1. The best trades come together slowly. You notice them from far away and have to wait for more pieces of the puzzle to emerge before you can pull the trigger and place an order to buy or sell short. Meanwhile, you have to keep an eye on the developing trade. One way to keep track of it is to put it on the wall. Another way is call the Chihuahua trade, which is to place a small order there instead of an alert.
2. How to grade your entries and exits.
The Buy Grade = the high of the day minus buy price / the high of the day minus the low of the day
The Sell Grade = the sell price minus the low of the day / the high of the day minus the low of the day
The result is expressed as a percentage: if you buy at the low of the day, your grade is 100%, and if you buy the top tick, your grade is 0. Grades below 25% are poor, above 75% superb, and between 25% and 75% satisfactory. The goal is to score above 50% on my entries and exits.
3. The amount of money in your account at the end of a month or a quarter is extremely important for plotting the equity curve. That curve provides an accurate measure of your performance as trader.
The best way to rate your performance in any single trade is to measure the number of points gained or lost against the market’s recent volatility. A well-drawn channel on the daily chart serves as an excellent reflection of that market’s recent volatility. For swing trades, I use a channel around the longer moving average on the daily chart. For day-trades, I use a channel on a 5-minute chart, also centered around the longer moving average.
4. The Trade Grade = exit price minus entry price / the upper channel line minus the lower channel line
Upper Channel Line = EMA EMA * Channel Coefficient
Lower Channel Line = EMA -EMA *Channel Coefficient
Here I fall back on the old school system and call every trade that captures 30% or more of the channel an A trade. Sometimes there are even A trades. Any trade that captures 20% to 30% of a channel gets rated B; 10% to 20%, C; below 10%, a C; and below zero it becomes a D trade.
5. A man who owned a flower shop said that he had to “buy well to sell well.” Flowers have to be sold quickly, before they wilt. Buying at a low price gives the shop owner more pricing power. If business becomes slow, he can drop his selling price and still be profitable. Buying well—getting a low price—helps him sell well. Entry point is very important. The way we sell will depend on why and how we buy.
6. There are two types of buying. One is value buying: “buy low, sell high.”
The other is momentum buying: “buy high, sell even higher.”
7. A value buyer tries to identify value and buy near or below it. He wants to sell when prices become overvalued. To help define value I put two moving averages on a chart and call the space between them the value zone. To help define overvalued and undervalued zones I add channels to my daily and intraday charts. The space above the upper channel line identifies the area of mania, and the space below the lower line the zone of depression. The space above the value zone but below the upper channel line is the area of above value, and the space above the lower line but below the value zone is the area of below value.
8. Putting a plan on paper has a powerful psychological effect on most people. It reduces stress and increases profitability. We make our best decisions when we feel relaxed. Writing down a plan and executing it from a sheet of paper helps you reduce tension by separating the two jobs you have: analyzing and trading.
9. You also need to be clear about your timeframe for selling. One of the worst mistakes of chronic losers is to a convert a day-trade gone bad into a long-term position. On the other hand, watching a live screen is usually counter-productive for a position trade. A trader who watches a live screen almost always loses his position by getting out too early on some minor signal, and misses the big trend he was aiming to catch. Clarity is a virtue in trading.
10. In summary, we can divide selling choices into three main categories:
1. Sell at a profit target above the market.
2. Be prepared to sell below the market, using a protective stop.
3. Sell before the stock hits a target or a stop—because market conditions have changed and you no longer want to hold it. In other words, you may decide to sell if a stock does not move within a specified period of time or if it traces a suspicious price or indicator pattern.
11. Once you select a buy candidate, you need to ask several questions:
1. What do you think the profit target is—how high is this stock likely to rise?
2. How low does it need to fall to convince you that your decision to buy was incorrect and the time has come to cut losses?
3. What is this stock’s reward-to-risk ratio, meaning what is the relationship between its potential reward and risk?
12. A good way to set a target for a swing trade is to use either a moving average or a channel. A good way to estimate a profit target for a long-term trade is to look at long-term support and resistance.
People want to make money but do not know what they want from the markets. If I am making a trade, what am I expecting of it? Having a profit target works better for me, although sometimes it leads to selling too soon.
13. Beginners who look at charts are often mesmerized by powerful trends. Experienced traders know that big trends look clear only in retrospect. All trades are perfectly visible in the rearview mirror, but the future is vague, changeable, and unclear.
14. Now we are ready to begin setting profit targets. Let us discuss the tools available to us. My favorites are:
1. Moving averages
2. Envelopes or channels
3. Support and resistance zones
4. Other methods
15. Robert Rhea described the three stages of a bull market. During the first stage, prices recover from the oversold excesses of the preceding bear market—they rise from deeply undervalued levels back to value. During the second stage, rising prices reflect improving fundamentals. Finally, during the third and final stage, prices rally on enthusiasm, optimism, and greed—people buy “because prices have always gone up.”
16. The markets run on a two-party system. When the bear party loses power, we can anticipate that the next election will go to the bulls. The first target for a bullish move would be a rally back to value, up to the moving average. This approach to buying below value and setting the profit target in the value zone works especially well with the weekly charts.
17. One of the essential values of keeping a Trading Diary is that it encourages you to return to every closed-out trade a month or two later. It makes you re-evaluate your performance with the benefit of hindsight. If you keep learning from your experiences, you will become a better trader tomorrow than you are today!
18. The following week EXTR exploded to the upside, almost reaching its upper channel in a single day. It closed near the high, but the following day it had a narrow range and could not rise any higher. I saw this is a sign of resistance and sold
19. The stock breaks below the support line but closes above it. The false downside breakout is one of the most bullish signals in technical analysis.
20. Here you can see that the stock’s price has recently broken below long-term support at $4.05. The decline had stalled and the trend had changed from down to sideways. Both MACD-Histogram and Force Index are trending higher—a bullish sign. I decided that a rally was likely to occur and carry prices into the value zone on the weekly chart.
21. Notice a severe downspike of Force Index several days prior to the right edge. Such downspikes identify the areas of panic and a washout of weak longs, clearing the air for an advance.
22. On the technical side, I did not like the fact that it had a very narrow range on the day it hit its slower moving average on the daily chart. The value zone serves as natural resistance for both upmoves and downmoves. The narrow range showed a lack of progress in an area where resistance could be expected.
23. When in doubt, get out!
24. Moving averages on the weekly and daily charts present good profit targets for the rallies that jump off the bear market lows. Moving averages do not make good targets during steady uptrends.
25. A bearish divergence between prices and weekly MACD-Histogram; a breakout of prices to a new high with no follow-through; a bearish divergence of Force Index; and completely flat MACD-Lines.
26. A stock keeps moving up, fluctuating between value (its moving average) and the overvalued level at its upper channel line. When a stock is rallying in this fashion, the space between the two EMAs, the value zone, is a good place to buy. The upper channel line shows where that stock becomes overbought and marks a good zone for profit-taking.
27. I call stocks that have fallen more than 90% “fallen angels” and often look for buy candidates among them. The idea, of course, is to buy after a stock stops declining. It is OK to buy cheap but not OK to buy on the way down.
28. The latest bullish divergence was of a “missing right shoulder” type, meaning the indicator could not even decline below zero. It showed that bulls were growing strong, as bears were running out of breath.
29. First of all, it is important to have confidence in your profit targets and not sell too soon. Second, it does not pay to kick yourself over a missed opportunity. This will only lead to reckless trading down the road.
30. Those who reach out for more than the market is willing to give often end up with much less. The power word in life, as well as in trading, is “enough.” You have to decide what will make you happy and set your goals accordingly. The pursuit of your own goals will make you feel in control. To always crave more is to be a slave to greed and advertising. To decide what is enough is to be free. Paradoxically, being willing to accept less often gives you more. My point is that “enough” is better than “more.” It leaves you feeling calm and in control— and these feelings lead to greater profitability in the long run.
31. An even greater source of stress for greedy traders comes from powerful moves that overshoot their targets and keep on going. A trader looks at a market from which he exited with a nice profit and starts kicking himself as that market continues to move in the same direction - only now without him.
32. Once prices blow through your initial target, where will you take profits? I wait for the first day when the price fails to reach a new high for this move and sell either near the day’s close or soon after the opening the following day. It is important not to try to reach for extremes. The top tick of a rally is the most expensive tick in the market—fortunes have been lost hunting for it. The logic behind the “no-new-high” tactic for a fallback target is straightforward. When a super-powerful move cannot reach a new high, it gives you a sign that the bulls are starting to run out of breath.
33. Moving averages can provide targets for rallies from deeply oversold levels. Channels or envelopes can provide targets for short-term traders. These tools help catch short-term swings. Support and resistance zones provide better targets for long-term trades. We can identify support and resistance by looking for price levels where a great deal of trading has taken place, clearly more than the areas immediately above or below.
34. Each price tick reflects an agreement between a buyer and a seller. A trading range represents a general consensus of value between masses of buyers and sellers. A congestion zone on a chart tells you that many market participants consider that level a fair value and are prepared to buy or sell there. Professionals know full well that most breakouts are false and are followed by retracements. They tend to trade in the opposite direction, selling at the upper edges of congestion zones and buying at their lower edges.
Support and resistance are built on two powerful emotions—pain and regret. People who have bought in the range only to see prices drop feel a lot of pain. They are waiting for prices to return so they can “get out even.” Their selling, driven by pain, is likely to put a lid on any advance. People who sold short in the range are also waiting for a pullback. They regret that they did not short even more. Their regret will lead them to sell short when prices return to the level where they shorted, resisting the advance.
35. The downspikes of Force Index tend to identify important market bottoms.
36. Currencies are notoriously hard to trade since they move nearly 24 hours a day. If you are a swing trader, looking to catch price moves that last a few days to a few weeks, you are better off staying away from currencies. Leave them to day-traders and to long-term position traders. These people can benefit from the currencies’ well established tendency to run in long trends.
37. After the Euro hit resistance at point C it stalled and went flat for several months. At the same time, the behavior of MACD-Histogram in area C indicated that prices were likely to rise higher. The new MACD-H peak C, the highest in over a year, showed that bulls were at a record strength. This meant that the price level associated with this indicator peak was likely to be exceeded.
38. Looking at support and resistance helps you set reasonable targets for long-term moves. The great value of such long-term targets is that they help you fix your eyes on a remote but reachable goal. This helps you hang on to a long-term move and not get thrown off your horse by the short-term action of prices or indicators or both.
Another benefit of having a long-term target is that it reminds you to sell in a predetermined zone. If you buy low, it would be useful to have a reminder to help you sell high. Many traders become more bullish near the tops, along with the rest of the market crowd. A target tells you when your goal has been reached. It may not be a perfect goal, but it is your target. You have set it, and now it tells you to take profits, go home, take a nice vacation, and look for the next trade.
Psychologically, it is much harder to trade long-term trends than short-term swings. That’s why having a price target is so important - it increases your psychological holding power.
39. The stock established three lows during the past six months at $5.50, $5.40, and $5.37. This pattern told me several things. First of all, the support was solid. Even when the stock was pushed to a slightly lower low, it refused to accelerate to the downside, but instead recoiled and came back up. Furthermore, the fact that STTSY kept stabbing to lower lows looked tremendously bullish to me. Those quick stabs seemed to indicate that some powerful interests were trying to push the stock a little lower in order to frighten holders into selling so they could buy up their shares. “a paranoid view of the markets.”
40. This trade confirmed to me that I am temperamentally better suited for shorter-term trading. Since I am determined to learn to hold long-term, I must adapt by adding some elements of short-term trading to my long-term positions. I decided that in future long-term trades I will establish a core position that I will hold from start to finish—its smaller size will produce less stress. At the same time, I will put on larger short-term trades in the direction of my long-term trade.
41. Price targets help you hold on to the stocks that move in your favor. Stops help you sell when the stocks turn against you. Even a profitable trade deserves to have a protective stop. Some traders also like to ride runaway trends by using trailing stops that follow rapidly moving prices.
42. Every trade deserves a protective stop. Follow this simple rule: you may not put on a trade unless you know exactly where you will place your stop. You must make that decision before you enter a trade. In addition to the stop you need a profit target to evaluate that trade’s reward-to-risk ratio.
43. Let us summarize what we have discussed so far:
• You need stops; a trade without a stop is a gamble.
• You need to know where you’ll put your stop before you enter a trade (if the reward-to-risk ratio is poor, do not enter that trade).
• Everybody needs hard stops; only expert discretionary traders are allowed to use soft stops.
• Whenever you change a stop, you may move it only in the direction of the trade.
• It is perfectly fine to re-enter a market after it hits your stop.
44. The Iron Triangle of risk control
1. Set a stop on the basis of chart analysis and calculate the dollar risk per share by measuring the distance from the planned entry price to the stop level.
2. Use your money management rules to calculate the maximum amount you may risk on a trade in your account and decide how much you will risk.
3. Divide the number of dollars in line 2 by the number of dollars in line 1 to find out how many shares you may trade.
As a rule of thumb, I am attracted to trades with reward-to-risk ratio of 3:1 or better. I would be very reluctant to enter a trade whose reward-to-risk ratio is 2:1 or lower.
I almost always use limit orders for entering trades and taking profits at target levels. A limit order says, in effect, “my way or the highway.” I will only do business at a level that suits me, and will not accept slippage on an entry or on profit-taking. If I miss entering a trade as a result of a limit order, I do not complain—there will be many other trades in the future. If you try to enter a trade using a limit price and do not get filled, you lose nothing. The situation with protective stops is completely different. If you miss an exit from a trade, you can get caught in a waterfall decline. A trader can lose a lot while fiddling with limit orders, trying to save a few pennies. When the trouble hits, run without haggling. That is why I use limit orders for entries and profit-taking but switch to MIT (market if touched) orders when using stops.
45. Using soft stops requires two things—iron discipline and full-time attention to the screen. You have no business using soft stops if you are not in front of the screen, ready to execute a trade when the market hits your level.
46. One major misconception about stop is that one should place stops on long positions immediately below the latest low. There is one major problem with placing a stop immediately below the latest low—it very likely will lose money. The trouble with such stops is that markets very often trace out double bottoms, with the second bottom slightly lower than the first. The level immediately below the latest low is where amateurs cut and run and where professionals tend to buy.
47. Whenever prices approach a bottom area, I become very alert to the possibility that they could penetrate to a lower low. If prices fall to a new low, while the indicators fall to a more shallow low, creating a bullish divergence, I wait for prices to rally slightly. When they rise above the level of the first bottom, they flash a buy signal. I consider this one of the strongest and most reliable trading signals—a double bottom with a bullish divergence, with the second bottom slightly deeper than the first.
48. As a stock sinks towards the level of an important low, its trading volume tends to dry up. All eyes are on that stock, but there is not a lot of activity, as people wait to see whether the support will hold. A small sell order, thrown at the market while buy orders are thin, can push the stock down, below its previous low. That’s the area where many serious pros love to operate. As the falling stock sets off the stops of public customers, the pros snap up shares at a discount. If there are so many shares for sale that the stock accelerates down, they quickly cut their losses and let it slide, but this rarely happens. Normally, the number of shares sold by the people with stops is not that great. As their sales get absorbed and the decline stalls, the pros jump in, joining the feeding frenzy, buying below the lows. The stock rises back into the range, leaving behind a brief downspike—a trace of the pros’ fishing expedition. They have just scared a bunch of anonymous amateurs into selling them goods at a discount.
49. Looking at many charts, I saw that there had been very few instances when a stock declined exactly to its previous low and held there, without going a tick lower. Normally, it either held well above that low or went well below it. The level of the previous low was where the pros rejigged their positions. The action was tight, and there was very little slippage there. Once the stock fell a tick below its previous low, it was in public stops territory, and the slippage became hot and heavy.
50. Nic’s stop: Nic suggested looking for the low where most people would place their stops and then examine the bars that bracketed that low on each side. He would then place his stop a little below the lower of those two bars. This very tight method of placing stops is especially suited for short-term swing trading. Trying to catch a bottom tends to be a dangerous business. A very tight stop like this one does not allow any time for dreaming. It tells the market to put up or shut up.
51. The planned duration of your trade helps determine how far from the entry to place your stop. As a rule, a shorter time horizon calls for tighter stops, while a longer timeframe tends to require wider stops.
52. A beginning trader is better off staying away from day-trading. This extremely fast game tends to quickly destroy amateurs. Nor would I recommend long-term trend-trading for those who are just starting out. The best way to learn is by making many small trades, keeping a diary, and practicing your entries and exits. Long-term trades do not provide the necessary level of activity to gain that experience. Swing trading is a good place to start learning to trade.
53. If you decide to learn long-term trading, you will need wider stops. If you identify an uptrend and go long, your stop belongs at a level that is safe from the normal chop of prices. A major uptrend is naturally swingier than a little price move. If the noise level is greater, the stops have to be wider. The key point to keep in mind is that as the width of your stops increases, the size of your trade must decrease, making sure you stay within the iron triangle of good money management.
54. When you switch from a target to a trailing stop you must be willing to give up a part of your profit. On the plus side, a trailing stop can deliver extra profits if the trade moves beyond your target. On the minus side, you risk giving back some profit if the trade reaches the profit target and reverses instead of going any further.
A variety of techniques to use trailing stops:
• You can use a multibar low as a trailing stop; for example, you can keep moving your stop to the lowest low of the last three bars (but never against your trade).
• You can trail prices with a very short moving average and use its level for a trailing stop.
• You can use a Chandelier stop—every time the market makes a new high, move the stop within a certain distance from the top— either a specific price range or a number based on an ATR (average true range). Any time your stock makes a new high, you place your stop within that distance from the top, like hanging a chandelier.
• You can use a Parabolic stop.
• You can use a SafeZone stop.
• You can use a Volatility-Drop stop.
• You can use a Time Stop to get out of your trade if it does not move within a certain time. For example, if you enter a day-trade and the stock does not move within 10 or 15 minutes, it is clearly not doing what you expected and it is best to scratch that trade. If you put on a swing trade which you expect to last several days, but then a week goes by and the stock is still flat, it is clearly not confirming your analysis and the safest action would be to get out.
55. A Parabolic Stop
Stoptomorrow Stoptoday AF (EPtrade −Stoptoday)
Where Stoptoday the current stop
Stoptomorrow the stop for the next trading day
EPtrade the extreme point reached in the market in the current
trade. If long, this is the highest since the purchase day.
If short, this is the lowest low since the shorting day
AF the Acceleration Factor
On the first day in a trade, Acceleration Factor equals 0.02. AF increases by 0.02 each day the rally reaches a new high or a decline reaches a new low, up to the maximum of 0.20.
The Parabolic system works well in trending markets but leads to whipsaws in trendless markets. It can generate spectacular profits during price trends but chop up an account in a trading range. Do not use it as an automatic trading method.
56. If you become interested in trailing stops, test them like any other method. You want the size of your trades while you test the method to be so small that neither profit nor loss would matter to you. Then you can concentrate on mastering the new approach and leave moneymaking for later, when you have a higher degree of confidence in your new method.
57. SafeZone stops are designed to capitalize on the concepts of signal and noise in the financial markets. If the price trend is the signal, then the counter-trend moves are the noise. We can define a trend as the slope of a 22-day EMA. When the trend is up, we can define noise as that part of each day’s range that protrudes below the previous day’s low, going against the trend. If the trend is up, mark all downside penetrations during the lookback period, add their depths, and divide the sum by the number of penetrations. This gives you the Average Downside Penetration for the selected lookback period. Multiply the Average Downside Penetration by a coefficient, starting with a 2, but experiment with higher numbers. Subtract the result from yesterday’s low, and place your stop there. If today’s low is lower than yesterday’s, do not move your stop lower since we are only allowed to raise stops on long positions, but not to lower them.
58. Volatility-Drop: I call my trailing stop a Volatility-Drop. I do not think of using a trailing stop until my target is hit. At that time the trade has fulfilled its duty, I do not want to give all my accumulated profit from this trade back but am willing to risk a portion to find out whether the move has more life left in it. If the market is willing to go crazy and have this huge momentum move, I am willing to stay with it. Suppose I use Autoenvelope to set my price target when I enter the trade. The normal width of the envelope is 2.7 standard deviations. If I want to switch to a trailing stop once that target is reached, I will place it one standard deviation tighter—at 1.7 standard deviations. As long as the move continues along the border of a normal envelope, I’ll stay with it, but as soon as the price closes inside of the tighter channel, I’ll be out.
If my target is hit and I see bearish signals, I won’t use a trailing stop. If I see a negative price action—like a wide bar closing near the low on heavy volume, I will take my profit at a target and be gone. But when the market is moving well, with higher highs and higher lows, I will follow.
59. If you do not like how your long position is acting, you have two choices. If you’re in a short-term trade, you can just shoot it, accept a lower profit than planned, and move on. If you are in a long-term trade, you probably do not want to sell your entire position. You may want to take partial profits and maintain your core position, with an eye towards repurchasing the shares you’ve sold at a lower price.
60. let me restate one of the key points about market analysis— our research can never be complete. You cannot be an expert in both fundamental and technical analysis, psychology and cycles, positions of insiders and Federal Reserve policies, and so on.
One problem with fundamental information is that it flows into the markets in bursts rather than in a steady stream. A chunk of fundamental information can hit a stock and make it leap. This is especially likely to happen when a company releases its earnings reports.
Keep in mind that an earnings report rarely comes as a surprise for those who closely track the company. There are two reasons for that. First, there is an entire industry of earnings watchers and forecasters. Pros with a lot of experience tend to be right about their forecasts. Those who pay them for their research usually buy and sell ahead of the actual reports. The other reason why stocks seldom jump on earnings reports is that the drift of those reports is often leaked in advance of their official release. I think that the volume of insider trading in the stock market is much greater than most people think.
A tiger does not change its stripes. I believe that insider trading is linked to the way the company is managed and its type of business. Large contracts involve multiple participants and take weeks to negotiate, creating more chances for information leaks. A company cannot change the way it does business or its management method—if it leaked information in the past, it will leak in the future.
Those of us who take a fairly skeptical view of companies’ ability to keep secrets tend to hold a position, either long or short, straight through the earnings reports. In my experience, it generally pays to be skeptical about the sudden impact of earnings reports. Still, once in a while a skeptic gets burned, and the welts can sizzle.
61. The markets do not exist to put money into the pockets of amateurs. When outsiders and latecomers start making a lot of money, the market is near the top. It can only go way down, returning to the equilibrium.
Bernard Baruch’s book
62. I’ve come to believe that the New High–New Low Index (NH-NL) is the best leading indicator of the stock market. New Highs are the leaders in strength—they are the stocks that on any given day have reached their highest point for the past 52 weeks. New Lows are the leaders in weakness—the stocks that have on that day reached their lowest point for the past 52 weeks. The interplay of new highs and new lows provides better information about the health or weakness of a trend than merely looking at market averages.
While the timing of NH-NL signals is not as precise as other indicators, such as MACD or Force Index, it is very useful because it helps us recognize when it is a good time to accumulate stocks and when to unload them.
63. A decision-making tree is a set of rules that helps you decide what to do and what not to do in any given situation. Professionals develop their decision-making trees slowly and gradually, in the course of their training, education, and practice. The decision making tree for buying must begin and end with money management.
Your first question must be: Does the 6% Rule allow me to trade? Your last question before putting on a trade must be what size the 2% Rule allows you to trade.
64. To draft a decision tree for selling you need to consider several questions:
1. Is this a short-term or a long-term trade? As a general rule, trend traders tend to be long-term oriented and swing traders short-term oriented.
2. Where will you place your stop? As a general rule, stops should be tighter for short-term trades and more relaxed for long-term trades. Still, the majority of long-term trades require more leeway.
3. Listen to different types of “engine noise” for short-term or long-term trades. A short-term trader may watch the daily charts and indicators for any signs that his trade is becoming overbought and topping out. A long-term trader needs to focus on the weekly charts and wait for much louder “engine noise” before getting out of his trade.
65. An experienced trader can actually combine long-term and short-term approaches in a single campaign. He or she may apply short-term trading skills to long-term trades by trading around a core position. You can maintain a core long-term position through thick and thin but keep trading shorter-term in the direction of that trade with a portion of your account.
66. These two risks—the price risk (to go up) and the cost of the dividend—pretty much cover the waterfront of sell short.
67. It is a well-known fact of human psychology that people underestimate common dangers and overestimate unusual dangers.
68. Occasionally you will encounter a fast market. There will be slippage and your loss may be bigger than anticipated. Still, if you short large, liquid, actively traded stocks, such unpleasantness will occur very rarely.
69. The short-sellers provide an important public service in the markets. First of all, by selling overvalued shares, we increase their supply and dampen excessive market volatility. Extremely volatile markets tend to hurt public investors. Selling more stock when prices are high tends to smooth out wild peaks. Second, when a stock is in a severe decline, short-sellers are among the first to step in and buy, cushioning that decline.
The great advantage of selling stocks short is that they tend to go down about twice as fast as they rise. This applies to all timeframes—to monthly, weekly, and daily, as well as intraday charts. Generally, the faster the trade, the less time you spend exposed to market risk. Selling short allows you to profit faster—or to leave sooner if you find you’ve made a mistake.
In general, you want to be more short-term oriented in shorting than in buying. You are surfing against the gently rising tide, the downtrends are faster and more furious than the uptrends, and there is no point in giving a short trade too much time to “work itself out.” Give the downtrends less time to put up or shut up than you would give to an uptrend.
The one great disadvantage of selling stocks short is that the broad stock market has a centuries-old tendency to rise over time. The estimates of the angle of this so-called “secular rise” vary. Still, an average 3% rise per year seems like a reasonable estimate. This means that in shorting you are swimming against a gently rising tide.
70. A friendly reminder: do not try to make a lot of money on the first short, or on the second short for that matter. Go short just a few shares.
71. I did not like TVL as a short pick that day. First of all, the time was not right for shorting. The stock market had just established an important double bottom and rallied from it. The tide of the market was moving up, and I had already covered almost all of my own shorts. Furthermore, it did not feel right to short a stock that kept reaching new highs almost every day for several weeks. My camper made two mistakes by shorting a rising stock in a strong market.
72. Shorting is different from buying because mass psychology is different at tops and bottoms, in uptrends and downtrends. Stock market bottoms tend to be narrow and sharp, while the tops tend to be broad and uneven.
Stock market bottoms are built on fear. Fear and pain are sharp and powerful emotions. A selling panic shakes out weak holders, and once they are out, the stock is ready to rise again. As long as you do not buy prematurely and then panic and sell at the bottom, buying tends to be fairly permissive
The fundamental asymmetry of tops and bottoms is clearly reflected by the Force Index. Its downspikes tend to serve as good markers of public panics that clear the air and augur new advances. A downspike of Force Index does not necessarily nail the exact day of the bottom, but it shows where the weak holders are dumping their shares, and the buying opportunity tends to come within days.
Tops are built on greed, a happy emotion that can last a long time. As bulls make money, they call their friends and tell them to buy, even after their own money runs out. That’s why the tops tend to last longer and be more irregularly shaped than the bottoms. You can see that the upward spikes of Force Index do not identify tops but rather confirm the ongoing uptrend.
While the bottoms tend to stand out clearly on the charts, the tops tend to be broad and less defined, with many false breakouts. Whenever the bulls find more money, they toss it at their favorite stock, making it rise above a seemingly well established top. Those brief, upward fake-outs are very typical of market tops.
This kind of behavior at the tops makes shorting much harder than buying. Tops demand wider stops, increasing the risk per share. If you use tight stops, your risk of a whipsaw is much greater with shorts than with longs.
Keep in mind that shorting near the top tends to be harder than buying near the bottom. At the end of a downtrend, markets often appear exhausted and listless, with low volatility and tight price ranges. On the other hand, when prices are boiling near the top, you can expect high volatility and wide price ranges.
You need to short smaller positions and be prepared to re-enter if stopped out. If you commit all your permitted risk to one entry, a single false breakout will kick you out of the game. It pays to trade a size smaller than the maximum permitted by your money management rules. It makes sense to keep some risk capital in reserve. You can either use wider stops or be prepared to reenter if stopped out. You need to be able to hold on to your bucking horse
73. Shorting of JCP stock:
• The stock was expensive, just below its all-time high.
• It had broken out to a new high two weeks earlier; that breakout failed and the stock fell back into the trading range. A false breakout to a new high is one of the strongest shorting signals in technical analysis.
The ideal place to sell or sell short is near the upper channel line. I try to avoid shorting below value, below the daily EMAs. I refuse to sell short at or below the lower channel line because there prices are overextended to the downside.
74. It’s a question of what you prefer— fast dimes or slow dollars.
Shorting downtrends: The idea is to sell short when prices are near value, in the middle of the chart. The time to cover shorts and take profits is when prices fall to or below the lower channel line. We want to short value and cover in the undervalued zone.
75. To summarize the lessons from this trade:
• Make a strategic decision on the weekly chart, tactical plans on the dailies.
• A divergence of MACD-Histogram is one of the strongest signals in technical analysis.
• Trading within a channel lowers risk but also reduces potential rewards.
• You must rate all your short-term trades by the percentage of the channel captured in that trade.
• Trading within a channel, you must have your finger on the trigger, ready to exit with a good grade, without waiting for super profits.
76. A more focused approach is to take a specific trading idea from fundamental analysis and put it through the filter of technical analysis. The key principle is to use fundamental information as an idea generator and technical studies as a trigger. The technicals can either release you to pursue that trade or stop you from going any further. No matter how good a fundamental story, if the technical factors do not confirm it, there is no trade. This rule applies to both bullish and bearish fundamental information. When the fundamentals suggest a trade and technical factors confirm that signal, you have a very powerful combination.
77. To summarize the lessons from this trade:
• Fundamental information can provide useful trading signals, as long as technical analysis confirms them.
• The value zone between two moving averages serves as a magnet for prices—they tend to return to it from above and from below.
• The amount of money we have riding on a trade tends to negatively impact our decisions.
• It pays to keep good records.
78. When looking for stocks to sell short, I want to look at the most expensive stocks first. When looking for stocks to buy, I want to begin with the least expensive stocks. Buy low, sell high!
www.tc2000.com
www.tradestation.com
79. Short Interest Ratio indicator: It reflects the intensity of shorting in any given stock. It compares the number of shorts held by the bears with the “free float” in any given stock. The free float is the number of shares available for shorting. You find it by taking the total number of shares issued by the company and deducting three share groups: the restricted stock granted to executives, shares held by “strategic shareholders” who own more than 5% of company shares, and, finally, insiders’ holdings. When you subtract the number of shares that cannot be easily sold from the total number issued by a company, you find the number of shares that are in play—the free float.
When the Short Interest Ratio rises, it shows that the bears are becoming angrier and louder. You must keep in mind that every short position must eventually be covered. When shorts panic and run, they will cover at any price. Short-covering rallies are notorious for their speed. A growing Short Interest Ratio delivers a warning that the bears are becoming too numerous. When this happens, a stock becomes subject to a violent upmove.
There is no clearly defined safe or dangerous level of the Short Interest Ratio. It varies from stock to stock, especially in optionable stocks, where speculators may sell the stock short and at the same time write a put, in effect balancing the two, trading a spread rather than expressing any great bearishness. As an estimate, a Short Ratio of less than 10% is likely to be tolerable, while a reading of over 20% marks a suspiciously large crowd of short-sellers.
80. Days to Cover indicator: To calculate it, divide the total short interest in a stock by its average daily volume. It shows how many days it would take for all the short-sellers to cover their positions if they all panicked and decided to cover at once. If the number of Days to Cover is less than one, you have a small crowd at a wide door, and a panic is unlikely. If Days to Cover rises above 20 (it sometimes goes above 50), it tells you that the stock has become a safety hazard for the bears—it would take many days for them to escape, and some of them are sure to get killed as they try to push through the narrow doors. As a rule of thumb, when the Days to Cover indicator is below 10 the danger of a squeeze is low, while a reading above 20 sends a definite warning.
81. Misery loves company and happiness loves solitude. Short Interest Ratio and Days to Cover help you find stocks whose short side is not overcrowded.
As a matter of fact, the volume of shorting in futures or forex is exactly equal to that of buying! For every contract bought there is also a contract sold short. A futures trader who never sells short is a curiosity. An options trader who never sells short (i.e. never writes options) is most likely a loser. And a forex trader who does not sell short simply does not exist.
Futures: Recommended Literature
Winning in the Futures Markets by George Angell
The Futures Game by Teweles and Jones
Economics of Futures Trading by Thomas A. Hieronymus
Options: Recommended Literature
Lawrence McMillan’s Options as a Strategic Investment.
Sheldon Natenberg’s Option Volatility and Pricing Strategies.
Harvey Friedentag’s Options:Investing Without Fear
As Oscar Wilde said over 100 years ago, “Every true idealist is after money—because money means freedom, and freedom, in final analysis, means life.”
82. HANDLING PROFITS— THE PERSONAL DIVIDEND
One of my early priorities was making best use of any trading profits, which included building my equity base and paying down my mortgage. Based on my treat-it-like-a-business philosophy,
I thought, 搒uccessful businesses issue dividends._ I set very aggressive goals each quarter—basically trying to bring home more money trading than I earned in my job. As long as I achieve 100% or better of the goal I set for myself each quarter, I create a pot of 5% of quarterly profits as the dividend. That is then divided equally among the recipients who can do what they want with the money.
83. Amazingly, the most psychologically comfortable position for most traders is a slight decline in their stock. It is not sharp enough to be painful, and with the stock near your entry price there is probably not much reason to sell. With no action required, you have a perfect excuse to sit back and do nothing. It feels good not to have to make any decisions! That is how a small loss can gradually become bigger and worse. Traders with no clear selling plans can end up being boiled alive, like a frog.
84. Price and value are not the same. Price can be below value, above it, or equal to it. The distance between price and value may be large or small, increasing or decreasing at any given time. Most buying decisions are based on the perception, however vague, that price is below value. It makes sense to buy below value and sell above value.
Most buying decisions are based on the perception, however vague, that price is below value. Most people buy when they think the crowd does not recognize the true value of their trading vehicle. They think they see ahead of the crowd, and expect to make money after the crowd also sees what they do and drives prices higher. Traders buy when they think that some future event will cause an increase in the value of their trading vehicle.
85. Whatever your trading vehicle, it pays to define your work along the three axes: fundamental/technical, trend/countertrend, and discretionary/systematic. Being clear about your likes and dislikes will help you avoid flopping around the markets, the way so many people do.
It is important to realize that in each of these great divides both sides are equally valuable. Your choice will depend primarily on your temperament. Professional traders tend to have an open mind. They are always curious about other people’s opinions and are respectful towards them.
Trend vs. Counter-Trend: Most charts show a mix of directional moves and choppy trading ranges. Experienced traders know that the trends, so clearly visible in the middle of the chart, become increasingly foggy as you near the right edge. Riding a trend is like riding a wild horse that tries to shake you off at every turn. Trend trading is a lot harder than it seems. At the same time, one of the few scientifically proven facts about markets is that they oscillate. They continuously swing between being overvalued and undervalued. Countertrend traders capitalize on this chop of the markets as they fade (trade against) the extremes
Discretionary vs. Systematic: Discretionary traders keep turning their studies this way and that as they decide whether to buy, sell, or do nothing. System traders prefer to dump market data into a computer, test a set of rules for buying and selling, and then turn the system on and follow its signals.
The problem with fundamental analysis is that values change slowly but prices fluctuate all over the lot. One of my students summed up this problem when he said: “Prices are connected to values by a mile long rubber band”.
86. A faster moving average represents a short-term consensus. A slow moving average represents a longer-term consensus. I call the area between the two lines “the value zone.”
Using moving averages to identify value helps differentiate between two different types of trading. A trend-following trader wants to buy when prices pull back towards a rising moving average. A countertrend trader recognizes when the prices get too far away from the value zone, and gets ready to trade the snap-back.
The slow EMA (exponential moving average) rarely changes direction; its angle identifies the increase or the decrease of value. The faster EMA is more volatile. When prices dip into the zone between the two lines during an uptrend, they identify good buying opportunities. Prices are attached to values with a rubber band
This is the choice you need to make: you can trade in the direction of a long-term moving average or you can bet on prices returning to their moving average after they become overextended. The first approach is called trend-following; the second, counter-trend trading.
There are three types of traders: trend-followers, mean-reversal (counter-trend) traders, and day-traders. Most of us fall into one of these trading styles without giving it much thought. Very few of us make a conscious business decision. The choice is up to your personality.
Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis, Richard Weissman
Robert Pardo’s Design, Testing and Optimization of Trading Systems.
87. The systematic and the discretionary approaches can be bridged—just do not try to do it in the middle of an open trade. Do not change your horses in the middle of the stream you’re trying to cross.
88. In this field “less is more.” An abundance of tools only increases the level of noise and adds to the confusion. I established a rule of “five bullets to a clip”—allowing me to use no more than five indicators on any given chart. You need to choose a small handful of tools that feel comfortable to you others—just be sure to understand how your indicators are constructed, what they measure, and what signals they give.
· MOVING AVERAGES
· ENVELOPES OR CHANNELS
· MACD LINES AND MACD-HISTOGRAM
· FORCE INDEX
· THE IMPULSE SYSTEM
Beginners’ childish faith in the power of technical analysis is often coupled with a great deal of laziness. If you do not do your own research, you will not have the necessary confidence during the inevitable drawdown periods.
89. NH-NL (New Highs) minus (New Lows)
The New High–New Low Index tracks the strongest and the weakest stocks on the exchange and compares their numbers. It measures the balance of power between the leaders in strength and the leaders in weakness. This is why NH-NL is a leading indicator of the stock market. The broad indexes, such at the S&P500, tend to follow the trend of NH-NL.
90. With a waterfall of sensations coming at you from life in general and from markets in particular, your mind must automatically sort out what to see and what to filter out. Most people are unaware of this filtering process. In fact, what you think are the objective signals from the markets tend to be highly filtered messages. You can see that most traders respond not so much to the markets but to the contents of their own heads. When people trade on the basis of their fears and fantasies instead of the reality of the markets, the results are likely to be poor. This explains why so many traders lose money and wash out of the markets.
91. Good records are essential for successful trading. You must write down your trading plans and compare your performance with those notes. We are just about to discuss a simple system of record-keeping. Your ability to follow that system will be an excellent predictor of your success or failure. If you keep good trading records, you will be very likely to succeed.
To become a successful trader you must make your own decisions. You will need to insulate yourself from others while you make your trading plans and implement them. Stay alone with your trade, learn all you can, make your own decisions, record your plans, and implement them in silence. You can discuss your trades with the people you trust after those trades are closed—but not a moment sooner. Many people fear solitude, but you need it for trading.
The edge that the winners have over losers in the financial markets is very narrow. If you start putting on trades whose size makes you tense, your performance will decline, and you will begin losing. One of the key goals of money management is to put your mind at ease by providing a safety net for your account.
One of the most common problems among traders is fear of pulling the trigger. In a nutshell, fear of pulling the trigger is the result of trading too large a size. A trader afraid of pulling the trigger must take a break from trading and sharply reduce the size of his trades. He can build up that size only slowly and gradually.
92. The two pillars of money management are the 2% and 6% Rules. Following the 2% Rule will keep any loss in your account to a relatively small, livable size. The 6% Rule will define a series of losses after which you must exit the markets and wait on the shore.
93. THE 2% SOLUTION—PROTECTION FROM SHARKS
• The distance from your entry price to the stop level defines your maximum dollar risk per share.
• The 2% Rule defines your maximum risk for the entire position.
• Knowing the risk per share and the total permitted risk makes it easy to calculate the maximum number of shares you may trade.
94. THE 6% RULE—PROTECTION FROM PIRANHAS
The 6% Rule requires you to stop trading for the rest of the month after your cumulative loss for that month reaches 6% of your account equity.
95. The 2% Rule and the 6% Rule provide guidelines for pyramiding— adding to winning positions. If the stock you bought rallies, you can move your stop above breakeven and then you may buy more of the same stock. You must handle each addition as a separate trade and make sure the risk of the new position is no more than 2% of your account equity and your total account risk stays under 6%.
96. Whenever you put on a trade, you must have two goals. The first, of course, is to make money. The second is to become a better trader. You can reach the first goal in some trades but not in every trade. On the other hand, becoming a better trader is an essential and very reachable goal for every trade. Whether you win or lose, you must become a better trader at the conclusion of each trade. If you haven’t, the trade has been wasted. All the energy and time you put into analysis, all the risks you took with your money—wasted.
97. Money management and record-keeping, taken together, create a rock-solid foundation for your survival and success.
98. The proof of a successful strategy is growing equity. We tend to become a little arrogant and careless after a big win or a string of wins. That’s when, feeling invincible, we start feeding our equity back into the markets.
www.snagit.com, Microsoft Outlook.
Total Workday Control, Michael Linenberger
99. When you scan a large number of stocks, you can keep brief notes on the potentially interesting ones in a spreadsheet or on a notepad with three columns: Date, Ticker, and Comment. The idea is to narrow down your search to a few actionable stocks.
