An Active Traders Guide

An Active Trader’s Primer Your free trading guide to learn the secrets of successful trading from the pros. These selected trading education articles are key to making more money in any market. Get your Active Trader’s Primer today and start building your portfolio to greater profits.

Introduction As anyone who makes all or part of his or her living in the financial markets will tell you, making money at it is like any other business – it is dependent on what you put into it. Because we have been in the business of supporting the active trader for more than 25 years, we know that one of the earmarks of a successful trader is the willingness to put time into education. That’s why, in addition to providing market data and professional decision support tools, we also offer seminars and mentoring – to help you get better at what you do best. In that spirit of continuous progress learning, we offer this primer of selected trading education articles in four categories of topics that matter to those who want to make more money in the market – an introduction to the markets, characteristics of a successful trader, technical analysis techniques, money management and the psychology of trading.

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To quote one of the article’s authors on the “recipe” for success: You need: • A reliable data provider •

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A reliable execution service at a rate that suits you

An understanding of how your competition operates in the markets you wish to trade A methodology that allows you to approach trading from a winner’s perspective An understanding of the shortcomings of any method you are using

Discover the data and software package preferred by thousands of active traders like you by visiting our website (http://www.esignal.com/), or see what we offer in trading education at: http://www.esignallearning.com/. In the meantime, we hope you will find in this selection of articles we offer with our compliments information that can help you make better trades.

Contents An Introduction to the Markets “Markets – An Overview” excerpted from the eSignal Learning Foundation Course, unit 1 “2 Behaviors That Differentiate a Successful Trader’s Approach to the Markets” by Ron Wheeler Trading Styles “Technical Trading” by Nick Sudbury “Mastering Momentum Trading Using Technical Analysis” by Alan Farley Technical Analysis Techniques “Analyzing and Anticipating Price Movements: Two Approaches – Not Necessarily Opposing” excerpted from the eSignal Learning Foundation Course, unit 3 “The Technical Analysis Toolbox” excerpted from the eSignal Learning Foundation Course, unit 4 The Psychology of Trading “Trading and Psychology” by Bennett McDowell “Only the Zeros Are Different: How Great Traders Go Bad” by John A. Sarkett

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An Introduction to the Markets In the spirit of the title of this collection of essays, these two articles are the kind of basic information that can help someone new to trading understand how the markets operate, what types of markets he or she may want to get into, as well as the techniques that can help the trader maximize profits while minimizing risk. “Markets – An Overview”, an excerpt from the eSignal Learning Foundation Course, unit 1, is an excellent summary-level view of the markets you can trade and a helpful roadmap. “2 Behaviors That Differentiate a Successful Trader’s Approach to the Markets” provides an excellent perspective on how to determine market behavior that reveals reasonably predictable opportunities, as well as sound advice about money management techniques that can help minimize your risk when “predictable” turns the corner to unpredictable.

Markets – An Overview

As excerpted from the eSignal Learning Foundation Course

There’s an old saying that if you don’t know where you’re going, any road will get you there. To make sure that you get on the road that’s right for you, this introduction to the markets provides you with some guidance to help you identify where you want to go in your financial future and how to map out your journey to get there. Depending on how much you already know, you may be able to skim through this article quickly, or you may need to take things a bit more slowly. Either way, it provides a foundation on which to build an understanding of the markets, a roadmap for what types of markets you might want to trade. A financial instrument is a legal document that grants a right or gives formal expression to a contractual relationship. Among the many different types of financial instruments are stocks, bonds, mutual funds, futures, options, and currencies. 4

A stock is a security that represents ownership in a company. Stocks fall into two basic categories: common stock and preferred stock. There are two basic ways to make money through buying stocks. One way is to collect dividends, which are a portion of the company’s profits that are paid out to the shareholders. The other way is to sell your shares for more than you paid for them. The increase (or decrease) in the price of the security since it was purchased, expressed as a percentage, is the return. A stock’s performance typically is calculated in terms of a 12-month period and expressed in a measurement called annual return, or annualized return. Stocks are often categorized and described in different ways. They can be categorized by the size of the company, or market capitalization, as largecap, mid-cap, small-cap, and microcap. In general, small-cap stocks have tended to be riskier than large-cap stocks but are also considered to offer more potential for growth. Stocks can be described according to their risk and return potential, as growth stocks, income stocks, blue chip stocks, and speculative stocks. Growth stocks offer a potential for higher returns, but generally with more volatility, and generally do not offer dividend payments. Income stocks tend to be less volatile and pay high dividends. Blue chip stocks are companies that have consistently exhibited steady growth and profitability. Speculative stocks are high-risk investments and tend to be very volatile. Stocks can be described in relation to general market activity. Cyclical stocks parallel the ups and downs of the economy and the business cycles. Defensive stocks are less affected by the vagaries of the business cycle. A bond is a debt instrument that pays interest over a fixed term. Bonds are issued by corporations and governments when they want to raise cash. Because the interest rate and amount of each payment are determined at the time the bond is offered, bonds are often referred to as fixed-income investments.

There are several types of government bonds. Municipal bonds (munis) are issued by cities or sometimes state government agencies or local political entities. The U.S. government issues Treasury bonds, Treasury bills (T-bills), and Treasury notes. All are considered very low risk investments, backed by the “full faith and credit” of the U.S. government, but their return is also low. Investors trade bonds in the hope of selling them for more than the purchase price, just as with stocks. Bond prices have an inverse relationship to interest rates: As interest rates rise, bond prices fall; and as interest rates fall, bond prices rise. Bonds are compared to one another in terms of yield and rating. Bonds rated Baa or higher by Moody’s and BBB or higher by Standard and Poor’s are considered investment-grade bonds. The lowestrated bonds tend to have the highest yields and are known as high-yield bonds or junk bonds. A mutual fund is an investment fund that manages the money of a large number of investors who have pooled their money together. Mutual funds can be categorized according to the types of securities they invest in: stock funds (equity funds), bond funds, or money market funds. Some funds invest in more than one type of security; for example, balanced funds invest in both stocks and bonds. There are also several different kinds of specialized funds. Examples include international funds, global funds, precious metals funds, and sector funds. Mutual funds can also be categorized according to their investment objective: current income, some income and growth, or future growth. Derivatives are financial instruments whose prices derive from an underlying item, either a commodity or a financial security. When you trade in derivatives, you are not buying or selling the underlying item; instead, you are trading in contracts. Futures and options are considered derivative investments. A futures contract is an agreement to either buy or sell a certain amount of a commodity at a specified time at a particular price, called the exercise price.

The value of the contract is determined by open auction on a futures exchange. When you buy a futures contract, you are going long, or taking a long position; when you sell, you are going short, or taking a short position. Only a very small percentage of futures contracts are settled by delivery. Instead, traders offset (close out) their position before the delivery date by entering into an equal number of the same contracts on the opposite side of the market. An option is a right to buy or sell a certain quantity of a financial product, called the underlying security, at a specified price (the strike price), up to a specified time (the expiration date). Underlying securities can be stocks, bonds, stock or bond indexes, or futures contracts. Options that give you the right to buy are called calls; options that give you the right to sell are called puts. When you buy a call option, you are expecting that the price of the security will go up. When you buy a put option, you are expecting that the price will go down. Trading options costs less than trading the actual securities. The price of trading the option is called the premium. For conservative investors, options can protect their portfolios against major drops in stock prices, to lock in a favorable purchase price, or even to acquire some immediate income. For more aggressive investors, options provide an opportunity to leverage their investment by realizing a much larger gain than they could by owning the underlying security. Foreign exchange currency trading, also known as Forex or FX, involves buying one country’s currency while simultaneously selling another country’s currency. A position in a currency is either a bullish or bearish outlook versus other currencies. If the outlook is bullish, a trader can profit by purchasing that currency against other currencies. However, if an outlook is bearish, a trader can profit by selling that currency against other currencies. The financial markets are places where investors trade stocks, bonds, and other financial instruments. 5

Stock exchanges started out as centralized facilities for trading. The first stock exchange organized in the United States is the New York Stock Exchange (NYSE). The NYSE is a traditional, floor-based exchanged, as is the American Stock Exchange (AMEX) and some smaller regional exchanges. An electronic exchange is an advanced computerized telecommunications network. The best known electronic exchange is the NASDAQ. Many newer and smaller company stocks aren’t listed on a traditional exchange or the NASDAQ. Instead, they are traded over-the-counter (OTC). Electronic communications networks (ECNs) collect, display, and execute orders electronically. An index is a mathematical composite of a market’s activity at any given hour of any trading day. Prominent indexes include the Dow Jones Industrial Average (DJIA), which is calculated from 30 blue chip stocks, and the S&P 500, which tracks 500 U.S. large-company (large-cap) stocks.

Over the course of these travels, I have spoken with many fellow educators and speakers and learned many things about the markets and trading in general. Most of us – while we may look at different theories and patterns to find our trades – all believe, at least in part, that successful trading comes about as a result of consistent application of two essential behaviors: 1. Learning to identify “predictable” market behavior 2. Applying good money management techniques to your trading decisions

Securities prices move in response to supply and demand, and prices rise and fall in recurring cycles. A bull market is a time of prolonged rise in prices. A bear market is a time of prolonged fall in prices. A bear market in stocks usually results from a widespread anticipation of declining economic activity; a bear market in bonds is caused by rising interest rates.

Let’s start with that first one, identifying “predictable” market behavior. I am a big proponent of making sure that the word “predictable” is thoroughly explained. First and foremost, no market is 100% predictable. As I mentioned earlier, in my travels, I have heard fellow educators talk about the types of market behavior they believe make the most sense to target for potential trade setups.

Investor emotions also influence stock prices. Greed and fear can cause investors to act too rashly. However, knowledge and discipline can help you avoid the traps of your emotions and help you make money whether markets are high or low.

For example, I have heard that trading market tops and bottoms is too unpredictable and should be avoided. Yet, another educator says that trading market tops and bottoms is where the most money can be made.

2 Behaviors That Differentiate a Successful Trader’s Approach to the Markets By Ron Wheeler, eSignal Learning

I have spent the better parts of the last 14 years developing a unique perspective on trading and especially the trading industry. As a member of the Trading Education team at eSignal Learning, 6

I’ve had the privilege and honor of traveling around the United States and Europe educating thousands of traders – from small groups focused on the advanced concepts of Gann and Elliott Wave as used in the eSignal, Advanced GET Edition, software – to hundreds of people at larger trade show events.

Some traders and educators like to avoid trend breakouts; others make that a cornerstone of their trades. Some traders believe that the trend may not truly be your friend. New traders find that this confusion of ideas leaves them feeling that they don’t know what to believe, and most importantly, whom to believe. Most of us in the trading education field truly have your best interests in mind, and we want to help you become successful in the market. Of course, as in

any field, there are a few unscrupulous people out there, but, as you gain knowledge and experience, you will be able to spot them.

tops and bottoms typically starts a very profitable run in the market that makes up for the losses you suffered trying to find them.

When it comes to my trading and the methods I teach, I prefer to follow the market according to the Elliott Wave theory for two important reasons. First and most importantly, the model is mathematical in nature because it is derived using the Fibonacci number sequences and the ratios the sequences provide.

Similarly, trend breakouts are low probability but provide a higher return on profits once the trend starts. To me, trading with the trend is the easiest type of trading you can do and has the highest degree of accuracy. Of course, you pay for this greater degree of accuracy by having the smallest amount of profits available. I find that the trend is most definitely my friend because the Elliott Wave cycle tells me when the trend is complete, and it’s time to go the other way.

Second, the models we teach with the Advanced GET system have verified everything of value I have learned from my fellow traders and lectures over the years. For example, I spoke of hearing that trading at market tops and bottoms can be unpredictable. It’s true; it is one of the hardest trades to master and has the highest probability for error in our systems. On the other hand, finding the

At the core of Elliott Wave theory is the belief that market trends last for 5 cycles or waves. At the completion of the 5-wave pattern, the market typically ends the trend, and we see a correction or a complete change in trend. The cycles themselves are

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defined by Fibonacci ratios. So, Wave 2 is typically a 68.1% retracement of Wave 1, Wave 3 is a 162to-262% extension of Wave 1, Wave 4 is typically a 25-to-68.1% retracement of Wave 3, and Wave 5 is typically a 68.1-to-100% extension of Waves 1-2-3. (See the accompanying chart for an example.) This is what I mean when I say “predictable”. I am looking for a repeatable sequence of chart patterns. As the pattern or trend grows, it becomes more predictable because the market is following the Fibonacci sequence throughout the move. For this reason, the midpoints of Wave 3’s and the ending points of Wave 4’s are the most predictable patterns I look for in trading, and they form the core of two of our Advanced GET strategies – the eXpert Trend Locator (XTL) Breakout and the Elliott Type I Trade. On the second chart, I have an example of this behavior on the 5-Minute British Pound. The Wave 5 low indicates that the down trend is complete, and the market is ready for a reversal; this is also our Elliott Type II Trade. You can try to buy into the market at the end of the Wave 5 (higher risk) or wait until the new trend is confirmed (lower risk). In that second chart, we also see a new rally that stalls at the previous Wave 4 and starts a small profit-taking decline. If this small decline can hold a 61.8% retracement, re-rally and break the previous high, you have the potential for a Wave 3 rally. Essentially, you are seeing the development of the Waves 1 and 2 forming. The blue bars in Advanced GET are our XTL study, and a second blue bar also confirms the trend breakout. We would take profits at the projected targets of Wave 3, but, because the market is not 100% predictable, we use a trailing stop to protect us in the event of a pattern failure. Once we fall below the Regression Trend Channel, we take the remainder of the position off and await our next move. In addition, the black bars, as defined by the XTL study, indicate a neutral or non-trending bar and can be confirmation that the Wave 3 is complete. At this point, the market is ready for the 25-to-61.8% 8

retracement of the Elliott Wave 4. It’s important to note that I am not looking for everything to trade to these levels to the tick; it’s a range, and, if the market starts moving in another direction before these levels are hit, my money management will protect me. The market has now moved into Wave 4 and hit our projected levels of retracement. As we cross the Regression Trend Channels, the Wave 5 is assumed to have begun, and we enter into the market at the cross of the channels. Our stop would be placed immediately below (a few pips) the current Wave 4. I prefer to use Gann Levels to predict the top of Wave 5 instead of the Fibonacci levels because, over time, they have proved to be more reliable for this sequence than the Fibonacci levels. In Advanced GET, the Make-or-Break (MOB) tool uses principles of Gann to find the Wave 5 target. Of course, the more experienced trader can use a Gann Box as well. Our target has been hit, and it’s time to exit the trade and prepare for a correction or a major trend reversal. In this article featuring the British Pound, we have seen an example of many of the kinds of patterns that Elliott Wave can provide. While I want to re-iterate that nothing is 100% predictable, these patterns can help the trader find most of the key areas of price movement and an opportunity to get into and out of the trend at the most predictable places. Ultimately, traders have to find out for themselves which trades fit their personality. Some traders prefer to trade with a higher degree of accuracy and like trading within the trend. Others have a more aggressive style and prefer market tops and bottoms. The market provides all of us with different opportunities to buy and sell, and understanding where those patterns are appearing is the first step to becoming a successful trader. That leads me into the second component of successful trading, applying good money management to your trading decisions. 9

As has been the theme throughout this article, nothing in trading is 100% accurate, and the trader must prepare for those times when the patterns break down. Patterns can break down for a multitude of reasons that range from world events to company fundamentals news items. Some of these can be anticipated, but none are 100% predictable. In my trading, my money management follows two simple rules. I never risk more than 1% of my capital on any trade, and I make sure the trade has at least a 1.6:1 reward-risk ratio. I look at all trades as the same. I don’t “double up” because of multiple losses or have such good feelings about “this pattern” that it makes me break my rules. If I am wrong in my analysis, I admit it and take a loss. An example of what I mean is illustrated by Wave 4, which has multiple levels of support or resistance

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and can occasionally give false signals of a breakout. If I get trapped in a false breakout, and the market has not yet hit my first profit targets before reversing, I simply get stopped out. As we can see in the following example chart, I thought we had the proper entry for the new Wave 5, but the market had other ideas. Because the market was still in the Wave 4 range, and a Wave 5 was still projected, I re-entered the market at the next breakout of the updated Regression Trend Channels. The reason we must exit the market when the first breakout fails is because there is no guarantee that the market will break out again. (Remember: Nothing is 100% predictable.) If the market does break out again, however, you must have the confidence to re-enter the move. As you can see in the chart shown above, if you had, you would have

been rewarded for your effort. Finally, the last thing I verify is that the trade has a 1.6:1 reward-risk ratio. This simply means that, if I am risking 1 dollar on the trade, I expect a 1.60 profit. This can be done using the Fibonacci ratios we talked about earlier or tools such as the Advanced GET MOB tool. In my trading, I prefer to use Gann Levels to locate profit-taking levels. The reason we look to the 1.6:1 ratio is that, if you are trading at 50% accuracy and keeping true to your reward-risk tolerances, you can and will be profitable at that rate of accuracy. Even if your accuracy were to dip (as it can during the course of your career), profitability can still be maintained. It is important to remember that, if the trade at the initial entry point does not fit the minimum reward-risk ratio, you should not place the trade.

This means that, at the entry, you need to have identifi ed on your chart both the stop and the profi t targets. Do not enter a trade until you know where those two points are. As you become adept at trading and learn the different signals of trend reversals and early warning signals of trade failures, you may notice that your reward-risk ratio declines somewhat as you learn to take profits early. This should not hurt you because this is where your accuracy as a trader will increase. Even though, in my own trading, I have plans in place to take profits before reaching 1.6:1, in the event of a trade failure, I still verify that the trade has the required distance before I enter the trade. In other words, I am fully expecting to make my 1.6:1 target, but, if the market does not cooperate, I am prepared to take less to avoid a loss and protect my gains. 11

I am an advocate for developing processes to manage my trading decisions. These processes involve the creation of mechanical, set trading rules that I do not deviate from. This helps me maintain discipline in choosing and taking trades on a day-today basis. I mentioned at the beginning that, while trading educators may have different approaches to how we trade the markets, one thing we all have in common is the discipline to follow our patterns and avoid taking unnecessary risk. As you advance in your career, remember that successful trading revolves around the two key behaviors I introduced at the beginning of the article – learning to identify “predictable” market behavior and applying good money management rules to the trades you take. If you can master these behaviors, you too will be on your way to becoming successful.

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Trading Styles Technical Trading By Nick Sudbury*

Technical analysis is widely used to augment many different trading philosophies, but in a broad sense, can also be thought of as a trading style in its own right. Technical traders study price movements through the use of charts. By identifying particular known patterns, often in conjunction with technical indicators, adherents believe it is possible to gauge the prevailing market sentiment and, hence, gain some insight into how the price is likely to change. Popular Patterns One of the best-known formations is the head and shoulders, where a high (the left shoulder) is followed by a higher high (the head) and then a lower high forming the right shoulder. This pattern often heralds a breakout from the neckline — the line linking the lows on either side of the head. Another popular pattern to look for is a congestion area, which is essentially a consolidation phase following a move. The majority of these tend to resolve themselves in the same direction as the preceding trend. Technical traders generally use indicators in conjunction with the charts to help gauge the strength and direction of the underlying price movement. An indicator is solely designed to help interpret the price movements; it is not in any way intended to be a substitute. Which Ones (and How Many) to Use? Traders should not be misled by the precision and, in some cases, the complexity of the formulae used to calculate the indicators because the final interpretation inevitably remains more of an art than a science. One aspect of this is learning just which of the hundreds of indicators to actually use. The mere fact that there are so many indicators reveals the truth of the matter, namely, that some work better in certain circumstances than others.

Because there is no universally accepted view as to which ones are the best, most traders evolve their own short list of favorites that they become familiar and confident with. As tempting and as easy as the technical analysis software makes it to keep adding extra indicators to the charts, it is most certainly not a case of “the more the better.” Few traders use more than two or three in a single analysis because any more would just be likely to confuse the issue. The final selection is largely a question of personal preference and experience, but most would agree that it makes sense to pick indicators that complement each other rather than those that measure the same phenomena. For example, there would be little point in using both Stochastics and RSI because both measure momentum and have overbought / oversold levels. One of the most popular and intuitive indicators is the moving average. This simply calculates the average (usually closing) price of a security over a specified period of time. Moving averages are lagging indicators and are used to emphasize the direction of the trend. For example, when a stock moves below its moving average, it is a negative trend and visa versa. Views differ as to the best periods to use, but, for longer-term traders, the 50and 200- day moving averages are among the most widely watched. Combining Moving Averages and the Relative Strength Index A chart combining two moving averages provides one of the most popular ways to identify a trading signal. If the shorter (faster) moving average moves above the longer (slower) moving average, this represents a buy signal, while a sell signal is given when it dips below. The number of signals generated depends on the length of the moving averages -- the shorter, the greater the number of signals but the more that will be false. Because of this, moving averages are best used in conjunction with another indicator, such as the popular Relative Strength Index (RSI). 13

The RSI compares the number of days that a stock finishes higher against the number that it ends lower. In value, it ranges from 0 to 100 with, in general, a stock being considered overbought if it reaches 70 — a sign to consider selling. Similarly, if a security approaches 30, it is usually regarded as a buy signal. In a true bull or bear market, these numbers tend to be changed to 80 and 20, respectively.

In its purest form, volatility generates negative feedback as price swings randomly back and forth. However, if focused into a single direction, positive feedback awakens and generates momentum into strong price trending. Traders’ recognition of these active-passive states will likely determine their ultimate success in market speculation.

Neophytes fall quickly under the spell of fastmoving markets. However, momentum is far more The majority of analysts use a 9- to 15-day RSI. The difficult to trade than most participants admit. When shorter the number of days used, the more volatile an emotional crowd ignites sharp price movement, the indicator but, also, the more susceptible it greed clouds risk awareness. The anxious trader becomes to big surges or falls in stocks dramatically then chases positions just behind the big volume, affecting the RSI, potentially resulting in false buy where odds of a reversal quickly increase. or sell signals. Obviously, the majority seek their profit through The strength of the RSI as a complementary momentum. But, most ultimately fail as this wicked measure to the moving average can be seen from beast devours equity. Those who survive commit the chart of the Dow taken from Market Center. themselves to mastering the diverse skills needed to The index crossed above its 20-day moving average play this dangerous game. on August 18th, indicating a positive trend. The As traders gain experience, fresh dangers block the Dow continued to rise, peaking at a high of 10,363 road to success. The swing of negative feedback on September 7th. At this point, the nine-day RSI, triggers many false alarms while real entry signals, which is shown along the bottom of the chart, streaming from multiple sources, remain unnoticed. hit the overbought level of 70.409, heralding a In the confusion, profitable trades are missed comsubsequent fall in the index back toward the lagging pletely or entered just as the trend dies. moving average indicator. Either way, bad choices consume inexperienced *Reprinted (and modified) with permission from Nick trading dollars and the markets tally more losers. Sudbury. Nick Sudbury is a financial journalist who has worked both as a fund manager and as a consultant to the industry. He has an MBA and is also a chartered accountant.

Mastering Momentum Trading Using Technical Analysis By Alan Farley, Editor / Publisher, Hard Right Edge*

Outside the Box Markets must continuously digest new information. Cyclic impulses of stability and instability gather force through the pulse of this future discount mechanism. Each small event shocks the common knowledge, building a dynamic friction that dissipates through volatility-driven price movement. 14

Trade

Momentum

Swing

State

Positive Feedback

Negative Feedback

Basis

Demand

Supply

Impulse

Action

Reaction

Condition

Instability

Stability

Price Change

Directional

Flat-Line

Strategy Chart

Purpose

Indicator

Reward Trend

Thrust

Lagging

Risk

Range Test

Leading

Like magnetic fields, polar forces drive market conditions. Alternating cycles of activity and inactivity continuously fuel the dynamics of price movement. Traders must recognize current axis conditions before executing positions.

Winning Momentum trading can be mastered. Three disciplines will break destructive habits and reprogram trading for success: •

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Abandon the adrenaline rush. Forget the excitement. Profit is dependent on detached and disciplined execution.

Learn the numbers. The nature of price movement must be ingrained deeply enough to allow spontaneous decision-making during the trading day. Cross-verify. Objective measurements must filter unconscious bias.

Studying supply and demand on a scrolling ticker or NASDAQ Market Depth display provides a solid first step for understanding the inner workings of rapid price movement. Combining this with an understanding of time-of-day tendencies strengthens awareness of profit and danger zones. And, understanding all the players proffers a needed edge on the competition. But, the study of technical analysis uncovers greater secrets as insider deception and herd emotions are exposed. Properly applied, patterns and indicators reduce the false entries associated with failure. And, they invoke natural risk management. Technical analysis teaches traders when to painlessly exit momentum positions and move on to the next opportunity. Action-Reaction Cycle

Prices rarely move in a straight line. As shocks destabilize a market, a counter-force emerges to restrain price back toward its stable state. After each forward impulse, a backward reaction follows. Burning the fuel of the crowd’s money, markets seek equilibrium before proceeding with the next impulse. Traders fail to consider this phenomenon when they enter their momentum trades. Simply put, both action and reaction must be considered in developing appropriate entry-exit points. This requires more complex planning than most anticipate. Successful strategies often demand execution opposite to the natural tendencies of the trader: •

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Entry on counter-trend reaction and exit on accelerating thrust Entry on accelerating thrust and exit on subsequent reaction

Exit strategy can confuse trader logic more than entry. Effective risk management may require reversing the entry process entirely: •

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Exit on further reaction when counter-trend entry fails

Exit on accelerating impulse when thrust entry succeeds

Choosing the wrong action-reaction trigger will produce frustrating results. Every trader knows the pain of making a low-risk entry, riding a profitable trend, then losing everything on a subsequent reaction. This experience can be avoided using technical analysis to identify momentum signposts and locate natural escape routes. First Pullback Buying the first pullback following a breakout offers very high reward:risk. Inevitably, an impulsive crowd will be waiting to jump in on a second chance. Use support and resistance or short-term moving averages to identify your entry point. (Day Traders: a 5-to 8-period SMA on a 5-minute bar is highly effective.)

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Identifying Momentum Well chosen technical analysis tools signal awakening momentum and track subtle changes in strength and duration. The power to identify these transforming conditions just prior to significant price movement is the key to profitable entry. All momentum study falls into one of two broad categories: •

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Trend-following indicators gaze into the rear view mirror and average price over defined time series. They are most valuable early in a trend for identifying momentum. Trend-leading oscillators measure developing range and movement from price bar to price bar. They provide valuable information late in a trend by identifying turning points.

Effective analysis must investigate the nature of momentum change. Physics teaches that an object in motion tends to remain in motion. Profitable entry-exit will capitalize on this universal tendency. With most indicators, this requires combining snapshots of different period lengths in order to measure momentum acceleration-deceleration. Three types of technical tools provide complete resources needed to accomplish these complex tasks: •

Line Tools visually illustrate rate of change and action-reaction points:

Trendlines Trendlines display “average momentum”. While a line drawn under any two lows has limited value, the addition of a third low creates order and a prediction point for future reversals. Combined with other chart features, trendlines uncover dynamic momentum information.

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Price Channels Channels predict order with only two distinct trend lows. But, these must be matched by two corresponding highs of the same slope. While logic suggests that these formations rarely occur, the opposite is true. They are easier to locate than clean trendlines.

Arcs Rounding formations are difficult to quantify. The evolving slope may not maintain a constant rate of change. This reduces its effectiveness for prediction. Use arcs as visual tools to estimate rounding reversal bottoms and tops.

Fibonacci Ratios One of the most powerful tools in technical analysis, Fibonacci remains poorly understood. This “proportional force of nature” measures retracement and testing of trend impulses. For moves to remain intact, the 62% level must provide support.

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Averaging Tools combine and smooth data sets into directional and acceleration forecasts:

Moving Average Crossovers Simple crossovers mark key shifts in momentum. They form the foundation of many complex trading strategies. But, watch out. This method has severe limitations in sideways markets. During negative feedback, moving averages will emit continuous false signals.

Averaging Rainbows Use of five or more color-coded moving averages displays continuous data on evolving momentum change. In addition to targeting price strength within the rainbow bands, the lines themselves draw complex patterns with superb predictive capacity.

Moving Average ConvergenceDivergence (MACD) Gerald Appel’s classic moving average interaction tool found new power when expressed as a histogram. Momentum changes accurately track the oscillating slopes. Create profitable entry-exit rules with this rewarding tool.

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Strength Tools measure rates of price and range ascent-descent over different time frames:

Rate of Change Directional price movement often hides within the twists and turns of price bars. Rate of change indicators filter visual data into actual price progression. ROC lines develop their own support / resistance, trendlines and patterns. Key pattern breaks in advance of price can trigger important convergence-divergence signals.

Relative Strength Index Don’t trade without this important tool. RSI measures the “quality” of price movement by comparing UP days with DOWN ones. Like ROC, RSI creates patterns that respond more quickly than price change. Use overbought and oversold levels to close positions and prepare reversal strategies.

Stochastics Stochastics accurately measure short-term shifts in price momentum. But, once this indicator pierces the extremes of its wide bands, useful information ceases. As trend takes over, it wobbles randomly until conditions change. As lines move back into the center zone, measure strength through double top/bottom formations.

Bar Range Analysis Short-term traders should closely examine small price bar formations. Narrow and wide range bars signal measurable change within the crowd and impending price movement. One classic pattern is NR7, the narrowest range bar of the last 7. These predict breakouts that can be safely traded in the direction of the first impulse.

Trendlines Trendlines join three or more reaction lows or highs into a straight line. This core element of technical analysis has many applications beyond its well18

known uses. Standing alone though, trendlines contain limited information regarding momentum shifts. The indicator plots average momentum for the trend being studied and nothing else. The rate of price change up or down the line always remains constant. Trendlines will provide significant momentum change feedback when compared with other chart data. As constant ROC indicators, these straight lines will measure convergence-divergence against any other price inputs. Trend Relativity The relationship between trendlines and other chart properties shifts relative to the time frame of each element. The trader must properly tune time to explore different aspects of momentum. Make certain the time inputs match the holding period for the intended execution. When day trading, for example, the plot of a 6-month trendline has no meaning unless price touches it that day. But, the return of a 5-minute candlestick to a 3-hour trendline will pinpoint an excellent entry zone. Three common chart features will measure momentum change when combined with trendlines: • • •

Other trendline(s) Moving averages

Price bars or candlesticks

When one or more of these elements accelerates away from the studied line, momentum is increasing as it diverges. Conversely, as these indicators roll over to point back “home”, signals flash converging deceleration. Combining all of these features into a single momentum system will produce powerful trading signals. Moving Averages Moving averages contain more immediate feedback on momentum change than trendlines but are burdened by one severe limitation. Their computation forces useful data to lag current events. By the time a simple 20-bar average curves upward to reflect ac-

celerating price, the move has already matured and may even be over. While exponential calculations (EMAs) and other smoothing adjustments speed up signals, action bells ring way too late for most momentum entries. Using multiple moving averages overcomes this time drawback and provides timely feedback on momentum change. The simplest tool for this study is the Moving Average Crossover. Two averages are chosen based on different time frames and their convergence is tracked. Signals are generated when the short average crosses above or below the longer one. The challenge with crossovers is finding the time sequence that elicits the most profitable information about the studied market. Also, filters must be built to ignore crossovers in choppy conditions when moving averages give false signals. An effective technique for studying momentum change is the MACD Histogram, popularized by Dr. Alexander Elder in his book Trading for a Living. Using 12- and 26-period moving averages smoothed by 9 periods, MACD creates a visual momentum ladder. As MACD rises, momentum increases. A zero line pinpoints the center balance zone. Positive acceleration flags as columns thrust above this point. Likewise, down steps below the line signal negative acceleration. Moving Average Rainbows provide multi-time frame, multi-dimensional views of shifting momentum. Rainbows combine 5 to 8 averages, colorcoded by the user’s software program. Identifiable patterns develop between the averages, allowing for sophisticated analysis of impending acceleration and deceleration. Like spreading fingers, rainbow averages respond incrementally to advancing trends and provide targeted entry-exit points. Strength Indicators Analysis of a closing bar’s contribution to recent price action creates a variety of strength indicators. These important tools range from simple comparisons with prior values to complex pattern analysis based on expansion and contraction of high-low bar lengths. Their common theme identifies the momentum pulse in the relative strength of closing price. 19

While endless techniques accomplish this same task, several contain all the horsepower needed to beat the momentum monster. Price Rate of Change offers an elementary computation for tracking momentum. Price bar patterns often hide developing directional movement. ROC compares current price with the value x periods ago and plots it below the bar chart on a line graph. As momentum escalates, ROC often curves upward ahead of a breakout. And, this versatile indicator works just as well signaling impending breakdowns and plunges. Stochastics and RSI are well known for targeting overbought-oversold zones in constricted ranges. These popular oscillators also have tremendous value in charting momentum. Plotting their values on a chart reveals pattern characteristics similar to price bar ascent and descent. These tools differ from price due to the extreme zones they cannot pass. In theory, price can go upward to infinity. Oscillators can go no further than 0% or 100% before turning back. But, as their directional movement follows price swings, patterns of acceleration-deceleration quickly reveal themselves. Futures markets have used range bar analysis for years. A classic on the subject, Toby Crabel’s Day Trading with Short Term Price Patterns and Opening Range Breakouts, investigates how expanding candle and bar patterns characterize momentum in many commodities and indices. The emotional crowd provides fuel as bar range stretches in the direction of the prevailing trend. Finally, a climax bar prints a sharp reversal under surging volume. Computation indicators (such as stochastics) measure bar range indirectly. By going straight to the bars themselves, visual analysis yields profitable short-term prediction. However, not all markets can be accurately examined through range changes. Low volume stocks, for example, carry high spreads that will distort signals. Limit bar analysis to highly liquid markets with low spreads and high average daily movement.

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The Momentum Pulse Momentum generates force as increasing volatility resolves itself into directional movement. This dynamic trending state invokes a measurable shift from negative to positive feedback. While subsequent thrusts may appear chaotic, price movement contains many cyclical features. Pulses will often be proportional in time duration and length. This tendency allows traders to calculate reward:risk through measured move analysis. As an added benefit, these expected reversal points can also be watched for profitable swing entries. Markets inhale and exhale. Each burst of market excitement alternates with extended periods of relative inactivity. Prices trend only 10% to 20% of the time. The balance is spent absorbing instability created from a momentum thrust. The interface between the end of an inactive period and the start of the next surge often hosts a “quiet” neutral point. Paradoxically, this Empty Zone will ignite well-tuned entry signals. Prior to beginning each new breath, the body experiences a moment of silence as the last exhalation completes. The markets regenerate momentum in a similar manner. The Empty Zone emerges as the return to stability concludes. Because instability alone will change that condition, volatility then sparks a new action cycle. Cross-Verification Momentum change indicators work best when combined with other technical tools. This process of cross-verification searches for repeated confirmation of any signal through other methods of technical analysis. But, watch out. Many indicators are built on top of better-known calculations. Accidentally using one of these derivative measurements carries substantial risk. It will automatically confirm your findings just by recalculating a tool already used and give false confidence to the trade. Verify technical conditions using dissimilar forms of analysis. For example, after seeing momentum surge on stochastics, try duplicating that observation using a line tool. Or, when multiple moving averages suggest an impending thrust, analyze the recent

short-term price bars to locate narrow-range days. Fibonacci ratios offer the most powerful form of cross-verification in all of technical analysis. Price impulses faithfully retrace similar percentages of a completed move before finally reversing or continuing the prevailing trend. Examining the price action near these support / resistance zones will identify significant bounce reversal opportunities when other indicators offer support.

Finally, consider the real nature of your trading account size and leverage. The well-greased competition can overcome transaction costs by moving large blocks. Balance the leverage of your account against the costs of taking positions. And, use drawdowns as a signal to lighten up and slow down. *Reprinted (and modified) with permission from Alan Farley.

Using Fibonacci requires only a calculator or Fib Line Grid (available with most charting analysis software). Hidden support / resistance exist at 38, 50 and 62% of the prior trend. Price will often bounce like a pool ball back and forth across this marvel of mathematics. Exit Traders fail when they don’t manage their losses. The lure of the big gain disables unbiased evaluation. Danger increases significantly when trading in a high momentum environment. The wide swings ensure price will move through a 10 to 40% range in a very short time frame. While position traders can consider well-placed stops, many short-term and day trading vehicles don’t allow limit management. Positions should never be entered without anticipating an appropriate escape route. Winning is a tough game. Each trader must compete against all other participants and take their money. And, exchange rules always favor market insiders highly skilled in shaking small players out of their positions. To find an edge, remote traders must replace mechanical self-control (stops) with strong mental discipline. Use technical analysis and drill key price swing numbers of favored markets into memory. Target an acceptable tick loss average. If the average tick gain isn’t larger, the winning percentage will need to be well above 70% to turn acceptable profits. Improve results by getting your loss average down before considering how to let your profits run further. And, keep current, accurate records. Relying on memory to determine results allows the mind to play cruel tricks. 21

Technical Analysis Techniques Because you conduct your trading as a business, you are aware of the importance analysis plays in it just as it does in any successful venture. Let these two excerpts from the Foundations course manual used by the trader-instructors of eSignal Learning give you a glimpse into the world of analysis as it relates to the components of the market’s movements and how it informs your trade decisions. “Analyzing and Anticipating Price Movements: Two Approaches – Not Necessarily Opposing” excerpted from the eSignal Learning Foundation Course, unit 3, compares the two basic types of analysis – fundamental and technical – not so much from an “either-or” perspective, but an “and” point of view that allows for combining the best of both. “The Technical Analysis Toolbox” excerpted from the eSignal Learning Foundation Course, unit 4, provides an overview of some of the “moving parts” involved in the market data fed to the charts you use to analyze the markets. It gives you something of a “Cliff Notes” for both the picture part of the charts (patterns) and the formulas (math-based indicators) that can help you see how a market you’re following may be trending.

Analyzing and Anticipating Price Movements: Two Approaches – Not Necessarily Opposing As excerpted from the eSignal Learning Foundation Course

Fundamental analysis and technical analysis are two approaches that investors use to anticipate price movements in the overall market and in individual securities. Fundamental analysts, or fundamentalists, believe that factors or conditions within the overall economy and within individual companies are what drive prices. Fundamentalists concentrate on macroeconomic factors and conditions, called fundamentals, that cause market moves and changes in stock prices, and they seek to identify key indicators of the stock’s “real” value. 22

Fundamentalists, in general, take a long-term view, whereas technicians tend to look at short-term price movements. However, the two approaches are not necessarily incompatible. Many investors meet with success by using both. The central principle of technical analysis is that prices are determined by factors or conditions within the market itself. Technical analysts, also called technicians, seek to identify patterns in prices that they can use to predict future movement. Fundamentals Fundamental measures of valuing stocks include earnings per share (EPS), price-earnings (P-E) ratio, book value (shareholder’s equity per share), priceto-book ratio, return on equity (ROE), price-sales ratio, and revenue growth rate. Most fundamentalists base their stock valuations and predictions of price trends on earnings. A company’s earnings per share (EPS) are its net income or profit divided by the number of shares of stock outstanding. Earnings are generally stated as trailing earnings over the past 12 months. The price-earnings ratio, or P-E ratio, is a stock’s current market price divided by its annual earnings. The P-E ratio is not an absolute indicator of the value of a stock; rather, it expresses the relationship of a stock’s price to its earnings. Book value, also called shareholder’s equity per share, is the company’s net assets divided by the number of shares of stock outstanding. In bull markets, fundamentalists often look for companies selling below book value. A company’s quick assets represent what the company would be worth if it were liquidated immediately. The relationship between a stock’s market share price and the company’s quick asset value per share is called the price-to-book ratio. A price-to-book ratio less than 1 means that stock is selling at a discount to the company’s ready cash. Return on equity (ROE) is calculated by dividing a company’s trailing earnings to its shareholders’ equity (total assets minus total liabilities).

The price-sales ratio (PSR) is the current market value of the company (current share price times shares outstanding) divided by the revenues (sales) over the previous 12 months. PSR is often used to value new companies in hot industries or to compare companies to other companies in the same sector. Companies whose sales are growing faster than the economy as a whole tend to be very attractive, so some fundamentalists look for revenue growth rate that is higher than the expected increase in the gross domestic product (GDP). Fundamental measures are not helpful in valuing a new company without an established track record, and new companies are often the ones that offer significant investment opportunities. Technical Analysis Technical analysis began more than 100 years ago with the use of charts; for that reason, technicians are often called chartists. Technical analysis thus involves identifying and interpreting stock price movements over short periods and taking advantage of the findings to lock in gains.

trendlines indicate resistance levels, the price at which holders sell in rising markets, and support levels, the price at which buyers buy in markets that are trending down. A breakout occurs when the price “penetrates” a resistance or support level. A basic principle of technical analysis is that once a trend is established it is more likely to continue than

According to the principles of technical analysis, stock prices move in a cycle that involves five phases: accumulation, recovery, speculation, distribution, and readjustment. Technicians believe that chart formations indicate when the market is about to turn up, turn down, or trade in a narrow range. There are two basic types of stock charts. (1) Bar charts (also called vertical line charts) involve plotting price ranges for the period under consideration, with each new period (usually a day) plotted to the right of the previous one. Price is plotted on the vertical (y) axis, and time on the horizontal (x) axis. (2) Reversal charts (also called point-and-figure charts) show price changes only, without concern for time. Trendlines (also called trading channels) show the current price range of a stock. Upper and lower

to reverse. The moving average is considered an early warning signal of a trend. Many technicians believe that in a bull market, increased volume indicates a rally, whereas declines in volume signal a pullback. The opposite is true in a bear market: volume increases on reactions and declines on rallies. The end of a trend (a price reversal) is also marked by heavy volume.

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Technical analysis can also involve examining indicators that indicate the overall strength of the market. These indicators include the advancedecline ratio, the number of new highs and lows for the year set in a day, various short sale ratios, and the ratio of low- to high-priced stocks. So, Which One Is Better? In one sense, you might think of the distinction between the fundamental approach and the technical approach as equivalent to the distinction between investing and trading. Fundamentalists, in general, take a long-term view; technicians tend to keep their eye on the short term. However, the two approaches don’t have to be incompatible, any more than investing and trading are. Most technicians are aware of – and may take into consideration – fundamental conditions. And most fundamentalists also pay attention to at least some of the technical indicators. In fact, many investors have met with success by using both. For example, they use fundamental analysis to identify promising stocks, and they then turn to technical analysis to time their purchases and sales. Other fundamentalists hold that stock prices are based on investors’ emotions. Proponents of the market psychology theory of stock price movements point out that it accounts for why stock prices sometimes rise when economic conditions are weak and why they sometimes fall even when economic conditions are strong. These fundamentalists also point out that when investors become optimistic about a company’s prospects, they buy its stock, sometimes even when prices climb beyond what the fundamentals support. Conversely, investors sell when they become pessimistic, even when the fundamentals are still good. And technicians try to recognize market participants’ attitudes by identifying patterns on charts. In the long run, what strategies you choose in a given situation, and how you carry them out, will depend on where you think market prices and / or the price of an individual stock are heading. 24

The Technical Analysis Toolbox As excerpted from the eSignal Learning Foundation Course

Technical analysis is based on a number of underlying concepts: Securities prices move in trends much, though not all, of the time. Trends can be identified with patterns that tend to repeat themselves. Primary trends, which generally last months to years, are interrupted by secondary minor movements, called pullbacks or corrections, in the opposite direction that last generally weeks to months. Once a trend is established, it is more likely to continue than to reverse; generally it remains in place until a major event stops it. The price bar, or bar, is the basic building block of technical analysis. It is a visual depiction of the trading action in a security for a given period of time, often a single trading day. Each price bar is a visual depiction of four values: the open, high, low, and close. The height of the bar indicates the range of price activity – the taller the bar, the greater the range.

A line chart shows only the closing prices plotted for each day.

Volume indicates the total amount of trading activity. Volume is also recorded on a chart, represented by a vertical bar at the bottom under that day’s price bar. Volume is considered important in interpreting the significance of a price move. The core of technical analysis is that the price bar represents all the dynamics of supply and demand for a given security for the day (or other given time period) and that a series of bars on a chart shows how the dynamics evolve over time.

Candlestick charting was developed in Japan over 150 years ago and has become popular among technicians over the last 15 years, especially in short-term trading. Candlesticks record the same information that price bars record but allow for easier interpretation and analysis. The open and close mark off the top and bottom of a box, called “the real body”. If the close is higher than the open, the real body is white; if the close is lower than the open, the real body is black.

The trend is the direction of the market. All the tools you will use in technical analysis are dedicated to identifying and measuring the trend so that you can participate in it. Some configurations of a series of price bars (e.g., three to five bars) are moves that may foretell a new trend, continuation of an existing trend or the 25

reversal of an existing trend. A series of closes on the high is a bullish sign that a new trend may be starting or that an existing trend is probably going to continue. A series of closes on the low suggests that a down trend is forming or accelerating.

The resistance level is the price at which traders can’t resist selling and taking profits, or higher than which they will resist buying. It is also called a rally high.

An inside bar is a price bar in which (1) the high is lower than the previous day’s high and (2) the low is higher than the previous day’s low. An inside bar is generally believed to reflect indecision among traders. An outside bar is a bar in which the range between high and low is outside the range of the preceding bar. If the open is at the low and the close is at the high, it’s a bullish sign. If the open is at the high and the close is at the low, it’s a bearish sign. A close that is at or near the open is generally believed to indicate indecision in the market. But when it occurs at one extreme of the range, it can signal that a trend is about to continue or reverse. Markets sometimes move sideways in a flat, horizontal pattern that is called the trading range. Periods of trendless, or sideways, movement are referred to as consolidation. The support level is the price at which traders consistently step in to hold up the price and prevent it from dropping any further. It is also know as a reaction low.

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Whenever a support or resistance level is broken by a significant amount, it reverses role: That is, a resistance level becomes a support level, and a support level becomes a resistance level. A trendline is a straight line that starts at the beginning of the trend and stops at the end. Trendlines are used to confirm or refute that a security is trending. To draw an up trendline, you need to be able to identify at least three lows. The more lows that touch the trendline, the more valid it is.

To determine whether a pattern is, for example, a true double bottom, look for the following: The price must rise above the confi rmation line, a horizontal line drawn from the highest high in the middle of the W. (The point where the price rises above that line is the confi rmation point.) The two lows are spaced at least 10 days apart, sometimes several months. The price variation between the two lows is small, only a few percentage points. A channel is marked by a pair of trendlines, one drawn along the highs, the other along the lows. Chart patterns are among the most powerful indicators in the technician’s toolbox. They can be broadly categorized as continuation patterns and reversal patterns. Examples of continuation patterns (patterns that indicate that a trend is continuing) are ascending triangles (bullish) and descending triangles (bearish), flags, and pennants. Flags and pennants generally signal a pullback – a minor move in the direction opposite the primary trend – before the main trend resumes. Reversal patterns signal that a trend is about to reverse itself. Three of the most notable reversal patterns are the double bottom (bullish), double top (bearish), and head-and-shoulders formation (bearish).

The center peak of the W is at least 10% higher than the lower of the two bottoms. A large increase in volume takes place after the price exceeds the confirmation point. Pullbacks occur after the price exceeds the confirmation point. The ideal double bottom is easy to spot, but in real life, it can be tough. As noted earlier, sometimes the bottoms are separated by several months. Moreover, one or both bottoms can have a rounded, rather than pointed appearance, and there may be several pullbacks that obscure the pattern. Analyzing trendlines and charts is often difficult, and interpretations tend to be subjective; for example, what one technician calls a triangle, another may see as a wedge. Moving averages, however, are objective and precise. In fact, one use of moving averages is to confirm your interpretation of chart patterns that you believe you are seeing. The moving average (MA) is an average of a certain number of prices, generally closing prices. A moving average is used to identify the beginning of a new trend or the end or reversal of an existing trend. Because it follows market activity, rather than anticipating it, the moving is known as a lagging indicator. The moving average “crossover rule” is to buy at the point where the price crosses above the moving average line, and to sell where it falls below the moving average line. At first, this simple rule seems clear and powerful because the result is that you 27

signal line, it’s a buy signal. When the MACD line crosses below the signal line, it’s a sell signal. Many people find it difficult to read the MACD indicator, except when the signal line is actually crossing the MACD line. The MACD histogram provides the same information in a way that is more easily interpreted by the eye. Histogram changes are generally used to spot early signals to get out of a position. Analyzing moving averages is most useful when the market is uptrending or downtrending. They are not very helpful during trendless phases. buy at a low and sell at a high. To overcome the potential of whipsaw losses, technicians have devised a number of additional tests, or filters. The moving average convergence-divergence (MACD) indicator uses two exponentially adjusted moving averages. The MACD line is calculated by subtracting the long-term MA from the shortterm MA. When the MACD line is rising, the two averages are converging; when it is falling, the averages are diverging. If the difference between the two is 0, a crossover is taking place. The second line is the trigger, or signal line. It is a moving average of the MACD line – so it’s an indicator of an indicator.

When the two lines cross, you have a buy or sell signal. When the MACD line crosses above the 28

Technicians believe that you can determine when the market becomes overbought or oversold by following momentum – the rate at which prices change. Momentum indicators reveal nothing about the direction of a trend; they are concerned only with speed, or rate of change. Because momentum is a leading indicator, it can add important information to the data generated by lagging indicators, such as moving averages. Most technical traders measure momentum by basing it on the number 100. Multiplying by 100 to benchmark an indicator is called oscillation. Oscillators show values relative to a starting point. The Relative Strength Index (RSI) is one type of oscillator; it has a range of 0 to 100. When the RSI hits 70%, the security is considered overbought; at 30%, the security is considered oversold. RSI is more often used to

confirm buy or sell signals generated by other indicators.

numbers in retracement analysis are 62, 38 and 50%.

The stochastic oscillator differs from other oscillators in that it examines not just the closing price, but also the entire trading range. It looks for the high-low range over a particular number of trading days or periods, and the relationship of the close to the low over the same time frame. The stochastic oscillator generally is most effective in a sideways market.

Technical analysis is a visual pursuit – for the technician, a world of information lies in what the untutored eye may see as an incomprehensible mass of dots, squiggles, and lines on a chart. To reveal and interpret the information that these “pictures” contain, you need to begin at the beginning: with the individual components. We hope that this article has given you a good start in understanding these building blocks that make up technical analysis.

The Fibonacci sequence of numbers, first identified by 13th-century mathematician, Leonardo Fibonacci, forms the basis of one indicator that technicians use to determine the extent of market pullbacks, or retracements. During retracements, Fibonacci numbers can be used to anticipate support levels in an up trend) or resistance levels (in a down trend). The most commonly used Fibonacci

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The Psychology of Trading Trading and Psychology

By Bennett McDowell, Founder and President, TradersCoach.com*

I am often asked, “How important is psychology in trading the financial markets?” The answer, VERY IMPORTANT! Most traders, when analyzing charts and “back testing” trading systems, fail to realize how different the results would be if they were actually trading with real money as the market is unfolding instead of looking at the market after the fact. This is why I am not a “back testing” fan — because the results are usually nowhere near the reality of how YOU would actually trade. Most new traders fall victim to their own fear and greed when trading, which causes them to exit profitable trades prematurely or enter trades caught up in the excitement of the moment. We have all felt the anxiety that can creep into our souls as a trade becomes profitable in a short period of time. That anxiety wants us to exit the trade now and take the quick profit. Taking the quick profit will relieve the anxiety and make us feel good. Maybe the cause of the anxiety is the greed to take the quick profit or the fear that the market will turn against us and cause a loss. Whatever the reason, exiting the trade because of anxiety makes it an emotional trade, and good traders do NOT trade on emotions. Or, perhaps you have trouble “pulling the trigger” and entering trades when your trading system indicates you should. Most often, fear is at work here. The trader fears another loss! Not trusting your trading approach and yourself can make you a victim of fear. Or, perhaps you live in the past and not the present, and you are, again, afraid of reliving past losses or even failures. Or, perhaps you don’t like using “stops” or correct “trade size” or don’t adhere to “stops” you have 30

already set. Dig deep enough into your psyche, and you will uncover the reasons. This is why I say that I could give a good solid trading system to 100 traders, and almost all of them would trade it slightly differently based on how their emotions caused them to trade. In the end, only those traders who can best manage their emotions will have a chance to win consistently. So, while a trading system or approach is important, so is money management and learning how to manage your psychology. It will take time, experience and dedication to overcome your human shortcomings, something we all have to deal with. This is why 90 percent of the traders lose in the financial markets. We are all subject to fear and greed, but only a small percentage of traders can manage their emotions well enough to let themselves win. Bennett McDowell provides private consultation / coaching services to traders throughout the world and has been published in numerous newsletters and magazines, including Tradersworld.com magazine and The Long And Short Of It™, a TradersCoach.com member newsletter. Website: www.traderscoach.com. *Reprinted (and modified) with permission from Bennett McDowell

Only the Zeros Are Different: How Great Traders Go Bad

By John A. Sarkett, Developer, Option Wizard*

Like a pilot, a police officer or a trapeze artist, a professional trader knows he or she must follow the rules just to stay alive. Usually, this bracing thought is enough to focus the mind. Usually, this awareness suffices. But, occasionally, the realization is lost. Mistakes follow. Losses mount. An otherwise great trader succumbs. A great trader goes bad. How to avoid that tragic circumstance was

the subject of a Futures Industry Association presentation in Chicago by Ray Kelly, professional trader and trading coach. “Large traders trade more zeros than small traders, but the process is the same,” Kelly says. “Both on the upside and the downside.” The catalyst for destruction, Kelly says, is most often ego. Ego is the Ebola virus to the active trader. There is an antidote, however — balance, humility and the ability to accept being wrong. Can you or I become infected? Of course we can! What can be done to protect against ego and its devastating effects? Kelly says pay close, introspective attention to the following four areas: Self-knowledge, market knowledge, trading strategy and risk management. Answer the hard questions for yourself, before the market does. Like meditation, or exercise, attention must be paid each day for maximum effectiveness. Self-Knowledge First, when you come into your trading room, leave your ego entirely outside the door. Kelly defines ego as the sense of who we believe we are: A trader, a religious person, a father, a spouse, etc. When the over-inflated ego gains the throne, rules go out the door. Egotism consumes natural and healthy caution, replacing it with an illusion of invincibility. An overdeveloped ego fells even the most successful, sometimes especially the most successful trader. Expecting occasional failure, the trapeze artist practices with a net. He or she knows that the body is not more durable than the concrete below. The trapeze artist knows that he or she can only exist in the high-flying environment by following the rules. Trouble is, ego is not software that can be easily re-installed in the trader psyche. It is hardware. You and I are hard-wired with ego. Ego is self-identity.

Ego never wants to be ignored, left out, left behind. But, sometimes it gets out of control and becomes self-absorbed and unrealistic. Sometimes, you have to decide not to run with the crowd. But, to do so, you have to go against your wiring. There is something in the human that wants to believe in the hero, the guru, the champion, and, for many, that belief is coupled with a desire to become that person. If you can’t become the hero, it is almost as good to run with him or her — a dream come true! Usually, you can’t. You may only watch the hero from the stands or the balcony. But, in the financial markets, you have the opportunity to participate directly or partner with the prospective hero. His or her glory becomes your glory. This prospect is so appealing, so motivating, it will cause some of us to leave sense, common or otherwise, far, far behind. Watch out! In the 1980s, I participated in a risk arbitrage managed account program at a major brokerage firm, supposedly run by supertraders. Ascending to the hero’s podium, my account executive disclosed that returns were expected to be 60 to 100 percent, but, if only mediocre returns were generated, the return might be as low as 30 percent or so. Hundreds of trades (and commissions) later, I went through the laborious task of reconstructing the trading history and actual return of my account. It was 12 percent, exactly the money market rate of the day. Contrast the swashbuckling image of the wannabe trading hero with the wry and self-deprecating words of $1.5 billion Chesapeake Capital CEO and former Turtle Trader Jerry Parker (another FIA speaker), who says, “We know we don’t know what we’re doing.” Far from true, (he meant that we can’t predict rate cuts, market movements, the future), but this kind of modesty contrasts sharply with what is said by those promising spectacular returns and is undoubtedly a better and safer way to sail the market oceans. His trading methodology is to take trend-following 31

positions across many markets, expecting a few large gains to outweigh numerous losses. Defining Success While the psyche is often looking for others to admire and emulate, it is not taking the time and effort to define success for itself. This is usually too much hard work. Easier and more fun to soak up the vibes from the hero or try to be one yourself. What is success? For speaker, Ray Kelly, it has been earning 200K to 300K each year, 40 percent returns, no drawdowns and the opportunity to spend time with his wife and children, he says. To define your own success, you must answer these questions. • • • •

•

Who am I?

Why do I trade?

How do I prepare?

 hat are my beliefs about myself? W About trading?

Am I ready to handle the pressures of trading?

Sound too easy? Have you ever actually done it? Kelly says, “Great truths unfold at the level of the student. As a student learns more, these questions become deeper and more profound.” Ray Kelly’s own introspection involved working through a family background that included an alcoholic father and a very religious Catholic background. The religious background left him believing that it was evil to be rich. The instability in his home made him feel that, somehow, all the tension and insecurity was because of him. Therefore, he was not worthy of success. These powerful subconscious beliefs limited his success, that is, until he worked through them. When he resolved his own conflicts, he was able to progress to a higher level of trading success. Do these subconscious messages really sabotage your trading? Kelly relates the story of a trading associate. His son died in a tragic accident. Blaming himself, he started losing significant sums the very next week. 32

Kelly further cites a university study that indicates a high degree of unresolved guilt among prisoners. The study concludes that prisoners committed crimes so that external activity would match internal guilt, not the other way around. Other enemies of trading success: Divorce, employment change, trauma, illness or anything that creates emotional distractions or pain. “If you owned a Testarossa, you wouldn’t think anything of having it checked and tuned on a regular basis,” Kelly says. “Many trader egos are too big for a regular tuneup, however.” What to do? Often you do not realize that you are laboring under the weight of conflict. It shows up as poor performance or an inability to follow your rules. Losses are the inevitable by-product. What to do? It depends on the person and the severity of the problem. The best course to take is to do introspective exercises constantly. Know the resources you need before you need them. If you are already in the fire? Walk away. Take time off. Get counseling. Don’t trade in the financial markets until your conflicts are resolved. Do not make the expensive mistake of thinking that, whatever “it” is, it will go away if you ignore it. Other questions to ask yourself about your state of mind, according to Kelly, are: •

• • • •

Do others comment on my personality traits negatively? Do I suffer extremes in emotion?

Is my body sending me a message?

Am I uncomfortable with this subject?

Do I take responsibility for my actions?

“Society teaches us to places blame, to externalize our failures,” Kelly says. “Bad system. Bad broker. Bad quotes. Introspection is just too painful for most.” But to be a successful trader, you must go against the grain and do the heavy lifting of introspection.

Approach the Markets with Equanimity Kelly says to incorporate a “bottlecap” mentality into your trading. “Like Laverne & Shirley on the TV sitcom at the Schott’s Brewery, you put one bottlecap on after another, and then you go home and plan your excitement after work,” he says. “Don’t seek excitement from the markets, or, unhappily, you may find it.”

trading. Part of market knowledge is defining how much you expect to make in the markets. If you’re a typical newcomer, you may be looking to double your money. There is, for example, a popular phrase in options trading: “percent to double” (i.e., the percent your underlying must move to generate a doubling of your options price). For a pro like Jerry Parker, CEO of Chesapeake Capital, the answer is much more modest. His goal: 2 percent per month.

Similarly, R. Jerry Parker says trading is a brickupon-brick enterprise, but that Commodity Trading Advisor (CTA) clients prefer a “rock star” approach. Trading Strategy “They want magic,” he says. Third, develop your trading system. For Chesapeake Trading in some 70 of the most liquid 150 Capital, the system is rule-based, trend-following, futures markets, patiently seeking break-outs, the diversified, no bias short or long. Chesapeake system is a technical, trend-following system. The system will generate 200 trades per “This flies in the face of what clients want: year, of which some six will pay for losses and Graduates of fancy schools, huge research, an generate returns, he says. Obviously, if you invest intuitive approach that knows what’s going to too much negative emotion in the 194 losers, you happen before it happens (e.g., be overweight in the likely won’t be around for the six big winners. stock market before an interest rate cut),” Parker says. “But, obviously you can’t know what’s going to happen before it happens, and maybe the rate cut Market Knowledge is the start of a major trend, and maybe it’s o.k. to Market knowledge is the second major pillar you get in after. That’s our approach.” must depend on to avoid a market catastrophe. You must ask yourself, continuously: • • • •

What affects markets?

How? How might things be changing? When do you know you are wrong?

What are you trying to extract from the markets?

Kelly cites as a successful example trader David Druz, who runs the Tactical Asset Management Fund. Druz defines exactly what his system does: “My trading system captures the capital that hedgers use to defend positions.” He has back tested and quantified it, and so he knows and expects that his system will generate 30 percent drawdowns. But, over time, he has achieved excellent results because he is focused, he understands his markets, he has good money management rules and he looks to a realistic time horizon within which he plans his

Kelly also advises traders to develop a trading system that they can actually follow. A system that is geared to their own personality and financial means. Kelly says, “If you have abstract ideas of what you want and how you are going to accomplish it, that is what you will get, an abstract result.” Test your system, he says. • • • • •

What are the characteristics of the system? Is it consistent?

Do you understand why it works? Does it work in all markets? Does it fit your personality?

Then, attend to business: Do your homework every night. Your competitors do. Determine your answers the night before the market.

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Risk Management Fourth, and most importantly, you must manage risk. No matter how great your knowledge of yourself and the markets is or how sound your system is, if you don’t manage risk, you won’t last.

would put them out of business, and the goal is to stay in business.

Kelly says the successful, long-term trader must answer:

Kelly notes that, when losing, amateurs increase bet size, but professionals decrease size. Don’t try to catch up on one trade. If your system is sound, it will make money over time. You will recapture losses over time. And, that’s okay. Because you are looking for 2 percent a month, correct? Not a fast double play.

•

• •

•

•

How much risk per trade? (Various traders risk .05 to 5 percent of capital per trade. You must fit this figure to your system.) Do I understand my risk?

Is my system discretionary or systematic? (A systematic approach takes all signals generated by a trading system. A discretionary system does not mean haphazard trading but, rather, allows the trader to make exceptions to what he or she buys or sells within the framework of the signals generated.) Where are my stops, what is the meaning of my stops? Quantify risk. Two words that separate the world of success and the world of failure.

Losses are expected. You are not a bad trader if you experience them. Options broker Jerry Kopf, Benjamin & Jerold, Chicago, puts it this way, “It’s okay to be wrong. It’s not okay to stay wrong.” Kelly makes a distinction between what some people call “drawdowns” and what he calls “losses” A “drawdown” is a loss taken within a defined strategy. It is part of the strategy. If you do not have a strategy, it is a loss. People misname the loss in the hope of avoiding the pain and to deceive themselves. A drawdown is not a personal statement about you; it is an expected part of the business plan. Unwilling to take a small loss? For those involved in the spectacular blow-ups of recent times, small losses no longer were acceptable, so they were forced to accept disastrous losses. Keep losses predetermined and small. At best, professional traders are right 50 percent of the time or less, so they must take only small losses. A few large losses 34

“Money management is crucial,” Kelly says. “This is why the exchanges have revolving doors — for those who don’t master this critical skill.”

Two Last Questions: The Bottom Line Am I profitable?… …And… …Am I as profitable as I could be at my full potential? If not, you must discover the reasons and make changes. Ray Kelly repeated one message over and over at the presentation: “If you want to keep getting what you are getting, keep doing what you are doing.” Like the pilot, policeman or trapeze artist, you respect the rules of the game, you respect the boundaries, you respect how hard the concrete is, and how soft you are, and so you survive. The alternative is too costly in every way. Ray Kelly was a veteran trader, financial consultant and seminar speaker. R. Jerry Parker is CEO of Chesapeake Capital, Richmond, Virginia. David Druz is CEO of Tactical Investment Management Fund. Jerry Kopf is a partner in Benjamin & Jerold Discount Stock and Options Brokers John Sarkett writes on and trades in the financial markets. Developer of Option Wizard software (option-wizard.com), he can be reached at [email protected]. *Reprinted (and modified) with permission from John A. Sarkett