The New Sell and Sell Short E-Book

Alexander Elder

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Trading Series
• Sprache: Englisch

Seitenzahl: 427

Veröffentlichungsjahr: 2011

Beschreibung

A detailed look at one of the most underestimated aspects of trading-selling In The New Sell and Sell Short, Second Edition, Dr. Alexander Elder explains how to exit a stock at the right time and how to initiate a short position to profit from a stock that is showing weakness. Often overlooked, selling properly enables a trader to cut losses and maximize profits. Moreover, short selling in a weak market can generate big profits and should be a part of every trader's arsenal of tools. The new edition contains numerous examples of short selling stocks from the 2008-2009 bear market, demonstrating very clearly why traders do themselves a disservice by only focusing on the long side. In addition, the new edition contains an extensive study guide to help readers master the material prior to trading. Elder shares real-world examples that show how to manage your positions by adjusting your exit points as a trade unfolds. * Contains new examples and insights from the 2008-2009 market meltdown * Includes an extensive study guide with 115 questions and answers and 17 chart studies * Discusses the selling process from a variety of angles: technical, fundamental, and psychological * Explains how to maximize winnings in a profitable trade and how to minimize losses when a trade doesn't go as planned * Offers detailed guidance for traders of stocks, financial futures, commodities, and currencies * Explains how to set profit targets and stop-loss orders prior to entering any trade Other bestselling titles by Elder: Trading for a Living, Come Into My Trading Room, and Entries and Exits Understanding where and when to sell is essential to successful trading. The New Sell and Sell Short, Second Edition is the definitive reference to this overlooked, but vitally important, aspect of trading.

Leseprobe

Table of Contents

WILEY TRADING SERIES

BOOKS BY DR. ALEXANDER ELDER

Title Page

Copyright Page

Dedication

Introduction

WHY SELL?

ABOUT THE Q&A

PART ONE - PSYCHOLOGY, RISK MANAGEMENT, & RECORD-KEEPING

CHAPTER 1 - ON BUYING

THE THREE GREAT DIVIDES

ONE TRADER’S TOOLBOX

CHAPTER 2 - TRADING PSYCHOLOGY AND RISK MANAGEMENT

YOUR MIND AS A TRADING TOOL

RISK CONTROL

CHAPTER 3 - ON KEEPING RECORDS

GOOD RECORDS LEAD TO GOOD TRADING

TRADER’S SPREADSHEET—BASIC ACCOUNTABILITY

TRADING DIARY—YOUR KEY TO LASTING SUCCESS

HOW TO DOCUMENT YOUR TRADING PLAN

MARGRET’S METHOD—PUT IT ON THE WALL

HOW TO GRADE YOUR PERFORMANCE

TWO TYPES OF TRADING

PART ONE QUESTIONS - PSYCHOLOGY, RISK MANAGEMENT, & RECORD-KEEPING

Question 1—The Stress of Holding a Position

Question 2—Your Trading Edge

Question 3—The Three Great Divides

Question 4—Price and Value

Question 5—Fundamental and Technical Analysis

Question 6—Trend vs. Counter-Trend Trading

Question 7—Systematic vs. Discretionary Trading

Question 8—Technical Toolbox

Question 9—Trading Psychology

Question 10—Trading Discipline

Question 11—Dealing with Losses

Question 12—Overtrading

Question 13—The 2% Rule

Question 14—Modifying the 2% Rule

Question 15—The 6% Rule

Question 16—The Top Two Goals for Every Trade

Question 17—Learning from Experience

Question 18—A Record-Keeping Spreadsheet

Question 19—Trading Mistakes

Question 20—Trader’s Diary

Question 21—Diary Entry

Question 22—Trading Plan vs. Diary

Question 23—The Monitoring Screen

Question 24—Comments on the Screen

Question 25—Pinning a Chart to a Wall

Question 26—Sources of Trading Ideas

Question 27—Grading Buys and Sells

Question 28—Grading Completed Trades

Question 29—Buying

Question 30—Value

Question 31—A Trade Diary

Question 32—Grading a Trade

Question 33—Value Buying vs. Momentum Buying

ANSWERS TO QUESTIONS - PART ONE: PSYCHOLOGY, RISK MANAGEMENT, & RECORD-KEEPING

Question 1—The Stress of Holding a Position

Question 2—Your Trading Edge

Question 3—The Three Great Divides

Question 4—Price and Value

Question 5—Fundamental and Technical Analysis

Question 6—Trend vs. Counter-Trend Trading

Question 7—System vs. Discretionary Trading

Question 8—Technical Toolbox

Question 9—Trading Psychology

Question 10—Trading Discipline

Question 11—Dealing with Losses

Question 12—Overtrading

Question 13—The 2% Rule

Question 14—Modifying the 2% Rule

Question 15—The 6% Rule

Question 16—The Top Two Goals for Every Trade

Question 17—Learning from Experience

Question 18—A Record-Keeping Spreadsheet

Question 19—Trading Mistakes

Question 20—Trader’s Diary

Question 21—Diary Entry

Question 22—Trading Plan vs. Diary

Question 23—The Monitoring Screen

Question 24—Comments on the Screen

Question 25—Pinning a Chart to a Wall

Question 26—Sources of Trading Ideas

Question 27—Grading Buys and Sells

Question 28—Grading Completed Trades

Question 29—Buying

Question 30—Value

Question 31—A Trade Diary

Question 32—Grading a Trade

Question 33—Value Buying vs. Momentum Buying

GRADING YOUR ANSWERS

PART TWO - HOW TO SELL

THE THREE TYPES OF SELLING

CHAPTER 4 - SELLING AT A TARGET

SELLING AT A MOVING AVERAGE

SELLING AT ENVELOPES OR CHANNELS

SELLING AT RESISTANCE LEVELS

CHAPTER 5 - SELLING ON A STOP

THE IRON TRIANGLE

MARKET OR LIMIT ORDERS

HARD AND SOFT STOPS

A BAD PLACE

REDUCING SLIPPAGE—TIGHTER BY A PENNY

NIC’S STOP—TIGHTER BY A DAY

WHEN TO USE WIDER STOPS

MOVING STOPS

A SAFEZONE STOP

VOLATILITY-DROP TRAILING STOPS

CHAPTER 6 - SELLING “ENGINE NOISE”

WEAKENING MOMENTUM

AN “ENGINE NOISE” EXIT FROM A SHORT-TERM TRADE

A DISCRETIONARY EXIT FROM A LONG-TERM TRADE

SELLING BEFORE EARNINGS REPORTS

THE MARKET RINGS A BELL

TRADING WITH THE NEW HIGH—NEW LOW INDEX

THE DECISION TREE FOR SELLING

PART TWO QUESTIONS - HOW TO SELL

Question 34—A Plan for Selling

Question 35—The Three Types of Selling

Question 36—Planning to Sell

Question 37—Targets for Selling

Question 38—A Stock Below Its Moving Average

Question 39—Moving Averages as Selling Targets

Question 40—Regrets About Selling

Question 41—EMA as a Profit Target

Question 42—Channels as Price Targets

Question 43—Measuring Performance Using Channels

Question 44—Selling Targets

Question 45—Reaching for More

Question 46—The Top of a Rally

Question 47—Prices above the Upper Channel Line

Question 48—Profit Targets

Question 49—Support and Resistance Zones

Question 50—A Protective Stop

Question 51—Breaking through Resistance

Question 52—A Trade without a Stop

Question 53—Changing Stops

Question 54—Re-entering a Trade

Question 55—Deciding Where to Set a Stop

Question 56—The Impact of the Last Trade

Question 57—“The Iron Triangle”

Question 58—A Limit Order

Question 59—Soft Stops

Question 60—A Stop One Tick below the Latest Low

Question 61—A Stop at the Level of the Previous Low

Question 62—A Stop That Is “Tighter by a Day”

Question 63—Trade Duration

Question 64—Wider Stops

Question 65—Moving Stops

Question 66—The SafeZone Stop

Question 67—Trading with the SafeZone

Question 68—The Volatility-Drop Method

Question 69—“Engine Noise” in the Markets

Question 70—Selling “Engine Noise”

Question 71—New High-New Low Index

Question 72—Not Liking Market’s Action

Question 73—Earnings Reports

Question 74—The Market “Rings a Bell”

Question 75—Trading with the New High-New Low Index

Question 76—A Decision-Making Tree vs. a Trading System

Question 77—A Decision-Making Tree

Question 78—Value Buying and Selling Targets

Question 79—Support, Resistance, and Targets

Question 80—Multiple Targets

Question 81—Holding, Adding, or Profit-Taking

Question 82—Handling a Profitable Trade

Question 83—Placing a Stop

Question 84—The Impulse System

Question 85—The Signals of NH-NL

Question 86—The Decision at the Right Edge of the Chart

ANSWERS TO QUESTIONS - PART TWO: HOW TO SELL

Question 34—A Plan for Selling

Question 35—The Three Types of Selling

Question 36—Planning to Sell

Question 37—Targets for Selling

Question 38—A Stock Below Its Moving Average

Question 39—Moving Averages as Selling Targets

Question 40—Regrets About Selling

Question 41—EMA as a Profit Target

Question 42—Channels as Price Targets

Question 43—Measuring Performance Using Channels

Question 44—Selling Targets

Question 45—Reaching for More

Question 46—The Top of a Rally

Question 47—Prices above the Upper Channel Line

Question 48—Profit Targets

Question 49—Support and Resistance Zones

Question 50—A Protective Stop

Question 51—Breaking through Resistance

Question 52—A Trade without a Stop

Question 53—Changing Stops

Question 54—Re-entering a Trade

Question 55—Deciding Where to Set a Stop

Question 56—The Impact of the Last Trade

Question 57—“The Iron Triangle”

Question 58—A Limit Order

Question 59—Soft Stops

Question 60—A Stop One Tick below the Latest Low

Question 61—A Stop at the Level of the Previous Low

Question 62—A Stop That Is “Tighter by a Day”

Question 63—Trade Duration

Question 64—Wider Stops

Question 65—Moving Stops

Question 66—The SafeZone Stop

Question 67—Trading with the SafeZone

Question 68—The Volatility-Drop Method

Question 69—“Engine Noise” in the Markets

Question 70—Selling “Engine Noise”

Question 71—New High-New Low Index

Question 72—Not Liking Market’s Action

Question 73—Earnings Reports

Question 74—The Market “Rings a Bell”

Question 75—Trading with the New High-New Low Index

Question 76—A Decision-Making Tree vs. a Trading System

Question 77—A Decision-Making Tree

Question 78—Value Buying and Selling Targets

Question 79—Support, Resistance, and Targets

Question 80—Multiple Targets

Question 81—Holding, Adding, or Profit-Taking

Question 82—Handling a Profitable Trade

Question 83—Placing a Stop

Question 84—The Impulse System

Question 85—The Signals of NH-NL

Question 86—The Decision at the Right Edge of the Chart

GRADING YOUR ANSWERS

PART THREE - HOW TO SELL SHORT

CHAPTER 7 - SHORTING STOCKS

YOUR FIRST SHORTS

THE ASYMMETRY OF TOPS AND BOTTOMS

SHORTING TOPS

SHORTING DOWNTRENDS

SHORTING FUNDAMENTALS

FINDING STOCKS TO SHORT

SHORT INTEREST

CHAPTER 8 - SHORTING NON-EQUITY INSTRUMENTS

SHORTING FUTURES

WRITING OPTIONS

FOREX

PART THREE QUESTIONS - HOW TO SELL SHORT

Question 87—Shorting a Stock

Question 88—Risk Factors in Shorting

Question 89—The Impact of Shorting

Question 90—Short vs. Long

Question 91—Disadvantages of Shorting

Question 92—Learning to Sell Short

Question 93—Shorting vs. Buying

Question 94—Shorting Stock Market Tops

Question 95—Shorting in Downtrends

Question 96—The Tactics of Shorting Downtrends

Question 97—Shorting the Fundamentals

Question 98—Looking for Shorting Candidates

Question 99—The Short Interest Ratio

Question 100—Trading the Short Interest Ratio

Question 101—Markets Need Shorting

Question 102—Who Shorts Futures

Question 103—Shorting Futures

Question 104—Long Rallies and Sharp Breaks

Question 105—Writing Options

Question 106—Writing Covered Options

Question 107—Naked vs. Covered Writing

Question 108—The Demands of Naked Writing

Question 109—Brokers Against Traders

Question 110—Forex Market

Question 111—Learning to Become a Better Trader

Question 112—Trading Signals of the Force Index

Question 113—False Breakouts and Divergences

Question 114—Shorting and Covering Signals

Question 115—Shorting Tactics

ANSWERS TO QUESTIONS - PART THREE: HOW TO SELL SHORT

Question 87—Shorting a Stock

Question 88—Risk Factors in Shorting

Question 89—The Impact of Shorting

Question 90—Short vs. Long

Question 91—Disadvantages of Shorting

Question 92—Learning to Sell Short

Question 93—Shorting vs. Buying

Question 94—Shorting Stock Market Tops

Question 95—Shorting in Downtrends

Question 96—The Tactics of Shorting Downtrends

Question 97—Shorting the Fundamentals

Question 98—Looking for Shorting Candidates

Question 99—The Short Interest Ratio

Question 100—Trading the Short Interest Ratio

Question 101—Markets Need Shorting

Question 102—Who Shorts Futures

Question 103—Shorting Futures

Question 104—Long Rallies and Sharp Breaks

Question 105—Writing Options

Question 106—Writing Covered Options

Question 107—Naked vs. Covered Writing

Question 108—The Demands of Naked Writing

Question 109—Brokers Against Traders

Question 110—Forex Market

Question 111—Learning to Become a Better Trader

Question 112—Trading Signals of the Force Index

Question 113—False Breakouts and Divergences

Question 114—Shorting and Covering Signals

Question 115—Shorting Tactics

GRADING YOUR ANSWERS

PART FOUR - LESSONS OF THE BEAR MARKET

CHAPTER 9 - BEARS MAKE MONEY

THE BEAR WAS BEGINNING TO STIR IN ITS CAVE

THE SENTIMENT INDICATORS ARE EARLY

THE TOP OF THE BULL MARKET

BEARISH DIVERGENCES AT THE 2007 TOP

THE BUBBLE POPS: MGM

SHORTING A HIGH-FLYER

A BEAR MARKET IS A DESTROYER OF VALUE

SWINGING IN AND OUT OF A MAJOR DOWNTREND

TRADING IN A DOWNCHANNEL

PREPARED FOR A SURPRISE

“BULL MARKETS HAVE NO RESISTANCE AND BEAR MARKETS HAVE NO SUPPORT”

FOR WHOM THE BELL TOLLS OR THE HOUND BARKS TWICE

MR. BUFFETT BUYS TOO SOON

MAY I POUR SOME GASOLINE ON YOUR FIRE?

KEEP SHORTING ON THE WAY DOWN

CHAPTER 10 - GROPING FOR A BOTTOM

THIS STOCK MARKET IS NOT GOING DOWN TO ZERO

A “DOUBLE HELIX” GIVES A BUY SIGNAL

JUST IN TIME FOR THE PARTY

MY FAVORITE MAJOR BOTTOM SIGNAL

SELLING A BULL

EVERY BULL STUMBLES

A SCREAMING SHORT

CONCLUSION

REFERENCES

Acknowledgments

ABOUT THE AUTHOR

WILEY TRADING SERIES

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.

The Wiley Trading series features books by traders who have survived the market’s ever changing temperament and have prospered—some by reinventing systems, others by getting back to basics. Whether a novice trader, professional or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future.

For a list of available titles, please visit our Web site at www.WileyFinance.com.

BOOKS BY DR. ALEXANDER ELDER

Trading for a Living

Study Guide for Trading for a Living

Rubles to Dollars: Making Money on Russia’s Exploding Financial Frontier

Come into My Trading Room

Study Guide for Come into My Trading Room

Straying from the Flock: Travels in New Zealand

Entries & Exits: Visits to Sixteen Trading Rooms

Study Guide for Entries & Exits

Sell and Sell Short, First Edition

Sell and Sell Short Study Guide, First Edition

Copyright © 2011 by Dr. Alexander Elder. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

A previous edition of this book, Sell and Sell Short by Dr. Alexander Elder, was published along with a study guide in 2008 by John Wiley & Sons.

All charts unless otherwise noted were created with TradeStation.

Copyright © 2001-2010 TradeStation Securities, Inc. All rights reserved.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at http://www.wiley.com/go/permissions.

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ISBN 978-0-470-63239-0 (hardback); ISBN 978-1-118-00555-2 (ebk.); ISBN 978-1-118-00556-9 (ebk.); ISBN 978-1-118-00557-6 (ebk.)

To Inna Feldman,the manager of elder.comwhose care, kindness, and integrityhave helped shape our companyfor the past twelve years.

INTRODUCTION

There is a time to grow and a time to decline. A time to plant and a time to reap.

That cute puppy bouncing up and down in your living room will someday become an old, decrepit dog whom you will have to drive to the vet’s office to put it out of its misery.

That stock you bought with such great hopes and which you enjoyed watching grow has now rolled over and is cutting into your capital instead of increasing it. It is high time to look for an exit.

Buying is fun. It grows out of hope, great expectations, a chest full of air. Selling is a hard, unsmiling business, like driving that poor old dog to the vet for its final injection. But sell you must.

And once you and I talk about selling—that essential reality at the end of every trade—we will not stop. We will talk about selling short. Amateurs don’t know how to short and are afraid of it, but professionals love shorting and profit from declines.

Stocks go down much faster than they rise, and a trader who knows how to short doubles his opportunities. But before you sell short you must learn to sell and sell well.

So let us take off those rose-colored glasses and learn to sell.

WHY SELL?

The markets inhale and exhale. They get a full chest of air and push it out. They must fall just as certainly as they must rise.

To live happily in the markets, you need to get in gear with their rhythm. Any beginner buying stocks knows how to inhale. Knowing when to exhale—when to sell—will set you above the crowd.

We buy when we feel optimistic—or are afraid of missing a good thing. Perhaps you read a story about a new product or heard rumors of a merger. Maybe you ran a database scan or found a promising chart pattern on your screen. You go online or call your broker and place an order to buy. You receive a confirmation—you own the stock. Now the stress begins.

If the stock stays flat and goes nowhere, you feel restless. Did you pick the wrong one again? Other stocks are going up—should you sell yours?

A rising stock creates a different kind of anxiety. Should you take profits, add to your position, or do nothing? Doing nothing is quite hard, especially for men, who are told from childhood “Don’t just stand there, do something!” When your stock drops, you feel pain—“I’ll sell as soon as it comes back to even.”

For many, the most psychologically comfortable position 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. No action is required, and you have the perfect excuse to do nothing.

Throw a frog into a pot of hot water and it will jump, but if you heat the frog slowly, you can cook it alive. Traders with no clear selling plans, holding a slowly sinking stock, can suffer a great deal of damage.

Stress is the enemy of good decision making. It is hard to be objective when our skin is on the line. This is why I urge you to write down a plan before you enter a trade. Your plan must list reasons for entering a trade and define three numbers: your entry price, a protective stop, and a profit target.

Make your decision to sell before you buy. This simple rule will allow you to use your intellect instead of some other point of your anatomy and then boil like some poor frog. You are likely to increase your profits, reduce losses, and improve your equity curve by writing down your selling plan before you buy.

Why do so few people do it?

Two reasons. First, most traders have never been taught what you have just read. Beginners and outsiders simply do not have this knowledge. The other reason is that people like to dream. A written plan cuts into their sweet daydreaming business. A vague fantasy of riches feels nice and comfy. Sitting up straight and writing down your specific goals and contingency plans takes away that happy fantasy.

Since you have picked up this book I’d like to think that you have chosen the pleasure of real profits over the sweetness of daydreaming. Welcome to the book, and let us move on to selling and selling short.

ABOUT THE Q&A

It feels exciting to discover an attractive stock and watch it go vertical after you buy. It is just as exciting to see it collapse soon after you short. This joy is only a small part of the game.

You can expect to spend the bulk of your time doing your homework. At times you might scan a long list of stocks and not find anything particularly attractive. At other times you may find a stock that you like, but your money management rules will not allow you to buy. You can put on a trade in moments but spend half an hour documenting it in your diary. The toil of homework takes up the bulk of a serious trader’s time. Whoever said “success is 10% inspiration and 90% perspiration” must have come through Wall Street.

I created the questions and answers in this book to help you prepare for the road ahead. My goal was to point out some of the best opportunities, flag some of the worst risks, and get you into the habit of tracking your performance. I often say to my students, “Show me a trader with good records, and I will show you a good trader.” I hope this will help you acquire the habit of asking hard questions, testing all ideas on your own data, and keeping good records.

I took great care in crafting the answers in the back of the book. I wanted to go beyond merely saying that A was right and B was wrong—I wanted to explain the reasons behind the answers.

Please do not rush through this book. Trading is a marathon, not a 100-yard dash. Take your time to think and work through a few questions each day. After you have worked through the answers and rated your performance, put it aside for two or three months, then pick it up again and retake the tests to see whether your grades have improved. Trading is like many other serious pursuits—the more you put into it, the more you will get out of it.

Trading is a lonely business, which is why I encourage traders to connect with others and share research and learning. Some of my students have become good friends. Now, by picking up this book and facing its hard questions, you have made the choice to face reality. I wish you success in your trading career.

Dr. Alexander Elder New York City, 2011

PART ONE

PSYCHOLOGY, RISK MANAGEMENT, & RECORD-KEEPING

To be a successful trader you need an edge—a method of discovering opportunities and placing orders. An edge plus a lot of discipline will put you ahead of the pack.

A beginner has no plan and no edge. He hears different bells on different days and jumps in response to all of them. He may buy today after seeing a piece of news about earnings. He might sell tomorrow after seeing—more likely imagining—a head-and-shoulders top. This is the normal stage of initial ignorance. To move beyond it, to graduate to trading for a living, you need a clear concept for buying and selling. You need to define a trading plan that is fairly clear and bulletproof in order to enjoy a rising equity curve.

My own search for an edge led me to focus on the gap between price and value. Surprisingly few people are aware of it, although when I point it out on a chart they see it immediately.

The concept is quite simple: 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.

Few technical traders ever think about the difference between price and value. Fundamental analysts are much more attuned to the idea, but they do not own it—technicians can use it as well.

Most buying decisions are based on the perception that price is below value. Traders buy when they think that some future event will increase the value of their trading vehicle.

It makes sense to buy below value and sell above value. To implement this idea, we need to answer three questions: How to define value? How to track its changes? How to measure the distance from price to value?

CHAPTER 1

ON BUYING

Trading requires confidence; but, paradoxically, it also demands humility. Since the markets are huge, there is no way you can master everything. Your knowledge can never be complete.

This is why we need to select an area of research and trading and specialize in it. Let’s compare financial markets to medicine. Today’s physician cannot be an expert in surgery, psychiatry, and pediatrics. Such universal expertise may have been possible centuries ago, but modern physicians must specialize.

THE THREE GREAT DIVIDES

A serious trader also needs to specialize. He must choose an area of research and trading that appeals to him or her. A trader needs to make several key choices:

• Technical vs. Fundamental Analysis

Fundamental analysts of stocks study the values of listed companies. In the futures markets they explore the supply-demand equations for commodities. Technicians, by contrast, believe that the sum of knowledge about any stock or future is reflected in its price. Technicians study chart patterns and indicators to determine whether bulls or bears are winning the current round of the trading battle. Needless to say, there is some overlap between the two methods. Serious fundamentalists look at charts, while serious technicians like to have some idea about the fundamentals of the market they are trading.

• Trend vs. Counter-Trend Trading

Almost every chart shows a mix of directional moves and choppy trading ranges. Powerful trends fascinate beginners: if you were to buy at a bottom, so clearly visible in the middle of the chart, and hold through the entire rally, you would make a ton of money. Experienced traders know that big trends, so clearly visible in the middle of a chart, become foggy near the right edge. Following 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.

One of the very few scientifically proven facts about the markets is that they oscillate. Markets continuously swing between overvalued and undervalued levels. Counter-trend traders capitalize on this choppiness by trading against the extremes.

Take a look at the chart in Figure 1.1, and the arguments for and against trend or counter-trend trading will leap at you from the page. You can easily recognize an uptrend from the lower left to the upper right corner. It seems appealing to buy and hold—until you realize that a trend is clear only in retrospect. If you had a long position, you’d be wondering every day, if not every hour, whether this uptrend was at an end. Sitting tight requires a great deal of mental work!

Swing trading—buying below value and selling above value—has its own pluses and minuses. Trading shorter moves delivers thinner returns, but the trades tend to last just a few days. They require less patience and make you feel much more in control.

In his brilliant book Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis, Richard Weissman draws a clear distinction between three types of traders: trend-followers, mean-reversal (counter-trend) traders, and day-traders. They have different temperaments, exploit different opportunities, and face different challenges.

Most of us gravitate towards one of these trading styles without giving our decision much thought. It is much better to figure out who you are, what you like or dislike and trade accordingly.

• Discretionary vs. Systematic Trading

A discretionary trader looks at a chart, reads and interprets its signals, then makes a decision to buy or sell short. He monitors his chart and at some point recognizes an exit signal, then places an order to exit from his trade. Analyzing charts and making decisions is an exciting and engaging process for many of us.

Figure 1.1 Moving Averages Identify Value Daily chart of MW, 26-day and 13-day EMAs

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; you can see that prices almost always get only so far away from the EMA before they snap back. When a rubber band extends to the max, it warns you to expect a reversal of the latest move away from value.

A systematic trader cannot stand this degree of uncertainty. He does not want to keep making decisions every step of the way. He prefers to study historical data, design a system that would have performed well in the past, fine-tune it, and turn it on. Going forward, he lets his system track the market and generate buy and sell signals.

Systematic traders try to capitalize on repeating market patterns. The good ones know that while patterns repeat, they do not repeat perfectly. The most valuable quality of a good system is its robustness. We call a system robust when it continues to perform reasonably well even after market conditions change.

Both types of trading have a downside. The trouble with discretionary trading is that it seduces beginners into making impulsive decisions. On the other hand, a beginner attracted to systematic trading often falls into the sin of curve-fitting. He spends time polishing his backward-looking telescope until he has a system that would have worked perfectly in the past—if only the past repeated itself perfectly, which it almost never does.

I am attracted to the freedom of discretionary trading. I like to study broad indexes and industry groups and decide whether to trade from the long or short side. I work to establish entry and exit parameters, apply money management rules, determine the size of a trade, and finally place my order. There is a sense of thrill in monitoring the trade and making a decision to exit as planned, jump a little sooner, or hold a little longer.

The decision to be a discretionary or a systematic trader is rarely based on cost/benefit analysis. Most of us decide on the basis of our temperament. This is not different from deciding where to live, what education to pursue, and whether or whom to marry—we usually decide on the basis of emotion.

Paradoxically, at the top end of the performance scale there is a surprising degree of convergence between discretionary and systematic trading. A top-notch systematic trader keeps making what looks to me like discretionary decisions: when to activate System A, when to reduce funding of System B, when to add a new market or drop a market from the list. At the same time, a savvy discretionary trader has a number of firm rules that feel very systematic. For example, I will never enter a position against the weekly Impulse system, and you couldn’t pay me to buy above the upper channel line or short below the lower channel line on a daily chart. The systematic and the discretionary approaches can be bridged—just don’t try to change your method in the middle of an open trade.

Another key decision is whether to focus on stocks, futures, options or forex. You may want to specialize even further, by choosing a specific stock group or a few specific futures. Making a conscious decision will help you avoid flopping around, the way so many people do.

It is important to realize that in all of these choices there is no right or wrong way. What you select will depend primarily on your temperament, which is perfectly fine. Only greenhorns look down upon those who make different choices.

ONE TRADER’S TOOLBOX

In the first edition of this book, I dedicated an entire section to a description of my trading toolbox—its development and its current state. Some readers liked that, but many complained that they already had this information from my earlier books.1 As a result, in this edition I decided to limit a discussion of the tools I use to a thumbnail sketch.

Looking at a day’s bar or a candle on any chart, we see only five pieces of data: open, high, low, close and volume. A futures chart also includes open interest. This is why I have a rule of “five bullets to a clip”—allowing no more than five indicators on any given chart. You may use six if you desperately need an extra one, but never more than that. For myself, I do well with four: moving averages, envelopes, MACD and the Force Index.

You are not obligated to use the same four indicators. Please feel free to use others—only be sure to understand how they are constructed, what they measure, and what signals they give. Choose a handful of tools, and study them in depth until you become comfortable with them.

What about classical charting, with its head-and-shoulders tops, rectangles, diagonal trendlines, and so on? I believe that much of their alleged meaning lies in the eye of the beholder—traders draw lines on charts to confirm what they want to see.

I am suspicious of classical charting because it is so subjective. I trust only the simplest patterns: support and resistance lines as well as breakouts and fingers, also known as kangaroo tails. I prefer computerized indicators because their signals are clear and not subject to multiple interpretations.

Many beginners have a childish faith in the power of technical analysis, often coupled with quite a bit of laziness. Each month I get e-mails from people asking for “the exact settings” of moving averages, MACD, and other indicators. Some say that they want to save time by taking my numbers and skipping research so that they could get right on to trading. Save the time on research! If you do not do your own research, where will you get the confidence to trust your tools during the inevitable drawdown periods?

I believe that successful trading is based on three M’s—Mind, Method, and Money. Your Method—indicators and tools—is just one component of this equation. Equally important is the Mind—your trading psychology—and the Money, or risk control. All three are tied together through good record-keeping.

CHAPTER 2

TRADING PSYCHOLOGY AND RISK MANAGEMENT

What are your trading tools? You probably have a computer, some software packages, and a database. You probably visit several trading-related websites and may have a shelf of trading-related books. If you think that this is all, you are overlooking a hugely important trading instrument.

YOUR MIND AS A TRADING TOOL

Your emotions, hopes, and fears have a direct and immediate effect on your trading. What goes on inside your head has a greater influence on your success or failure than any technology.2 Your decision-making process must be transparent and unbiased to enable you to learn from your experiences and become a better trader.

Trading psychology is discussed in all of my books, but especially in Trading for a Living. Let’s touch on just a few key points:

• Solitude is essential

When feeling stressed, we tend to huddle and imitate others. A successful trader makes his or her own decisions. You need to isolate yourself while you make and implement your own trading plans. This does not mean becoming a hermit. It is a good idea to network with other traders, but you should not talk about your trading plans while a trade is still open. 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 closing a trade. You need solitude to focus on open trades.

• Treat yourself well

If your mind is a part of trading, you’ve got to treat it well. It only seems as though impulsive traders have fun—losers tend to be extremely harsh and shockingly abusive towards themselves. They keep breaking the rules and hitting themselves, breaking and hitting. Beating yourself will not make you a better trader. It is better to celebrate even partial achievements and soberly take stock of your shortcomings. In my own trading, I have a reward system for celebrating successful trades, but do not punish myself for losses.

• Some traders are destined to fail

The markets produce endless temptations, which is why people with a history of poor impulse control are likely to lose in trading. Those who are actively drinking or using substances are highly unlikely to succeed. They may have a few lucky trades, but their long-term forecast is grim. If your drinking, eating, or other behavior is out of control, you are better off not trading until you resolve your addiction problem. Obsessional nit-pickers and greedy people who cannot tolerate losing a dime are also unlikely to do well in trading.

• It is better not to trade when you are in a foul mood

Remember that even a good trader has only a very narrow edge. Anything that reduces that edge shifts the balance of power against you. Feeling calm, relaxed, and in a pleasant mood is extremely important for your success. If you have a severe toothache or if a problem with a spouse distracts you, you would be better off taking a break from the markets. If you feel preoccupied, stand aside until your personal stress clears up.

• Successful traders love the game more than the profits

On Sundays, with my weekend homework completed and plans for the next week drawn up, it is a pleasure to anticipate Monday’s opening. A surfer probably has a similar feeling at night, knowing he’ll be going to the beach in the morning. This feeling comes from being prepared.

• Keeping records: actions are more important than dreams

It is easy to talk about discipline on a weekend, when the markets are closed, but let me see you in front of a live screen five minutes after the opening bell. You must write down your trading plans and faithfully implement them. The ability to keep records is an excellent predictor of your future success or failure. If you keep good trading records, you are very likely to succeed. If you fail to keep good records, your chances of successful trading will be slim to none.

RISK CONTROL

If trading is a high-wire act, then risk control means putting on a safety harness. It will save your life in case you slip.

Overtrading means putting on trades whose size is too large for your account. When the stakes become dangerously high, we become stiff with tension, spontaneity goes out the window, and our performance deteriorates. Sensible risk control keeps the size of your trades at a fairly relaxed level.

The two pillars of money management are the 2% and 6% Rules.3 They will help save your account from the two main causes of trader mortality: the 2% Rule from shark bites and the 6% Rule from piranha bites.

A shark bite is a single disastrous loss that severely damages one’s account. A poor beginner who loses one-third of his equity would have to generate a 50% return on his remaining capital simply to break even. The victim of a shark attack loses much more than money: he loses confidence, becomes fearful, and cannot pull the trigger. We can avoid this problem by following the 2% Rule which keeps any loss to a small, livable size.

The 2% Rule prohibits you from risking more than 2% of your account equity on any single trade.

Suppose you have $100,000 in your account—the 2% Rule tells you that your maximum permitted risk on any trade is $2,000. You decide to buy a stock that is selling for $40 and put a stop at $38, risking $2 per share. Dividing your total permitted risk by your risk per share ($2,000 by $2) tells you that you may trade a maximum of 1,000 shares. You are perfectly welcome to trade a smaller position—but never bigger, which would push your risk above the 2% limit.

The 2% Rule forms the basis of what I call “The Iron Triangle of Risk Control.”

1. The distance from your entry price to the stop level defines your maximum dollar risk per share.

2. The 2% Rule defines your maximum risk for the entire position.

3. Dividing your permitted risk by your risk per share gives you the maximum number of shares you may trade.

The 6% Rule requires you to stop trading for the rest of the month once your cumulative loss for that month reaches 6% of your account equity.

Most people tend to push harder when things go badly. We often put on more trades when losing, trying to trade our way out of a hole. In fact, a better response is to step back and take some time off. The 6% Rule forces you to do just that by capping the maximum monthly loss in your account.

A piranha is an aggressive fish found in the rivers of South America. Its main danger comes from the fact that it travels in packs. A careless bull who stumbles into a piranha-infested river might be reduced to a collection of bones. The 6% Rule defines a series of losses after which a bull or a bear must exit the markets and wait on shore.

The 6% Rule forms the basis of the concept I call “Available Risk.” Approach every trade with a question—does the 6% Rule allow me to trade? You know how much money, if any, you have lost during the current month. You also know how much money you have exposed to the risk of loss in your open trades. If your previous losses for this month plus your risk on existing trades expose you to a total risk of 6% of your account equity, you may not put on another trade.

Most traders go through emotional swings, feeling elated at the highs and gloomy at the lows, while losing money to sharks and piranhas. If you seriously plan to become a successful trader, the 2% and 6% Rules will convert your good intentions into the reality of safer trading.

CHAPTER 3

ON KEEPING RECORDS

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.

There is a lot of randomness, and the best-planned trades can go awry. Even a top trader cannot win in every trade—this is a fact of life. On the other hand, becoming a better trader is a realistic and essential goal for every single trade.

You must keep learning from your experience. Whether you win or lose, you must become a better trader after each trade. If you don’t, you have simply wasted an opportunity. All that energy and time you put into analysis, all the risks you took with your money—for naught.

The best way to learn is to keep good records. A wannabe trader without records is a dreamer. All numbers relating to your trades must go into a spreadsheet, and a visual record of your trades must go into your diary.

GOOD RECORDS LEAD TO GOOD TRADING

The best way to learn from your experience is to keep good records. They transform your fleeting experiences into solid memories and lessons. Your market analysis and decisions to buy or sell become deposits in your data bank. You can draw on those memories, re-examine them, and use them to grow into a better trader.

The rules of money management will help you survive the inevitable rocky times. The record-keeping methods I am about to share with you will put your learning into a solid uptrend, and your performance will follow. Money management and record-keeping create a rock-solid foundation for your survival and success. The rest—the analysis and techniques—you can pick up from this book, my other books, or those written by other serious authors.

Almost anyone can make an inspired trade, hit the market right, and watch profits roll in. No matter how inspired, a single trade or even a handful of trades will not make you a winner. You need to build a pattern of trades that has a record of success over a long period of time.

Seeing your equity grow quarter after quarter and year after year is the proof of your trading prowess. We tend to become arrogant and careless after a big win or a string of wins. That’s precisely when, imagining we can walk on water, we start feeding our equity back into the markets.

Any trader will occasionally hit the market right and score a profit. Even a monkey throwing darts at a stock page will occasionally pick a winner. A single profit does not prove anything. Our most important challenge is to maintain a positive slope of our equity curve. For that you need to keep two sets of records.

TRADER’S SPREADSHEET—BASIC ACCOUNTABILITY

Whenever I talk with traders, I am amazed how few maintain records of their trades in spreadsheets. Many rely on their brokers, but those statements do not provide the necessary level of detail. This is why I recommend using your own spreadsheet. My company, www.elder.com, offers the basic spreadsheet shown on the next page at no charge, as a public service to traders. You can e-mail us at [e-mail] and ask for the template (Figure 3.1).

You do not need to become a spreadsheet expert, but a basic ability to manipulate numbers will give you a much greater degree of control over your trading. If beginners took one tenth of the time they spend looking at indicators and invested that time in learning basic Excel, their payoff would be much greater.

A basic spreadsheet takes just a minute to update after every trade. In my own spreadsheet I have a tab for each of my accounts and a summary tab where I record the value of all accounts on a weekly basis to track my equity curve.

Figure 3.1 shows the headings as well as a few lines from my spreadsheet. The text explains the meaning of every column.

Figure 3.1 A Basic Record-Keeping Spreadsheet

TRADING DIARY—YOUR KEY TO LASTING SUCCESS

Make mistakes—but do not repeat them! People who like to explore and learn always make mistakes. Whenever I hire people, I tell them that I expect them to make mistakes—it is a part of their job description! Making mistakes is a sign of learning and exploring. Repeating mistakes, on the other hand, is a sign of carelessness, or some psychological problem.

The best way to learn from your mistakes is by keeping a trading diary. It allows you to convert the joy of successes and the pain of losses into the bankable gold of experience.

A trading diary is a pictorial record of your trades. It documents your entries and exits by using charts with arrows, lines, and comments. I create a diary entry for every purchase or sale. To make sure my diary is always current and up to date I have a rule—no breakfast until my diary for the previous day is completed. This encourages me to update the diary before the market opens and a new trading day begins.

It is important to document every trade. The only exception to this rule is very active day-trading. If you make a dozen trades each day, you may allow yourself to create a diary entry for just every third or fourth trade.

Why a pictorial diary in addition to the spreadsheet?

You probably carry with you photos of people and things you care about. In your wallet, purse, or on your desktop, you have photos of your wife, girlfriend, husband, children, dog, house, or car. Now I also want you to carry the pictures of your trades, so that you get to know them more intimately than before. Creating and maintaining a trading diary is the best way to learn from your experience.

My favorite tool for taking pictures of charts and making notes on them is a program called SnagIt. It makes it easy to capture images from any charting program, draw and write on them, and paste them into your diary. I use it almost daily for updating my diary or sharing trading ideas with friends. Whenever we shoot each other an e-mail, we tend to send charts captured and marked up with SnagIt instead of writing long messages.

My program of choice for keeping a trading diary is Microsoft Outlook. This is a fantastically powerful program, but most people only scratch its surface by using it for e-mail.

Figure 3.2 A Trading Diary in Outlook See the description of the meanings of colors in Figure 3.3.

Go to the Calendars tab in Outlook, create a new Calendar, and name it Trading. You can view any Calendar in a daily, weekly, or monthly format. I prefer a monthly format, which serves as a table of contents for all of my trades, both open and closed (see Figure 3.2).

Together with two trader friends, Kerry Lovvorn and Jeff Parker, I have created an Outlook add-on especially for keeping a trading diary, which we named AK-47. Initially, the three of us built it for ourselves, but then we offered it to the public, and you can see its description on www.elder.com.

Whenever you click on a calendar to create a new record for a trade, Outlook allows you to label that entry. The labels show up in the monthly view, and if you set a system of rules for coloring labels, each of them will carry a message (see Figure 3.3).

Figure 3.3 Labeling the Entries in a Trading Diary

The calendar in Outlook gives you a list of colors—you can assign a name to each color, making your labels immediately recognizable. Here are the colors I’ve chosen, but you may well select different ones:

None. Entry into a trade that has been closed. Whenever I exit a trade, I do two things. I create a new diary entry, documenting that exit, but I also return to the record of my entry into that trade and

change the label to “entry closed.”

Red. Exit that resulted in a loss.

Yellow. Open trade. When I first enter a trade, I set its label to yellow. Whenever I glance at my diary in Outlook, the yellow labels call attention to themselves, reminding me that these trades are open and I need to manage them.

Purple. Planned trade. Once implemented, I drag the icon into the box of the day on which I traded and change the label to yellow for an open trade. Green. Profit.

Blue. Profit Demerit. I made money on this trade but less than I should have, or violated my own rules.

Brown. Research (a paper trade).

Figure 3.4 Trading Diary—DB, Entry, Weekly Chart

Most of my diary entries include two charts—a weekly and a daily. Depending on the trade, I might also add a monthly or intraday chart. Figures 3.4 and 3.5 show an example of a diary entry.

The weekly DB chart (Figure 3.4) shows the source of a trading idea—an e-mail from a friend who ran several market scans and shared the results with me. Diagonal red arrows mark bearish divergences. Thin vertical arrows show that the stock is prone to sharp drops. There is also a remark chiding myself for being a little too eager to enter. I was very bearish on the stock market and restless after missing an entry into a trade that came from my own scan.

The daily DB chart (Figure 3.5) below shows more bearish divergences and a false upside breakout (a hugely important trading signal). It documents my entry into the trade and grades the quality of my two sell orders on a 100-point scale. Having these charts in front of me today brings the experience of that trade back to life and allows me to learn from it. What did I do right? What did I do wrong? How could I have improved my entry into the trade?

Now, before we move on to the next chapter, would you like to see my exit from that trade, shorting DB? We have already looked at my entry, but what if I told you I forgot how I exited? What if I waved my hands in the air and told you that DB went down and I covered? How useful would that be to you?

Figure 3.5 Trading Diary—DB, Entry, Daily Chart

HOW TO DOCUMENT YOUR TRADING PLAN

I hope that by now I have convinced you that it is essential to keep a trading diary. Will you promise to keep one? If so, I’ll open my Outlook again and show you the exit diary. Take a look at Figures 3.6 and 3.7.

I believe that the best format for a trading plan is similar to the diary we have just reviewed. When you scan 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. Once you have a handful of candidates, it is time to work them up and create an action plan for each promising one.