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Trade the Trader
-Know Your Competition and Find Your Edge for Profitable Trading
Quint Tatro
To traders: May you always embrace the tape.
Contents
Chapter 1 I’m Trading Against You . . . . . . . . . . . . . . . . . . . . 1
Chapter 2 My Story . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Chapter 3 It’s All Opportunity . . . . . . . . . . . . . . . . . . . . . . . 19
Chapter 4 The Other Traders . . . . . . . . . . . . . . . . . . . . . . . 25
Chapter 5 Finding Your Edge . . . . . . . . . . . . . . . . . . . . . . . 33
Chapter 6 Timing the Entry . . . . . . . . . . . . . . . . . . . . . . . . . 47
Chapter 7 Trend Lines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Chapter 8 The Basics Are Not Enough . . . . . . . . . . . . . . . . 77
Chapter 9 Pick Your Time Frame . . . . . . . . . . . . . . . . . . . . 85
Chapter 10 Developing Your Plan . . . . . . . . . . . . . . . . . . . . . 97
Acknowledgments
I first want to give the glory to my Lord within whom I can do all things.
To my wife who is always my rock whether it be to keep me grounded or keep me standing tall. I love you more than ever and appreciate more than you know the patience you have had while I have been on this journey.
To my children who were also patient with me while I spent many weekends writing. May you always give 110% to all the tasks before you and never stop dreaming.
To my mother who believed in my writing long before a book was ever in the making. Your humility, dedication, and persever- ance have made me the man I am today. For that I am forever grateful.
To my father who opened my eyes to the world of finance, big dreams, and fortitude. It has been an honor to be a recipient of your wisdom.
To ‘Rev,’ who took me under his wing and graciously opened my eyes to the world of pattern recognition and double-meat sandwiches.
I would like to thank some dear friends who also continue to believe in me regardless of my multiple shortcomings: Steve McBroom—You have been a father figure to me for years, and I continue to learn from you daily. Thank you for always believing in me and making sure I know it. Anne Beaucage—I cannot imagine where I would be without your guidance. You led by example, and I will forever attempt to mimic your actions.
Prakash—You have become one of my best friends. I am continuously in awe of all that you believe I am capable of. Your continuous challenge makes me a better trader, a better man, and a better friend. For that I am grateful. To the people at FT Press: Your professional guidance with this project was fantastic. It was an honor and a pleasure to work with you all.
About the Author
Quint Tatro is President and owner of Tatro Capital, LLC, a pre- mier fee-based investment advisory firm located in Central Kentucky. Although the firm may be located hundreds of miles from Wall Street, Quint is regarded as one of the ‘Street’s’ best technicians and has frequented such shows as CNBC’s Fast Money and Fox Business’s Happy Hour, to relay his thoughts and ideas. In addition, Quint writes columns for financial websites such as Forbes.com, Minyanville.com, StockTwits.com, FinancialSense. com, and Tickerville.com
Financial management runs in the genes for Quint, as he comes from a family that has been involved in the financial world for more than 100 years. Long before he could ever officially be employed, he assisted his father, a 38-year veteran money manag- er, with various projects including research and economic forecast- ing. Gaining his official start in the business in 1999, Quint began as a retail broker in the family firm located in Rochester, New York. Rapidly growing his business, in 2000 he relocated to Lexington, Kentucky, and in 2003 he separated from the family firm, spreading his wings and launching Tatro Capital.
Furthering his experience and education, in 2005 Quint was given the incredible opportunity to serve as a general partner in a hedge fund located in Bradenton, Florida. During this time peri- od, Quint assisted in the management of a $60 million fund and daily operations of the entire business. In 2007, Quint once again found himself heading back to the Blue Grass to reestablish Tatro Capital and make his now distinguished services available to the general public.
Quint hails from upstate New York but left in 1996 to attend the University of Kentucky where he graduated cum laude with a degree in finance. In 2004 he married his college sweetheart Brandie, who has left the field of physical therapy to enroll as a full-time mom raising their children.
Quint and Brandie are active members of Southland Christian Church and each posses a unique heart for missions, particularly the region of northwest Haiti.
Chapter 1 I’m Trading Against You
I sat in front of my six screens like a hawk high on a limb, watch ing the flickering symbols race across my level-two quote box. Market breadth had been horrible all day, notching 5 – 1 decliners over advancers, capping off a week that looked as if the indices would finish close to 5% in the red. I had been nailing the short side all week and was ready to book hefty gains against unsuspect- ing latecomers and amateur traders who actually believe they have a leg up with their basic technical analysis. I sifted through count- less charts, and each one walked a very fine line, looking as if at any moment they would plunge to their deaths, cratering into the abyss. I imagined the number of traders cuing up these exact charts for shorts, and I shook my head again at what would surely be their misfortune. For a moment, I remembered what it felt like to be in their shoes. I recalled the days when I felt empowered by my basic chart knowledge. It would be a time such as this that I would believe the moons had aligned for a perfect trade, a trade that would correspond with all that I had learned from basic trad- ing, netting me huge profits. Unfortunately, over the years it became clear that basic strategy no longer was enough. I had wit- nessed time and again how the basics would work for only a moment, at which point an immediate change of character would set in, robbing me of my hard-earned capital. This time was differ- ent. This time I sat with the hawks, not with the unsuspecting squirrels gathering their charts like nuts, moments before those nuts were snatched up and taken away by a bigger, craftier prey. The same stage had been set this time, the players identical, and even though I already knew an incredible bounce was forthcom- ing, the exciting anticipation continued to build.
The market had been moving methodically lower all day.
However, subtle signs told me to prepare for yet another play on those who equip themselves with sticks in a fight only won by bazookas and heavy tanks. I sat observing how the S&P 500 was bouncing back and forth, grasping for a bottom, when in reality it looked as if another breakdown was a foregone conclusion. Each rally attempt was met with selling, and each move back into the extremely short-term base seemed to be with more vigor and intensity than the one before.
I again pondered what most traders would be thinking as they observed the action and lined up the stocks they would short on yet another thrust lower. I could almost feel their passion through the tape as I watched the intensity build. I noted in my chat room how I had not yet seen the “towel trade” and until I did, I would believe new lows were pending, with a better opportunity to cover and book profits. Many in the room I had traded with for years and knew that the “towel trade” was merely my way of describing the move at which point most traders throw in the towel and, in this case, either give up on their longs or press their shorts. The con- gruent force sparking a breathtaking move, yet one that would only last a moment. Most in my chat room had been on a similar jour- ney as I, and had finally arrived at the place where we were in a position to profit from the towel trade, instead of being the ones throwing in the towels.
The clock struck noon, and while a rumble in my stomach reminded me that I hadn’t eaten anything since beginning my day around 4:45 a.m., I couldn’t yet leave the screens until the trade had been executed with the money in the bank. I sifted through all my various charts, again noting that not one looked bullish, nor did any indicator I followed (such as breadth or sector leadership), yet I refused to be the greater fool. I had no intentions of playing the hero, throwing hard-earned capital at a declining market hoping for a bounce, but I knew very well that just when everyone moved to one side believing that a continued move into the abyss was a foregone conclusion, a change was imminent. This was the trade I was waiting for.
Even though I had seen the trade play out hundreds of times before, it never got dull. Finally, after observing the market for almost four hours, the drop began. At first it started in a slow and methodical fashion as the recent support gave way and traders realized what was happening. Within seconds, my alert box started to trigger stock after stock that was breaking below a predeter- mined level, of which I acted on not a single one. Rather than add new shorts, I watched closely as my existing inventory started to show even a greater profit, and one by one, stocks began a rapid and vicious decline. I was curious what was happening among the masses, so I took a quick glance at the StockTwits Twitter screen. As I suspected, trader after trader was adding short inventory almost as fast as their arrogance grew over what they believed to be certain riches. I covered half of my shorts and watched as the speed of the decline increased with the S&P losing a quick 5 points. I wondered whether a lull would set in, as traders regrouped, but in a blink of an eye another 5 points had disap- peared, and that was my cue to exit my shorts completely and go straight to cash. One by one, my stocks vanished off my screen while the realized profit column grew with my extracted funds. It was only 2:30 or so in the afternoon, but I was done for the day, with one month’s worth of profits in the bank, and it was only the 5th of February.
The move was what I had been waiting for all week, and was my cue to take profits and start the weekend early. My timing wasn’t exact, but within the hour on that Friday, the market started to reverse in a rapid fashion, repairing all of the almost 2% decline it had seen during the day, to close positive, squeezing the accounts of the unsuspecting traders yet again.
You would have to be living under a rock not to see the trading wave sweeping the nation as average investors move in mass toward the world of stock speculation. Not only are they fed up with the traditional Wall Street advisory practice, but they’ve been burned studying balance sheets and listening to management and are not interested in buying the next great American franchise at a deep discount, for a longer-term hold. No, these educated individ- uals are searching out and learning the core principals of technical analysis, behavioral economics, and even the likes of momentum investing. As they learn, they quickly see the real potential for rich- es. However, just as quickly as the number of people moving toward this field grows, the landscape shifts, with the greatest prof- it potential coming not from just trading the market, but from trading the traders.
You see, what most investors don’t understand as they start to learn their basic technical patterns, such as cup and handle break- outs, or as they study their MACD (Moving Average Convergence / Divergence) or RSI (Relative Strength Index) indicators, is they are the ones actually in play. Seasoned traders are no longer just cuing off of charts or indicators, they are also analyzing those same charts to determine what the amateurs are doing, and are seeking to profit from the ignorance of the newcomers. It’s a chess game where the successful traders are thinking two and three moves ahead, playing off the basic strategy of the newcomers. Those sim- ply pursuing a basic path of understanding technical analysis will find it is a road that ultimately leads to frustration, whereas those looking to trade the traders will be met with an endless world of opportunity.
It took me a long time to figure this out, and before I did, I was the trader licking my chops at the number of shorts setting up on a Friday afternoon whoosh, as I just described, only to lose my shirt on the reversal. You see, in that specific example, three levels of traders are present, with most occupying the first two areas:
■ Level one: Although level one has dramatically thinned out after the 2008 bear market, there are still those who believe jumping in to catch a falling safe is the prudent way to go. In my example, this group would have been buying the market the entire way down, losing their shirts along the way, and were the ones throwing in stocks at any price during the towel trade mentioned earlier.
■ Level two: The second level is the unsuspecting, semi- educated trader who realizes buying sunken ships is a loser’s game and knows that shorting them is the way to profits. This trader stalks his prey, and relies on basic technical analysis or other advanced indicators to tell him when it’s time to move in. For our previous example, this is the trader who shorted on the towel trade believing the breaks would continue to plummet.
■ Level three: Level three is not occupied by many investors. However, this is the group who more than like- ly has already moved through level one and level two, understanding that it isn’t just economic forces or corpo- rate profits that move stocks but that it is the traders act- ing in concert who create market movement. They thus understand what traders are thinking and doing, which gives them a greater edge toward capturing profits.
Traders are always in a state of flux when it comes to the way they approach the market. I believe this is so because it is real money and potential profits or losses that are involved, and there- fore everyone is always attempting to glean a new edge. The mar- ket is quick to grade your approach in that it only takes seconds before you know whether or not your strategy was correct.
Because of this rapid evaluation, traders are more inclined to move quickly to change, seeking out a better and more appropriate way to approach their investing. From my vantage point, the masses are moving to a strategy that involves some sort of technical analysis or indicators far away from the basic buy-and-hold approach of tradi- tional Wall Street. As a result of the vast number of people shifting to this strategy, it is becoming saturated to the point that it rarely works as effectively as it once did. To truly succeed in trading, you need to seek out another level, not only possessing a basic founda- tion and proven edge, but also seeking to understand the move- ment of others and how to profit from this. If you do not grasp the theme of trading the trader, you will have a frustrating career in stock speculation, regardless of how passively or methodically you approach the business. It’s really quite simple: If you are following technical analysis, you are either stalking the movement of others, or your movements are being stalked. If you don’t know on which side you fall, odds are you are someone’s next meal.
Chapter 2 My Story
My journey into what I consider successful trading was quite sim- ilar to what most traders experience, except for the fact that I was exposed to the financial world at quite an early age. One can debate whether this early exposure was, in fact, beneficial. Over the years, I have come to realize that it is easier to learn a success- ful trading style if you approach the subject with little to no under- standing of other strategies. It is always my preference to guide someone through the world of successful trading who does not possess any financial background and therefore no preconceived notions or investment bias. Nonetheless, I am very proud to have been raised by a successful investment manager, which resulted in financial discussions being commonplace around the dinner table. Whereas my early education resulted from osmosis, it wasn’t until years later that a brief chat with my father set me on a path that now finds me sharing what I have learned with you.
I was in high school at the time, and I can still vividly recall the conversation. My father and I sat in the living room, having just finished watching a classic movie (an evening ritual). I turned to him and asked, “Dad, how can I make 10 million dollars?” Mind you, while both my father and mother imparted many pearls of wisdom along the way, it was his response that evening that I value more than he’ll ever know. Most parents, when asked something like this by their children, might chuckle and perhaps make an offhanded comment about winning the lottery or maybe a sugges- tion to “marry well.” Paradoxically, even though we have little dif- ficulty telling our children that they can be anything that they want to be in life, I doubt that few would take a question like this seri- ously. However, one look at my face and my father could tell that I was not joking. At that age, my ideas were simple, and despite hav- ing an excellent jump shot and a mean crossover, I knew that my chances in the NBA were about one in a gazillion. I didn’t want to waste my time and energy doing something that wasn’t going to reap some serious fruit. My father didn’t bat an eye, and with a sense of pride he said to me, “You can make 10 million dollars in the stock market.” Well, that was that, and from that point forward I set my sights on achieving a goal to become financially successful through the trading of stocks.
Now, it certainly would be colorful if I could relate that I then attended an Ivy League college followed by a brief but extremely successful stint as an investment banker, which led to becoming a billion-dollar hedge fund manager. After all, isn’t that the path taken by all successful traders? Not quite. After high school, I said goodbye to upstate New York and embarked on a state education at the University of Kentucky, where I was inducted into the world of what I like to call academic finance. While I learned the basic vocabulary of the financial world, my real education in the finan- cial markets would come years later. My final year in college was a rocky one because I had thrown myself completely into an Internet start-up that failed miserably when the technology boom went bust. While the experience of my first real business venture was a tough pill to swallow, it instilled in me a sense of humility that I carry to this day. It was through this failure I learned just how elusive success can be, and I began to grasp the value and impor- tance of managing risk. In 2000, I left Kentucky and headed home to Rochester, New York, to nurture the seed that was planted dur- ing that earlier conversation with my father. It was then that I became a stockbroker.
My first experience in the brokerage business was typical. I was given a phone, a list of names, and a pitch. The difference was that I wasn’t selling a stock idea. Instead, I was pitching a seminar wherein the prospective investors would learn all about what our firm had to offer to meet their estate-planning needs. It didn’t take long before the wind came out of my sails and my energy level waned. Even though I was like a starry-eyed kid around the flick- er of the ticker, I just couldn’t get excited about financial or estate planning. In less than a year, I decided that a move back to Kentucky was in the cards. With a little money in my pocket and a new bounce in my step, I figured that opening my own brokerage office in Kentucky was the next logical move. Again, my ideas were simple. I believed if I was the proprietor of my own business I could choose the direction as I saw fit, thus moving closer toward my goal of true money management.
The year was 2001, and my plug for new clients was, “Sell everything.” Most investors were still disillusioned by what was happening in the markets, although they believed that the then bear market was nothing more than a mere correction. This was an opportunity to scoop up depressed tech stocks, they thought, shares of companies they knew little about. It was at this point that my passion for equities and investing started to shine. Like many who have entered this field, I sought to utilize the same education- al tools of others. From early on, I was taught that Warren Buffett was the pillar of investment success and that his strategy was by far the best method available for securing wealth in the market. Believing this, I devoured everything on the subject that I could, even going so far as to read and reread The Intelligent Investor, the fundamental investment bible written by Benjamin Graham and David Dodd. Learning how to calculate intrinsic value and the importance of remaining extremely patient while waiting for opportunities to present themselves wasn’t all that hard.
Furthermore, it wasn’t that difficult to understand that valuations during the tech frenzy were out of control and that, in fact, a rever- sion to the mean would be coming soon. I made a calculated deci- sion that the best opportunity I had for building a business at this time was by bucking the trend of other advisors who were attempt- ing to calm their clients by suggesting that they ride out the storm. Being very young and having a relatively small list of clients for ref- erences didn’t make it easy for me to obtain new business. This was especially so when you consider that my strategy was a bit brash, since we would begin the client relationship by going completely to cash and then remain that way for the next several months. Luckily, a few took a shot with me, which laid the foundation for a successful business as the markets continued to plummet and we stayed sidelined. It was then that I learned just how valuable capi- tal preservation can be.
As time passed and the tech bubble burst, stocks retreated from beyond the stratosphere, and eventually incredible values became apparent. I would like to say that it was at this point I went all in on deeply discounted value stocks and thus secured the first fortune of my career, but that would be untrue. Although I did allocate funds back into the market, I did so at a very tepid rate.
And even though I had a few good years as the market recovered, I realized quickly that I still had no real clue what I was doing. Sure, I had proven I knew how to buy low and sell high, but man- aging funds through the ups and downs of an increasingly volatile marketplace was still foreign to me. I decided that it was time to pursue a serious education in trading.
If nothing else, the sheer volume of Jim Cramer’s voice was tough to ignore. His popularity was growing, and it wasn’t long before anywhere you looked, there he was talking about the mar- kets in a way few outside of Wall Street had ever witnessed. At the time, his radio broadcast was syndicated in Kentucky, and once I got a taste of this style that seemed so fresh, I didn’t miss a show. It makes no difference how I view his material now; the simple fact is that Jim Cramer was instrumental in bringing trading to the masses, and he was a major force in influencing my career as a trader. The minute that I became exposed to what Jim was teach- ing, I was sold. I remember heading to the bookstore as soon as I could, buying a copy of his book and devouring it the next day. It was as if the world I had always been craving was revealed to me and Jim Cramer had opened the door. Naturally, I gravitated to his daily writings on his website, TheStreet.com, and it wasn’t long before I paid for a subscription to his journal on Real Money and eventually became an Action Alerts Plus subscriber. I soaked up everything I could, reading his daily posts three and four times, studying the companies he was tracking, and investing personal funds in the stocks listed in his subscription portfolio. At the time, one thing I enjoyed about Jim was that he always seemed to be where I was, emotionally. This, of course, was solely dependent on how the market performed that day. If the market was up, I was happy, and so was Jim. I could expect a virtual high five after the close and an extremely positive radio show. However, if the market was down, it was a safe bet that I was depressed, and I could tell that he was also frustrated. Despite the ups and downs, he did a fantastic job of motivating his followers to stay in the game and encouraged us all to pull ourselves back up again for the next day. I accepted this emotional roller coaster as part of the game, taking it at face value that the moods of all successful market participants correlated with the ups and downs of the market itself. Over time, I quickly learned that this roller coaster was exhausting and, for me at least, unsustainable.
Although Jim stoked the passion that had been inside me for many years, the emotion itself was not translating into market suc- cess, and soon I was searching for a new teacher. During my foray into Jim’s world of online blogging, I was exposed to another trad- er and author whose material was exceptional, refreshing, and above all, unemotional. Rev Shark, as he was known on the Web, seemed to take a humble approach to the market, and I was quick- ly drawn to his style of allowing the market to tell him what to do (instead of imposing his beliefs on the market). Rather than riding the emotional roller coaster and anticipating its next move, Rev seemed to always be taking a much more reactionary approach, one that was appealing to me. He never seemed to have trouble sitting on the sidelines if he didn’t have a good feel. When favor- able conditions emerged, however, he would attack quickly. After reading his columns for several months and applying much of his method with great success, I felt compelled to reach out to Rev and let him know just how much I appreciated his work.
Rev Shark and I began exchanging email in which we dis- cussed the markets, individual stocks, and trading strategies. He introduced me to the likes of Bill O’Neil and Investor’s Business Daily and to the works of Nicholas Darvas and Richard Smitten. He expressed a desire to help me learn, and when I realized he was open to dialogue, I wasted no time absorbing as much as I could. Over the next several months, our relationship evolved to the point where I started to contemplate whether a business opportunity were possible. After much prayer and contemplation, I ultimately submitted to him a business proposal for a joint venture. Lo and behold, in the summer of 2005, I was off on a new adventure as my wife and I relocated to Florida. I would start working directly with Rev, gaining an education over the next two years that would lay the foundation for everything I did professionally thereafter. From 2005 through 2007, I received what I would call the equivalent of an MBA in trading. If I wasn’t buying or selling stocks, I was writ- ing about them. And if I wasn’t writing about them, odds are I was thinking about them. My days and nights were literally consumed with all things related to stocks and trading. We had early success, but spent much of 2006 and 2007 fighting an uptrend, during which I learned the importance of grinding it out and about how true market success is a marathon and not a sprint.
As 2007 came to a close, it became apparent that once again it was time for me to move on, taking all that I had learned and applying it firsthand. Although our professional collaboration has since come to an end, Rev Shark will always be one of the greatest professional influences in my life, for the time he spent educating me in all areas of stock speculation. With a solid foundation in place, I left Florida in 2007 and relocated back to Kentucky and reestablished my own firm.
Rev Shark had given me many of the tools that I needed to succeed in the stock market, but I felt that I still had many holes in my game. My approach was artistic in nature, and I wasn’t able to articulate well just what my trading style was. I discovered that although I was more successful than many traders, my profits were sporadic at best. I often experienced long winning streaks followed by heavy draws. I had certainly built a firm foundation of knowl- edge, but I soon realized that I needed to improve both my tech- nique and my execution, and so I set on a course to develop what would eventually become the successful style that I now utilize. Most traders have the same goal: make money consistently. Many struggle in their pursuit because they bounce from strategy to strategy, failing to first construct a core foundation and then develop a style to adapt to various market conditions. No singular strategy works in every market, yet many traders are searching for that one-size-fits-all method. Given the ever-changing investing landscape and the number of players involved, I believe that is a fruitless, if not a losing, proposition.
Currently, the common belief is that “buy and hold” is no longer viable. I discuss publicly how much I reject this strategy, but who is to say that we won’t enter another raging bull market where it works very well? If you abandon the buy-and-hold method, is the alternative plan as simple as trading for the shorter term? If you develop a core foundation based on a buy-and-hold strategy, shouldn’t you also be aware in which environment this strategy is inclined to work, instead of believing that it applies to all market conditions? Still, it is not even that simple.
The difference between those who constantly seek a success- ful strategy and those who experience consistent success is rooted within a system that is timeless and applicable to all markets regardless of market direction. Successful traders, in addition to possessing a strong foundational strategy, are also keenly aware of those with whom they are trading against and among, and they will always be conscious of what the masses are doing, so as to capital- ize on the movement of the herd. In short, to be consistently suc- cessful in trading, you must be armed with an adaptable style and ever cognizant of the trader landscape.
It has taken me more than ten years to develop the basis of my strategy, and still I continue to hone and adjust, learning every day from the market itself. If you are looking to become successful you will immediately improve your chances if you settle on one system and strive to perfect it instead of changing it depending on your mood, the markets, or your last few trades. It is only after perfect- ing your system that you will be able to adjust your style to fit a variety of markets and gain an advantage over others.
Although many different stock-speculation strategies exist, I lay out in the following chapters what I believe to be the best one. If you learn and implement this strategy, you will have a much greater chance of attaining whatever stock market goals you have for yourself, be it $1 million or even $10 million. There is no shortcut, and there is no way around the hard work success demands. Those who promise effortless stock market riches do a disservice to the noble and challenging craft of the stock trader. With an open mind, an aptitude to learn, and a heart to practice, you can achieve greatness. However, it will come only with devo- tion and commitment.
Chapter 3 It’s All Opportunity
Every trader must overcome a certain psychological roadblock before ever making any true progress. That is, every trader who wants to achieve success must accept and embrace this simple yet profound truth: There is no good or bad in the market, simply opportunity. Most people misinterpret the market to be either good or bad as it relates to price action going up or down. If the market advances on a particular day, you assume that the market had a “good day.” Conversely, when the market declines, it is said to have had a “bad day.” If you subject yourself to the ebbs and flows of the tickertape without taking control of your investments, you will naturally agree with this statement because you will see your investments rise and fall with the market (and thus you will feel good one day, bad the other). The problem with this ingrained assumption is successful and consistent traders must never view the market as good or bad, but rather as a world of opportunity.
They must seek to take advantage of the price action regardless of the direction. The moment you stop allowing the general market movement to dictate your emotions, you unleash a powerful world of opportunity that just seeks to capitalize on market movement, rather than be subject to the general direction for a particular day. I was taught from a young age to seek out solid investment opportunities, buy them, and let them work. So, it took me a long time to truly embrace the philosophy that I could make money even in a stagnant or declining market. It wasn’t until I finally removed good and bad from my vocabulary that I unleashed the power I had to take advantage of any situation available to me on any given day. It sounds simple. Ask yourself if you have, in fact, embraced the world of opportunity that comes with price move- ment, or whether you are still hoping for a general direction, be up or down, to play out. If deep inside you desire the market to move in a certain direction, you will never truly unlock your ultimate potential, and you will therefore limit your trading performance for as long as you hold this mindset.
Most investors would agree that a market has three states of being: advancing higher, declining lower, or moving sideways. Should you approach the market conditioned only to think that making money is possible when a market advances, you are taking advantage of just one-third, or 33%, of the general market oppor- tunities, and are thus subjecting yourself to an immediate disad- vantage. On the other hand, if you are open-minded to profiting from price action alone, regardless of whether it is up or down, you place yourself in a much better position to profit because you open yourself up to the entire market on any given day. The trick, of course, is to remove any and all bias from your inner being. The market does not care what you think, nor does it care where you believe it should go. To truly take advantage of the opportunity that is price action, you must not overlay any bias whatsoever; other- wise, you will immediately be viewing the market one way and allowing the good versus bad mentality to creep back in.
When approaching the market, you must ask yourself a few questions. Do you have a bias toward market direction? That is, before even approaching the buying or selling of stock, do you believe the market will advance or decline? Perhaps you are read- ing a tremendous amount of negativity in the press and, therefore, believe the stock market should be declining. Or maybe you have just heard about great advancements in the health-care industry and so conclude that those stocks will be benefiting greatly. Or maybe you have just enjoyed a lovely dinner engagement where intelligent people working in the financial industry laid out their case for a particular stock, industry, or a market move in general. This is actually the way most people approach the market, and sadly, it is the way most will lose all their investment dollars.
Internal feelings, general consensus, and other people’s opinions should never serve as the foundation for your investment strategy. These are all qualitative variables that can be manipulated or skewed to actually fit your own bias. Conversely, a true quantita- tive system cannot be argued with, and therefore seeks only to cap- italize on the opportunities at hand, not on something that might transpire.
I often joke to other traders that if I were trading from a remote cabin, far off in the woods with only my charting software, my performance would improve dramatically. Regardless of how hard they try not to, most traders associate some sort of bias with a stock or industry, and thus encounter frustration and derive poor performance. The truth is that those desiring sustained success must consciously lay any bias down if they want to progress. For example, at the time of this writing, most traders believe that com- mercial real estate companies are suffering greatly and it is only a matter of time before their stocks experience an aggressive sell-off. Much data supports this view, and intelligent people are paraded in front of the camera almost daily to discuss the imminent demise of these companies. However, the stocks themselves do not yet reflect this widely held belief. In fact, early on in the market advance of 2009, these stocks were acting extremely bullish. Even so, most traders discounted their action due to their industry affil- iation. Because so many investors viewed this sector as bearish, believing prices would soon be declining, they missed the oppor- tunity that a significant rise in price actually presented. Although in the future these stocks might, in fact, reverse and plummet, there is great money to be made playing the opportunity rather than standing firm in an opinion or investing bias. Throughout my career, I have learned that most investors cannot disassociate themselves from the actual underlying company, nor from their internal bias about where they believe the price should go. Those who can are already in a much different league than those who cannot. Traders who can think like this, simply looking at a pattern as an opportunity regardless of any other investing bias, will imme- diately and dramatically improve their results.
In early 2005, prior to my time with Rev, I fell prey to this first- hand, learning just how expensive it can be to hold on to a stock because of strong bias. I rode a position in Winn Dixie stock, all the way into its bankruptcy. I recall the experience as if it were yester- day, remembering how I had done due diligence on the fundamen- tal aspects of the company, believing that they were going to reverse course and become a fantastic investment. I had pored over financial documents, listened to conference calls, and visited stores. I believed I had done all the necessary homework and stood firm as the price eroded before my eyes day in and day out.
Despite the declining stock value, I remained steadfast and truly believed that I would soon reap a fortune as others eventually real- ized what a great value the stock was. Finally, after months of an unending decline, my heart sank as I received word that the com- pany would file for bankruptcy protection. All my hard work, and investment dollars, went up in smoke. After this experience, I vowed never again to lean on any investing bias; instead, I would respect only what the market was telling me.
Before you can truly venture into the world of successful stock trading, you must accept this fact: The market is neither good nor bad; it is just a wonderful world of opportunity. Furthermore, it is not your job to determine where it should go. Instead, you want to humbly seek to profit from whatever direction it moves. That is, you want to embrace whatever may come your way and open your- self up completely to the true opportunities presented day in and day out.
Chapter 4 The Other Traders
After you have firmly grasped that the market is neither good nor bad but simply a world of opportunity, you must begin to embrace the fact that within this world of opportunity are countless traders seeking to capitalize on the same opportunities as you. Some haven’t a clue what they are doing, but more and more are learn- ing, studying, and utilizing basic trading strategies, such as tradi- tional technical analysis. To remain one step ahead of this crowd, you must not only study the underlying market character, you also need to study the current market players. The sooner you realize you are trading against other traders and not just the stocks or the market, the better off you will be.
Different market environments call for different strategies.
Those investors who remain the most flexible have the opportuni- ty to realize the most profits. Although I am a firm believer that over several years the fundamentals of a company will ultimately determine where its stock price goes, most traders live within much shorter time frames. Your goal is not to just take advantage of the fundamental prospects of a company or market, but the anomalies that present themselves day in and day out, from which great profits may be realized. Typically, these anomalies could be recognized and capitalized on through traditional technical analy- sis. Now, however, you must be familiar enough with traditional methods so that you have the confidence to trade among the traders who sometimes overwhelm a method to the point of fail- ure.
You should look no further than 2009 as a reminder of just how important it is to focus on the actions of others when approaching your trades. Coming off one of the worst annual declines the mar- ket had seen in decades, 2009 started off no differently as the mar- ket quickly dropped more than 25% within the first two months. Broad complacency over stock prices led to a national panic, at which time investors everywhere sold stocks at any price to secure the little money that was left within their accounts. Looking back, I am not sure whether I will ever see anything like the first two and a half months of 2009. However, the experience throughout the remainder of the year left a lasting impression on me.
After a steep decline to start 2009, it was widely accepted that at some point an oversold bounce would set in. When the March 6th bottom arrived and the bounce began, it was a broad belief that the move up would be nothing more than a dead cat, oversold bounce, that would ultimately either lead to new lows or a signifi- cant double bottom, which traders could accept as the final gasp of the bear market. Unfortunately, neither scenario played out, and for the remaining nine months, traders were forced to accept a different paradigm that I believe set the stage for a new style of trading never before seen in our history. Despite net mutual fund withdrawals and an overwhelming shift from stocks to bonds, the S&P 500 finished the year up a staggering 23%. This number is even more impressive considering that at one point in the year the market was down more than 25%. You might assume that this meteoric rise gave way to vast fortunes within the trading world, when in reality this is far from the truth. Of the traders who used traditional technical analysis to move them out of the market before the 2008 decline, very few capitalized in the manner the market moved in 2009. Investors who did capitalize on the returns of 2009 were more often than not passive. They were investors who had also suffered incredible losses in 2008 and were simply returning to a level their accounts had been at halfway through the decline itself. When 2009 came to an end, most traders expressed that they were too cautious and not will- ing to embrace higher prices. I doubt many went any further to study the character of the market at that time, which led to this general theme of extreme caution. I would argue that despite any hind-sight resolutions, if 2009 were to repeat itself in the same manner, most traders would adhere to the same caution, strug- gling to embrace the move just as before. I believe this is because few investors will ever understand the true nature in which the move itself transpired.
One of the basic tenets of technical analysis is its attempt to study the footprint of institutions so that you may actually see what the larger mutual funds’ money is doing as they move in and out of stocks. Traditionally, through this study, you could learn enough about money flow to hop along for the ride. Looking back over 2009, you must ask the question how such a steep rise was possi- ble, when there were actually net mutual fund redemptions. Meaning how is it possible for a market to advance more than 20% when more money moved out of the market than in?
While the return was impressive within itself, the character of the ascent along with the characteristics of the traders must be studied because the move transpired in a technical manner that had never been seen before.
Most traders would agree that throughout 2009, there weren’t many significant pullbacks, yet those that arrived developed in such a way as to infer lower prices were on the horizon and, as a result, these were incredibly challenging to accept as prudent points of entry for going long. A basic tenet of a sound technical trading strategy is to study the character of the consolidation or reversal when a broad move pauses. A healthy consolidation, whereby longer-term investors replace shorter-term traders, can be seen through a methodical “backing and filling” (or a pattern that looks like a staircase with a rise higher followed by a small retreat). It is through this consolidation that various stocks begin to develop new bullish patterns, offering new trading opportunities to the astute observer. Under this traditional premise, you might assume that 2009’s 23% rise had its fair share of healthy pullbacks and subsequent bullish setups. However, this assumption based on basic technical analysis would be incorrect.
From the very beginning of the rise, it almost seemed as if the disbelief of the investing community was, in fact, the catalyst behind the rise itself. Although this is true in part for any reversal, where short covering provides the initial force behind higher prices, sustained moves higher are known to be followed by actual demand for stocks rather than bearish investors reversing their positions. It is at this time that institutions provide notable volume, scooping up select stocks becoming new market leaders and letting even the casual observers know that an advance is widely support- ed. Even though a wall of worry or a market that moves higher based on pessimism rather than optimism is a common, short- term investing theme, 2009 was much different. Not a single text I have ever read says that any sustained rally may come from a con- tinuous stream of pessimistic investors seeking to capitalize on a reversal, thereby setting the stage for repeated and continuous short squeezes higher. From my vantage point, this is what hap- pened throughout 2009. The ease with which retail investors could short stocks through inverse ETFs (exchange traded funds), in combination with the vast amount of traders who understand and attempted to apply basic technical analysis, along with the broad pessimism surrounding the economy, created an environment prone to short squeeze after short squeeze, sending the market higher with very few participating.
For example, you didn’t have to be a technical analysis guru to be aware of the head and shoulders pattern that had developed on the S&P 500 around July of that year, shown in Figure 4.1. This historically bearish pattern, where the movement of a stock or market takes on the look from which it is named, received unprecedented attention in not only trading circles but also in the mainstream financial media. I would argue that this very notoriety was the primary reason the pattern was doomed to fail, simply because of the number of traders looking to play it. When the pat- tern didn’t result in lower prices as traditional technical analysis would suggest, it set the stage for one of the biggest short squeezes in the history of the market, as shown in Figure 4.2. Figure 4.2 In July 2009, the head and shoulders pattern failed to break down, resulting in a dramatic short covering rally higher. Chart courtesy of Worden—www.Worden.com.
From that point forward, not a single market drop looked like healthy consolidation from a traditional sense and was therefore embraced by the general trading world as the top. Opportunistic traders sought to capitalize on this, positioning on the short side only to be squeezed time and again. As the masses moved in to short, the trade quickly became overcrowded and did not work. As
Figure 4.1 In July 2009, the market had carved out one of the most widely dis- cussed head and shoulder topping patterns in history.
these traders reversed their positions, it resulted in an incredible move higher, altering the technical picture from looking rather bearish to new highs in the blink of an eye. This played out time and again to the point where a “bearish pattern, turned bullish break” became the norm. Although I didn’t trade the pattern as often as I should have, one of the most successful long side trades of 2009 was buying what is traditionally called a bearish wedge, a pattern that would normally be shorted. True to its name, the bearish wedge is a consolidation pattern insinuating lower prices in the future. Bearish wedges were common in 2009 after a decline. However, because many investors attempted to capitalize on these patterns to the short side, the patterns no longer played out as they traditionally would. Instead of shorting these traditionally bearish patterns, the profitable trade became buying them, throwing con- ventional technical analysis out the window. It became so success- ful that traders jokingly dubbed the pattern the “bullish cliff,” stat- ing that the steeper the decline before the consolidation, the more leverage to use going long. It was humorous at the time, but little did we know how much foresight it actually contained.
To understand 2009, you must understand the general investor mindset leading up to that year. The incredible decline of 2008 led many on a quest to not just understand how to avoid such a drop but to profit from it. Few strategies, outside of technical analysis, protected traders from the bear market of 2008 while also allowing them to profit from it. When the decline was over and the damage done, the frustrated masses flocked to technical analysis, seeking to understand more about the strategy and use it to their advan- tage. Of course, once again, the crowd was simply setting them- selves up for disappointment. The untold masses seeking to utilize basic technical analysis led to the direct opposite outcome from what most were hoping for. Time and again, these strategies failed in 2009. You would be wise to remember that when so many are utilizing the same strategy, it will rarely work.
In 2009, basic technical analysis was thrown out the window, and simply doing the opposite would have netted the investor a hefty profit. Can you then conclude that traditional technical analysis is dead, never to be successful again? I believe that con- clusion is foolish. However, I will argue that the successful trader’s strategy will account for the ever-changing landscape that is made up of other traders. Rather than being held to a specific set of rules or style, what we learn from 2009 is that you must be willing to adapt to what other traders are doing, seeking not just to capitalize on the market itself, but also on the actions of others you are trad- ing against. Most will review the rise off the March 2009 bottom and simply conclude that next time they will buy into the weakness and hold longer, capitalizing on higher prices. If this is their only takeaway from 2009, most traders will completely miss some of the most important lessons presented. The real lesson is that you must not only observe the market, but you must also observe the market participants. When the masses have moved to using traditional methods, such as technical analysis, you must be willing to trade on the failure of these patterns to exploit the crowd’s movement for your own benefit.
Chapter 5 Finding Your Edge
Now that you have had a glimpse into the world of trading the trad- er, you must understand that before you can derive any edge from this, you must first have a viable and proven strategy in place. It is from this foundation that your versatile strategy will be supported. Imagine, if you will, a trained chef entering your kitchen to whip up a quick dinner. With a firm knowledge of what seasonings or spices pair well, I suspect the chef could take whatever you hap- pened to have on hand and cook an incredible meal. On the other hand, if I were to enter your kitchen with the task of making din- ner, more than likely we’d be calling out for Chinese. Simply stat- ed, I do not possess the foundational knowledge of what works well with what when it comes to cooking. Not only do I not know what pairs well, I am not familiar with most of the ingredients. If I were to consult anything more than a basic cookbook, I would have to also research the various ingredients along the way, to truly under- stand the instructions. Because of my limited knowledge, if my desire were to become a real chef or someone with a similar capa- bility, the best place for me to start would be the basics. I would first have to develop a strong foundation from which I could build on over time. This is true in any profession, and trading is no dif- ferent.
I am always amused when someone close to me suggests they are considering going into trading. Typically, this person hasn’t a clue about the vast workings of the markets, but may have been intrigued by a commercial or other advertisement discussing just how easy it is to take control of their investments. In the past, I would genuinely point the novice to a few books, or suggest some other means of education. Now, I just invite them to my office to discuss their desire further. It rarely fails that when someone steps into my office, seeing the multiple computers, eight monitors, and access to such tools as real-time futures charts, global markets, and forex (foreign exchange), not to mention news from every source imaginable, all being piped in at a ridiculous speed, that a light bulb goes off, and the reality sinks in, that a person like me will be on the other side of their trades. It is only then that they realize this game is not man versus market, but trader versus trader. It doesn’t mean that you must have sophisticated or robust equipment to succeed, but it does mean that you must understand the business, possess a proven strategy, and fully grasp whom it is you are trad- ing against.
No shortcuts exist when embarking on the journey of becom- ing a successful and consistent trader. It is also dangerous for you to jump too far ahead, starting to analyze what other traders are doing without having a firm foundation already in place that can provide the footing for a flexible strategy. It would be easy for you to simply conclude that in a current environment all traders are buying stocks that are breaking out of consolidation patterns and therefore shorting those same stocks or betting against these traders may be the better play. In reality, this might be a time when what the masses are doing works very well and fading them is a lost cause. Rather than jump too far ahead less you become complete- ly confused, let’s first begin with your basic strategy.
If I were to ask you to write down your trading strategy, could you? If someone were to ask you how you buy and sell stocks, could you clearly articulate for them your detailed process? More than likely, you develop a detailed list before heading out to run errands. Or maybe you follow a strict regimen when approaching a large purchase, such as checking various websites or scanning periodicals for consumer feedback. Yet when it comes to invest- ments or trading, you might follow no defined system that you are confident provides you the edge needed to profit. However, having one is a must.
At the core of every successful trader lies a defined trading strategy, which ultimately provides a statistical and proven edge. While you will refine your strategy over time, thus also improving your edge, your job is to execute this strategy over a large enough sample set of trades to be consistently successful. For example, let’s assume that you have a proven strategy that yields you a slight edge, and over a large enough trading sample you may see 55% of your transactions as profitable trades. If this were the case, to be consistently successful you would just exercise your strategy, actu- ally losing 45% of the time; yet because of the slight odds in your favor, you would still be profitable. For some reason, we’re led to believe that to be successful traders we have to pick incredible stocks or take unbelievable amounts of risk. The reality is that you simply need a slight edge and the patience to exercise that edge over and over again.
In my experience of training numerous individuals over the years, I have often found that most developing traders lack a solid strategy and thus have no real foundation in place to build on. The first thing I typically ask people is to articulate the trading strategy that provides them their edge. Most of the time, I hear rambling answers that contain something about buying low and selling high. Such traders and I often spend the first several hours together defining a new strategy from the beginning and laying the initial bricks that will ultimately serve as the foundation for success. I have read that upward of 90% of those attempting to trade stocks fail. I would actually argue that this number is much higher. The greatest paradox is that failure in trading does not at all corre- late with a lack of proven strategies available for you. Countless strategies provide a proven statistical edge. The problem with most people, I believe, is that quite often the strategy selected does not mold well with their own unique personalities. Furthermore, traders often believe that a set strategy should work in all environ- ments, when, in fact, the best traders alter their strategy to adjust to the environment they’re in at the time. This continuous failure leads to the endless search for a new strategy, which ultimately creates more frustration and soon leads to yet another failure. The truth is that most people spend a lifetime searching out new trading strategies, on a cycle of continuous failure, whereas the successful trader spends a lifetime honing the strategy already con- sistent in bringing gains.
Value Investing
The mother of all strategies known to traders is value investing, made most popular by the great Warren Buffett. This buy-and- hold strategy is typically taught in the academic world and tradi- tionally passed through various generations. Although many traders debate the merits of this strategy, particularly during bear markets, there is no question that the strategy has proven success- ful for those who have mastered it. You might be able to argue against a buy-and-hold strategy for a random set of stocks over a given time period, but the argument that Warren Buffett has not been successful adhering to this strategy simply does not hold water.
I firmly believe that if you want to set off on this path, enough resources are available for you to become extremely successful. You can still find all of the late Benjamin Graham’s material, the individual who taught Warren Buffett, and any number of other books on the subject.
You need to ask yourself one question when you approach a style such as this: Do I have the patience and the fortitude to wait for my analysis to come to fruition? I believe that although you might want to invest like Warren Buffet, you will not stomach watching your nest egg decline by tremendous amounts in the short term as you wait for your analysis to be proven right by the market in the long term. When asked about a declining investment such as Coca Cola (KO), a stock Warren Buffett has owned for decades, he traditionally states that he cares not where the stock price is but rather how the business is doing. He argues that you should never act as if you own shares of stock but instead act as though you own the entire business. Although this might work well for him, most traders cannot sit through the incredible ups and downs in price over the years. It is a sound strategy, but it might not suit your personality.
While reviewing the performance in 2008, I read up on some of the most notable value investors of our time. It was not uncom- mon to see negative 60% and 70% returns during a time of terri- ble market performance. I have no doubt that most of these investors will do extremely well over the next decade and make back their unrealized losses and much more. However, you must honestly ask yourself whether you could handle such a decline. Typically, that answer is no, yet value-based investing remains one of the most popular and widely accepted strategies around. If you set off down this path, yet cannot accept the drawdowns in your account, you are once again destined for failure.
Day Trading
Despite being shunned by the general public as a credible way in which to approach the market, day trading is one of the most effi- cient and successful ways in which to make consistent profits. Most of the successful traders I know, while they may follow a different strategy to select and manage their trades, share a common bond in that they go to cash each and every night before closing up for the day and are therefore deemed day traders. Their goal is to pos- sess no overnight risk whatsoever, coming into each day with a clean slate, an open mind, and the willingness to deploy capital as their strategy dictates in either direction depending on what the market presents them.
I have great experience with day trading, and I can tell you the exhilaration and freedom from day trading is fantastic. Markets have become increasingly volatile, and to see the market shift in an extremely short time period is not uncommon. A day trader has the unique advantage of playing the day’s move regardless of whether that move correlates with the previous day’s move. In contrast, if you come into the day holding positions, you will already be biased as to the direction you desire. Holding positions over night means that you are more than likely positioned for the previous day’s trend, when the next day may be different.
On the surface, the life of a day trader looks attractive, and I suspect that is one of the reasons so many traders are initially drawn to the style. However, more often than not, most learn that day trading is not for them and is an unrealistic venture for them to pursue (because of their schedules, their temperament, or per- haps a combination of both). Furthermore, you might make the classic mistake of believing that day trading is the actual strategy, when in reality day trading is merely a general term that means an individual ends the day with no positions. Within this general style lie hundreds if not thousands of different strategies. Individuals often believe that day trading may be the style for them and move head long into this world without having a set strategy to follow, once again setting themselves up for failure.
It reminds me of someone driving along on a nice sunny day and noticing a jogger out for a run. The driver thinks to himself how nice it would be to be back in shape, outdoors, enjoying a run on a beautiful day. When he returns home, he puts on the old ten- nis shoes, throws on the shorts, and heads out for a run. Within a block or two, he is reminded of the harsh reality that running isn’t as easy as it looks and that he is incredibly out of shape. When watching the runner strutting along, the driver failed to see the countless hours that the runner had been training. He didn’t see the early mornings, the runs in the rain, the cold, or the early days when just running a mile or two was exhausting. He saw the end result, appreciated the beauty of it, and wanted to skip all the work and enjoy the prize. Clearly that isn’t going to happen in running, and it won’t happen in trading.
Most people who observe a day trader, or start to study the craft, set themselves up for immediate failure because they do not properly assess their own personality, much less their own sched- ule, before determining whether day trading is even an option for them. At its most basic, day trading generally requires an incredi- bly demanding schedule. To capitalize on the opportunities pre- sented on any given day, you must be able to sit at your computer throughout the entire trading day. Unfortunately, you cannot dic- tate when the great opportunities will come. Instead, you are at the mercy of when the market wants to make these opportunities avail- able. Although this might be a reality for some, odds are that you may have other obligations throughout the day to attend to that do not allow you to sit and monitor markets each and every day, all day long. Furthermore, like myself, some people just don’t enjoy being tied to the computer and positions all day long. As I mature through adulthood, I have begun to once again appreciate stepping outside during the day, enjoying lunch with friends and family or the occasional vacation. I do dabble with a day trade here and there, but I much prefer to see a position work for me over time, not a trade mandating I watch its every tick.
As stated previously, don’t be confused by assuming that day trading is a strategy within itself. It is not. You cannot just adopt the term day trading to supplement your lack of a solid trading strate- gy. Once a strategy has been put in place, you might decide to day trade that strategy. However, the time frame does not come before the strategy. Day trading is a world within itself that comprises many different strategies, most of which do share a common bond with our next general category, the world of technical analysis. Technical Analysis
Unlike its counterpart fundamental analysis, technical analysis is not traditionally passed on from generation to generation, nor is it taught at the academic level as a method of successful investing. In fact, technical analysis often receives negative press despite the fact that the foundation of technical analysis, a chart, is used to dis- play a stock’s movement on almost every media outlet that discuss- es investment information. Many of the same people who refuse to respect technical analysis will actually talk about uptrends, sup- port, and resistance. It’s really quite humorous.
Although the popularity of technical analysis has grown to unprecedented levels, and therefore has become quite saturated, it remains one of the best investment methods for you to follow when developing your own personal investment strategy. Like the world of fundamental value investing, technical analysis may be broken into several categories with a primary principal woven throughout. The common principal is the adherence to quantifi- able evidence shown through historical price and volume, allowing you to infer where a stock may move next. Based on my experi- ence, the best way to describe technical analysis to a novice is by explaining that charts graphically represent other traders’ emo- tions. I explain how historical price, which is directly tied to the emotions of other traders, enables you to find key inflection points whereby a move may begin or end. After these inflection points have been determined, you can then position your capital accord- ingly (in your attempt to profit).
The world of technical analysis is vast in that the individual strategies within the general investment methodology are too numerous to mention within the scope of this book. I have seen technical traders find their edge mastering such indicators as trend lines, moving averages, pivot points, stochastics, relative strength, and Fibonacci numbers. To assume that one method is superior to another is arrogance. Over the years, I have learned to greatly respect most individual strategies within the world of technical analysis. This respect has not come blindly. It has come over many years from directly witnessing traders gaining an edge via these methods.
Over the past decade, markets have punished buy-and-hold investing, which encompasses many of the traditional investment styles widely taught and accepted. Therefore, basic technical analysis has boomed in popularity as traders seek yet another style that might be their ticket to riches. For the astute trader, this new popularity and shift toward technical analysis has created another layer of incredible opportunity. It is no longer enough just to fol- low the basics of technical analysis. Instead, the real edge now is trading the traders who are trading the basics. Never before has a “trade-the-trader” style incorporated into the foundation of an existing strategy been more important, or more lucrative. Unlike other styles of investing that may remain true forever, technical analysis must always be tweaked, because of the ever-changing landscape and mood of the trading world. However, never view this as insurmountable. Instead, accept this fact as one of the many routine challenges on the way to consistent profits. I have come to learn that embracing this is half the battle.
We have covered only a few brushstrokes here. Literally hun- dreds, if not thousands, of proven strategies exist from which you may choose to find your edge. These are proven strategies that traders at this very moment make consistent profits from year after year. However, despite the large number of strategies available, most people will continue to struggle and fail at trading, regardless of the relevant resources available to them. With so many success- ful and consistent strategies available, it raises the question as to why more people are not successful at trading stocks? I believe that even though the number of proven strategies is great, if you do not seek to master the strategy that fits your personality, tem- perament, and schedule, you are certainly doomed to fail. Adhering to a proven strategy that fits your personality is the foun- dation of successful investing.
Imagine, if you will, pursuing a passion for golf. You study pro- fessional players’ swings, play hundreds of rounds, and ultimately seek professional help. Despite your best efforts, you still can’t improve your score, and your frustration builds with every passing day. One day, however, you learn that there is an appropriate club length for each person and that you have been playing with clubs 6 inches too short. The short clubs never allowed you to have an adequate swing. In fact, they were slowly damaging your physical health, placing strain on your lower back and shoulders. Finally, you are fitted for the appropriate-sized clubs. Upon swinging the clubs, you immediately notice a world of difference. The clubs themselves do not immediately improve your score, but they no longer hinder the success you desire. Well, friend, if you are attempting to trade without a strategy that suits you, you are like the golfer with short clubs. You are doomed from the start and will never be in a position to prosper until you alter the basic founda- tional issues.
The truth is that most traders never truly subscribe to a specif- ic strategy. Even if you do, it might not be the one that fits you best. Furthermore, you may desire a strategy to work consistently, on every given trade, when in reality this is impossible. You might not be willing to ride out the lean times (nor are you taught how to). Therefore, you might become frustrated with a strategy during one if its natural downtimes and abandon it altogether. Whether it is for a lack of a good fit, or a period of drawdown, the trader who ventures down this path mistakenly believes that it is the strategy that is at fault, when it is really the trader who is in the wrong. Once one strategy is abandoned, the trader moves on to the next strategy, ultimately repeating the process, and thus sparking the vicious cycle I call the endless strategy search.
Perhaps you are on the endless strategy search right now, and that is why you are reading this book. Those traders on the endless strategy search hop from book to book, website to website, trading service to trading service, trying to find that magic strategy that will make it all click. Although they might enjoy brief periods of suc- cess, failure always ensues, and frustration builds. The idea of abandoning stock trading altogether seeps in, yet they see others supposedly having success and so they refuse to give up until they have discovered the secret. Eventually, some either become skep- tical of the stock trading community as a whole, never truly believ- ing that anyone is really successfully trading stocks, or they go broke. A few lucky ones, those who make up the small percentage of those finding success, finally find a strategy right for them and ultimately learn the tools needed to succeed over the long term. Your strategy is like the foundation of a house; it must be stur- dily in place before other layers can be built on it. Furthermore, you must know it is successful (in that it gives you the edge need- ed to make consistent profits over time). So far, we have discussed various strategies and could discuss many others, but the purpose of this book is to walk you through a strategy that I have developed over the years and that has worked very well for me, and will work well for you. It might not be something you adopt completely, but it will set you on the proper path to developing your own unique and ultimately successful strategy.
Chapter 6 Timing the Entry
Most people believe that the stock market represents what is tak- ing place within the economy at that time. The successful trader, however, knows that this couldn’t be further from the truth. It is this very misunderstanding that separates most people from their money. Although a firm grasp of the economy might assist you in formulating a thesis or a theme from which you may consider your investment options, we have already discussed the extreme impor- tance of allowing price action alone to be your primary guide, rather than your own opinion on where the market should go.
Throughout my career, I have seen countless extremely educated people lose fortunes in the market as they have bet in the direction of their economic opinions rather than with what the market is actually doing at that time. Unluckily, most of these investors end up being right as to their forecasts and market predictions.
However, by the time the price action begins to confirm their eco- nomic opinion they have lost a tremendous amount of money or given up completely. Before going any further into this book, you must understand and accept the fact that the market can do any- thing at any time regardless of how irrational it may seem. Once you have truly embraced this, you can move on to the next step, which is to capitalize on this movement.
Whereas many traders apply their economic opinions to their market endeavors, many others seek out quantitative information to guide them in their investment selection process. Never before have you had such accessible information, from economic reports to fundamental research. With one click of the mouse, you can gather all publicly available information about a company: its financial status, projections, analyst research, and opinions about the future direction of a stock or market as a whole. Even if you have the time to sift through all the research available, rarely does this path provide a true market edge. In my experience, it is not enough to understand the inside and out of a publicly traded com- pany or its prospects for future growth. You must also time the pur- chase correctly so that the price action correlates with your opin- ion of where it should go. The timing of the purchase may be the most crucial element. Unfortunately, rarely does a person who understands the fundamental aspects of a company study this key part of the trade.
Let’s assume for a moment that two traders have spent a con- siderable amount of time digesting all the information about a local publicly traded company: ABC Corp. Both investors come to the same conclusion that the company has incredible prospects for growth, which should translate into a much higher stock price. The stock and market as a whole has been trending lower of late, so both assume that the stock is of good value, at that time selling at $30 per share. Investor 1, believing that attempting to time the market is a futile endeavor, does not hesitate and places an order immediately to buy 100 shares of ABC Corp at the market.
Investor 2 moves from a study of the fundamental aspects of the company to the technical movement of the stock, seeking to learn where the stock has traded in the past and whether, in fact, the stock is ready for a turn. Instead of just jumping in, Investor 2 wants to try to improve not only his purchase price but also the time he has to wait with his capital committed for the upward move to begin. Upon further investigation, Investor 2 believes that although the stock is fundamentally attractive at the $30 price, he sees no other evidence supporting a turn and that previous bot- toms in the stock have come only after prolonged sideways action signaling the stock is done going down. Unlike Investor 1, who already purchased shares, Investor 2 waits patiently while the stock continues its slide. Investor 1 initially pays no attention to the con- tinued decline in price of ABC Corp, reminding himself he will rarely purchase a stock at the exact bottom and it is his persever- ance that will prevail. Investor 2 continues to wait patiently, stalk- ing the stock’s movement and attempting to time his purchase appropriately. After several weeks, the stock declines from $30 to $25 and starts to head toward $20. Despite Investor 1’s research and fundamental belief about the stock’s valuation, he starts to believe he was wrong in his evaluation. He thinks that by now the stock should have turned around. Investor 1 continues to devour all the information readily available to him but learns nothing more than he already knows. His frustration grows as he watches his investment decline. More time passes, and finally both investors recognize that ABC Corp has stopped going down. On one partic- ular day, the stock hits a low of $18 and rapidly surges back to $21. After a long time of waiting patiently, this reversal gets Investor 2’s attention, and he begins studying the stock even further on a daily basis. After some time, he realizes that the stock is now trading between $20 and $22, moving sideways in this range for several weeks. After this consistent back and forth, one day the stock breaks above $22, at which point Investor 2 immediately places his order for 100 shares. Over the next few weeks, the stock rallies 5 points, leveling off around $27 per share. After several months, the trade has so far shown Investor 1 a $3 (or 10%) loss, while Investor 2 has a $5 (or 23%) profit. Despite the vast difference in returns in the short term, some would hear that story and ask what the big deal was? If both investors desired to hold the stock for a signifi- cant amount of time, would an $8 difference in purchase price make that much difference? The short answer is a resounding yes, in that repeating this example several times over the course of both investors’ careers adds up to a significant amount of capital. The emotional effect the exercise can have as a lasting effect on an investor’s success rate is even more important, something we dis- cuss in a later chapter.
Ultimately, the stock market is made up of human beings, and its movement is based on the cumulative emotions of all people participating. Although many variables may aid you in trading, the success rate of these trades can be increased substantially if you will also incorporate a study of price or the actual movement of the stock before committing capital to your idea. Furthermore, if you desire to set aside the outside qualitative variables, such as eco- nomic forecasts or fundamental prospects for the company or mar- ket, making a study of price and price alone, it is in my opinion that this is adequate enough to create a consistent and successful edge from which you may exploit and garner your profits. To study price, you must find a way to see the historical movement of a stock over time, in graphic form. Fortunately, like the plethora of fundamental information available at your fingertips, price can be seen through stock charts, which are just as easily accessible in a variety of places.
Charts have been used for centuries as a way to display a his- torical record of an index or stock’s progression through time. Over the past several decades, stock charts have been increasingly used as investment tools. Despite their current ubiquity, I believe most people still do not truly understand how best to use a chart to give them an edge in making money.
To understand why a chart can provide any edge at all, we must first break down the basic emotions tied to a stock purchase, and thus lay the foundation for analyzing stock charts. First, however, I must stress that just understanding this basic principal and attempting to apply a strategy based on it will not work.
Understanding charts and applying technical analysis is not as sim- ple as understanding the human emotion behind investing and attempting to exploit it.
People buy a stock for any number of reasons. The previous example discussed two investors who pursued their own funda- mental due diligence, but the simple fact is that most people either gather their stock ideas from others or they are directly connected in some way with the company in question. Perhaps you purchase a stock because it was recently written about favorably in a widely read publication. Or maybe a knowledgeable industry insider men- tioned it on television. Perhaps you work for the company, did at one time, or know someone who does. Although the reasons behind the purchase may differ from person to person, the emo- tional cycle after the purchase has been made is typically the same. It is this emotional cycle that you must understand if you’re going to seek to capitalize in the market based on price.
Let’s consider another example. For whatever reason, suppose you decide to buy a local packaging company stock: XYZ Corp. You have had an electronic trading account for years that you use occa- sionally to dabble in stock trading. So, with one easy electronic click, you buy 100 shares of XYZ at $40 per share. The purchase is new and exciting, and so for next several days you check your account continually, looking to see how XYZ Corp is doing. You immediately show a profit as the stock climbs from $40 to $41 and then to $42. You wonder why everyone is always so caught up with how hard the markets are, when clearly you have a knack for pick- ing stocks. You do a quick calculation in your head: If the stock advances just $1 per week, you will easily double your money over the course of one year. You go so far as to wonder what it would be like to be a full-time trader, leaving your mundane work for the exciting life and easy money of trading. A few weeks later when you are checking your account, you see that XYZ Corp has had a slight correction. After climbing as high as $43.50, is now back to your purchase price of $40. You shake it off, telling yourself that your patience will prevail and successful trading is all about riding out the ups and downs. You are a bit frustrated by having given back your $350 in phantom profits; after all, you had already spent the money in your mind. You quickly make the decision that when the stock reaches that level again, you’ll cash out for a quick $3.50 gain, or $350, and call this trade a success. The following day, you check your account and are floored to see that the price has con- tinued to drop from $40 and is now trading at $38.50. While you’re quite annoyed now that your stock is showing a loss, you again chalk it up to normal market movement and let it be. You do, how- ever, do a bit research into why the stock is trading lower and read a few news stories about the stock (after never having done so before). This new knowledge of why the stock dropped helps you to justify your hold. As the days go by, the stock slowly drifts lower and lower. One day, you check your account to find that your once $4,000 investment is now worth $3,000 (because the stock has dropped $10). Your frustration builds as you start to believe the game is rigged and you were duped. You hastily decide to sell the stock when it returns to your original investment amount. You remind yourself that time is on your side and you can wait patient- ly for the $30 stock to return to $40, at which time you’ll prompt- ly cash out and stay away from this ridiculous game of trading for- ever. As weeks stretch into months, the XYZ Corp stock continues to drift lower and lower. It is now that you might choose one of the many paths available to you and chosen by so many others in your situation. After months of languishing returns, frustration may lead to such discouragement that you just want to rid yourself of this stock and sell for a significant loss. Although that might seem log- ical, and is the case so often for so many, it has been my experience that most individuals hold on to the stock forever, whether it returns to its once famed price level or not.
I am always shocked to see stocks that will never return to the price at which they were purchased still held within portfolios. At some point, a stock’s decline becomes so great that some people prefer to accept the entire loss rather than sell the stock to recoup the dwindled capital amount. I call these portfolio graveyards; the stocks held are dead and will never again return to life. You might be able to identify with this, and perhaps you have a few graveyard picks still in your portfolio. After you read through this material, however, I hope that will never again be the case.
The purpose of the preceding scenario is not just to relay the psychological journey of an amateur stock operator. It is also intended to show you how a chart can help define your edge. Knowing where a mass of traders is within the emotional cycle of a trade is critical information. Readily understanding this informa- tion would be nearly impossible without charts, which in many instances are free.
In our example, the stock never did return to the original pur- chase price. Had it done so, odds are you would have sold out for even money to rid yourself of the trade. It is this emotional con- nection to price that is the basic foundation for all technical analy- sis. The key to remember is this: Each significant price point that you experienced correlates to an emotional response shared by many others. Therefore, recognizing and understanding these areas of critical emotion on a chart may provide you the edge nec- essary for future profits.
Suppose, for a moment, that you originally learned of XYZ Corp in a national magazine outlining the top ten small companies in the United States. Or maybe you heard about the company from an analyst interviewed on television. However you learned of XYZ Corp, odds are that many others did, too. You can safely assume that after digesting the same information, many acted as you did and is why the stock showed an initial profit. If you are our base case, but also a good representation of a larger group of traders, your key price points assume even more significance going forward.
At this point, you might be wondering whether it is realistic to assume that people may act in harmony without knowing about each other’s transaction. Yes, it is. The common thread among all those investors is that they are human and will experience similar emotions as the price moves accordingly. Some will argue that financial status differs significantly across the spectrum, and that more affluent investors will be less psychologically impacted by price moves. I would argue that an investor generally purchases an amount of stock relative to portfolio size and net worth, thus level- ing the emotional playing field. Whereas $1,000 might mean noth- ing to Billy Bigshot, he may in fact have purchased 1,000 shares and therefore be experiencing a $10,000 loss. The key is to under- stand that average investors follow a path similar to our example more times than not. This cycle allows the astute observer to gath- er information about key levels from which to then garner an edge to support trading decisions.
The preceding example highlights the emotional roller coaster that creates the key prices that hold significant meaning for a par- ticular stock, which you can see when analyzing a chart. Technical analysis as a strategy begins with the chart itself, instead of starting with a look at how the chart was developed. Ultimately, it matters not how these inflection points were created, only that we find a way to act on these emotional price points and use them to our advantage. In the beginning, your job is to interpret and exploit these inflection points for profit. This is the basic foundation of technical analysis, which has become the common pursuit of so many. Once you’ve mastered this, you may move on to the next level and actually trade the traders who are just trading the basics. At this new level, you suddenly have a world of opportunity unavailable to most others.
Chapter 7 Trend Lines
Once you understand that you can use charts as a graphical repre- sentation of human emotion, pattern recognition is the tool that will enable you to begin capitalizing on the opportunities that pres- ent themselves on a daily basis.
Charts are readily available for all to see and use. Interpreting and using these charts is a different matter altogether. To the untrained eye, a stock chart is like a book to an illiterate person. It doesn’t matter how big the words are printed or how basic the lan- guage. If the person has no comprehension or understanding of how to read, the book has no meaning. The information held with- in a single stock chart is so vast it is nearly impossible to unlock all the clues that a chart has to share about the potential of a stock or the general market. Attempting to decipher every bit of informa- tion is overkill. However, a basic understanding of charts can give you a significant edge in your pursuit of profits. When you begin to obtain profits by using basic pattern recognition, I believe you will embark on a lifelong quest to improve your chart-reading skills. You might wonder whether traders trade according to techni- cal patterns within charts because they lead to profits, or if techni- cal patterns within charts lead to profits because traders trade them. The answer is both. You must accept the fact that sometimes a chart pattern develops because it is self-fulfilling and enough traders are expecting the same result. With most traders position- ing for a move, it is sometimes forced to happen. As we’ll discuss, however, my goal for you is to eventually find an edge within the self-fulfilling nature of many patterns that allows you to capitalize when the obvious pattern fails.
My pattern-recognition strategy can be divided into two pri- mary categories: the lateral trend and the angular trend. At this point, you might be wondering about specific technical patterns that you’ve heard about and that have become popular over the years (e.g., cup and handle, head and shoulders, double bottom, and bearish wedge). Although increasing your knowledge about various patterns and the intricacies of each is important as you mature as a trader, within every famed pattern you can find later- al and angular trends from which you can make trading decisions. Consider, for example, the cup and handle pattern shown in Figure 7.1.
You can easily see where the cup and handle pattern derives its name. However, also plotted on the chart is the angular, descend- ing trend line connecting the key points that make up the handle. In addition, I have plotted on the chart the lateral trend that con- nects the left and right side of the cup. You can observe the pat- tern as a whole, but you can also easily participate in a cup and handle break, by actually trading the descending or lateral trend line, as we’ll discuss in Chapter 11, “Determining Entry Points.” The head and shoulders pattern is also mentioned quite often. You can see this pattern in the Goldman Sachs chart that Figure 7.2 shows. You can see the area that serves as the neckline for the head and shoulders pattern is also a clear lateral trend support line.
I have yet to find a popular pattern that doesn’t have its foun- dation in either a lateral or angular trend, and therefore I do not spend time teaching specific patterns. Based on my experience, it’s better to focus on the mechanics you can use to recognize and profit from the foundational trend lines instead of getting caught up in the multitude of specific patterns that exist today. There is also a dangerous tendency when reviewing named patterns to become somewhat blind to other possibilities. Let’s suppose you stumble on a cup and handle chart with the intention of playing only the pivot break above the handle’s highest point, the tradition- al execution for a cup and handle pattern. Observing only the named pattern, you may miss completely the ascending trend line that connects the lowest point of the cup and the lowest point of the handle and therefore not act on an ascending trend break down should this occur. You can see an example of this in Figure 7.3, the same American Express chart shown earlier in this chapter.
When you embark on the pattern-recognition strategy, it is easy to become overwhelmed and make trading much too compli- cated. In the beginning, you must start with the basics, similar to a batter who spends time in a batting cage or a golfer on a driving range. One of the best exercises to begin your foray into pattern recognition is to identify and observe lateral trends. A lateral trend means that you can draw a horizontal line on a stock chart, con- necting at minimum two high or low points, thereby creating a line that graphically becomes the lateral trend. Figure 7.4 is a daily chart of Apple Inc. (AAPL) in March 2009 that reflects a basic lat- eral trend line. At this point, do not infer anything from this chart. It is shown here just so that you can see what a lateral trend line looks like. Notice how the two highs can be connected to form a line. You can extend this line out into the future so that it becomes your lateral trend line.
In Chapter 6, “Timing the Entry,” I discussed how investors become emotionally attached to a specific price point. This emo- tional attachment creates an inflection point for the stock, a price at which an emotional connection exists that favors a substantial increase in volatility, once the stock trades at or near this key level. Initially, it might be a news event or some other catalyst that sparks the key reversal creating the first significant point. If the news was negative and the stock dropped significantly, many traders might resolve to sell once the stock recovers or returns to the level from which the weakness first set in. When the stock makes its way back to this first inflection point, traders who might have been waiting to sell will do so, thus exiting the game and sparking another rever- sal at or near the original level.
The second time our key inflection point comes into play, it is still primarily driven by the human emotions tied to this level rather than other traders trading the pattern being developed. The reason for that is it takes at least two inflection points to cre- ate a trend line. If the second inflection point is still in question, it is only an assumption by the trader who thinks this level will in fact prove significant. This is a dangerous assumption and one rea- son I rarely involve myself in a pattern before an identifiable trend (with two or more inflection points) is first developed. Once the trend is identified for all to see, the pattern quickly moves from one being controlled by traders originally involved to a pattern being traded by traders who have identified the key level in play. At this point, the trend line in question usually becomes self-ful- filling as you and other traders cue in on this level as a natural turning point for the stock. Should this inflection point be above where a stock is currently trading, it might act as a ceiling or resist- ance for the stock. Should this inflection point be below, it could easily act as a floor or support for the stock.
As more time goes by, these points take on greater significance as more and more traders can see them developing clearly. As more traders become involved with the key level in play, once this level is breached, the stock has the potential to begin a very large move as traders scramble to reverse their positions and new inflec- tion points for the stock begin to evolve.
Figure 7.5 shows a lateral trend line acting as resistance on the chart of IBM from August 2009. You can see that a line has been drawn connecting the peaks and thereby creating a natural ceiling for the stock over a certain period of time. Each time the stock returns to this level, it is sent back down as the level acts as over- head resistance.
One common problem with traders who study technical analy- sis is that they never take the time to truly understand why it works, and so they sometimes get a bit lost in the minutia of tech- nical patterns. Take, for instance, the preceding exercise. You will rarely be able to plot a flawless lateral trend line because rarely will a stock reverse at exactly the same price two or more consecutive times and thus allow you to plot this line perfectly. The stock will often reverse very close to the first level, but not precisely, before reversing. Or it might move above or below, albeit slightly, before turning around. Pondering the rationale behind the lateral trend, you should understand that the price point is of more significance Just as multiple points from which a stock declined may create a lateral resistance trend, as Figure 7.5 illustrates, multiple support points from which a stock reversed upward may create a lateral support trend line. Figure 7.6 is the same Goldman Sachs chart shown earlier.
EXERCISE
A basic exercise you can perform is to compile a current list of the NASDAQ 100 stocks. With that list in hand, visit any basic financial website that allows you to see a chart of a stock. At the time of this writing, I prefer FreeStockCharts.com, where you can set up the NASDAQ 100 within the left side bar and quickly and easily go through each name. Make sure the chart shows a daily time frame going back at least 12 months. One by one, input the symbol from your list, going through each individual name and seeking out lateral trend lines worthy of your attention. When you recognize one, write these symbols down on another ledger, along with the price at which the lat- eral trend line exists. If the program you are using to review the charts enables you to, physically draw this trend line across these points or print out the chart and with a ruler and pencil connect these key inflection points, making this line visible. It is important that you not only recognize the price at which the trend line exists but that you also see the trend line itself. At this time, there is no need to act on this from a trading per- spective. Instead, just begin to recognize these lateral trend lines and thus begin your pattern-recognition education. Also note that you don’t care why a certain level has become signif- icant. It makes little difference why the inflection points have been created. Rather, you need be concerned only with the movement of the stock at or near this level. Place these charts aside and review them periodically to see where the stock is trading in relation to the lateral trend line you have identified. Incorporate into your daily schedule some chart time to do this. Just as an athlete practices during the off-season and between games, a trader’s personal chart time is mandatory for consis- tent success.
earlier in the lateral trend’s history than it is later on. The reason for this is the same reason the lateral trend is created in the first place: The earlier the lateral trend is within its development, the more human emotion is present. Once the lateral trend has matured and the stock has returned to the key price point on more than two occasions, other traders have become involved and are trying to profit from the pattern.
Suppose, for example, that a stock reaches the $30 level and reverses, heading sharply lower. The $30 level becomes the point at which shareholders started to lose money regardless of whether they bought here or had unrealized profits, which is what connects this level emotionally with those holding the stock. Eventually, after a drop, the stock slowly recovers and returns very close to the $30 level. At this time, those who have been holding the stock sell because they feel relieved to have at least gotten back to where they were before the surprise drop. When the stock declines for the second time from this $30 level, it becomes clear that this level is now of significant technical importance and more traders than just those initially involved will be drawn to this company name, seeking to deploy whatever strategy they prefer, around this key level. It is at this point that the general area becomes more impor- tant than the specific price. As the stock returns to that general area of support or resistance, more and more traders become involved. It should no longer be viewed as an exact level but rather a general level from which we can gauge the stock’s next move. Before I discuss how to utilize the lateral trend for profit, we need to review the second basic category of pattern recognition: the angular trend.
The angular trend can be divided into two segments depend- ing on the direction of the angle, ascending or descending. Like the lateral trend, the angular trend can act as both a support or a resistance level and can therefore be used as a trading edge in either direction. Unlike a lateral trend, which typically marks a stock that has been moving sideways, the angular trend can be seen on a stock chart that has been increasing or decreasing in price over a set period of time. Figure 7.7 shows a basic outline of an ascending trend.
Ascending Angular Trend
Descending Angular Trend
Figure 7.7 A basic representation of an ascending and descending angular trend.
Much like lateral trends, an angular trend first begins with a key inflection point, sparked by an unknown catalyst. Let’s assume for a moment that a stock has been on a steady descent for some time because the general market has been weak and the prospects for growth for this company have been waning. When the stock reach- es a new all-time low of around $10 per share, the company announces a new product that should boost revenues significantly and revive the company’s stagnant brand. In only a few trading ses- sions, the stock shoots up 15%, moving from $10 to $11.50. You should have no anxiety over missing the initial move. Instead, you wait patiently for the appropriate point of entry, which will come
Figure 7.8 An ascending angular trend in IBM.
once the angular, ascending trend has developed and been con- firmed. When the initial move in the stock wanes, the stock should begin to digest the recent gains, possibly falling back to the $10.75 level. If the stock were to follow the development of a lateral rather than ascending trend, it might very well fall all the way back to the $10 level. However, in this example, that is not the case. For what- ever reason, something that is irrelevant to you the technical trad- er, the stock does not retrace its entire 15% move. Instead, after coming back toward the $10.75 range, the stock turns up again and advances to $12. The recent advance creates what is called a higher low, and marks the second inflection point needed to create our ascending angular trend. For whatever reason, traders were not willing to wait for the stock to give back the entire move and instead decided to buy up shares on the first sign of weakness. Figure 7.8 shows IBM in January 2009 after an angular trend began to devel- op as noted. It is at this point, after the angular trend has been established, that you can seek to profit from the pattern.
Similar to the previously mentioned bullish scenario is the bearish case at which point a stock tops out and subsequently starts its decline. Through its descent, the stock develops a series of lower lows and lower highs, thus enabling you to draw a descend- ing trend on the chart representing the stock in question. In our bullish example, where the stock initially reversed at $10 and subsequently put in a higher low at $10.75, these two points became the basis for the angular ascending trend. If you were to connect those points but continue your ascending line far- ther on the chart, you would be plotting a potential path for the stock to move and logical support points for pullbacks. Once the trend is established, many traders might seek to act on this line as a guide, from either a speculative perspective or from a longer- term investing perspective. If you desire to slowly accumulate shares of this company, you may use this ascending trend for some time as a point from which to add shares, or for a shorter term speculative trade you might look to buy the dip and profit from any bounce off this line. After the trend has been established, traders actually playing the trend influence it much more than do initial traders who have an emotional tie to the price point.
Once you know how to recognize these trends, you must learn how they provide you an edge in trading. You can use these trend lines as guides toward profits in two basic ways. The first strategy is to go with the trend, assuming it will continue and seeking to profit by buying or selling at predetermined inflection points. The other strategy is to buy or sell a stock after a definite change in trend has occurred. Chapter 14, “Using and Controlling Risk to Your Advantage,” discusses risk and trade management in detail. For now, however, we remain focused on the methodology behind capitalizing on the opportunities presented. Different market envi- ronments will typically favor one strategy over another, so it is important that you become proficient and comfortable in both trading with the trend and trading a break in the trend. This is challenging, which is why I recommend that you stick to just one discipline until you achieve a certain level of mastery and confi- dence. When you feel comfortable executing one strategy, you can explore the second strategy.
In conjunction with these strategies (going with the trend or trading a trend break), there are two methodologies of capital deployment: anticipatory and reactionary. Your schedule and avail- able time usually dictates which one you choose. A passive trader might not be willing or able to sit in front of a computer all day and may be forced to take a position in anticipation of a bounce or break occurring. The reactionary trader will see the action unfold- ing and then act. I don’t believe one methodology is superior to another, and that is why I never accept the excuse from those who say they just don’t have the time to be a successful trader. Many of the most successful traders are rarely able to be in front of their computer on a weekly basis, let alone a daily basis. It is a myth that all successful traders sit in front of multiple screens with access to lightning-speed information and trade a gazillion shares every day. Although this is certainly the case in some instances, it is not a mandate for success.
While your own schedule and the amount of time you can spend in front of the computer during a market day may vary, what will always remain consistent among all trading strategies or capi- tal deployment methodologies is the work involved in finding the patterns to trade. Unfortunately, this is just something that does not have a shortcut. Even though countless scanning products exist, there is simply no replacing the value gained when you take the time to go through hundreds of charts, not only stalking prey, but also gaining a feel and a perspective for what the market as a whole may be “saying.” To consistently identify a strong list of opportunities, it is important that you develop a daily or weekly routine that includes chart work. Although they might not always be successful, you will at least be ready should an opportunity pres- ent itself. A great way to begin is by repeating the previous exer- cise, consistently going through the NASDAQ 100 time and again. Through this exercise, you will begin to see the patterns emerge and trend lines develop. You will see the character of the stock as it moves around a key inflection point, and you will begin to attune to the market and its movements.
Figures 7.9 through 7.13 display different trading strategies, along with different capital deployment methodologies, across
Figure 7.10 Potash breaks above a lateral trend line once acting as resistance.
different time frames. Study these examples and use them for ref- erence as you eventually pursue your own opportunities in the future.
In late 2009, Fifth Third Bancorp had been consolidating under an angular descending downtrend for several months. On January 7, the stock broke above this downtrend and proceeded to pursue a multimonth rise. An anticipatory trader could have taken this trade ahead of the break, setting a stop below the previous November lows, while a reactionary trader could have moved in when the stock broke and closed above this line. Each trader would have secured a hefty profit over the next several weeks as the stock advanced.
In the early part of 2009, Potash had established a lateral trend going back to late 2008. The stock was not able to break this later- al trend until May 2009, when it moved approximately $10 from its initial break point. Once again, both the anticipatory and reac- tionary trader could have secured hefty profits on the trend break within a few short weeks. The stock did, however, revert back to its breakout level in June 2009, which would have stopped our disci- plined traders and left them with at least partial profits on the trade. All throughout 2009, Exxon Mobile used an ascending angular trend for support, as noted in Figure 7.11. In January 2010, however, the stock broke below this line, falling almost 10% before its recovery.
Many times, observing the weekly charts of the indices will be of great help as you evaluate the overall market health. Figure 7.13 displays the weekly chart of the NASDAQ 100 from its 2002 low Chesapeake Energy had already fallen a great deal from its all time highs in August 2008 prior to a relief rally that developed an ascending angular trend. In September 2008, the stock gapped below this line, never to see this area again. Observing the angular trend development, an anticipatory trader could have moved in with a short position ahead of the reversal, placing a stop above the previous July highs, while a reactionary trader could have moved in when the break occurred. Once the ascending trend line was vio- lated, the stock suffered a considerable decline, which would have resulted in significant profits for each trader.
through 2008. Once the index breached this line, the selling picked up significantly, signaling the end of a multiyear uptrend. If noth- ing else, this could have been used as a significant warning sign that a bear market was imminent and appropriate action could have been taken.
Chapter 8 The Basics Are Not Enough
A foundational trading strategy consists of both the understanding of pattern recognition and the ability to exploit these patterns for profit. It is my goal that by the end of this book you will possess both. Although these two items are essential, these basic under- standings are not enough, and so it is also my goal for you to learn when to alter this basic understanding to profit not only from the moves in the stocks but also from the moves of others. As you start down the trading road, you will quickly see that if you were to pur- sue just the basics, many times you would be a sitting duck, open- ing yourself up to losses from those who have already moved on to the next level of trading the trader.
For hundreds of years, people have studied crowd mentality when it comes to the markets. These studies usually always come back to focus on fear and greed, especially during times of great volatility. The masses are always assumed to be moving blindly about, with the common thread being their emotional attachment to the broad market movements, over which they have little or no control. Strategies have been developed to capitalize on these mass movements, yet I believe we’re seeing a fundamental shift that mandates our trading must adapt to these changes, too. From my vantage point, the masses are no longer being led blindly about but are educating themselves to pursue at least some trading plan that gives them a better understanding of the market and its move- ment. If my assumption is correct, the basics that most people are gravitating toward may no longer produce the desired results. Considering that these basics were initially developed to exploit the masses, if these same people are now pursuing these strategies, how can they possibly provide the same edge?
At its core, technical analysis seeks to quantify and predict the movements of other traders, giving the applier of the technical analysis an edge. It is assumed that when you study technical analy- sis you are studying patterns being developed primarily by those not studying the same thing. Although this might have been true a few years ago, today the landscape has shifted dramatically. Instead of pursuing technical analysis with the assumption that the masses are not, I believe we must pursue technical analysis with the assumption that the masses are studying the same. It is only with this thought that we can look objectively and realize that at times, to be successful, we must trade the trader who is simply trading the basics.
For quite some time, technical traders had a strong edge just playing the basics. It was similar to two chess players competing but only one knew the rules or was well versed in the game. The match was no match at all because the player who had no real understanding moved blindly about losing game after game. Sure, that person might have gotten lucky a time or two, but over the long run the person lost consistently. Finally, the player without any real understanding got sick of losing and began to educate himself more about the game and basic strategy. Assuming now that both chess players have the same knowledge of the game, as well as the same understanding of basic strategy, who will win? The winner is usually the player who can think ahead of the other play- er. In chess, this can be several moves ahead. At some point, it will come to that in trading, too. However, for the time being, you need to ponder only what the next move will be and make your decisions accordingly.
Let me explain further.
Odds are, you are already familiar with some common techni- cal analysis terms, such as support and resistance. Furthermore, you are probably already aware of technical patterns, such as the previously mentioned cup and handle and the head and shoulders. If you are not aware of any of this, while you may believe you are with the masses, you are actually behind the masses and need to catch up quickly. Let us assume for a moment that you understand basic technical analysis enough to decipher patterns as they devel- op on charts for key stocks or markets. Let’s also assume that a pat- tern begins to develop that can be plainly seen and leads you to position accordingly for what should be the market’s or a stock’s typical outcome. Years ago, you might have been part of a small group taking the action you did. Rather than be subject to the ran- dom ups and downs of the market, you would take your cue from the action itself. Once a pattern developed that you recognized, you would move in accordingly seeking a desired result. Now, you find that rarely do the patterns you have learned work as expected. Rather than be one of the few, you are now one of the many, and thus significantly decreasing the probability the pattern works in your favor. If the landscape has shifted and now the vast majority of traders are positioning for the same outcome that should tran- spire, doesn’t it make sense that the odds of this transpiring has been dramatically reduced?
As previously discussed in Chapter 4, “The Other Traders,” this was clearly obvious during the summer of 2009 when the S&P 500 had established a head and shoulders topping pattern that received more attention than I have ever before seen a technical pattern receive. The consensus was that the market had topped out and was preparing to roll over. This was confirmed by a head and shoulders pattern so widely accepted that the pattern itself was doomed to fail. Figures 8.1 and 8.2 display this pattern and its out- come over the next several days.
After this now famous head and shoulders pattern failed, tech- nical analysis received extremely negative press when pundits relayed to us all just how wrong the pattern in question resolved itself. I viewed the outcome as something quite different and was convinced more than ever that technical analysis had power beyond even my wildest expectations, as long as I embraced the next step of understanding.
Figure 8.2 The S&P 500 rallied significantly once the head and shoulders pat- tern failed to break lower.
The problem for most investors is that their belief about what technical analysis is ends with the basics when it should, in fact, just begin there. If at its core technical analysis is the graphical rep- resentation of traders’ emotions and now most of those traders are seeking to capitalize by using basic technical analysis, your goal is no longer to assume the basics will always work. Instead, you must sometimes be able to alter your strategy to trade the traders who are trading the basics.
It is important that this idea soaks in. I cannot stress enough how incredible the possibilities are for profit once you understand trading the trader as an edge within itself. Simply imagine if instead of waiting for the head and shoulders pattern noted in Figures 8.1 and 8.2 to resolve itself downward, you immediately went long on its failure.
In the past, large financial institutions or mutual funds often provided the technical analysis footprints you could follow to gain a general perspective for where the market or a stock was moving in the future. These funds didn’t usually bother to cover their tracks; instead, they moved like an elephant through the woods, plowing over whatever stood in their path, leaving a trail for most to follow. Over the years as competition in the institutional world has grown, it behooves mutual funds to be as strategic as possible as they attempt to outperform their peers. One of the ways in which they have done this is by no longer being so brazen with their purchases or sales. Mutual funds now understand the grow- ing world of technical analysis and have the ability to significantly improve their results by using their size to influence the patterns traders are playing. As the mutual fund world has become increas- ingly more competitive, in addition to other products such as ETFs (exchange traded funds) or retail brokerage firms competing over this money, these financial institutions have been forced to alter their strategies a great deal.
To assume these funds and their traders don’t know what the average Joe is doing, seeing, or feeling is an ignorant mistake. Traders at these mutual funds now prey on the basics of technical analysis to execute a better price point regardless of whether they are buying or selling. Have you ever been stopped out of a stock at a predefined level only to see it roar back with a vengeance after stopping you out? Did you feel like a sitting duck or that someone might have known exactly where your stop was? Well, would you be upset to know that probably both were true?
Suppose, for example, that a mutual fund has its eye on stock XYZ and wants to own several hundred thousand shares. In the past, these funds might have just start buying shares day in and day out without regard to any hint of secrecy. The rapid rise in price accompanied by a significant increase in volume would make it apparent the stock was under institutional accumulation. Because of the increased competition today, traders at these firms are now well versed in technical analysis and pattern recognition, and they understand that most retail traders are now using these strategies for their edge. These institutional traders also have the money and power to create or break their own patterns. Odds are that on the rapid price decline, where you were stopped out only to see the stock reverse course immediately, an institution sold a significant number of shares at a key level where they knew basic stops would be placed. Once this level was breached and the stock fell swiftly, due to the large number of stop orders in place, they were able to reverse their position and buy those shares at a lower price and thus lower their total cost basis in the stock a great deal as they bought into the drop. Is that wrong or illegal? Not at all, it’s just the reality that most institutions have already accepted that the land- scape has changed and to compete they must also change. Understanding a basic pattern recognition strategy is a must and lays a foundation you can build on. However, once you gain this understanding, you must quickly thereafter start to think one step ahead. Throughout this book, I first lay the foundation for a sound trading strategy with pattern recognition at its core. I then conclude with a discussion about how to evolve this strategy from the basic to the advanced. It is extremely important that you first master the basics. Only then can you start to trade the trader.
Chapter 9 Pick Your Time Frame
In the world of mathematics, the word fractal describes a shape that can be subdivided into parts, each a smaller copy of the whole. One of the greatest qualities about the pattern-recognition strate- gy is that it is fractal, in that you can use it across a multitude of time frames. For instance, the reasons how or why lateral or angu- lar trends apply to stock movement are true over the course of sev- eral hours, as well as over several days, weeks, months, and even years. Because of this fractal nature, pattern recognition is a strat- egy suitable for a variety of traders regardless of their available time during the trading day to actually trade stocks. Because inflection points gain significance through human emotion, this emotion is present and can be seen just as easily on a ten-minute chart as it can on a weekly chart. Of course, the size of the move and time it takes to play out will usually correlate with the time frame you are reviewing. For example, look at the American Express (AXP) chart that Figure 9.1 shows and verbally state what you see based on what you learned in the preceding chapter. I suspect you said something about the ascending trend and maybe went into a bit more detail about how you would trade the potential break down or reversal at support. Would you be sur- prised if I told you this was a ten-minute chart over a series of three days? What this means is that each bar represents a ten- minute time frame rather than one day, as is commonly the case.
How about the Gilead Sciences (GILD) chart that Figure 9.2 shows? Take a look at this and again relay your thoughts as if I were sitting in a chair next to you right now.
Would you be surprised to learn that this chart is actually a weekly chart covering the past three years?
One reason I never accept the excuse that someone does not have the time to become a successful trader is because of the frac- tal nature of pattern recognition. Sure, you might not have the time to trade ten-minute patterns, or maybe not even the time to trade daily patterns. However, if you want to be successful trading stocks and cannot review weekly charts sometime during the course of a month, you should probably avoid trading altogether. The good news is that with this strategy, a few hours per month can yield incredible results.
While the fractal nature of pattern recognition lends flexibility to traders with different schedules, it also opens the door for a common mistake among traders. Many traders never honestly assess their own schedules to gain a true understanding of how much time they can devote to trading. Without this finite under- standing, it becomes a challenge to hone in on a time frame that suits you and the time you have to trade. What I will call time frame jumping can lead to frustration as you struggle to fit your personal schedule into the time frame you desire to trade, instead of adopting the appropriate time frame that fits your personal schedule.
Trading is all about knowing yourself. To be a truly successful trader, you need to look deep within, making a conscious decision to wrestle with those ugly qualities you don’t want anyone to know about. If you do not do this, the market will seek out these quali- ties, prey on them, and use them to separate you from your capi- tal. Maybe you struggle with emotions and tend to get caught up in the excitement when stocks are moving quickly. Out the window goes your discipline, and soon you are chasing names, filling up your position sheet with a long list of stocks that you aren’t even sure why you bought in the first place just a few hours later. Or perhaps you wrestle with pride. Despite losing money time and time again, you still believe you know what the market should do. Rather than humbly approaching the market movement, willing to flow with whatever happens, you attempt to impose your beliefs on the market and force your strategy on the action. Although this might work for a season, it won’t work for long, and you will quick- ly lose. Maybe you haven’t truly reflected on your personality and how that correlates with your trading, or perhaps you are trading one time frame when in fact your schedule mandates you trade in another. A trading mentor and dear friend always encourages me with these words: “Be comfortable in your own skin.” These words ring in my ears loudly, and I admonish you to take them to heart. Pause a moment and reflect on this a bit and how it applies to your own trading.
Before placing a single trade, you must firmly understand your schedule and how it influences the way you trade stocks. So often when I work with traders one on one, reviewing their previous trading records, I see a big disconnect between the trading world they desire to live in and the reality in which they actually live. When questioned about specific trades, they may discuss the pat- tern they saw that had evolved over the past day or two, or how a specific move in the market or other sectors sparked them to action. As they continue to tell me their stories, I see and hear strategies that would be suited for traders who can sit in front of the computer all day, capitalizing on the short-term fluctuations or swings in price or sector action. Even though the strategies are often sound, they don’t quite fit with the life of business owners who in reality can sit at their computer only once or twice a day, checking the market for an hour or two at the most.
I’ll never forget one of my boot campers, John, a dentist from Michigan, who struggled with this precise issue. John had an advantage over most investors in that his pattern-recognition skills were impeccable. He had become a student of chart reading and had approached the tape with the same precision as his successful dental practice and his scratch golf game. Despite these skills, however, he could not make consistent profits and was becoming discouraged by the endless downward spiral that seemed to plague his trading. As our dialogue increased before his visit, I assumed the issue would relate to his risk management or capital deploy- ment. I thought that possibly John, like many in 2009, was getting too hung up on his opinions or a bias and was scared to deploy cap- ital on the long side. Like approaching the market, I should have known better than to assume I understood what the issue was before spending significant time with him. I was pretty confident that even before he ever stepped foot on Kentucky soil, I had all the answers he needed. As we settled in during that first evening and discussed the past year, I quickly learned just how incorrect my assumptions were.
John talked to me about his daily routine. He told me that despite a full-time dentist practice he still put in many hours per day of chart work and market study. He followed along in my chat room and studied the stocks discussed there. His daily regimen produced a plethora of opportunities. However, when it was all said and done, his P&L did not reflect his skill level or work ethic at all. Despite his clear understanding of pattern recognition, John assumed he was missing something in his reading of the tape. John assumed that for him to become more consistently profitable he had to find better opportunities. Regardless of the fact that his ini- tial assumption, like mine, was wrong, he possessed the humility to accept the fact that something had to change. He wasn’t making money, and that was the only indicator he needed to know about. As we spent hours discussing his trading, it became incredibly clear to me that the issue John was facing had nothing to do with mechanics. He could read the tape very well and knew how to check his emotions at the door. However, one glaring issue kept coming to light. With regard to moving in or out of a position, John often mentioned the short-term sentiment of the market or the short-term movement in his stock or another that led to his deci- sion. When asked about a specific trade, he often said something like “I saw the ten-minute chart bottoming.” Or “I played the real estate names because that day I saw financials turning green.” It became clear to me that John was attempting to blend a very short- term strategy, or at least observe all the variables that would go into a short-term strategy, while in reality only being able to devote part of his day in front of the computer. You see, despite John’s desire to sit and trade all day, his ongoing dental practice obligations kept him away from the screens for several hours. When he would return to the screen, he would catch just a glimpse of what was happening during that moment and would often make his deci- sions based on that information. Because the market often moves in a chaotic fashion in the short term, it was impossible for John to gain any sort of rhythm or sustain any momentum in his account if he was trying to trade on one time frame because he didn’t really have the schedule to do so.
After recognizing this, it became clear to me that John did indeed have the potential to dramatically improve his returns but first needed to solidify his strategy much more. John had all the time in the world to study charts and find appropriate patterns. His schedule before and after market hours allowed him this luxury. However, when the market opened, he was distracted with other obligations. When he sat at his computer, he would make snap decisions based on short-term information that could change (often even between his patients). I strongly encouraged John to take a big step back and recognize that despite the allure, at this point in his life he did not have the schedule that allowed for short term trading. To be successful, he would have to focus his energy on a much more methodical approach, recognizing the opportuni- ties presented in various patterns, taking them, and letting them play out. Furthermore, I encouraged him to avoid any “noise” that contradicted this strategy, shutting down the chat room and turn- ing off the television if necessary.
To help John make this transition, we implemented some guidelines. John had lost a tremendous amount of confidence over the years, and it was important to rebuild this as quickly as possi- ble. To do so, we had to reduce his portfolio risk, which meant that first we significantly reduced the capital John was trading so that he could become comfortable with his new strategy without being concerned about his entire account. Once he gained confidence for the time frame of his focus and had some “wins” under his belt, we increased the money he traded in a methodical fashion. We then limited the number of trades John could have at any one time to four. This kept John focused on selecting only the best four stocks. If another arrived that he thought had more merit, he would simply have to wait until either taking profits or it could replace one of his original four. Finally, we set a specific time frame that John would look at when selecting his trades. We banished the 5-, 10-, and 30-minute chart, and John could not delve into this short-term world. He needed to focus on the daily charts and thus give his trades much more time to play out (and not be shaken or distracted by the intraday movement). We concluded his rules by simply stating that once a position was taken, with a precise plan laid out from the onset, he would stick with that plan no matter what. As is my custom, I follow up with all my students on a regular basis. John came to visit me in October 2009 and spent much of the end of 2009 reflecting on his experience with me and his new strategy. As of the first week in 2010, John had returned more than 3%, taking very limited risk, and was feeling more confident than ever. By the end of June, John was up over 10%, while the gener- al market as measured by the S&P 500 was down close to 8%. An 18% outperformance halfway through the year is fantastic. John understands that there will be progress and there will be setbacks. However, I believe that John now has the requisite foundation in place, is comfortable in his own skin, and is making progress toward consistent success. John and I have since become great friends, and during a recent visit I smiled ear to ear as I heard his lovely wife talk about just how much their lifestyle had improved as a direct correlation to the reduction in frustration he experi- ences trading. Bravo John!
You might be under the impression that your trading time frame will somehow correlate with your returns. The excitement and faster pace of shorter-term price movement often insinuates greater opportunity for gain. I can understand how you may view those trading in this world and surmise that their returns should be exor- bitant. It has been my personal experience, however, that this could- n’t be further from the truth. Just as more opportunities for success are presented through shorter-term charts, so are the opportunities for failure, which can quickly alter your emotional capital if you experience a few losses in a matter of hours rather than days. I remember vividly when it first all clicked for me. It was as if I were an artist finally finding my canvas. I understood pattern recog- nition and how to capitalize on the opportunities that were present- ing themselves day in and day out. I had developed a way to calcu- late my risk ahead of my trade and had developed a profit-taking strategy that never let gains turn into losses. I saw firsthand how exercising my statistical edge over a sample set of trades produced a consistently rising equity curve. My excitement grew as I viewed my trading like I was the casino, with a small house edge, capitaliz- ing on the never-ending supply of players that sit starry eyed at the blackjack table attempting to secure their future fortune. The house knows it may win some hands, it may lose some hands, but over the long haul its proven edge will bring in enough money to build lavish buildings and famous fountains. The system all made sense to me, and before long I concluded that to dramatically improve my returns and reach my maximum potential, like a vast casino floor, I had to be in as many trades as possible. Although the outcome I desired might have been possible statistically and is the foundation for many black-box computer strategies, I did not con- sider the human factor or my personal emotional makeup.
The day began, and it didn’t take long for me to find my first few trades based off 30-minute chart patterns I had been studying over the past few days. I did not hesitate entering the trades, setting my stops as well as my profit-limit orders. Within the first 20 minutes, I had come across two oil and gas names that looked to be rolling over on the 5-minute charts. Again, I entered the trades and kept right on moving along. By 10:30, my daily alerts started to trigger, notifying me of longer-term trades I had been stalking for some time. I did not hesitate to enter those trades, too, adding even more inventory to the position sheet but remaining well in control of all that was going on. As I entered those specific trades based on the daily charts, my early trades on the 30-minute charts were stopped out for losses (while my 5-minute chart patterns played out and reached their first few profit levels quite quickly). While I was assessing the initial stop damage, taking some gains in the 5-minute chart patterns, I again had a few more alerts go off for charts based on ten-minute patterns. I scrambled to review those charts, while at the same time trying to manage my existing trades and review other daily alerts that started to trigger. While I booked early gains on the 5-minute chart patterns, the subsequent share amounts were stopped out and I was caught off guard when they reversed hard and created a little more slippage than I would have liked in the account. As the day wore on, I became more and more entrenched in the management of my own little casino floor. A few initial losses did more psychological damage than I expected, which had me hesitating on subsequent trades as they set up. When I began hesitating, I began missing opportunities.
It was the longest trading day of my life! When it was over, I had traded more that day than I had on any particular day in many years. The net return, while positive, wasn’t nearly enough to jus- tify the tremendous amount of work I had put in during the day. Furthermore, as I wrapped up the day, I stumbled on a few daily patterns I had missed throughout the day as my attention was focused elsewhere. This was rather discouraging because these patterns had evolved into what would have been outsized gains far greater than what I had made the whole entire day. In addition to all the frustration surrounding the actual execution and trade man- agement of that day, I realized that my enjoyment level was far below normal. I couldn’t put my finger on it. Some time later, I told a friend that the day was my first when trading felt like actual work. I subscribe to the idea “blessed is the man who cannot tell the difference between his work and his passion.” That particular day was no fun at all.
My statistical edge is proven, and I still do believe that grow- ing the sample set for my trading style would reap great returns. However, it is not something I desire to pursue. Rather than increase the size of the casino floor, I just want to hone in on the time frame and patterns that I find most comfortable. I want to strive for perfection within this world, and rather than increase the number of trades I enter, I want to increase the risk I take per trade. I accomplish the same end result without the manic activity. The fact that pattern recognition may be applied across a num- ber of time frames is both a blessing and a curse. You must first honestly assess the time you have to dedicate to trading, and there- by focus solely on the time frame that correlates with your person- al strategy. When you have a firm grasp on pattern recognition as a strategy, and a core time frame from which to trade, you are ready to learn about actual trade management and the science behind consistent profitability.
Chapter 10 Developing Your Plan
I’m going to assume we share the same understanding about the lucrative potential stock trading holds, and that you are seeking to implement a strategy that enables you to make consistent profits over time. What I do not know, however, is what your understand- ing is of the work ethic it takes to become successful within this field. I am consistently dumbfounded at the number of people who believe that with just a little work they can make consistent money trading stocks. It is true that the barriers to entry are extremely low, and almost anyone can open a trading account online and within minutes be in the game. However, to correlate the ease from which you can start trading stocks to the success you will have is a terrible mistake. You must know that the minute you sit in front of a computer screen studying the markets, you are facing not only the smartest people in the world, but the most competitive. You are facing ex-professional athletes who already know what it takes to succeed in the athletic arena. You are facing Ivy League schol- ars who calculate risk as if they were ordering a pizza. Finally, you are facing institutions that have an endless supply of capital from which to move markets, move stocks, and bounce you around like a Ping-Pong ball in the wind. After opening a trading account, like David facing Goliath, you are undermanned, underequipped, and the odds are significantly against your success. If you are not ready to commit the time and energy it takes to gain an edge against these challenging odds, do yourself a favor and find someone capa- ble of managing your money with a proven track record of success in a variety of markets. If you have the drive, determination, and humility to learn, however, let’s press on.
While I’ve made my frustration level for those who believe this is an easy game evident, I always must check this attitude at the door. It is these traders who think it’s easy who will fall on the other side of your trades. Although equity trading is not always a zero sum game, those that do not understand or appreciate the work it takes to become successful do provide liquidity in the market, making your job and subsequent profits possible. I have been involved in many activities in my life, from athletics and academics to relationships and parenting. I can honestly say that stock trading trumps everything I have ever done when it comes to the work ethic needed to keep my edge. In my opinion, the stock market presents all participants with endless opportunity five days per week. However, only a small percentage of investors truly under- stand this and do the hard work required to become consistently successful. Are you ready to do the work needed to succeed? “Plan your trade and trade your plan” is one of the oldest axioms passed among traders everywhere. Successful traders know that the less emotion they bring to the table when a trade is placed or being managed, the better off they will be. You are human and therefore possess emotions that can alter your actions, especially when you see your money increase and decrease before your eyes. Simply put, you must have already laid out what you should be doing ahead of time so that you do not make snap decisions on- the-fly.
Planning all the facets of your trade from the entry point, stop loss, risk taken, and exit strategy is as fundamental as the play called in a huddle for a football team.
Yes, a trader can be as free as a quarterback to call an audible, but the premise of planning ahead, before the action heats up, remains the same. Imagine a football team snapping the ball and the quarterback waiting until the defensive linebacker is running full steam at him before calling the play. I’m going to go out on a limb and say that the quarterback would be walking around with a few bumps and bruises after that game. This will not work during a football game, and it will not work during trading.
As someone who has made himself accessible to other traders and is always willing to help, I am often requested to diagnose var- ious trading issues and investor styles. It is an experience I am always humbled by. However, over the years, I have now found that most conversations don’t go any further than the initial dia- logue. The reason for this is the first question I ask any trader I am working with: May I see your trading journal? This is not a trick question. After all, it is through written words I can better under- stand just what the trader was thinking before placing the trade. I can then see how the trader executed this plan and exactly what went wrong. As you can imagine, few who reach out to me actual- ly have a written trading journal for their stocks, and therefore have no documentation to follow when they are in a trade. These are the traders attempting to call a play when the center has already snapped the ball. It just won’t work.
I suspect most traders revert to a trading journal after they reach a certain level of frustration in their trading. My adoption of the journal-writing habit was similar but unique in that I had already been experiencing a level of success, but one that was far from consistent. As I began to review the only trading logs I had, my brokerage statements, I could tell very little about my actual trading strategy. It seemed easy to be a rearview mirror trader looking over buys and sells, cross-referencing those stocks to where they were months later, and surmising I just needed to either stay in a winning trade longer or cut a loser quicker. Regardless of how often I tried to implement such changes, how- ever, it just never worked without a written record.
I subscribe to the belief expressed by Albert Einstein that the definition of insanity is doing the same thing over and over while expecting different results. Yet I also have learned that without the proper information, reflection, and study, simply altering the action might still not provide the desired result. Accordingly, each year I began reviewing trade record after trade record, coming away with the same realization: I sell too early. With a strong work ethic of reviewing a vast number of charts while playing favorable patterns, there aren’t too many winning stocks I haven’t invested in. Unfortunately, I stayed in those stocks for only a very short peri- od (and they went on to mature into significant winners without me). As I reviewed this behavior of mine happening time and again, it seemed like an easy fix, with a logical adjustment of just holding on to winning stocks longer.
Each year, I made a new resolution to hold on to stocks that were acting well, longer. I wrote about this resolution, I discussed it with other traders, and like the early days of an exercise or diet plan, for the first few weeks I honored this resolution with incred- ible determination. Did it help me to start producing phenomenal returns? Nope, not even close. Time and again, the exercise mere- ly led to more frustration as I bent my rules, trying to stay in names that no longer were worthy of my capital, wondering whether this would be the one I would sell far too early. It was a vicious cycle for me, but one that I couldn’t properly diagnose, not because I wasn’t studying the trades, but because I wasn’t studying the prop- er trading material.
I believe it was by accident that I first started a trading journal, but looking back, I’ll call it a divine intervention. I remember counseling another trader who had reached a maximum frustration level to the point of quitting. I could see he had reached the tip- ping point, yet I couldn’t let him give up the game he loved so much. MeatBaron, his Internet moniker due to his Canadian Butcher Shop business, had all the qualities needed to succeed: passion, humility, and a strong work ethic. Even so, he consistent- ly was being beaten down by the incredible volatility the market had been dishing out for a series of months.
Before he threw in the towel, I issued him a challenge, saying that before he took any trade, I wanted him to articulate to me exactly why he was taking the trade and that I might try to punch holes in his read. Furthermore, I told him that when he became confident in a read, could articulate the read well, and could also defend his reasoning after my interrogation, he would take the trade and watch it play out from beginning to end, regardless of the changing market, his opinion, or anything else that might alter his read. What the trader didn’t know is that I had made a person- al resolution to take all the trades along with him, so that I too could experience the emotional roller coaster when real money was on the line. I wanted to get more into his head and learn where his brain went after the trade was executed, but I also wanted to have the stocks he was trading in front of me so that I could study them right along with him.
I suspect there was a bit of intimidation at first because for the next couple days MeatBaron was silent. It is not uncommon for me not to trade for several days at a time, but at this very moment there were trades to be had, so I guessed a fear of articulating his ideas was holding him back. He finally reached out to me, express- ing his desire to take a particular trade that was setting up. He told me he had recognized a key level in the stock around a specific price point; we’ll say $20, and the stock looked as if it were going to break above that level with unusually high volume. As I suspect- ed, his read was not the problem, and the stock was, in fact, look- ing ripe for a significant move higher. I asked him where his stop would be and the various profit levels he was looking for. He answered without hesitation. As we were chatting online, I was copying parts of our conversation into another document, which ultimately became the format for my trading journal I use today. I also suspected I would need to use his exact words again in the future if he started to eventually doubt his read, the market, or the way in which the stock was acting. After some more discussion, we concluded that the trade was worthy of his capital. As I previously decided, I did not hesitate taking the trade and immediately bought an amount equal to the desired risk I was willing to accept on the trade. As the day concluded, the stock broke out and reached not only the first predetermined profit level but also the second. It was a very profitable trade within the first day, and with a raised stop level was certain to not turn into a loser. As I reviewed my notes from our previous conversation, I took the liberty of updating where the trade stood at the end of the day, and was amazed at my own lack of emotions over the trade, because I had simply been following a predetermined plan and not having to guess what my next move would be. A new world was opening for me, and I could tell this was the missing piece. I was also quite excited about the progression I believed MeatBaron had made that day, and reached out to him to discuss the day and the trade. “Excellent read,” I said, as I began the conversation. “I went ahead and took the trade with you and was pleased to see both your first and second targets reached.” I anxiously awaited his response because I believed we were well on our way. It took several min- utes for the trader to respond, and when he finally did, he simply said, “I didn’t take the trade.” My heart sank. I asked what hap- pened. MeatBaron simply relayed that he hesitated, and when it was time to commit his capital, he just couldn’t pull the trigger.
Regardless of how positive the exercise was, the trader I was work- ing with had confidence issues that went far beyond what I initial- ly thought. It took several more trades, and several more weeks, until the trader who consistently articulated to me excellent reads with excellent strategies was actually taking the trades he was lay- ing out. We spent hours poring over our notes and reviewing trades. They were not all profitable, but eventually MeatBaron saw that he did in fact have a statistical edge, yet in the early going his confidence level had not allowed him to exploit this edge at all. From that point forward, he and I both began our trading jour- nals, and he has gone on to experience an incredible amount of success in trading. He knows that confidence no longer correlates with his profit and loss. His execution of his edge will bring him the profits he desires.
You must keep a trading journal for each and every trade you place for a number of reasons. First and foremost, your trading journal provides you with a road map you are going to follow when the actual trade is placed. With an ever-changing market, there are constant distractions and many changing variables, all vying for your attention after you are already in a trade. A trade journal helps you to stay focused on the trade you are in. When you feel there has been a change in the environment, or in your trade itself, you can review your initial thoughts via the trade journal to cross- reference. If nothing has changed with your initial read, your trade should remain. It is important for you to remain steadfast when you are in a trade and not allow the outside distractions to change your plan. This trading journal will also give you a paper trail or historic documentation that you can review to gain a better under- standing of your strengths and weaknesses, and most important, to improve on your trading regardless of whether the trades were profitable.
It is of utmost importance that if you do not already keep a journal, you begin to do so at once. There is no grand format, and you may develop your own journal according to your own person- ality. However, a few key variables must be included regardless of whether this journal is kept electronically or in an actual binder. These variables are as follows and should be notated in the follow- ing order. At this point, don’t concern yourself with the particulars of the list. We’ll delve deeper into each aspect in subsequent chapters:
DEVELOPING YOUR PLAN
1. Stock: Simply notate the symbol so that it can be recalled at another time.
2. Long or short: It’s easy to assume you will remember this basic variable, whether you are buying a stock long or selling a stock short. However, I always prefer to write it down so that my memory will be crystal clear.
3. Stop and reasoning: The point at which you would remove this position and why.
4. Trade reason: You should be able to clearly articulate why you are taking the trade. If you are following the pat- tern-recognition strategy, this should include a quantita- tive rationale and nothing qualitative, such as another person’s recommendation or the feeling that a stock will act a certain way because of outside influences. It is this section where the more precise you can be in your rea- soning, the better. Over time, and as you become more familiar with charts, this section will become much easier. I always tell my students to pretend they are telling me why they entered a specific trade. I encourage you to do the same. If you cannot do this, you should not take the trade.
5. Risk per share: The difference between your entry point and your stop. (You will usually enter this once the actual trade is placed.)
6. Total risk for the trade: Multiplying the number of shares you have taken by the risk per share will give you your total risk for the entire trade. This number should actually be determined well before any trade is placed, and will be the variable from which your share count is determined.
7. Profit levels: Calculating ahead of time where you will take profits is imperative to a successful trade plan. This allows the trader to remain focused on the objectives after the trade has actually been placed.
8. Updates: Any journal should also contain an update sec- tion in which you comment on the trade and relay any- thing you might be seeing or feeling while the trade is being managed. This section is critical for future growth as you recall what your emotions were at the time of the trade. In this section, you can update where and when the trade is ultimately closed and the gain or loss incurred.
The key to any trading journal is that it is implemented. Do not get hung up on the details at this stage. Instead, understand that your journal will evolve as you evolve as a trader. If you take this process seriously, however, you will have a written account of this evolution and be able to look back on this process and actually see the improvements taking place.
Keeping your trade journal current is not an easy task.
However, you must consider that doing so is critical. You would never think of starting a business and not keeping accurate finan- cial records to document your progress. As a business owner, you would most likely pore over these documents to both better under- stand where your business is and to better understand where it is going. You’d also want to learn from your mistakes, illuminate or reduce your weaknesses, and capitalize on your strengths. In the highly competitive world of stock trading, this is no different, and taking the time to document your progress is essential to your suc- cess. Not only should you rigorously document all your actions, you should also you review your trading journal on a consistent basis. I usually review my journal at the end of each day, with a longer review at the end of each month. By this evaluation, I can adjust my game to capitalize on the opportunities that are sure to be pre- sented the next time I sit in front of the screens.
Regardless of how hard, how time-consuming, or how awk- ward it may seem, start your trading journal now!
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发表于 2013-6-15 11:34:08
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