buying versus selling activity within each customer type? Think about this and read on. Volume data has a variety of applications related to market analysis, including: 1. Serving as a barometer for measuring a quantity of transactions which in many cases can help identify liquidity as well as assist with comparing one financial instrument to another based on the quantity of volume. 2. Serving as a signal to confirm price movements or as a predicator of developing price movements. 3. Serving as an indicator to help identify support
and resistance price levels which may be achieved by analyzing significant volume gathering or lack thereof at these price levels. 4. And finally, serving as an identifier or confirmation of ‘value’ or lack of ‘value.’ Value can be judged by the comparative amount of volume at one price level versus another. In other words, value can be simply defined as price levels or a range of prices which attract more volume versus other prices, be it intra-day, daily, weekly, monthly, etc. As market activity builds over a day, week, month, etc. certain price levels attract more volume than others. Those prices that comparatively lack volume can be seen as rejecting a price movement—the opposite is true for those prices which accept a price movement. Over a subjective time period value areas may be confirmed by greater volume at certain prices levels versus less volume at other price levels. Of course, value areas change and continue to develop; nevertheless they provide an important tool to understanding and evaluating market activity. VOLUME 2 ISSUE 2
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TRADING TOOLS view, meaning cumulative data for all traded prices, as well as in a micro view - detailed data for each individual traded price. Timestamps are also provided to supply a time series for the data. Finally, the data is made available intra-day, currently every 30 minutes, and end-of-day. The CBOT is currently planning to make the data available more frequently.
Figure 1. - Customer Type Indicator (CTI) codes
The Chicago Board of Trade (CBOT®) has developed and made available an enhanced version of volume data named ‘Liquidity Data Bank’ (“LDB”®). LDB enhances normal volume data by not only reporting the total volume transacted but also reporting the quantity of volume transacted by different customer types. LDB goes further by breaking volume within each customer type into buy volume versus sell volume. This allows the user to assess gross volume activity within each customer type and also evaluate which customer types are net long versus net short. LDB data is available daily, intra-day and at each price level traded. This article will continue to explain the data, describe possible practical applications of the data and discuss how to receive the data. LDB is a large set of data and is open to a variety of types of analysis and interpretations and the CBOT is simply a provider of this information. Ultimately, it is the individual trader or firm which must research and interpret this information and draw their own conclusions.
Customer types are formally referred to as Customer Type Indicator codes or CTI codes. The Commodity Futures Trading Commission (CFTC) defines four CTI codes: CTI 1, CTI 2, CTI 3 and CTI 4. The complete definition of each CTI code is listed in Table 1. CTI 1s are locals, meaning individual members trading their own accounts. They are often speculative traders many of whom are either scalpers or day traders. CTI 2s are member firms trading for a house account. CTI 3s are individual members executing trades for the personal account of another individual member. Finally, CTI 4s are non-member customer transactions. LDB data can be used for market analysis in ways similar to normal volume data. If you use normal volume data as a barometer for the level of market activity or liquidity, LDB can build upon this by providing additional details specific to customer types. By understanding customer type volume
About LDB data LDB® or Customer Type Indicator (CTI) data (see Figure 1) provides detailed information on the number of buy and sell transactions for four different customer types. The key is buy and sell. Not only does LDB data tell you how many contracts one customer type bought, it also tells you how many contracts that same customer type sold. The net sum of these two numbers will tell you whether or not this customer type is a net buyer (net long) or net seller (net short). LDB data is provided in a macro Table 1 - Applications of LDB data
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data you can gain a better feel for who is participating in a market, at what prices and at what times. For instance, with LDB data you can compare the amount of volume activity within one customer type to another or compare one customer type’s activity at one price versus another price. You can also look at changes in gross customer type activity, such as percent of overall volume, over a period of time. Correlation studies can also be conducted to compare customer type volume activity to price movements.
Correlation analysis Correlation studies between customer type volume data and price movements can be set up in a variety of ways. You can simply compare the data over the same time period or use one component as a lagging indicator or forward looking predictor. In other words, today’s customer type activity may help explain tommorrow’s price movements. For example, one customer type may have heavily overextended a position on day one for various reasons; therefore on day two the same customer type had to reverse the position, driving a price movement. Or, the opposite may be found; a correlation between yesterday’s price movements and today’s customer type activity. With LDB correlation analysis, both price and volume can be used as either the independent or dependent variable. Intra-day analysis should not be ignored either. Whether it is analyzing correlation over the same periods or lagging one component, LDB data provides the means to conduct various types of analysis. Calculating support and resistance is another type of market analysis which usually requires evaluating volume data. LDB data can be used for this type of analysis since different types of volume, meaning different customer types, may be seen participating at different frequencies and times, and at different price levels. Moreover, you can analyze whether each customer type was net long or net short at these price levels and determine the level of significance. The level of significance can be determined by comparing net long and net short amounts for each customer type at different prices - prices which have comparatively greater net long or net short amounts can be viewed as more significant. This information can be compared to previous periods to back-test possible support and resistance behavior around the determined price levels. Further, the conclusions drawn can be used and continued to be evaluated over time. At certain times and prices, various customer types and their activity may help define sup-
port and resistance. One possible explanation may be related to one customer type accumulating large positions over a day, week, month, etc. at specific price levels and responding in a manner that helps define support or resistance when these prices are tested. Finally, LDB data can be used to help identify value areas. Value areas can be viewed as prices which attract more volume versus others and a marketplace can be seen as accepting these higher volume prices, establishing value, versus rejecting lower volume prices. So, volume is a key identifier of value; however by segmenting volume into customer types the information available to identify and analyze value increases. Over time, through analyzing LDB data, you may determine patterns of customer type activity in relation to high volume or low volume areas. Determining significant changes in customer type activity within or outside of value areas can help confirm existing value areas or define new developing value areas. And in the end, this information may help create trading opportunities.
Availability of LDB Data LDB data is available directly from the CBOT or from software firms such as MDB Analytics, Inc. which offers a product named ‘Liquidity Analyzer.’ The CBOT provides direct access to LDB data to individuals and firms via its ‘Liquidity Data Bank Data Feed.’ The feed allows firms to directly develop to the CBOT’s LDB data. In order to receive the data, the CBOT requires users of the data to sign a LDB License Agreement. For more information on direct LDB access, please contact me at my email address:
[email protected]. Liquidity Analyzer is a front-end display application which allows end-users to display, chart and analyze LDB data. Liquidity Analyzer provides a variety of charting and query features which assist in analyzing LDB data. For more information, please visit www.liquidityanalyzer.com. Mark Haraburda is a Director of Market Data Products with the Chicago Board of Trade. He can be reached via email at
[email protected]. The views and opinions included in this article are solely those of the author and do not necessarily represent the views of the Chicago Board of Trade. The content in this article is intended for purposes of information and education only and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options contracts. VOLUME 2 ISSUE 2
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BOOKS FOR TRADERS Private Thoughts from a Trader’s Diary Type: Hardcover, 259 pages Date Published : 2002 Prices : S$70.00 By Larry Pesavento Imagine sitting in the trading room of two professional traders, and and have them share with you the complete details of each trade they make for weeks! They share with you the exact reasons they decide to make each trade, how they select an entry point and initial stop, how they adjust their trade as it moves in their favor, how they decide on when and where to take profits (and why), and every other aspect of their decision making process.
Options Trading: The Hidden Reality Type: Hardcover, 430 pages Date Published : 2006 Price: S$155.00 By Charles M Cottle This new book is an expanded revision of “Options: Perception and Deception” and “Coulda Woulda Shoulda”. “Options Trading: The Hidden Reality” not only printed in color has 100 more pages and features more dissection illustrations on popular wingspread (stretched-out condors, slingshots and skip-strikeflies) and calendarized spread (double diagonals, straddle strangle swaps and double calendars) configurations. I think what made OP:D in such demand were the 3D graphics and the Skew Library. They are both brought back in color along with the appendix proving Chapter 2’s Options Metamorphosis.
Warrior Trading: Inside the Mind of an Elite Currency Trader Type : Hardcover, 192 pages Date Published : 2006 Price : S$72.00 By Clifford Bennett Warrior Trading provides traders with a path to trading success by
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developing a mentality and emotional framework common to successful traders. Warrior Trading includes an enhanced discussion of technical analysis, and an explanation of how global economic forces are changing and impacting the markets. Filled with in-depth insights and expert advice, this comprehensive guide explains the importance of understanding the market’s underlying fundamental and technical realityletting traders take advantage of those moments when the perceptions of most traders are at odds with the underlying reality to score big in the market.
The Little Book That Beats the Market Type : Hardcover, 224 pages Date Published : 2005 Price : S$33.00 By Greenblatt and Tobias This is a short and simple book that convincingly explains how anyone can use a “magic formula” to more than double the stock market’s return. The formula is new, unique, simple – encapsulating the best of Buffett. The incredibly robust results are a clear breakthrough in both the academic and professional world. The simple aspect is the key.
Foundational Analysis: Selecting Winning Stocks Type : 81 minute DVD Date Published : 2005 Price : S$170.00 By David Nassar According to legendary educator and best-selling author David S. Nassar, the mantra of trading can be cut down to a simple formula: Filter, filter, filter! Over 80% of all market participants consistently lose money. To be truly successful as a trader, you must be able to cull the superfluous noise out of the market. In today’s media-frenzy world, there is an abundance of “market food” being fed into the market each day – information that is cooked up by analysts and given to the market by brokers.
Using Opening Range Breakout In Short Term Trading Type : DVD Videoseminar Date Published : 2005 Price : S$85.00 By Murray Ruggiero In Short Term Methods for Trading Futures and Equities, Murray Ruggiero teaches the variations of Opening range breakout used by Toby Crabel, Larry Williams and Sheldon Knight. He then tests them on both a basket of commodities as well as a basket of individual stocks. This presentation will benefit both Futures as well as stock traders. In the presentation Murray also discusses how using split adjusted stock data can lead to 200400% error in back tested results. He discussed how he solved this problem and shows his opening range breakout systems on the Nasdaq 100 stocks, based on the work of these masters in this area, including Toby Crabel.
Hit and Run Trading Type : Hardcover, 174 pages Date Published : 2004 Price : S$168.00 By Jeff Cooper Discover winning methods for daytrading and swing trading from the man who wrote the bible on shortterm trading. Professional stock trader Jeff Cooper first released his original Hit & Run Trading Book almost a decade ago, taking the short-term trading world by storm. Now, he’s back with a newly updated Hit & Run Trading Volume I. Jammed packed with a full arsenal of new tools and strategies to help day traders compete and survive in this fast-paced, volatile arena.
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and trading exploits of floor traders on all the major stock, options, and futures exchanges...a $17 value! The information you need to invest successfully in the stock market is on the Internet, FREE of charge. This guide tells you what is available, where it is and how to use it. In every business successful executives collect relevant, accurate and timely information before making important decisions. They absorb information to educate themselves in order to build the knowledge they need. They use best practice processes to manage their businesses. They develop the skill to make judgments based on information required by the processes. Without adequate knowledge, process and information they cannot make correct decisions.
The Great Cycle Type : Hardcover, 225 pages Date Published : 1993 Prices : S$85.00 By Dirk Stoken Long out of print and unavailable, this classic on cycles will prove to be a welcome addition to the library of serious students of cyeles in the stock market. The Great Cycle is a compelling look at long-term cycles. Dick Stoken-a renowned financial author, investor and trader- painstakingly examines the economy’s cycles, thereby showing investors how to predict and profit from extreme swings between economic optimism and pessimism.
Peak Performance Course for Investors and Traders Type: 5 books and 4 CDs Date Published: 2005 Price : S$1,320.00 By Dr. Van Tharp It contains five books by Dr. Tharp, and four CDs. These CDs help guide you through exercises in the course on such topics as: how you think when you make profits and lose money; stress reduction; programming yourself not to repeat your mistakes; and trading unemotionally. Dr. Tharp carefully crafted the information from his studies into a model that
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trades has been difficult for many traders—at least until now. Value-Based Power Trading brings to life the dormant potential of the Market Profile™, providing traders with an explicit, rulebased system that utilizes the insights afforded by the profile to generate consistently profitable trading signals.
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Type: Set of 16 CD-ROM’s Date Published: 2005 Price : S$850.00 By Lawrence McMillan To meet the demands of different learning styles, Larry McMillan is now offering his successful Live Online Seminars on CD-Rom. These seminars include the same information and follow the same outlines as the live seminars, yet you can listen to them over and over again. These seminars include the same information and follow the same outlines. Complete detailed outline of each of the 16 courses is shown below. These CD’s are an audio presentation illustrated with Power Point slides. Each CD ranges from one hour to 1 ½ hours, depending on the number of questions and answers posed at the end of each session. Total running time of these CD’s is approximately 24 hours. The skill level of these courses is from beginner to advanced. A complete A to Z education in options is provided.
Value-Based Power Trading Type: Hardcover Date Published: 1993 Price : S$80.00 By Donald Jones Market Profile™ continues to revolutionize futures market analysis. By organizing price and time into a usable format, the Market Profile™ provides extraordianry insights into the dynamics of the marketplace. Indeed, through the prism of the profile, many traders feel they can actually “read” the market.
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Trading Spreads and Seasonals Type: Hard cover, 324 pages Date Published: 2000 Price: S$288.00 By Joe Ross In Joe Ross’s seventh published work, he brings common sense to commodity futures trading. He leads you through the maze of intra and intermarket spreads and helps you to find opportunities in seasonal trading. He details the unique use of Bollinger Bands and RSI as applied to spreads. Covers the fundamentals, the technicals and the historics, to produce stateof-the-art solutions to the oldest of commodity trades, spreads and seasonals. (from Bob McGovern’s Introduction)
Unfortunately, the process of translating Market Profile™ analysis into profitable
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SLIPSIDE There is this kid who is being very bad and he asks his father “I’ll be good for $100” and his dad says “Son, when I was your age, I was good for nothing”.
A shopkeeper was dismayed when a brand new business much like his own opened up next door and erected a huge sign which read ‘BEST DEALS.’ He was horrified when another competitor opened up on his right, and announced its arrival with an even larger sign, reading ‘LOWEST PRICES.’ The shopkeeper panicked, until he got an idea. He put the biggest sign of all over his own shop. It read ‘MAIN ENTRANCE’.
An unscrupulous businessman was feeling very ill and went to the doctor. The doctor examined him and backed away, saying, “I’m sorry to tell you this, but you have an advanced case of highly infectious rabies. You must have had it for some time. It will almost certainly be fatal.” “Could you give me a pen and paper?” said the businessman. “Do you want to write your will? “ “No, I want to make a list of all the people I want to bite.”
A farmer and his wife went to a fair. The farmer was fascinated by the airplanes and asked a pilot how much a ride would cost. “$10 for 3 minutes,” replied the pilot. “That’s too much,” said the farmer. The pilot thought for a second and then said, “I’ll make you a deal. If you and your wife ride for 3 minutes without uttering a sound, the ride will be free. But if you make a sound, you’ll have to pay $10.” The farmer and his wife agreed and went for a wild ride. After they landed, the pilot said to the farmer, “I want to congratulate you for not making a sound. You are a brave man.” “Maybe so,” said the farmer, “But I got to tell ya, I almost screamed when my wife fell out.”
Two buddies were walking down the warf one day. Jack asked Joe what is 99+347. Well Joe said, that’s easy boy, it is 446.Joe boy your getting some smart Jack said. Well Jack I been eating smart pills. You got anymore Joe. Yes I got More. So then Joe puts his hand down the ass of his pants and takes one out and gives it to jack. Then Jacks says my Joe, this tastes like shit. Joe says well Jack,your getting smarter already. A man and a woman are in a supermarket. They are standing in front of the water aisle. The man wonders aloud, “Who would buy all this expensive Evian water anyway? “ The woman says, “Evian... It’s naive spelled backwards.”
A young stockbroker decided to take a day off and visit some of his professors in his old school. When he made his way into the entrance he noticed a dog was attacking a small child. He quickly grabbed the dog and throttled it with his two hands. The next day the local newspaper reported the story with the headline, “Valiant student saves boy from ferocious dog.” The stockbroker called the editor and strongly suggested that a correction be issued and that the paper will tell the readers he was a successful Wall Street stockbroker and not a student. The next day the newspaper issued a correction and the headline read, “Pompous stockbroker kills school mascot.” 32
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An elderly couple were driving across the country. The woman was driving when she got pulled over by the highway patrol. The officer said, “Ma’am did you know you were speeding?” The woman turns to her husband and asked, “What did he say?” The old man yelled, “He says you were speeding!” The patrolman said, “May I see your license?” The woman turned to her husband and asked, “What did he say?” The old man yelled, “He wants to see your license!” The woman gave him her license. The patrolman said, “I see you are from Arkansas. I spent some time there once and went on a blind date with the ugliest woman I’ve ever seen.” The woman turned to her husband and asked, “What did he say?” The old man yelled, “He thinks he knows you!”
INTERVIEW
HANK PRUDEN
Interview with Hank Pruden
H
ank Pruden is an internationally- known educator and speculator. He is a professor in the School of Business at Golden Gate University in San Francisco, California where he has been teaching for 20 years. Hank is more than a theoretician; having actively traded his own account for the past 26 years he has placed real equity at risk based upon the theories he teaches. His personal involvement in the market ensures that what he teaches is practical for the trader, and not only abstract academic theory. He is also the Executive Director of the Institute of Technical Market Analysis (ITMA). At Golden Gate he developed the accredited courses in technical market analysis in 1976. Since then the curriculum has expanded to include advanced topics in technical analysis and trading. In his courses Hank emphasizes the psychology of trading as well as the use of technical
analysis methods. He has published extensively in both areas. Hank has mentored individuals and institutional traders in the field of technical analysis for many years. He is currently on the Board of Directors of the Technical Securities Analysts Association of San Francisco and is past president of that association. Hank was also on the Board of Directors of the MTA and has served as Vice Chair of the Americas with IFTA. For eleven years Hank was the editor of MTA Journal, the premier publication of technical analysts. From 1982 to 1993 he was a member of the Board of Trustees of Golden Gate University. Hank completed his Ph.D. (with honors), at Lundquist College of Business, University of Oregon. He also holds an MBA from the Haas School of Business, University of California, Berkeley and a Bachelor’s of Science degree from California State University, Chico.
Professor Pruden, currently on a yearlong sabbatical from Golden Gate University, is a visiting professor/visiting scholar at Euromed-Marseille Ecole de Management in Marseille, France. In collaboration with other professors at Euromed-Marsaille, Hank has co-authored two articles. With Dr. Bernard Belletante, Hank published a realtime test of the Wyckoff method projecting a new bull move in the DJIA in the IFTA Journal. The Journal of Technical Analysis published his work with Dr. Bernard Paranque and Dr. Walter Baets. While in France, Hank is acting as a roving ambassador of education for IFTA. He is working to develop courses and introduce technical analysis into colleges and universities and to assist individual technical societies with their educational offerings at the operational level. His objective is to identify what needs to be taught at these schools and how it should be taught in each of VOLUME 2 ISSUE 2
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INTERVIEW the individual countries, accounting for cultural differences. Hank will be traveling throughout Europe and the Middle East in the coming months to meet these objectives. The roving ambassadorship is similar to a role Hank has fulfilled since 2000 in South and Central America ‘s financial communities. He helped to launch the Brazilian Technical Society and has been a keynote speaker in Brazil, Argentina and Mexico. Bilingual in Spanish, Hank has been able to address complex and sensitive financial and intercultural issues without the confusion or misunderstanding of translation
Educational Philosophy For over a quarter of a century, Hank has taught technical analysis at the university level. A popular scholar, he has won multiple “best teacher and best scholar” awards based upon his ability to be easily understood by motivated beginners in finance and by experienced professional investors. Exposure to investment professionals during that time resulted in feedback as to what works best, resulting in continuous improvements in the curriculum. Getting students to progress from the definition level of instruction to application of theory has proven to be the greatest educational challenge during that time. Hank discovered that the same approaches cannot be applied at both beginning and advanced levels. Over the years Hank has taken his own academic theories and secondary research to develop the innovative, workable model, the ACTION SEQUENCE METHOD for building the skills and knowledge of intermediate learners of technical analysis. (The ACTION SEQUENCE is fully explained in the Journal of Technical Analysis article, “System States of Pedagogy and the Action Sequence Model” (Issue 58, Summer-Autumn 2002). While the Action Sequence Model may be very roughly thought of as paper trading,
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the model includes extensive feedback and replays the original sequence incorporating lessons learned from the previous experience. Hank emphasizes that the replay portion of the model is critical. In this way, the student is being trained to react appropriately to future market circumstances. As a consequence of the efforts of Hank and his colleague’s in the San Francisco financial community, Golden Gate University has the only academically accredited graduate certificate program in technical market analysis in the world.
Analytical Framework Being a teacher, Hank is able to define complex issues in simple terms. Applying this skill to trading, he found that traders like to use analogies to explain their world and to help them capture a deeper understanding of what it takes to be a complete, high performer. A favorite field from which to draw analogies is competitive athletics. One attractive analogy for the three part skills of the complete trader is the “triple threat” notion in football. In the early 1950s, TIME magazine ran a cover story on the then Princeton University All-American Dick Kazmier. The cover story was titled “A Triple Threat from a Single Wing.” Princeton’s football team operated out of a “single wing” formation. Kazmier personified the complete football player of his era: he was outstanding at the run, the pass and the kick. These three complementary talents, combined into one individual, made Kazmier an awesome competitor and an All-American performer. Applying this analogy to trading, Hank found that the 3-in-1 Trader must seek to develop a “triple threat” skill set. It is not running, passing and kicking, but rather: 1. Systems building 2. Pattern recognition 3. Mental state management These three decision frameworks, il-
lustrated in Figure 1, interact with each other and build on each other in a natural order of progression. A behavioral finance framework for system building provides the structure for integrating and interpreting indicators organized along the key dimensions of price, time, volume, and sentiment. A pattern recognition scheme for discretionary trading, such as the Wyckoff Method of chart reading and of technical analysis furnishes the trader with an almost ideal set of laws and principles that the trader can use as general guidelines to interpret chart patterns and to take action. A model of trader psychology for mental state control is needed for success in system or discretionary trading. Hank’s collaborative research with Dr. Van K. Tharp led to “The Ten Tasks of Top Trading,” a series of discrete contexts for selecting appropriate mental states and providing a logical and comprehensive sequence of tasks for the successful trader to follow. Pertinent papers can be found at http://www.hankpruden. com/tentasks.pdf Hank relies primarily on the Wyckoff Method of technical analysis. He likens this approach to Woody Hayes’ football philosophy at Ohio State - “three yards and a cloud of dust.” Although neither approach is fancy, both are effective and both produce winners. Richard Wyckoff was a trader in the early-to-mid 1900s. He tried to understand the logic behind market action. Like Hank Pruden, Wyckoff was able to explain complex issue in understandable terms, such as “Are you riding a dead horse? Get off and get a live one.” (from Fourteen Methods of Operating in the Stocks Market, 1909/24, as quoted by John Bollinger, CFA, CMT in Capital Growth Topics, May 18, 2001) By studying the actions of Jesse Livermore, James Keen, J.P. Morgan, and other stock operators of his day, Wyckoff developed a trading system which sought to explain the boom and bust cycle in stocks. The Wyckoff Method
uses price charts and volume studies to analyze and forecast the stock market. It also takes into account investor psychology and provides insight into why professional traders buy and sell stocks. Wyckoff emphasized the placement of stops and the importance of controlling the risk of any particular trade. Successful implementation of his model allowed Wyckoff to own a mansion in the Hamptons. A successful trader from Lebanon introduced Hank to this approach. After much study and practice, he realized this approach made a lot of sense to him, and it has been at the core of his analysis ever since. Hank also finds that teaching reinforces the concepts of the Wyckoff Method, and he has also found that most students who study this method are able to profitably employ it, given sufficient study and practice. Hank has also sought to expand upon Wyckoff ’s work. To this end, he has added some definition to several concepts. As an example, he has refined a checklist to identify market turning points during periods of consolidation. He has also added to the body of knowledge by creating a checklist to assess whether or not that consolidation will lead to a resumption of the prior trend. To obtain an overview of this investment tactic, readers may refer to Hank’s articles, “Wyckoff Laws: A Market Test” in the 2004 issue of the IFTA Journal and “Wyckoff Tests: Nine Classic Tests and Nine New Tests” which appeared in the Spring-Summer 2000 issue of the MTA Journal. This article is available at http://www. hankpruden.com/nineclassic.pdf Hank also has been working with Cusp Theory to study market behavior. In the Winter-Spring 2004 issue of The Journal of Technical Analysis, Hank coauthors an article entitled, “Interpreting Data from an Experiment on Irrational Exuberance: Applying a Cusp Catastrophe Model and Technical Analysis Rules” which explains this effort. His co-authors Paranque and Ba-
ets are at the Euromed-Marseille Ecole de Management.” Cusp Theory is useful to explain the tools of technical analysis, and may provide the mathematical tools to explain why the Wyckoff Method works. In the experiment described in the Journal article, Hank and his co-researchers observed that a collective irrationality drove members of the group. Others chose not to participate in a clearly overvalued market, and thus had no chance of winning. However, disinterested, outside observers would have been able to spot the awaiting calamity just by watching the price patterns emerge. While technical analysis captures the patterns of human behavior, Cusp Theory explains that behavior. Hank feels that this may be among the greatest contributions of Cusp Theory – reinforcing the fact that despite a human tendency to seek complex answers, simple information such as trendlines may be highly predictive of future price movements.
Current Views At this time, Hank believes that the major trend indicators, such as classic Dow Theory and 200- day moving averages of the major indices, are the keys to understanding the current market. His Wyckoff analysis gave major signs of accumulation followed by the start of a cyclic bull market in 2002-2003. Adding cyclic analysis to the equation, he finds that we are in a dominant bull trend with expectable corrections until a top is reached, most likely in 2005. In “Wyckoff Laws: A Market Test,” published in the 2004 issue of the IFTA Journal, Hank and Professor Belletante of Euromed-Marseille projected a target of 14,400 on the DJIA, expected to occur in 2005. Thereafter, as he explained in a MayJune 2004 presentation in Mexico City, he anticipates a trading-range market reminiscent of the 1970s.
Closing Advice Hank firmly believes that in knowledge, there is power. Those seeking
to master technical analysis need to attain basic knowledge and practical skills of the field before risking their assets. Investors at all levels often underestimate the level of skill required in this profession. Hank encourages newcomers to read the books written by John Murphy and Martin Pring as a starting point. He also considers Edwin LeFevre’s classic “Reminiscences of a Stock Operator” to be required reading. Experiential learning is also valuable in this field; well guided experience can save a great deal of time and losses for new traders. For the past seven years, Hank has been in demand worldwide, addressing professional societies and portfolio managers in Japan, Australia, Sweden, Singapore, Iceland, Italy, the Netherlands, Denmark, Germany and Canada. He also counsels investors in his offices in San Francisco and in their home countries. For more information about Hank’s work, please see www.hankpruden.com Hank welcomes the opportunity to discuss introducing technical analysis into European and Middle Eastern universities. While working in Paris over the next year, he is available to meet with representatives of the academic community or any IFTA society to discuss appropriate tactics. Professor Henry O. Pruden was interview by Mike Carr and appeared in the MTA Newsletter, TECHNICALLY SPEAKING , during the Fall 2004. We would like to thank Professor Henry O. Pruden, Ph. D allowing us to reprint this article. Professor Henry O. Pruden will be conducting a 2-day intensive study and skill building with the Wyckoff Method in Kuala Lumpur on June 10-11, 2006. For more information, please visit www.picapital.com.my Professor Henry O. Pruden is also conducting a 3 hour evening talk in Singapore on 5 June 2006. For more information, please visit www.tass.org.sg VOLUME 2 ISSUE 2
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PSYCHOLOGY
STUART MCPHEE
Exercise
Stuart McPhee, trader, author and editor of the Traders’ Journal, explains how traders can prepare their minds for top performance through physical exercise
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nfortunately, many people who start trading find success difficult to achieve, certainly in the period of time immediately after starting. Trading is a challenging endeavour that has torn people from all across the world across generations, from every extreme of their emotions. It is our money that is directly involved in trading and therefore at risk, and the potential of making more money is our primary motivation for beginning this undertaking. Therefore any emotions that we may associate with other endeavours are heightened because money is something that seems to accentuate any natural human emotions that we have. Ironically, it is the money that encourages the vast majority to attempt to trade yet it is the money that causes most people to fail. In his book, ‘Trade Your Way to Financial Freedom’, the renowned American psychologist Dr. Van Tharp discusses in several parts how important your psychology or mindset is to your trading success. He graphically depicts the significance of your psychology using a pie chart and explaining that there are three ‘Ingredients to Trading’. They are System, Money Management and Psychology. In the pie chart, the System is 10%, Money Management is 30% and the remaining 60% is psychology. Why does a psychologist who has spent his entire professional life counselling
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traders of all experience levels say that so much of your trading hinges on your psychology? The key is that your mind drives everything you do in your life and trading is no exception. Your emotions are a part of who you are and your decision making process. Decision making is a large part of trading, as you need to make decisions often and many of them are difficult decisions. Furthermore, people like to break rules, even ones they set themselves. There are some simple trading rules that have stood the test of time, and will always work yet most people cannot follow them. It is essential that you realise how important it is that you demand of yourself the highest level of discipline to ensure you implement the requirements of your trading plan ruthlessly and follow some of the time tested trading rules. At a presentation I gave a few months ago to a group of about 50 fellow traders, I was asked several questions, as per usual. After discussing the items above about emotions, sticking to a plan and the stresses associated with trading, I was asked about how you overcome the stresses and emotion of trading that seem to jeopardise so many traders around the world. I answered, “Exercise”. I immediately received many puzzled looks and someone said, “you mean practicing trading?”
It appeared to me that many had never considered a regimen of physical exercise in order to prepare well for trading. You don’t have to run in order to trade – you just have to sit at a desk. However when you consider the demons that haunt many traders and the obstacles we face, then think about the benefits of physical exercise, shouldn’t we mention the two together more often. More and more today, people not only mention the physical benefits of physical exercise, they also include now the mental benefits of physical exercise. These are numerous. Physical exercise can greatly improve both your mental and physical health. The physical benefits of aerobic exercise are well known and include improved muscle strength, flexibility, and cardiovascular endurance. Exercise also helps lower your blood pressure. My belief in the benefits of physical exercise with regards to trading is based on the ability of exercise to help combat stress, and help you think more clearly when you are facing adversity. Generally speaking, the lives of many have never been busier and more stressful. It has become a driving force behind most visits to doctors for people of all ages. Medically, when a person is experiencing stress, adrenaline pours into the blood stream as part of a person’s ‘fight or flight’ response and muscles throughout the body tense in anticipation of a challenge. Immediate
effects can range from a short temper and heightened emotions to difficulty sleeping. Many traders would agree that you can experience certain levels of stress when trading and it is often at these times that we do not employ the best judgement in our decision making. John McCarthy, executive director of the International Health Racquet & Sportsclub Association (IHRSA), says, “Regular physical activity can help counter the potentially damaging effects of stress on the body and may help prevent stress-related illnesses. These activities provide a natural way to release tension in the body and will often lead to an automatic state of relaxation that naturally follows a good workout.” Medically, during exercise the body starts to produce endorphins. Endorphins are chemicals that lead a person to feel peaceful and happy; they promote a sense of well being. This is a perfectly natural and effective tool in helping to manage stress. Exercise can also help some people sleep better and raises their self-esteem. By increasing your self-esteem, your self confidence grows and this can directly assist you with trading, as confidence is one of the more understated character attributes required by successful traders. Of perhaps less importance, exercising can help you physically look better, as those who exercise regularly, look more toned than those who don’t. Exercise is one of the most important parts of keeping your body at a healthy weight, and people generally feel much better and confident when they see themselves in a positive light. Again, those who feel more confident in themselves are likely to have more confidence in a trading plan they develop. The flow on effect can be very positive for their trading. Trading is generally decision making where we need to employ sound judgement on a regular basis. Along these lines, exercising can also help
your brain to work better. There have been numerous academic papers and research done to support the notion that exercise can improve a person’s ability to think more clearly. Exercise has been found to increase a person’s mood state and an overall improved sense of well-being, which in turn helps to keep stress, anxiety and depression to a minimum. Military forces all around the world engage in regular and demanding physical exercise in preparing for the demands of military operations. Officer training institutions generally enforce greater standards as officers are often required to make decisions and often do so under pressure and hardship. The physical exercise they endure enables them to think more clearly than the average person and remain level headed when the pressure is on and all seems lost. Could we as traders not benefit from a similar mindset where we are able to think clearly at all times and make sound decisions based on solid judgement? Wouldn’t this help us take a step towards overcoming the adversities we can face with our emotions and stresses? Focussing on the type of exercise, it is important that people don’t exert themselves too much. It has been found that a steady aerobic workout will produce far greater results than those that exhaust the body and leave a person folded over in pain and out of breath. A steady aerobic workout will greatly assist the brain’s ability to solve problems and make decisions fast and effectively. Generally after exercise, people are able to concentrate and focus much better than before. They are better able to block information that is irrelevant to the task at hand, and respond much faster to information relevant to the task. From a motivation perspective, it is important for those who have never really exercised before or where there has been a lengthy layoff, that they start off easy. Many unfit people set out to begin an exercise routine with
great ambition and enthusiasm and then find that they cannot stick to the routine and their motivation quickly disappears. These people end up on a never-ending cycle of great ambition, loss of motivation, and a steady slump back to where they started. This is often because they are not enjoying the exercising they are doing. This is a problem. Exercise is supposed to be a fun activity, even for the whole family and when you arrive back home feeling terrible, the motivation to go back out and do it again takes a big hit. This is when you will begin to think of all the reasons not to go again and then, you have taken a turn down the wrong road. Naturally, the fitter a person is, the more they will reap the rewards from aerobic exercise. Physical fitness does not come easy. The best strategy is to gradually increase the duration of your exercise sessions and, along with enhancing your physical fitness, your mental muscle will also begin to take shape. There is no doubt that regular and moderate aerobic exercise will help your brain to function more efficiently, and therefore reduce stress, think more clearly and remain level headed in times of emotion and adversity. In an endeavour where very few people succeed, it is in our very best interests to do everything we can to increase our chances. I strongly believe that physical exercise can greatly assist traders to think more clearly, reduce the effects of stress, and ultimately make better and timelier trading decisions. Stuart McPhee is a private trader, trading coach and Associate Editor of the Traders’ Journal. He has written numerous articles and texts including Trading in a Nutshell, 2nd Edition. He also conducts trading courses throughout South East Asia. Stuart can be reached at
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PSYCHOLOGY
GARY NORDEN
Our (Not So) Good Friend
Harry Hindsight
Gary Norden explains the dangers of the various biases especially that of hindsight bias
I
F ONLY; two small words which are spoken by thousands of traders and investors every week. ‘If only I had cut that position’; ‘If only I had bought some shares of Moonbound Mining’. Many traders are blessed with 20/20 Hindsight vision and hindsight will always be the scourge of traders. In this article I will approach hindsight from a couple of angles and hopefully offer some techniques to help reduce the effect that hindsight undoubtedly has on trading.
tablished and known, predominantly Gold mining firm has gone bankrupt. It is probable that many investors in Australia have held at least one of these stocks and so the reality is that when financial planners hold up a chart of the performance of the ASX 200, many or most investors will not have matched that performance. In years to come though, the stocks that no longer exist will not show up and people will assume that they can get the returns their financial planner suggests.
Hindsight Bias is a well documented heuristic in behavioural finance which has been shown to lead to over-confidence. In turn over-confidence is a very dangerous trait for traders as it can lead to misplaced views, poor trading decisions and losses.
This point actually hits upon another bias, called survivorship bias which is the view that because we only see the winners or survivors our view of the performance of whatever we are looking at will be distorted. Survivorship bias can therefore be seen to relate to hindsight as well.
Unfortunately hindsight is also used by many ‘educators’, financial planners and trading system vendors to substantiate their claims and to ‘prove’ certain facts. For example we have all been told that if we had bought stocks say 20 years ago we would have made X amount of money. But in reality it depends upon which stocks we bought. The Australian Stock Market is for example, at its all time high but this does not mean that all stocks are trading on or even near their high. Ansett Airlines, formerly a major airline has gone bankrupt as has HIH Insurance, previously one of Australia’s most prominent Insurance firms. Shares in Telstra and AMP, two more blue chip stocks, and probably the most widely held stocks in Australia have fallen by 50% or more over the past 4 years or so. Even during the biggest bull run that mining shares have witnessed in almost a generation, Sons of Gwalia, a 100 year old, well es-
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In Jan/Feb 2005 one of Australia’s leading technical analysts wrote the following statement about Aristocrat Leisure which was trading at $8.59 AUD: “Investors who climbed aboard after the dramatic fall from the $7.30 high on 31/8/01 to the 76 cents low on 30/5/03 have been well rewarded.” This statement is a clear example of someone using hindsight to try to appear to be smart. The fact is that when this company’s share price was trading at 76 cents it looked like the company was going bankrupt and those who bought shares at this time have been rewarded for taking a big risk. Sons of Gwalia, HIH Insurance, Enron and WorldCom shares fell sharply too but those who bought these at low levels were not rewarded and because they no longer exist our technical analyst will not be review-
ing them. I am sure though if she were presented with a graph of these latter stocks and if she knew which they were she would argue that they were clearly in a downtrend and should be avoided. The fact is though that the graphs of these latter stocks and that of Aristocrat Leisure were very similar and it is only with hindsight that we can try and find some differences. It is vitally important as traders that we understand this so that we can avoid the claims and views of people who make such statements. After the fact, traders, particularly technical and mechanical ones can examine the past data or graph and apply the multitude of indicators, patterns etc that are available and find out which one(s) worked best over the preceding period or which ones ‘predicted’ certain moves. This approach and other back testing techniques are said by their supporters to filter out the techniques which ‘work’ on a contract. However those who follow this approach are actually more likely to be practicing data snooping. Heavily influenced by hindsight they can easily discard poor performing indicators and find the ones which have performed well in the past but using these will only be successful in the future if the future exactly resembles the past; almost an impossibility. The question we need to ask ourselves is, ‘Could we have found these winning indicators before the period that we tested them on?’ Otherwise the work that we are doing is of little use and we are relying on hindsight to establish our trading techniques. While researching my book, ‘Technical Analysis and the Active Trader’, I discovered that this question has been posed and tested by some very thorough studies. In all the studies that I found the answer was the same; a trader could not have known before the period which indicator would perform the best in the future. I find these studies among the most interesting that I examine in my book but until now they have mostly remained within academic circles. The studies are far more thorough and robust than any system vendor would conduct and we should take note of their results. For example Professors Sullivan, Timmerman and White in their paper for the London School of Economics Financial Markets Group entitled ‘Data Snooping, Technical Rule Performance and the Bootstrap’ tested nearly 8,000 technical rules on 100 years worth of data on the Dow Jones Industrial Index. One test they conducted was to use only available information to construct a trading strategy; that is at any time they first found out which tool or indicator (out of the nearly 8000) had performed the best until that point and then used that one for future trades. They found that this
approach performed poorly and concluded, “…investors could not have known ex-ante the identity of the ex-post best performing trading rule”. So there is significant evidence that this back testing approach which has become very popular among private traders and has made many a trading software vendor wealthy, is no where near as reliable as those who use it believe. It is effectively a hindsight and data snooping based technique which has the added concern of making its followers over-confident in their trading. It is likely that most who use these techniques will fail even though they believe they have a ‘proven’ system. What I find particularly amazing is that in many countries and on most financial products there must appear a statement along the lines of ‘Past performance is not necessarily a representation of future performance’. There is a good reason for this, it is true. Yet systems which are ‘proven’ using past performance are becoming more and more popular among private traders partly due to their failure to understand the influence of hindsight in the results (as well as slick marketing). In fact it is not only private traders who are falling into this trap. Shortly after my arrival in Australia I was contacted by someone whose client was looking to provide capital for traders to start up hedge funds. The person who contacted me told me that his client was keen to allocate some funds to me but they wanted me to supply them with a ‘proven’ back tested system. I replied that I could supply them with dozens of systems ‘proven’ by back testing but these do not provide the client with any further proof of my trading ability or my ability to generate profits in the future than my current history and track record. What they should be interested in is my money management, knowledge of the markets and products that I trade and my understanding of decision making. Suffice to say I refused to design the trading systems that the investor wanted despite the fact that they wanted to invest with me. Unfortunately it is far easier to start up funds and entice money into funds using such back tested, hindsight influenced, results and sadly I know quite a few people who have invested in such funds and are nursing heavy losses despite the previous record. Unfortunately too, fund managers who use this approach, rather like private traders who use the same methods, will struggle to improve their performance as they do not know why they win or lose and the hindsight techniques which they adopt will always be behind the curve. VOLUME 2 ISSUE 2
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PSYCHOLOGY We have therefore seen that hindsight is all around us and that it can lead to over-confidence among traders and investors. In addition what some traders believe is thorough, reliable and robust research or back testing is heavily influenced by survivorship bias and hindsight. After certain moves, traders, mainly technical ones will pour over their charts and data to find which tool, pattern or indicator ‘predicted’ the move but in reality it is only with hindsight that these can be spotted. So what can we do help combat our use of hindsight? It has been suggested that merely warning people about hindsight bias is not enough because it is so ingrained in human thinking. So the answer(s) is not a simple one but does involve a different approach to trading than many traders use. Firstly we should recognise the fact that back testing relies upon hindsight. In fact as I discuss in my book there are many other problems associated with back testing. Importantly when we view past data, graphs etc we should not draw any conclusions regarding what we might have been able to predict in advance of it occurring. We should avoid the notion that all moves can be predicted in advance and that somewhere out there, there is a tool or indicator which can do this. After the fact we will always find one but the truth is more often than not we could not have found the right tool before the move, which is what we should be interested in. The idea that moves are forecast or predicted in advance stems from the belief that market participants know something and that this is the reason why they trade. I argue in my book that rather than knowing something, traders price in certain outcomes and that they may or may not be right. Our job as traders should be to work out what they are pricing in and whether there is any disconfirming evidence out there. This will help us work out the risk/expected return of various trades and outcomes including outcomes which are not on the graph. By learning the techniques required to do this as well as the thought process and knowledge of making good decisions our aim should be to make good decisions based on how we see the situation at that time. Once we have established a trade we should continue to monitor it and look for new evidence and information. Should information come to light which casts doubt on our original trade then we might need to close it out. We must remember that we entered the trade using information which was available at the time and because of the nature of the markets it is likely that sometimes the situation will change. Importantly it is very likely that this disconfirming information may come from
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outside of the graph or data of the contract we are trading. Looking for information which contradicts our original view is a major focus of my trading and teaching and is a technique which is actually the opposite of how many traders and investors conduct their analysis. While my view is that not all moves are predictable there are times when we can weigh up the information which is available to come up with great trading opportunities. In my experience, few private traders have the knowledge or understanding to trade in this way and are enticed by the mechanical or chart based methods which are simpler to execute. As long as we understand what a good decision is and we stick to making good decisions we should be comfortable with what we are doing. Good decisions will not always make money due to the nature of the markets but if the decision was based on sound analysis then that is all we can ask of ourselves. Sometimes the trade which makes money is actually a risky one and a trader who gets into the habit of taking risks may not last long. Importantly with a better understanding of the reasons and risks of a trade we should be able to learn, when possible, why our trade went right or wrong. My belief is that if we cannot learn from our successes and failures then we will always struggle in this business. Someone who uses a mechanical or chart based technique and simply changes to a new one if/when it fails is actually learning very little about the markets other than it is good at taking his/her money. As Baruch Fischhoff a renowned expert on decision making explained, it is difficult to learn from the past if one uses hindsight. If we fail to acknowledge that some events in the past were surprises and look for predictors, patterns etc in the belief that we will understand the past we will be actually be unable to learn from it. The many traders who do employ these techniques will always be relying on our old enemy Harry Hindsight. During a 16 year trading career, Gary has managed derivative trading desks for Investment Banks and traded his own money as a ‘local’ futures and options trader on the LIFFE floor. He now runs Marketwise Trading & Consulting which offers trading and options education courses. Gary is the author of ‘Technical Analysis and the Active Trader’ which investigates the use and effectiveness of technical analysis and offers insights into how the biases of behavioural finance affect traders and investors. More information is available at www.marketwisetrader.com
PSYCHOLOGY
DR. VAN K. THARP
How We Worry Ourselves Out of Profits
Dr. Van K. Tharp, author and professional trading coach, explains the powerful force of worry and how it can sabotage our trading
E
very time Michael thought about entering the stock market he said to himself “But what if I lose?” Those thoughts often paralyzed him from action or delayed his entry so long that many opportunities simply passed before he would pick up the phone. When Michael did open a position, all he could think about were negative consequences. “My trading system is wrong at least half the time—what if this is one of those times?’’ He couldn’t sleep because his mind was racing with those “what if ” thoughts. Michael suffered from a chronic “dis-ease” of the mind called worry. Current research suggests that both a biological component and a psychological component of stress impair human performance and that it is useful to consider these two components separately. The biological component is the fight-flight response, a primitive reaction that early man developed in order to survive. This physiological arousal causes people to narrow their focus and put more energy into what they are doing. It might help you run faster or fight more aggressively, but it does not help you invest more successfully.
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The psychological component of stress is what Michael was doing: worrying. It involves a concern for one’s performance and its consequences. It is the expectation of failure and the negative self-evaluation that accompanies failure. Worry is probably the precursor to the fight-flight reaction. Constant worry or intense worry certainly produces physical stress and, as such a herald, worry might be expected to only have a mild effect on performance. Research, however, shows the converse is true. Though physical stress at its extreme might result in death, worry generally has a much greater effect on human performance than its biological counter. Much of the experimental research on worry has dealt with a common problem of students—their concern about performance on an examination. Students who worry about test performance are likely to do poorly compared with students who are not concerned. The worry has nothing to do with preparation for the examination—it is simply the fear of poor performance. As a result, concerned students spend at least 25% of their conscious thought worrying about their grades on the examination rather than devoting their full effort to talking the examination. Michael, the investor who cannot sleep well because of his concern over possible negative consequences, will perform as poorly as the worrying students. His ability to forecast price movement or select good investment opportunities does not matter. His constant worry about his performance ensures that he will not achieve optimum results.
Worry and Information Capacity Our senses are constantly bombarded with millions of bits of information. One can only select a small portion of this information for conscious processing. Thus, people have a limited capacity for dealing with information that comes through the senses. You can test this capacity in yourself by reading the following list of numbers, closing your eyes and then recalling as many of them as you can: 78 23 81 59 44 90
37 17
4
91 16
55 98
11 84
Unless you have an elaborate strategy for organizing the numbers into groupings that you can memorize, the basis for most mnemonic techniques, you probably were not able to recall many of them. Fifteen twodigit numbers far exceeds the capacity of most people. Now imagine what other people will think of you if you don’t recall all 15 numbers. Perhaps they’ll think you are stupid or getting old or incapacitated. In addition, imagine that you will be fined $1,000 for each number that you miss. You could lose up to $15,000 if you miss them all. And what if the numbers you think you know turn out to be wrong? You really could miss all of them! Now, keeping all of these thoughts in your mind, try again to recall the numbers. Chances are you missed more of them, if not all of them, on the second attempt. Why? Because worry takes up precious processing capacity. When you worry and take up capacity, little remains to perform more important tasks such as investment decision-making. Worry takes away from your ability to pay attention to what is really going on in the market. You cannot notice subtle changes in the market or respond to them because you are too preoccupied with your fantasy of “what if.” Thus, if you worry about what will happen if you make a mistake, you probably will VOLUME 2 ISSUE 2
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PSYCHOLOGY make that mistake. By concentrating on potential mistakes, you make them happen.
per bushel. Let’s look in detail at the reactions of five commodity investors to this same event.
Worry and Perception
• An old man with a smile on his face had been stopped out of soybeans early in the day. He had a $3,000 loss at the time he was stopped out, but the closing price of the day would have amounted to a much larger loss. He felt good about himself for sticking to his trading plan, so he responded to the news by smiling and telling himself, “Great! You stuck to your system.”
All the information obtained through the senses about the world “out there” comes from a set of complex mental operations called perception. These mental processes interpret and attach meaning to the information the senses detect. For example, one might see a set of black markings on a white piece of paper and “perceive” it as a bar chart with a “head-and-shoulders bottom” or some sort of “resistance” or, to a non-technician, just meaningless lines. Perception is a filtering process, which selects information for conscious, processing. It selects information from the billion of bits impinging on our sensory apparatus, so we can cope with the world. The selection process is not random, however, but an active process that selects information according to one’s expectations. What one sees out there depends on what one expects to see. The investor who expects to see a bull market in stocks will tend to perceive information that supports his expectations. He will “see” bullish technical patterns in his charts and ignore any evidence that might contradict the possibility of a bull market. Worry is a form of perception based on negative expectation. People who worry anticipate negative consequences. Most stressful events are stressful because of the way they are perceived. The event is just an event. It is a person’s interpretation of the event that makes it stressful. Winners, for example, have learned how to make it “O.K. to lose.” Losers, in contrast, become extremely anxious over losses and, as a result, have difficulty “letting go” of them. A large loss, or even the potential for a large loss, may devastate the worrier. The person who dwells on the more positive aspects of the situation will view the same event as a lesson or even an opportunity. Suppose for example, the price of soybeans drops 20 cents
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• An active trader was convinced soybeans were due for a major rally. He had predicted the drop during the day and had used the opportunity to acquire a substantial long position in soybeans. He had a small loss on the day, but he felt a sense of satisfaction because his plan was working well. The only thing he said to himself was, “I’m right.” • A financial columnist was long in soybeans. He had absorbed the loss, because he did not enter a stop with his order. His predominant thought was that he did not stand a chance. If he entered a stop, he was sure it would be picked off by the traders on the floor. If he sold out at a large loss, it would probably be at the low price of the day. If he held onto his position, the market probably would continue to go against him. “Why me?” he thought. • A company president phoned his broker in a panic even though he was short in soybeans. He now had a $3,000 profit and he was concerned the market might go against him. His broker had convinced him to enter into the position and now he was afraid that he might lose his profit. “I’ll lose again! “ he thought as he called his broker to learn if he was still bearish. • A soybean farmer had sold his crop two months earlier at a much high-
er price because he was convinced that certain big companies were manipulating the markets down. The 20-cent price drop was, for him, further proof of manipulation. “Damn them,” he said to himself as he frowned. He remained in a bad mood the rest of the day. Notice how the same event is a totally different experience for each of these traders. Three traders actually lost money in the market, yet two of them had positive experiences. Two traders made profits, yet both of them were unhappy. Of course, most people are not happy about losses or sad about profits. These examples merely illustrate that profits and losses have nothing to do with experience. People create their own experience by the way they think. Each person experiences life differently because each person’s thinking is unique. People who generally worry a lot will worry a lot about their investments. People who worry about their investments will tend to do so constantly. In any situation, which might involve a threat to an individual’s self-esteem, worriers show a marked capacity reduction. Self-esteem situations involve a threat of failure, whether it’s a failing grade on an examination or performing poorly in the market. In fact, investing may pose a tremendous threat to an individual’s self-esteem. The losing investor may not only experience financial hardship, but may also feel that he has failed to prove himself to those he loves or to himself.
How to Deal with Worry How do you manage worry? If you can discover how you worry, then a simple solution to the problem is to do something else. If the new solution doesn’t work, then again do something else. Keep changing your approach until you find something that does work. This does not necessarily mean changing your trading system. If you execute a system poorly, you will execute a new system poorly. “Changing your
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PSYCHOLOGY approach” means to change how you think, how you make decisions, and how you execute your system. This solution is simple, but most people find it very difficult to accomplish because they are locked into certain patterns. Changing the way you think and perceive the world is not always easy. To change the way you think, you must first discover how you start the worrying process. Being objective about your own thinking is difficult while you are doing it, but much easier later when you can try two techniques to discover how you start worrying. The first exercise is to review a past, painful market experience. It is the quickest way to discover how you worry. You need only recall what happened just before the painful experience. You have no need to replay the experience itself. Review the experience as if you are watching a movie of yourself. Sit back in a chair and feel yourself in that chair watching yourself on a movie screen. As you watch your movie, determine what started the worry experience. Was it something you saw or read? Was it something you heard or something someone said? Was it a feeling? What happened next? Did you start talking to yourself? Seeing pictures? Did your self-talk and pictures trigger the bad feelings? How did you do it? When people worry they typically get themselves into a negative feedback loop. They talk to themselves, which produces bad feelings which results in more negative talk followed by more bad feelings and on and on. Others see images, which produce bad feelings, which make the images worse, and so on. What kind of loop do you produce? Once you discover how you start to worry and what kind of negative feedback loop you produce, figure out some ways to change it. Disrupt your loop in some way. If you say negative things to yourself, practice following those phrases with a picture of something
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pleasant. Try changing the quality of the voice you hear. If you say negative things to yourself, say it in the voice of some well-known cartoon character. Be creative. Do anything that is different until you find something that works for you. If you have trouble discovering how you worry from your past memories, then a second exercise is to keep a worry diary. When you feel anxious or worried about an investment, make a note of it in your diary. Do so at the time you are worrying. Don’t put it off. Be sure to include the following information: • What were you doing when you started to worry? • What triggered the worry? • Was it someone’s actions? • A memory? • A visual image? • A feeling? • How did you go about worry? • What kind of a loop do you set up for yourself? Is this a new or an old pattern? Later, when the experience passes, make a note in your diary about what you actually did. What could you have done instead? Also comment on your original diary entry. After recording your worry diary for several weeks, you can study it objectively. What kind of irrational fears do you have? How does worrying affect you as an investor? Most importantly, you can determine how you trigger an episode of worrying and how you go about worrying. When you have a good idea how you start to worry, select some changes you can make, such as those just suggested with the past memory technique. Become aware of when you start to worry and immediately select one of your changes. Once you discover how you go about worrying and have selected some alternative behaviors, practice using them. If you do so diligently,
then the process will soon become automatic. Imagine yourself in some future situation where you would normally worry and practice some of the alternatives you have selected. Once you can feel at ease in an imaginary situation, you should be able to deal with the real situation. Investors who go through this process frequently comment, “It’s just not the same anymore. I don’t know what happened, but it’s not the same anymore.” In the unique arena of professional trading coaches and consultants, Van K. Tharp stands out as an international leader in the industry. Helping others become the best trader or investor that they can be has been Tharp’s mission since 1982. Dr. Tharp offers very unique learning strategies, and his techniques for producing great traders are some of the most effective in the field. Over the years Tharp has helped people overcome problems in areas of system development and trading psychology, and success related issues such as self-sabotage. Dr. Tharp is the author of three acclaimed books published by McGraw Hill; the New York Times Bestseller, Safe Strategies for Financial Freedom with co-authors Steve Sjuggerud and D.R. Barton, Trade Your Way to Financial Freedom, and Financial Freedom Through Electronic Day Trading. In addition, Tharp is the only trading coach featured in Jack Schwager’s best selling book, The Market Wizard’s: Interviews with Great Traders. Website: www.iitm.com This article is taken from the book “How to Control Stress to Become A More Successful Investor”, the second volume of Dr. Tharp’s five volume course on how to develop peak performance in the markets.
PSYCHOLOGY
The Emotional
Dynamics of Trading Martin Kemp, an experienced and qualified facilitator/coach, explains some of the different emotions traders experience and what we can do to combat them
MARTIN KEMP
T
he markets offer an endless stream of opportunities to trade. Each trade or series of trades provides the chance to wipe the financial slate of the past clean, find trading redemption, and claim the lucrative future. Each trade has the potential to announce that your dues are paid, that you are maturing as a trader, and that finally you are poised to enter the elusive circle of consistent winners. The lure and promise of financial freedom through the clicks of a mouse offers a sense of adventure, challenge, and stimulation rarely matched in other activities or professions. Only a very select few are able to ascend and remain atop this Darwinist ladder and garner consistent profits. The majority of traders find themselves nursing a depleted account balance and a sense of bewilderment. Statistics tell us the cold hard truth that many losers fill the pots of a few winners. They don’t reveal the shattered emotional landscapes, and even financial ruin that take their toll on those at the bottom of the trading food chain. It is sometimes stated that you need to remain detached from your emotions whilst trading. This represents a noble aspiration, but aside from the fantasy world of the paper trader, where real, hard-earned money is on the line emotions will kick in strongly, and therefore we have to know how to make them work to our advantage. Despite our best efforts to override or subdue them, emotions, enhanced and crystallised into sharper focus by the market environment, will gnaw at us and dictate actions which are often contrary to what we intended when getting into the trade. Some traders struggle to take the action they know is right because they pay more attention to their own process in a negative way than to the process of the trade itself. The challenge is to fully accept your emotions as they arise during trading and in so doing, relate to them as reliable, trustworthy guides. The greater your emotional self knowledge the more clearly you will be able to gain transparency into the actions of the other market participants. VOLUME 2 ISSUE 2
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PSYCHOLOGY Understanding the market from such an emotional perspective brings many benefits. It means, for example, that you are able to fully embrace the risk inherent in trading. Knowing from your experience that anything can happen in the market, you will be prepared to catch and hold any emotional fallout that results from your trade. You feel secure within your overall expectation of profit, and are thus able to give breathing space to individual trades. It means that you are more likely to take the hard decisions quickly because you possess an inner fluidity that allows you to respond with nimbleness and acuity. The market maxim of following the line of least resistance probably equates to following the line of most resistance in yourself, something that becomes easier as you become accustomed to relating your nuances of feeling to the market action. Emotions can be good contrarian indicators. With practice, you can begin to guess where others are ready to throw in the towel and be there to gladly relieve them of their position. The candles on the charts are graphic illustrations of hope, fear, greed, and belief as well as the footprints of money. It is crucial to appreciate the emotional dynamics that underlie this game of wealth redistribution. In the market context some emotions may have a different resonance and payoff than in everyday life. For example, if you are in a place of deep despair and hopelessness in your everyday life, then perhaps this can be talked about, processed, worked through in therapy, or offered to your particular God. Usually there is a way of finding some light at the end of that tunnel. Transferring the same emotional dynamic with its inbuilt hope to the market, based on some apparently abiding faith that things will be OK is tantamount to financial suicide, a margin call probably being the only salvation.
Filtering Process It is important to create for yourself an inner filtering process, perhaps a small simple ritual, so that you do not find yourself bringing to the market arena emotions and qualities which serve you well in everyday life but which could prove detrimental to your trading. For example, determination is a great quality to possess when used for the right purpose. You need to retain a determination that you will triumph in your quest to achieve your trading goals. This does not mean that you have to express your determination on every single trade and try to force results where they aren’t going to happen. You also have to be on the lookout for when you are using a
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particular quality in the market that maybe belongs elsewhere in your life. Similarly, suppose you have recently been successful in some other endeavour in your life. You assume that the same set of principles apply to becoming successful at trading. You follow your common sense and replicate your approach. It yields disappointing, confusing results. You may feel like quitting; but if you can pause to reflect and consider, you may discover that it is in the ashes of this temporary distress that the phoenix of the winner is waiting for an invitation to emerge.
Spiritual Parallels The journey from loser to winner is, if you like, a trade in itself, the ultimate buy low sell high, exchanging ignorance, loss, and what you don’t yet know for self-knowledge, consistency and a degree of mastery. It’s a tough deal and only those who are willing to undertake serious, searing self-scrutiny and practice rigorous self-discipline will make it. Many, as they say, are called. Few make money. Indeed, there are many parallels and echoes, for those inclined to look, between what is required on a journey of spiritual development and that of becoming a successful trader. The Buddhist concept of ‘the narrow way’ certainly has resonance with the statistical certainty that many traders will fall by the wayside and only a small dedicated percentage will develop the requisite inner qualities and get through. Many spiritual paths demand of their adherents a degree of asceticism, forgoing something in the present and enjoying the virtuous action that will yield them future rewards. Deferring the temptation to snatch a quick profit and practising the patience that may bring the greater reward if a winner is allowed to run is just one example where an adherence to a more rigorous ethic could be more profitable. Most spiritual traditions encourage an awareness of the present moment, for it is in this ‘eternal now’ that one becomes free from the veil that masks the true reality of being. I am not especially trying to reconcile God and mammon here, but I am acknowledging that if you could remain in present moment awareness whilst you are trading, you are likely to be more effective than if you are caught up in the hopes and fears of the future and the regrets of the past. If you can trade from the place of ‘what is’, then you remain closer to the pulse of the action. Discipline is freedom, they say, and apart from perhaps becoming enlightened, nowhere does this ring more authentically than in the trading arena. A trading apprenticeship involves becoming unhap-
pily familiar with the trader’s lament, the phrase ‘if only’. Regret for trades not taken, not exited quickly enough, or exited too soon must be dealt with in a way that doesn’t prejudice future trading The winner changes if only to ‘only if ’ – only if he is disciplined, focused, alert, and grounded will he succeed. He develops an inclusive relationship with the inevitability of loss in its many guises. He learns to gracefully receive the lessons in humility the market so unfailingly provides.
Actual and Potential Perhaps the most crucial factor in determining trading success is how you manage the relationship between the apparently limitless potential for profit and your actual results so far. Anything not resolved within the boundaries of this relationship will leak out and seek expression elsewhere in your trading. If “potential” constantly looms larger for you than
“actual”, then impatience, frustration and recklessness will likely ensue, with predictably damaging results to your account. Similarly, if you dwell on the potential without undertaking the necessary psychological work to improve upon the actual, then you are merely attaching yourself to hope which is projected on to your trades. Hope is a burden that refuses to be displaced until it is ousted by something of substance. This is why it is so vital to grow your trading size slowly and incrementally so that the energetic relationship remains proportionate and balanced. The journey, ideally, synergised by self discipline, moves from the actual to the actualisation, cumulatively incorporating potential on its way, yielding its secrets in response to the intensity of commitment and effort expressed. We can regard the evolution of a trader as a Gestalt cycle moving through its respective stages, as illustrated below (see figure 1). This cycle relates to both micro and macro, anything from an individual trade to overall progress as a trader. Round and round we go, each time getting closer to what we know we are capable of. It is, of course, possible to interrupt the positive flow of the cycle and refuse to co-operate with the process, going AWOL in response to your own idiosyncratic resistance to change. In my work as a trading coach, I encourage people to always remain aware of their place and desired destination in terms of this model, and to use the information it imparts to make wise trading decisions.
Group Behaviour
Figure 1 - Gestalt cycle moving through its respective stages
The study of group dynamics tells us that when people engage or convene together for a particular purpose, they usually assign themselves a place or position within the overall group that is familiar to them. Often unconsciously, they seek to adapt to the pre-existing group based on their emotional history and what they have come to believe about themselves. Without awareness of this process, a karmic train of action is set in motion which somehow gives the market the responsibility of being the arbiter of what is truly deserved or desired. Understanding your chosen place in this anonymous cast of thousands, the group that are your fellow market participants, can shed light on your trading behaviour. Given the high-risk nature of the trading VOLUME 2 ISSUE 2
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PSYCHOLOGY environment, maybe it is inevitable that people seek out the safety in numbers of the losers rank.
to let go of accustomed assurances and allow themselves to enter the place of unknowing.
Consistent success comes to those who grasp the essence of the oft repeated but rarely followed rules, an essence that remains forever opaque to those who resist the necessary self-enquiry and self-discipline. Consistency originates in will and is nurtured on the firm foundations of self-esteem, self-acceptance, and self-responsibility. It requires that you have tamed your inner demons, or at least made a pact with them that they will strut their stuff on another stage well away from your trading.
Winners rely on their finely honed, seasoned market instincts. They engage with the uniqueness of each moment. It is my belief that an experienced trader can achieve far better returns through the disciplined use of market instinct and some simple tools than through a purely mechanical system. Systems appeal because they offer the illusion of control. However, even great systems, if they exist, extensively back tested and individually tweaked to carry the expectation of profit, are likely to produce losses if traded by someone who lacks emotional stability and self-discipline. Creating and developing a system is all very well, but if one of the reasons you are drawn to trading is because it offers an environment that imposes little structure, then what makes it likely that you will follow the indicated entry and exit points?
A playwright creates a drama based on the enduring premise that character is destiny. You become what you think, you create situations for yourself, consciously or not, that lead you to where your greatest learning edges lie. Beware what you ask the mercilessly neutral market environment to resolve. It could cost you a fortune.
Pain It’s unlikely you’ll become a truly great trader without a prolonged enrolment in the school of pain. Pain cuts sharply through our preconceptions and illusions and indicates to us that our market actions are inappropriate. There is chronic pain, which probably reflects a deep stubbornness, rigidity, and perhaps obstinacy for which the market will prove a costly healer. A degree of acute pain is the inevitable cost of being in the game. The language of pain is stark. It forces decisions, often in haste, upon us. Are we in or are we out, do we hold or do we fold? Pain can be a great teacher, alerting you of its imminent appearance, as you consider potentially unsound trading actions. It can and does catch you off guard. Unless you’re ready for it, it will overwhelm you into decisions you will regret. You need to become the master of pain rather than its slave. Those who resist pain may find themselves setting wide stops so as to postpone its arrival. Those who accept it learn to be comfortable with the messages it brings, even if this does stop some way short of a fully-fledged friendship!
Winners Winners develop a good, ongoing relationship with their markets of choice. Their expectations are realistic but always positive. Winners know the pitfalls well and are on respectful terms with them. They clearly understand the emotional potholes on the path to success and are able to see through their camouflage. They are not afraid of the markets because they trust themselves. They are brave enough
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For winners, the adventure of trading, ostensibly about the acquisition of money and its rewards, is an inner journey of expansion. They enjoy the visceral sensation of unknowing and uncertainty. They welcome the uncomfortable feelings of running their winners and cutting their losses and allow the unfamiliar to burn open new pathways for them. They enjoy defying their intuition and the boldness of the counter intuitive approach. They are untroubled by the energetic polarities of right and wrong. They just do. They have released themselves from conflict so they can watch and act with equanimity upon the flashing numbers that populate their screens. Knowing that change is permanent, in the markets as in life, they live in the present. They get themselves out of the way. They know themselves so they know others. Martin Kemp is an experienced, qualified facilitator/coach with a number of years full time trading experience. His focus is on large cap, very liquid FTSE stocks, primarily using CFDs, though he has also traded both FTSE and S&P emini futures. Martin offers one to one and group coaching sessions and workshops that focus on the emotional dynamics of trading. He can be reached at martinlaurencekemp@hotm ail.com
PSYCHOLOGY
JIM WYCKOFF
When
To Quit Your Day Job Jim Wyckoff, financial journalist and technical analyst, details some very important issues to consider before making the leap to trading full time
I
have had many readers through the years, most of whom were lessexperienced traders, tell me that at some point in the future they planned to quit their day jobs and trade futures full-time. While their optimism was certainly positive from the standpoint of eagerness to learn about a truly fascinating business, it is also probably unrealistic that they will ever make a good living as a full-time futures trader. At the end of this feature I have a few questions that may help determine if you are ready to attempt to join the elusive rank of ‘full-time’ trader. But first, I want to present you with some straight facts. I have been in this business nearly 20 years. I have read stacks of trading books and have voraciously studied markets and market behavior. I have
worked right on the trading floors of all the major futures exchanges. As a journalist, I have conducted countless interviews with the very best traders and analysts in the world. But I still cannot specifically predict what a given market will do in the future. Now, at this point a few of you may be thinking, “This is not very encouraging news. Maybe I should listen to some of those other guys that say I can have immediate trading success by learning their ‘secrets’ or adopting their ‘proven’ system or strategies?” While I hope this is not the case with you, I am very proud of the fact that I have made my reputation in this industry by refusing to be marketed and promoted (hyped) as something I am not, nor can ever be.
It’s very important to realize the fact that neither I nor anyone else, not even the most powerful computer trading systems, can predict what the markets will do in the future. Markets will never be tamed. I’ve said many times that my profession is not a business of market predictions, but one of exploring market probabilities, based upon fundamental and technical analysis – and human behavior. By exploring and understanding market probabilities, and human nature, one can achieve trading success. Many traders are lured by fast-talkers or fancy wording into thinking that someone or some firm has a sure-fire trading ‘secret’ or system that beats the markets on a consistent basis – and racks up big trading profits in the process. But the truth is, most of VOLUME 2 ISSUE 2
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PSYCHOLOGY these claims are half-truths at best and downright lies at worst – and come from people who are out to take your money. I tell my readers right up front that I have no ‘trading secrets’ and that achieving futures trading success is not easy and takes hard work. And even hard work does not guarantee futures trading success. Unfortunately for many traders, it takes the pain of losing substantial amounts of money early on before they finally realize what I stress to my readers right away. Okay, enough preaching from me. What are some clues that you could be one of the fortunate few that actually could succeed at being a full-time trader? I’ll get some questions for you shortly, but first I want to address an issue about which you may be pondering right now. That is: Jim, why don’t you only trade futures full-time if you are so knowledgeable? I have never attempted to be a fulltime futures trader. By ‘full-time’ I mean focusing only on trading futures and using the realized profits for my living expenses. In my case, that would mean no analytical service, no custom consulting, no educational writing – all of which I’m doing now. Since I have never tried to make a living only by trading futures, I cannot tell you whether I would be successful or not. The reason I have never attempted to trade futures full-time is because I truly enjoy the communications aspect of being a market analyst and a trading educator and mentor. I hope that those of you who have talked with me or emailed me would agree that I do really enjoy discussing markets with other traders. I do know that if I were to attempt to be a ‘full-time’ futures trader, the task would not be easy, even though I do have much experience and knowledge. Now, on to a few questions to ask yourself if you think you might be ready to trade futures fulltime:
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1. Are you a successful part-time trader? You’ll need to be successful at trading futures on a part-time basis before you think about moving into the full-time trader ranks. Don’t be fooled into thinking that trading futures on a full-time basis will allow you to spend more time to cure your part-time trading ailments. In other words, don’t say to yourself: “If only I could spend more time trading markets, I could have more success than I’ve had just trading ‘one-lots’ here and there.” 2. Do you have enough money available to live on when (yes when, not if ) you hit a streak of losing trades? A losing streak will inevitably occur – and probably sooner rather than later. And I don’t mean a losing streak of two weeks, but more like a stretch of poor performance of up to six months, or longer. 3. Do you have the psychological stamina to be a full-time futures trader? Quite frankly, most people do not. Can your psyche (not to mention your pocket book) handle six months of mostly losing trades? 4. Will your immediate family members support you – even during a prolonged rough stretch of trading? Believe it or not, this is a very, very important question. For example, if your spouse does not support your decision to trade full-time, then you are likely doomed to failure. The pressure of having to produce winning trades and knowing that your spouse is skeptical of your efforts is almost insurmountable. 5. On your part, will you be able to uphold your family or other important responsibilities even during a rough trading stretch? Or, will you brood and kick the dog when
he happens to cross your path? I think you’ll agree with me that those are tough questions to answer. One more thing: I do have many readers that are ‘full-time’ traders but who do fall into a different category than what I described above. These are people who do have enough money to trade futures on a full-time basis – even if their trading profits alone will not support their lifestyles. These are individuals who already have significant amounts of money derived from means other than trading futures. Also, I have many readers who are now full-time traders, and that have retired from another profession and want to spend the ‘autumn of their lives’ not in a rocking chair, but in a field that is challenging to them. Again, they, too, have other means of income besides just futures trading profits. Jim Wyckoff has been involved with the stock, financial and futures markets for more than 20 years. He was born and raised in Iowa, where he still resides. Wyckoff became a financial journalist with Futures World News for many years, cutting his teeth as a reporter on the futures trading floors in Chicago and New York, where he covered every futures market traded in the United States at one time or another. Not long after he began his career in financial journalism, he began studying technical analysis. By studying chart patterns and other technical indicators, he realized this approach to analyzing and trading markets could level the playing field between “professional insiders” in the markets and individual traders. His extensive studies of technical analysis and knowledge of markets led to several positions, including chief technical analyst at several well-known companies. He says his mission is not just to generate profits for traders but to also provide them with educational and insightful information because, in the fascinating business of trading, one never stops learning.
To advertise to the readers of The Trader’s Journal Call Dickson Yap at (65) 9788 8141 or email at
[email protected]
TRADING SYSTEM DEVELOPMENT
PRICE HEADLEY
Keep Systems Simple Price Headley, the founder of BigTrends. com, explains how traders should not try and complicate their trading systems
H
ow do you handle conflicting signals if you’re committed to trading systems? It’s a great question, so today we’d like to answer it with a quick lesson, and maybe a dose of ‘reality’. First, let’s get everybody on board with what a trading system is. As it sounds, a trading system is just a mechanized way of generating buy/ sell alerts. They’re typically based on specific chart events, but there are also other ways of producing these unbiased signals. For this example, though, let’s just assume that the trading system is based on a chart. The only other thing you need to know - whether you’re a novice or a pro - is that there are basically two kinds of mechanical trading signals. (This is possibly the most important thing to accept about trading, yet it’s the first aspect that’s forgotten.) The first kind of signal is one that assumes a trend will continue. Let’s call those ‘momentum signals’. The other kind assumes that a trend will reverse. We’ll just call those ‘reversal signals’. Here’s why it’s important to never forget this little duality........ if one type of signal is right, then by default, the other type of signal is wrong. With that in mind, let’s look at an example of each. After that, we’ll illustrate how trying to apply both at the same time can be maddening, as well as unprofitable.
Figure 1 - S&P 500 with MACD system trades (long only) - Daily
Table 1 - System test results for MACD signals
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A Momentum Based System Let’s run through an example of a momentum-based system first.....a ‘long only’ system, just to make it easy. For our charts today, we’re using TradeStation, but almost all charting software packages have a similar system-building function. The most common of all of these systems is a MACD (Moving Average Convergence Divergence) crossover system. Basically, these signals assume that once momentum has been developed, it will stay in place. The buy signal is generated on our chart below whenever the faster MACD line crosses over the slower one (we can’t get into the mechanics of these lines today). These entries are indicated on the chart of the S&P 500 with upward pointing blue arrows. For our exit, we’ve just applied a trailing stop, indicated by downward red arrows. A trailing stop just means we’ll make an exit when the index pulls too far back off its most recent high, but that stop level is continually adjusted to protect profits. Take a look at the chart, and then take a look at the summary of the systems success below that. (By the way, profitable trades are marked by a green line, while unprofitable trades are marked with a red line). Does the system work? On a hypothetical account that buys 10 option contracts per trade, the TradeS-
Figure 2 - S&P 500 with stochastic system trades (long only) - Daily
Table 2 - System test results for MACD signals
tation software says it does work. Take a look at the system profitability report. Even though there were more losing trades than winners, the winning trades were almost three times as big as the losing ones were. The average trade gain here (including winners and losers) was $99.59 (an arbitrary amount - we just need to know if the system works, which it would for any account size.) Over the last two years, this system would have netted us $1693 in profits, if we were trading options. In other words, given enough time, this system is one generally worth using.
A Reversal Based System OK, so what about a reversal-based system? Let’s build one using the stochastic oscillator - one of our favorites. Like above, let’s just use long entries to keep things simple. The buy signals are marked with blue arrows, and the exits are marked with red arrows. Profitable trades are traced with green lines, while unprofitable trades are marked with red lines. The bottom-line results are similar to those we saw with the MACD system. Using a reversal-based system, you would have netted gains of $1079 over the last two years with these signals.
But What if you Used Both? It’s tempting to use both systems, isn’t it? After all, even if there is some overlap in the signals, it couldn’t hurt. And where there’s not overlap, you’ll have an opportunity for more gains than you would with just one system, right? Unfortunately, that’s not true. The least profitable results were achieved when both of these systems were applied. The trade count more than doubled, but net profits actually went down! And more than that, this would have been a major burden to trade. Just look at the chart where both systems were applied - it’s a mess. And the actual dollars made? Only a profit of $851 was achieved when both of these systems were used simultaneously - the VOLUME 2 ISSUE 2
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TRADING SYSTEM DEVELOPMENT
Figure 3 - S&P 500 with stochastic AND MACD system trades (long only) - Daily
Table 3 - System test results for MACD and stochastic signals used together
worst results yet. Even when the entries were ‘unlinked’ with their original exits, the results were about as poor. The point is just this.....besides being chaotic, following too many signals can be counter-productive (as we saw in our last multi-system results). That’s not to say that we only follow one kind of system; we actually have several kinds of systems running at any given time. But any trader has to recognize how some mechanized signals can conflict with others. If you’ve got an oscillator and a momentum signal both ‘on’ at the same time, and you’re waiting for both of them to agree, well, you’ve got a long wait. Over the long-haul, you’re better served by using a system that works for you, and recognizing that there will be periods when that system fails. If you’re an advanced trader, and can mentally handle both types of signals at the same time, we’d recommend that you keep separate charts for both systems. That way, one won’t interfere with the other. In fact, some traders switch back and forth when the market environment changes .....which can be tricky to do. More than anything else, keep in mind that all systems will have periods of failure. If you can stick with them through those periods, you’ll be far better off.
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Price Headley is the founder of BigTrends. com, which provides investors with specific real-time stock and options strategies and investment education to profit from significant market trends. Price has appeared on CNBC, Fox News, CNNfn, Bloomberg Television and a variety of print and online financial news outlets, including The Wall Street Journal, Barron’s, Forbes, Investor’s Business Daily, USA Today, and Bloomberg Personal. He speaks regularly to investment audiences nationwide. He is a graduate of Duke University and a member of the Market Technicians Association. He is also a chartered financial analyst (CFA) charterholder and a chartered market technician (CMT) charterholder.
TRADING SYSTEM DEVELOPMENT
BRENT LEONARD
Option Trading
Using the Wyckoff Trading Range
Brent Leonard, options trader and technical analyst, explains how we can use options more effectively during different market stages
Figure 1 – Accumulation Schematic
I
t is a generally accepted fact that both Technical Analysis and option trading are best suited for short term usage, so it would only be natural that options could be profitably applied to the Wyckoff Trading Range while stocks and markets are mired in this non-directional state, essentially taking advantage of time decay while awaiting the eventual breakout – up or down. VOLUME 2 ISSUE 2
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TRADING SYSTEM DEVELOPMENT Richard D. Wyckoff was a pioneer in Technical Analysis who also owned his own brokerage firm, became an inveterate trader and teacher of stock market analysis. His Trading Range is an attempt to quantify a flexible yet somewhat predictable diagram of human emotion and reaction. Having studied and employed both topics for the better part of the last 20 years, I set out to combine them for optimum results, applying the best strategy for each stage of the consolidation, annotated with the Wyckoff 2 and 3letter acronyms. The first cause of action is at the SC, or Selling Climax, at which point the 9 Wyckoff Sell Signals have indicated target reached and downtrend broken ( also by Point & Figure and/or Chart Formation target). Usually this climax is not only on high Volume but also high Volatility, which pumps up the option premium, making them more expensive. It is at this point that one would want to sell puts to open. I shall use a stock that I want to own in this example, although the principle can be applied also, with more Risk and concomitant Reward, to indices and ETFs. Traditionally naked options have been considered quite risky, not only by traders, but by brokerages as well; but a naked (or uncovered) put is basically the same as a covered call – upside profit is capped for a certain premium received, and downside risk is large, down to zero if the company gets delisted. Consider two investors wanting to own the same stock: A buys the stock at 32; B, on the other hand, sells a 3 month, 30-strike put on it for $2; if the stock goes to 25 and stays there, A has a $7 paper loss, but B has taken on the stock for a $3 loss per each 100 shares. (The stock is “put” to him at 30, and he took in a $3 premium). Along with selling puts for approximately half the position one wants to own, they might also buy shares of the Security once they are fairly certain that the downside objective has been reached, through momentum oscillator reversals, Volume abating, etc. Per Wyckoff, the next event one might expect is the AR, or Automatic Rally test, up to a certain retracement area made evident by the inverse action similar to the Selling Climax – oscillators topping, volume fading, etc.
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Here at the AR a number of possibilities abound – one can close out the short puts, depending on the time value and current price; one can sell some stock if it is deemed too rich, or something has changed; or, one can sell calls – to form a short straddle along with the puts, or covered calls on the long stock. I would not recommend selling naked calls due to the unlimited upside risk! Compared to simply owning a stock in a sideways trend, the covered call can have a triple benefit: enhancing profits through the receipt of a premium, some price appreciation up to the strike price at which it might be called away, and any dividend that the stock pays during that option life. The option premium also offers some insurance protection if the stock falls rather than rises, in which case the stock is not called away and subsequent calls can be written. Since the passage of time is the ally of the short strangle-seller and covered call writer, one can well outperform the market during the ensuing Trading Range, fine-tuning at various turning points, e.g., Secondary Tests, upside Support retests, etc., until the SOS, or Sign of Strength presents itself. Consulting the proper Sector or Industry Group as well as the overall market will aid one. Wyckoff would also recommend Point and Figure charts for clarity and Count. Finally, when the Security (Stock, ETF, or Index) purports to have finished with the TR and breaks up through the Support level on high Volume, upturning Oscillators, and plenty of similar company, one would treat it like any upward-trending Security, until the next consolidation, buying to cover any remaining short calls (covered or strangled), and letting any short puts expire worthless – the option traders’ dream. Note: Now that options’ commissions have come down considerably, thanks to online trading, more sophisticated strategies are also more doable than in the past, such as Butterfly spreads, Condors et.al., while the Security is in the TR. Brent Leonard, CMT has been a Senior options trader (ROP) and Technical Analyst for the past 20 years, working for Baraban Securities, Charles Schwab & Co. and himself. He is co-editor of the TSAA Review and an Adjunct Professor in Technical Analysis at Golden Gate University. He also writes a Stock Market column for the Marina Times in San Francisco, CA.
CHARTING THOMAS BULKOWSKI
The Measure Rule Thomas Bulkowski, author and private investor, explains how to use the measure rule to predict a price target after the breakout from a chart pattern
I
n the second edition of my book, Encyclopedia of Chart Patterns, I explored how often a price prediction method, called the measure rule, works for over 60 chart and event patterns in both bull and bear markets. This article takes a closer look at the results for various chart patterns, including how often it works and what to look for. For most chart patterns, the measure rule is the height added to (upward breakouts) or subtracted from (downward breakouts) the breakout price. Figure 1 shows an example of the rule for an Eve & Eve double bottom.
Eve & Eve Double Bottom An Eve & Eve double bottom has two valleys near the same price. Each valley appears wide and rounded. If spikes are present, they are usually short and clustered, like cut grass. Contrast the Eve bottom with an Adam bottom in October. An Adam bottom appears narrow, usually with a one- or two-day downward spike. The various combinations of Adam and Eve peaks or valleys for double tops and bottoms give performance and identification differences. The time between the two bottoms of a double bottom varies, but the best performance comes from bottoms spaced 2 to 7 weeks apart. Valleys wider than 7 weeks show diminished performance after the breakout. The height of the pattern from the lowest valley to the highest peak between the two valleys is at least 10 percent, but allow variations. Tall chart patterns often perform substantially better than short ones.
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joins the armpits in the pattern, and it signals a trade when price closes above it (for down-sloping necklines only). For up-sloping necklines, use a close above the price of the peak located between the head and right shoulder as the buy signal. Otherwise, you may never get a buy signal for steep necklines. Volume is usually heavier on the head or left shoulder and diminished on the right shoulder. The measure rule is unique for head-andshoulders patterns (both tops and bottoms). Find the lowest valley in the head and measure the vertical distance from that low to the neckline. I show the measure between the head and point A in Figure 2. That gives the height. Add the height to the breakout price – the point where price pierces the neckline (for down-sloping necklines) or the peak Figure 1 - An Eve & Eve double bottom has a price target that matches the height price between the head and right shoulder (for up-sloping necklines). The result is the of the chart pattern. target price. Price hits the target 74 percent In the example shown in Figure 1, a throwback ocof the time in a bull market. curs after the breakout when the stock returns to the breakout price. A throwback happens 55 percent of Falling Wedge the time in the patterns I looked at. A falling wedge is a somewhat rare pattern, and Figure 3 shows an example. A wedge is a price patTo apply the measure rule to double bottoms, subtern bounded by two converging and down-sloping tract the lowest valley in the chart pattern (B) from trendlines. The trendlines will eventually join at the the highest peak (A) to get the height. Since the wedge apex. The breakout averages 57 percent of breakout is upward, add the height to the highest the way to the wedge apex. peak (A) to get a target price. Price reaches or exceeds the target 67 percent of the time in a bull market, or about two out of every three trades.
Head-and-shoulders Bottom A head-and-shoulders bottom, such as the one shown in Figure 2, has a left shoulder that is opposite a right shoulder with a head in between. The shoulder valleys should bottom near the same price and be almost an equal distance from the head. Symmetry is important for easy identification. The head must be below the two shoulder valleys otherwise you may be looking at Figure 2 - A head-and-shoulders bottom uses the neckline as the vertical measure a triple bottom. A neckline projected upward from the breakout point to compute a price target. VOLUME 2 ISSUE 2
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CHARTING Look for price to come close to or touch each trendline a total of five times or more – three times on one side and two on the other. Anything less than five touches and the pattern may be invalid. Price should also cross the pattern from side to side several times like that shown. Volume usually trends downward from the start of the pattern to just before the breakout. The measure rule for upward breakouts from falling wedges is the top of the pattern, point A in Figure 3. A downward breakout uses the height of the pattern (A – B) projected downward from the lowest valley in the pattern (B). Price reaches the top of the pattern 70 percent of the time in a bull market. For downward breakouts, the measure rule is less successful, working just 30 percent of the time. To increase the likelihood of a successful target, use half the height projected downward.
Figure 3 - A falling wedge with an upward breakout needs price to rise to the top of the pattern to hit its target.
Symmetrical Triangle Figure 4 shows a symmetrical triangle ABC. A symmetrical triangle is a chart pattern that has two converging trendlines that join at the triangle apex (C). The top trendline slopes downward and the bottom one slopes upward. Look for at least two touches of each trendline and make sure price crosses the chart pattern plenty of times, filling the pattern with price
movement. Avoid cutting off a rounding turn and calling it a symmetrical triangle. The traditional way to use the measure rule is to compute the height (A – B) and add it to the upward breakout price or subtract it from the downward breakout price. Price stages a breakout when it closes outside of the triangle trendline. This works 66 percent of the time for upward breakouts and 48 percent of the time for downward breakouts in a bull market.
Figure 4 - A symmetrical triangle uses the pattern’s height projected in the direction of the breakout to reach a target price, or a trendline parallel to the side opposite the breakout to get a target.
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An alternative way to compute a price target is to draw a line parallel to the bottom trendline (for upward breakouts like that shown by the dashed line) or parallel to the down-sloping line AC, beginning at point B, for downward breakouts. Begin drawing the line from the start of the pattern on the top (point A), ending directly above the breakout point (D). The price directly above the breakout becomes the target.
Upward Breakouts
Downward Breakouts
66% to 67%
N/A
Double tops (all variations)
N/A
70% to 73%
Head-and-shoulders bottoms
74%
N/A
Head-and-shoulders tops
N/A
55%
Triangles, ascending
75%
68%
Triangles, descending
71%
54%
Triangles, symmetrical
66%
48%
Triple bottoms
64%
N/A
Triple tops
N/A
40%
Wedge, falling
70%
30%
Wedge, rising
58%
46%
Chart Pattern Double bottoms (all variations)
Table 1 - The table shows how often the measure rule works for various chart patterns and breakout directions.
The Numbers Table 1 shows how often the measure rule works for popular chart patterns. For example, I looked at a database of the various combinations of Adam and Eve double bottoms and found 1,098 chart patterns that I tested against the measure rule prediction. The rule worked between 66% and 67% of the time in a bull market using data from 1991 to 2004 in as many as 1,100 stocks, but not all stocks covered the entire period, and I excluded data from the recent bear market. That means price met or exceeded the target price before dropping at least 20% (a trend change, measured from the highest peak to the close) or a close below the lowest valley in the chart pattern. Notes: N/A means not applicable. All variations mean the four combinations of Adam and Eve shapes for peaks and valleys. The table shows that price meets or exceeds the target better after an upward breakout than a downward one. For percentages below 50, use a projection that is half the height of the pattern. That will increase the probability that the price will hit the target.
(closer) target, use half the chart pattern height projected in the direction of the breakout. Once you have a price target, look for nearby support or resistance zones. This may be round numbers (10, 15, 20, and so on), prior peaks and valleys, horizontal price consolidation regions, trendlines, and even other chart patterns. Often price will stall at overhead resistance or underlying support as it nears the target price. Close out your position if price shows weakness or signs of reversing. Copyright © 2005 by Thomas N. Bulkowski. All rights reserved. All figures use Bulkowski’s proprietary software. Thomas Bulkowski (
[email protected]) is a private investor with 25 years of experience and author of several books: Encyclopedia of Chart Patterns, Second Edition (John Wiley & Sons, 2005), Getting Started in Chart Patterns (Wiley, 2006), and Trading Classic Chart Patterns (Wiley, 2002). Before earning enough from his investments to “retire” at age 36, he was a hardware design engineer at Raytheon and a senior software engineer for Tandy Corporation. His website, dedicated to chart pattern research, is at http:// mysite.verizon.net/resppzq7/.
Closing Position The measure rule is a tool used with chart patterns that suggests a price target. Typically, the height of the pattern is used in the computation. Add the height to upward breakouts or subtract it from downward ones to get a price target. For a more conservative VOLUME 2 ISSUE 2
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ECONOMIC CALENDAR
MARCH 2006 monday
tuesday
wednesday
thursday
friday
1
2
3
US – ISM Mfg index for Feb
6
7 US – Factory orders data for Jan
13
8
US – Retails sales data for Feb
20
21
US – Leading indicators data for Feb
27
9
US – Consumer credit data for Jan
14
10 US – International trade data for Jan
15 US – Import & export prices for Feb
22
US – PPI data for Feb
28
EU – ECB Governing Council meets to set interest rates
16 US – CPI data for Feb – Housing starts data for Feb – Philadelphia Fed Survey data for Mar
23 US – Existing home sales data for Feb
29
US – consumer confidence data for Mar
30 US – GDP Q4f
US – Wholesale trade data for Jan
17 US – Industrial Production data for Feb
24 US – Durable goods orders data for Feb – New home sales data for Feb
31 US – Factory orders data for Feb – NAPM-Chicago data for Mar – Personal income and outlays data for Feb
Legend BoE = Bank of England CPI = Consumer price index ECB = European Central Bank FOMC = Federal Open Market Committee MPC = Monetary Policy Committee PPI = Producer price index
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BoJ = Bank of Japan CPM = Chicago Purchasing Managers EU = European Union GDP = Gross Domestic Product NAPM = National Association of Purchasing Managers
APRIL 2006 monday
tuesday
wednesday
thursday
friday
3
4
5
6
7
EU – PMI manufacturingdata US – ISM Mfg index for Mar
JN – BOJ releasesMarch Tankan Survey
10
11
12
JN – BOJ begins two-day monetary policy meeting
17
18
UK – March retail sales data
19
Economic release GDP CPI ECI PPI Employment Personal income Business inventories Durable goods Retail sales Trade balance
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8:30 am 8:30 am 8:30 am 8:30 am 8:30 am 8:30 am 8:30 am 8:30 am 8:30 am 8:30 am
Housing starts Production & capacity utilization Leading indicators Consumer confidence Uni of Mic consumer sentiment Wholesale inventories Philadelphia Fed survey Existing home sales
JN – Minutes from March 8–9 BOJ monetary policy meeting US – Industrial Production data for Mar
21
EU – March CPI data US – Leading indicators data for Mar – Philadelphia Fed Survey data for Apr
27
28
US – Durable goods orders data for Mar – New home sales data for Mar
Release time ( EST) Economic release
US – Consumer credit data for Feb – Wholesale trade data for Feb
14
US – Import & export prices for Mar – Retails sales data for Mar
20
UK – Minutes releasedfrom April 5–6 BOE MPC meeting US – CPI data for Mar
26
AU – 1st-qtr. CPI data US – consumer confidence data for Apr – Existing home sales data for Mar
EU – ECB Governing Councilmeets to set interest rates
13
US – International trade data for Feb
US – Minutes from March 28 FOMC meeting – Housing starts data for Mar – PPI data for Mar
24
UK – BOE MPC begins twodaymeeting to setinterest rates AU – Marchunemployment data
US – GDP Q1a- NAPM – Chicago data for Apr
Release time ( EST) Economic release 8:30 am 9:15 am 10:00 am 10:00 am 10:00 am 10:00 am 10:00 am 10:00 am
Construction spending CPM report Report on business on-manufacturing report on business New home sales Chicago Fed national activity index Federal budget Consumer credit
Release time ( EST) 10:00 am 10:00 am 10:00 am 10:00 am 10:00 am 10:00 am 2:00 pm 3:00 pm
The information on this page is subject to change. The Trader’s Journal is not responsible for the accuracy of calendar dates beyond press time. VOLUME 2 ISSUE 2
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UPCOMING EVENTS 15th March – 18th March 2006
31st Annual International Futures Industry Conference Futures industry professionals attend the International Futures Industry Conference to exchange ideas, share information, discuss trends and network with peers. Boca has been the showcase for innovation. The place to introduce new products and express new ideas. The venue to seek convergence of the industry. Venue : Boca Raton Resort & Club, Boca Raton, Florida Organiser : FIA
24th March – 25th March 2006
7th Annual Technical Analysis Expo in Paris The expo is run by professional Technical Analysts and Traders who work on the markets throughout the year. Their lives revolve around stocks, futures, options or forex, and in order to pass on their knowledge, they have helped us to create this expo - dedicated to TA and Trading. Venue : Espace Pierre Cardin; Paris - France Organiser : Salon AT
31st March – 1st April 2006
Forex Trading Expo The Forex Trading Expo in Ft Lauderdale to learn ways you can confidently trade foreign currency and achieve the success you’ve been working toward! Compare trading systems, software programs, charting services, brokers, advisory services and more. Venue : Ft. Lauderdale Organiser : Intershow
5th May – 6th May 2006
Perth Expo 2006 A dedicated exhibition and educational seminar program for private/professional traders and investors. The wide range of seminars topics are designed to suit industry participants from the derivatives and equities market as well as private traders. Venue : Grand Ballroom - Burswood Convention Centre, Perth, Australia Organiser : Exhibitions Plus
22nd May – 23th May 2006
Derivatives & Securities World-New York This unique trade show and comprehensive seminar programme, acts as a meeting point for all those involved seeking financial solutions. It is your chance to network with your counterparts and update yourself on industry news, new products and developments. Venue : The Marriott Marquis Hotel, New York Organiser : FOW Note : Timing of events can be subject to change.
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