Trading Tools and Tactics E-Book

Greg Capra

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

Seitenzahl: 483

Veröffentlichungsjahr: 2011

Beschreibung

From the founder of the leading online trading education company Pristine.com, a simple technical method to trade or invest Many trading books present esoteric trading concepts and complicated indicators that may look good on paper when viewing the past, but prove ineffective in the real world. Trading Tools and Tactics: Reading the Mind of the Market doesn't just make investing look easy; it makes trading easy by teaching you not only how to identify price moves, but by helping you understand why prices move the way they do. * Covers managing trades and setting entries and stops, and helps you view how failed trades or chart patterns of the past can become new opportunities * Describes how to identify and understand supply and demand as it relates to resistance and support, as well as how to combine and read multiple time frames that offer the best opportunity to take profits * Details both concepts and practical tools to use for life, not just the current market Investing is all about finding the right price patterns to profit from by understanding support, resistance, trends, and volume?as well as identifying the best time frames to trade. Trading Tools shows you how to do just this.

Leseprobe

Contents

Cover

Series

Title Page

Copyright

Dedication

Introduction: The Journey Begins

UNDERSTANDING THE LANGUAGE OF CHARTS AND PRICE ACTION

HOW TO USE THIS BOOK

ABOUT THE CHARTS IN THIS BOOK

A NOTE ABOUT PRISTINE.COM

Chapter 1: Subjective Doesn't Work in the Market

THE GURU SYNDROME

THE PITFALLS OF FUNDAMENTAL ANALYSIS

TECHNICAL INDICATORS: ADDING SUBJECTIVITY TO THE CHART

APPROACHING THE MARKETS OBJECTIVELY

IN SUMMARY

Chapter 2: Candlestick Analysis

A SINGLE CANDLE

MULTIPLE CANDLE FORMATIONS

FAILURE IS NOT ALWAYS BAD

IN SUMMARY

Chapter 3: Support and Resistance

PRICE PATTERNS

RECOGNIZING REFERENCE POINTS

THE TWO FORMS OF SUPPORT AND RESISTANCE: MAJOR AND MINOR

HOW SUPPORT AND RESISTANCE AREAS FORM

IN SUMMARY

Chapter 4: Moving Averages the Right Way

A VALUABLE TECHNICAL MEASUREMENT

CONVERGENCE CAN HELP

MOVING AVERAGES AS FOCAL AREAS

STAYING OBJECTIVE

A FEW GOOD RULES WHILE USING MOVING AVERAGES

OTHER POINTS TO CONSIDER

MOVING AVERAGES TO FIND PLAYS

IN SUMMARY

Chapter 5: Volume Is Money

THE FALLACIES OF VOLUME

USING VOLUME PROPERLY

THE PRIMARY USES OF VOLUME

VOLUME AS IT RELATES TO TRADABILITY

IN SUMMARY

Chapter 6: Retracement Analysis

THE CONCEPT OF RETRACEMENTS

TO RETRACE OR NOT TO RETRACE?

RETRACEMENTS IMPLY A TREND

CONTINUING TO KEEP IT OBJECTIVE

WHAT LIES BEYOND 60 PERCENT?

RETRACEMENT LEVELS IN DOWNTRENDS

A SPECIAL RETRACEMENT PATTERN

RETRACEMENT LEVELS IN SIDEWAYS TRENDS

WHAT LIES BEYOND 100 PERCENT?

THE BIGGER PICTURE

IN SUMMARY

Chapter 7: Bar-by-Bar Analysis

OBJECTIVITY IS STILL THE GOAL

A QUICK REVIEW OF INDIVIDUAL BARS

HOW THE BARS INTERACT

ADDITIONAL THOUGHTS

IN SUMMARY

Chapter 8: Market Internals

DETERMINING PRICE MOVEMENT

WHEN TO BE DIFFERENT

FAVORITE MARKET INTERNALS

A QUICK OVERVIEW OF INTERMARKET ANALYSIS

IN SUMMARY

Chapter 9: Relative Strength

IDENTIFYING DIFFERENT TYPES OF RELATIVE STRENGTH

IS RELATIVE STRENGTH ALWAYS GOOD?

RELATIVE STRENGTH AND WEAKNESS WITH MORNING GAPS

RELATIVE STRENGTH WITH SECTOR ANALYSIS

RELATIVE STRENGTH TO MARKET INTERNALS

IN SUMMARY

Chapter 10: The Trend Is Your Friend

WHAT MAKES A TREND?

PIVOTS

WHEN PIVOTS COME TOGETHER

SOME SUBJECTIVE GUIDANCE

KEEPING IT CLEAN

CHECKING THE REACTION

FINAL THOUGHTS

IN SUMMARY

Chapter 11: Shoot the Gap

WHAT CAUSES A GAP?

FALLACIES ABOUT GAPS

GAPS AND THE DAILY CHART

THE INTRADAY PLAY

IN SUMMARY

Chapter 12: Frame-by-Frame

WHICH TIME FRAMES?

THE FIRST GOAL OF USING MULTIPLE TIME FRAMES

A POWERFUL CONCEPT EMERGES

WARNING SIGNS IN THE MICRO TREND

HIDDEN PATTERNS

IN SUMMARY

Chapter 13: Making Failure Work for You

DID THE PLAY STOP, OR DID THE PATTERN FAIL?

WHEN GOOD PATTERNS FAIL

CAPITALIZING ON PREDICTABLE FAILURES

EXPECTED (OR UNEXPECTED) FAILURE

IN SUMMARY

Chapter 14: Manage the Trade and the Money

MANAGING THE MONEY—SHARE SIZE

HOW MUCH TO RISK

MANAGING THE MONEY—THROUGHOUT THE DAY

CONSIDERATIONS WHEN SWING TRADING

BASIC TRADE MANAGEMENT CONCEPTS

MANAGING THE TRADE—STAYING WITH THE TREND

MANAGING THE TRADE—ZOOMING DOWN

IN SUMMARY

Chapter 15: Getting Through a Typical Trading Day

BEGINNING YOUR DAY

PLANNING YOUR TRADE, TRADING YOUR PLAN

AFTER THE CLOSE

MAXIMIZING THE WINNERS, AND HANDLING THE LOSERS PROPERLY

Chapter 16: There Is Only One Truth in the Markets

PRICE IS KING

Appendix A: Abbreviations

Appendix B: Trade Types

Glossary

COMMONLY USED MARKET TERMS

GLOSSARY OF COMMONLY USED TECHNICAL TERMS

About the Companion Website

Index

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.

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Copyright © 2011 by Greg Capra. All rights reserved.

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

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Library of Congress Cataloging-in-Publication Data:

Capra, Greg. Trading tools and tactics : reading the mind of the market / Greg Capra. p. cm. – (Wiley trading series) Includes index. ISBN 978-0-470-54085-5 (hardback); ISBN 978-1-1180-9855-4 (ebk); ISBN 978-1-1180-9856-1 (ebk); ISBN 978-1-1180-9857-8 (ebk) 1. Investment analysis. 2. Stocks –Prices –Charts, diagrams, etc. 3. Stock price forecasting. 4. Portfolio management. I. Title. HG4529.C366 2011 332.63′2042–dc22 2011010990

To all the prior, present, and future Pristine students.

Introduction

The Journey Begins

UNDERSTANDING THE LANGUAGE OF CHARTS AND PRICE ACTION

Twenty-two years seems like a lifetime ago, but back then I did not know the difference between a stock and a bond. I had a successful business, which I had organized to pretty much run on its own with good employees to carry out the day-to-day work. I began to take an interest in the market as I looked for what to do with my business profits. This soon became an obsession to learn how the markets operated, which is not uncommon for those who are bitten by the market bug.

Learning or wanting knowledge about the markets can be like a drug you have to have. If you feel this way—and I hope that you do, because as a trader you must have a passion and hunger to learn, excel, and be good at anything you do—I believe that this book will answer more questions about technical trading than you could ever imagine. If you have been trading for a while with the typical tools, this book is likely to shake some strong beliefs that you now have about technical trading.

When I began my quest, things were much different from today. There was not much information available about the markets. Day trading, as we use the term today, did not exist for the masses yet and was a couple of years off still. Many things we take for granted today, like even an intraday chart, did not exist. You could not place a trade yourself. The trade had to be placed by a licensed person. The only method of learning at the time was by reading books, and there were not a lot of them. Some of the things in these books made sense, but they did not enable me to make money.

At one point, I took a home-study course on fundamental analysis. I felt that if I learned about a company's fundamentals, and found companies that were undervalued, with low PE ratios, it was a method that could not fail. I came to realize that whenever a company goes bust, it will go always through a process of looking like a bargain and having lower and lower PE ratios. These stocks were much higher in price in the past and the current price seemed to be “cheap.” Strike one.

Somehow, which was just a gut feeling at the time, since I knew next to nothing, I realized fundamentals were not the way to the faster profits I was after. However, I knew enough to realize that my limited knowledge and desire to make faster profits were a dangerous combination. Put another way, I was dangerous to my own financial well-being. The allure of the market does that, so I was not different from many others. However, I was smart enough to realize the risk and was not going to go bust. For that reason, I put most of my savings into municipal and corporate bonds. My basic understanding of them was that holding quality bonds to maturity virtually guaranteed getting back all my money plus a profit. If you are not familiar with bond investments, while they are “relatively safe” if held to maturity, their value can swing up or down a lot before the bond's maturity date. So it is possible to lose money in these so-called safe investments if you have to sell prior to maturity. Luckily, my bonds appreciated nicely at the time, plus provided additional income.

My long-term bond investing and trading has always turned out well, which helped offset some losses in what turned out to be a bust in tax shelters I participated in. Honestly, I knew very little about these at the time, but saving on taxes with a potential for a return all sounded great. I lost virtually everything on them. Past performance is not a guarantee of future performance, or so it goes. It sounded too good to be true, but greed has a way of allowing us to rationalize a good sales pitch.

Greed helps drive the markets, and it is possible to make money in a hot tradable instrument. But without the knowledge of what you are investing in or having a trading plan for your short-term trades, it is a pure roll of the dice. Odds are that you have had or you will have similar experiences to mine at some time, if you are new to the markets. You may hit a winner from a friend's tip, or the tip may not work out. Either way, it is not your researched idea, so you are just gambling.

Information can and does come from sources other than you. However, as a professional investor or trader you will make sure that you have done the work so that the decision to act or not is yours. Everyone reading this book has had—or will have the experience if you are only just starting in the markets—of not having a stop-loss in place that turns into a freefall of prices. This disaster may raise the head of another known demon, that of averaging down in a loser to lower your cost, in an attempt get back to breakeven or better. This can result in financial suicide for those new to the market and even those who are experienced that trade without a thought-out money management plan for an advanced trading strategy.

If you are thinking that averaging down should never be done, it can be. But it should be planned out based on advance money management strategies combined with technical analysis of the instrument traded. There are many ways to lose money in the markets, but all “uncalculated losses” in the market come from not having a plan and the education to operate in the market or operating outside of that plan. But you will read much more on this later.

My mind-set began to change from the beaten down so-called bargains. It likely changed because what I was doing was not working, so my mind began to open up to other ideas I was reading. One of them was the concept of buying really strong stocks that were moving up already, rather than trying to catch bottoms that many times never formed (or when they did, prices often retraced back down quickly). Bottoming stocks typically retest those bottoms multiple times, since there are so many people that are tired of holding them. Each time prices rally, holders of the stock sell into the move. Bottoms just take time to form and a sustainable trend typically happens after multiple retests of the lows after one, and many times two, strong moves out of that base. As with all technical trade setups, there are future expectations as to how those setups are going to play out. Bargains or bottom patterns take time, sometimes a long time, so expecting quicker trading profits does not make sense. Sounds like common sense, but when you are trying to figure out how the market operates it is all a mystery. It was to me.

Okay, so why not take a stock that is already moving up and jump on board? Many of you probably know the outcome from this technique, especially if you have tried it. I found strong, on-the-move stocks. The day I bought them, however, they decided it was time to take a break. So they would begin falling. But not to worry, I would say. This is what happens when you buy strength. Falling from strength is not uncommon, but did I have a plan as to where they would likely fall to? Would that be a good place to buy more or would the fall have caused so much damage that the original reason for the trade no longer existed? And even before these questions, was a strong stock that was already up, up too much? It was too early in my development to have answers to such questions, but they are good ones for you to consider now. It will all come together as we delve into the coming chapters.

The only problem for me in buying strength was the late entry that is inherent with buying something once you know it is strong. The pullback then begins, and it always seems that when I went long, the pullback was above average. Then the stocks would continue to decline to the point where I would have to question whether they were strong stocks anymore. And right or wrong, I was in pain from being down so much money. I never really figured or accepted the possibility that the trade would fail. Out of pure desperation and fear of a greater loss, I would sell and move on. A week later I would check on the stock, and 100 percent of the time (I am making up that statistic, but if you have been there, you also believe it to be true), the stock had shot up by leaps and bounds---and I not only would have had my money back, but I would have been well in the black.

I also came to realize in this process that these really nice-moving stocks were not ones that the “experts” said to buy. Some did not even have PE ratios, because some did not even have earnings. By the time the experts recommended to buy these stocks, they were already up hundreds of percentage points. Strike two.

Through this process I began to learn a few things. First of all, if there is any correlation between the fundamentals of a company that are known to the public and the price of a stock, there is no way to predict it or profit from it. I began to realize that simply looking at what stocks were actually doing, rather than what people “said” they should be doing, was much more reliable. This was a huge moment for me and a step in the right direction. It led to what I now refer to as “the only truth” in the market (which you will read about throughout this book).

While it was a step in the right direction, I still had a long way to go. This led me into the technical world of stocks. Twenty years ago, when you became a technical trader, it was almost synonymous with saying a “technical-indicator” trader. The reason was simple. The faster method of trading was being instituted, and technical trading was fairly new to the masses.

Stock traders using technical analysis looked to the same programs and indicators that commodity traders were using. Computer-based charts and indicators were more commonplace when it came to commodities. This was not inexpensive at the time. For stock traders, there were chart books that could be bought and were mailed to you on a weekly basis. We've come a long way! Computers were showing their power (relatively speaking) and becoming more affordable, and data vendors were making daily price information available for download. This was the time of 286 speed computers and 2400-baud modems. It was not fast and compared to today, it was like the stone age of technical trading. It was new to everyone, and there was not a lot of information out there. The thrill of having a single silver bullet, one Holy Grail to predict price, was very appealing. This was especially true after being chewed and spit out by the market more than a couple of times.

The argument for technical indicators was also very well presented. The author always had charts of stock prices, and the indicator they were selling always moved up or down with the price nearly perfectly. It always seemed to be very accurate. Every big move up in price had a nice bottom set by the indicator. What a “no lose” situation. So I began trading with some of these much-touted technical indicators.

A funny thing happened. They did not really work. What do I mean by did not really work? Well, they would work sometimes. But anything works sometimes. If your system was to go long the market the day after your dog gets a bath, that would work sometimes also. But I would not want to trade by it. Also, these indicators often worked in hindsight, meaning, when the stock took off, yes, the indicator did also. But it did not lead as some suggested it did. And if it did seem to lead, sometimes it was wrong. And sometimes the indicator and the stock went up but then fell hard. There did not seem to be any way to distinguish real moves from false moves, and the best moves seemed to happen with price leading the way, with the indicator keeping me out until it seemed to be too late. Suggesting that indicators prices are same as saying the tail wags the dog. It was all an illusion.

I even took all of this to a new level. I not only tried all of the indicators available at the time, but I also tried various combinations of them. My thoughts were that if several point in the same direction at the same time, it must work. It did not. I then went to a level that few of you probably have; I wrote my own indicators. I figured that the concept was good; it was just that nobody had the right formula yet. With all of the research I had done, I already knew much of what did not work, so I should have been the perfect one to write the perfect indicator. You can guess the results of those many months of work.

Some of you are probably laughing at this point, and if so, it is only because you have been through this. It is at this point that the vast majority of people who set out to beat the market just quit. They quit out of frustration, losing too much money, or just lack of belief that it can be done.

Well, I was frustrated. I had lost some money. But I still believed it could be done. Something I always thought about was that the market is a zero sum game. For every dollar I (and all those like me) was losing, someone was making those dollars. This kept me motivated. Thinking back on it, the lack of information and the frustration I went through became my biggest allies. By sorting through so many things that did not work, I fell upon a hidden truth: the thing that did work. What worked was not a single indicator. It was not a single formula, and could not be explained in a single paragraph. What alone worked was understanding the language of charts and understanding price action. It was the knowledge that prices do move in certain repetitive ways. While these movements are not perfect, they are reliable enough to make money when understood properly.

While this seemed to me like a revelation at the time, today it just seems like common sense. It took a while to understand, but now it seems easy. The easy part comes from viewing or interpreting any chart in any time frame in the exact same way, without the subjectivity of indicators, trend lines, Elliot Waves, Fibonacci, Bollinger Bands, Gann, planetary alignment, and so on. This doesn't mean that every chart pattern is tradable (and we will discuss that in detail), but my analysis—and I hope soon yours—of any tradable instrument will be clear, based on a consistent, systematic method of analysis.

Currently, I am the President, CEO, and the majority holder of Pristine Capital Holdings. Since its inception in late 1994, Pristine.com has been dedicated to helping investors and traders find the truth in the market; to a way of reading price that keeps it simple and uses pure common sense. It is not always easy, but it is very learnable.

Years ago, I also formed a broker-dealer to help Pristine students get the best trading technology and service available. Back then (and even today), it was (and is) difficult to get the service active traders and investors needed. Many advancements and offerings at Pristine have been based on the question, what will help traders do the best in the market? Since then, many have found out about the great service, as well as very competitive rates, at Mastertrader.com. If you are a serious trader or investor you will want to contact them.

Like anything in this life, nothing is free, and the truly great things are worth working for. With that, I invite you to read and enjoy this book. At the end of the book, you will understand that there is only one truth in technical analysis. Enjoy.

HOW TO USE THIS BOOK

I suggest that you read this book through from cover to cover. In the beginning chapters I discuss, in a very detailed way, some of the essential concepts, such as candlesticks, support and resistance, and moving averages, and explain how the common use of many of these is incorrect.

We then move into some of the more detailed areas on the charts and again discuss the proper and improper use of tools like volume, retracements, and how to analyze every bar as it forms.

We next look at more advanced concepts. In a section called “market internals” we look at various ways to dissect the market. We examine the proper use of relative strength, and how to really understand the differences in trends. We then look at gap analysis and also take a look at how prices play out over multiple time frames, one of the most advanced topics there is for a trader.

Following, we delve into more specialized topics, such as how to make failures work for you, and we talk about the all-important concept of how to manage both the trade and the money. We then look at how to handle the trading day, and conclude with a wrap up repeating the most important truth you need to learn about the markets.

I am sure you will enjoy reading this book as much as I enjoyed writing it.

ABOUT THE CHARTS IN THIS BOOK

There are many charts throughout this book that illustrate the concepts being discussed. If you want to view the full color versions, you may do so at the companion website at www.wiley.com/go/capra. (password: trade123)

A NOTE ABOUT PRISTINE.COM

Our Trading Methods

As you may know, I am the founder of Pristine.com. We have been in the business of teaching our clients how to become professional traders and investors. We have been doing this since 1995. If you look around this industry, there are very few organizations that can claim that longevity. I am proud of what we have built at Pristine. Our clients range from regular people who want to manage and take control of their own IRAs, to people who want to become professional day traders.

You will notice throughout this book there are various references to the terminology we use at Pristine. It is how I talk, and the only way I know to look at the markets. I have tried to explain the terminology whenever I use it. There is usually an acronym associated with the terminology; if you begin to lose track of the acronyms, there is a list of most of them in Appendix A. As you will soon see, our trading methods do not rely on a myriad of fancy oscillators or proprietary systems. We read price patterns and have learned how to pull information from every bar that forms on a chart, and how those bars come together to form trends and turning points. If you have studied the market for any length of time, you know this is the only way to understand the market.

More Information for You

In this book, I sometimes refer to the courses or methods we use at Pristine. I did not want to bore you with continuous references to Pristine, so here in the Introduction I am writing to let you know that you can find further information about many of the methods discussed in this book by visiting Pristine.com. On this website you will find many useful pieces of information that are available for free, including many free webinars and free services. In addition, you will find a list of the offerings that we have. They range from our world-famous “Trading the Pristine Method Seminar” to a “Proprietary Trading Program,” for those who want to trade firm capital please visit www.pristine.com.

Chapter 1

Subjective Doesn't Work in the Market

Technical Analysis Is the Objective Standard

Webster's Dictionary defines subjective as “characteristic of or belonging to reality as perceived rather than as independent of mind.” When we want an opinion from a critic on how good a movie is, we are expecting a subjective review. When we read a restaurant write up, we also get a subjective review. We may see the movie or eat the meal, and have a different experience than the critic did. We will tend to follow the critics who agree with our subjective notions.

This is fine for movies and dinner and many other things in life. But the market is not a matter of opinion. There are several ways in which “subjective” enters the marketplace. Subjectivity can enter when traders try to rely on the latest guru in the marketplace, when they try to use fundamental analysis in their decision making process, and when they use technical indicators on their charts. While there are some others, these are the three biggest culprits. I am going to explain how you can fall into each of these traps, and how you can avoid them.

THE GURU SYNDROME

The first common way in which people let subjectivity enter their trading comes to people before they decide to do it on their own. There is a tremendous tendency for people to want to follow a guru, or anyone who speaks with authority. Often these people are followed without any track record, simply because they say things that “make sense” or agree with our views in some way. Unfortunately, what appears to be common sense rarely works in the market place.

If you take a look at the famous gurus over the years that made a name for themselves, most of those names are gone. There may be new names today, but they will be gone tomorrow. People make names for themselves by standing up and taking a firm stand on the market. For example in the 1990s, you may remember (if you were following the market then) several big names who decided to take a very bullish stance once the market began moving up. As time went on they got fame for their “prediction” and continued to pound the table to be long. When the market turned in 2001, it also turned on them. They dropped off the map or were even heckled for their views. Very few gurus maintained a name for themselves when the market turned. Just like many did with their stocks, these gurus rode fame as the market rallied, and crashed with the market.

Did some predict the crash? Sure. The problem here is that many predicted the crash up to eight years earlier. Again, little fame is justified for such predictions. In every market you will find bulls and bears. Some are right, some are wrong. Those that are consistently right are harder to find. Those that are consistently right are often looked at as foolish for periods of time where they go against popular opinion, even though it is the right thing to do at the time. They have found their own method or style, and know how to use it properly. New people to the market usually find in short order that the “experts” on TV are not making them any money.

After a while, many learn it may be best to find a way to develop a system, method, or style of interpreting the market, or individual stocks, in order to find their own plays. For traders or investors of the market who decide to do the work themselves, there are still two ways in which subjectivity is introduced to their studies. The first way is by relying on fundamental rather than technical analysis. While this debate has continued since the beginning of time, my view is unquestionably that there is no debate: technical analysis is what works in the marketplace.

However, even when traders take the technical route subjective issues can still creep in through the use of technical indicators. Following is a discussion of both of these issues that new self-directed traders may face.

THE PITFALLS OF FUNDAMENTAL ANALYSIS

Going back to the first time anyone charted the price of something that was sold in an open market, the debate between fundamental and technical analysis has existed. Fundamentalists claim that technicians are trying to look at the past and predict the future. Technicians claim that fundamentalists are trying to find the value of a company, which is impossible to do, and that is not relevant even if you determine what it is.

Fundamentalists look at the accounting numbers of the company. They look at things like price to earnings ratios (PE ratios), book value, and other accounting type numbers. They also look at things like the ability of current management, new products coming out, and recent acquisitions. They then take all this information, and come up with an exact price that the company should be worth. From that, they calculate the price per share, and if the number is higher than the current stock price, they consider it undervalued, and a buy.

On one hand, it sounds like looking at hard numbers may be very objective. But there are several problems with this. First, how do you know to trust the numbers you are looking at? Back when Enron was trading over one hundred dollars a share, it was considered a great fundamental value. The problem was, of course, that the numbers that were being looked at were all lies. They were made up by accountants and CEOs. Was that an isolated incident? Not in the least. WorldCom and many other companies have gone out of business or had huge price swings as the underlying accounting numbers were found to be a “tad bit off.”

Even if you are less skeptical, talk to an accountant of any business. There are huge ranges in acceptable accounting measures that are allowed. Some are just allowed, while some are in constant debate as to what is correct. So the officers of a company can have huge swings in their profit and loss statements, based on the decisions made on how to account for certain big numbers. Fundamentalists often look to a change in profits by even a penny as being a big deal, when the accounting choice may have changed the outcome by a dollar. It becomes quite silly at some point. So, using the fundamental numbers of a company is a very subjective way of valuing a company when you come right down to it.

Beyond that, there is a more basic problem with fundament analysis that makes it even more subjective. It assumes that someone knows the value of a company based on last year's or last quarter's numbers. But that picture is immediately clouded when an analyst says, “That was last year, you should see what they are likely to do this year.” So now they start talking about increasing the value of their “objective” analysis by a guess as to what may happen in the future. This is why hundreds of companies in the 1990s (and this still continues today) had soaring stock prices, with no earnings. Fundamentally, without earnings, there are really no numbers to work with to justify any price, let alone a higher value than the current price. Yet the promise of future earnings had stocks rise from one dollar to literally hundreds of dollars, based simply on the promise of great earnings someday. Does that sound like how you want to make your trading and investing decisions?

There is one more problem that puts an end to the conversation. It simply does not work. Many companies that show undervalued prices, and have low PE ratios are often undervalued for a reason. There is a tendency for the cheap to just get cheaper. They are rarely good buys. Likewise, companies, or their stocks, that seem overvalued, rarely come down when analysts say they should. They are overvalued for a reason. If you have ever tried investing using fundamental numbers, you have likely discovered these issues for yourself. Fundamental analysis is actually totally subjective, hiding under only a veil of objectivity.

Most Wall Street analysts use fundamental analysis, though the number of technical analysts has increased dramatically. The opinions of Wall Street analysts on a particular stock or the overall market really have not been much help at all to investors and traders over the years. Take a look at Figure 1.1. Back in 2000 as the price of the stock was reaching all-time highs, everybody loved shares of Yahoo. Merrill Lynch had it as one of their best ideas. As the price declined they reiterated their buy recommendation believing it was such a great company the price of the stock had to rebound. The price continued to decline throughout the year as the Wall Street analysts continued to suggest investors snap up the shares. Finally when the stock had declined by about 90 percent, Merrill Lynch downgraded the stock and stopped urging investors to buy!

Figure 1.1 Actual Analyst Calls Getting Yahoo! 100 Percent Backward

Chart courtesy of Mastertrader.com.

Technical analysis, on the other hand, looks to one thing: what the company, or price of the stock, is actually selling at. Technical analysis assumes that the price a stock is selling at is the perfect price based on the fact that all known quantities, whether in the past, or anticipated in the future, are built into the price. Tens, hundreds, thousands of investors and traders take positions on both sides of the stock price, and it trades at the price that they have determined based on supply and demand. It is the price. There can be no argument. When you think of it that way, any other method is useless.

Now, to determine the future price, technical analysis relies on patterns. Seeing prices that occur consistently in such a way it shows that there is ongoing demand for, or supply of, a stock. Learning these patterns is exactly what learning technical analysis is all about. Are their drawbacks? Of course, or else this debate would not exist. However, all drawbacks are a function of not understanding how to use technical analysis. For example, technical analysis finds patterns that are predictable, but it does not mean that every pattern you see will be a predictable pattern. Another example is the concept of multiple time frames. Smaller patterns exist inside bigger patterns, and if you do not know how they should interact, it can appear random. These concepts will be discussed more, later in this book. Most important for this chapter, regarding subjectivity, is the misuse of technical indicators. Many traders rely on technical indicators, but unfortunately these indicators take the objective chart and turn it subjective.

TECHNICAL INDICATORS: ADDING SUBJECTIVITY TO THE CHART

The term “technical indicator” refers to all the things on a chart other than price, which are derivatives of price. You may know some of them: Moving Average Convergence Divergence (MACD), Relative Strength Index (RSI), Stochastics, Gann Lines, Elliott Waves—the list goes on and on. There are charting programs that literally have over 200 of them. This alone should tell you the value of any one indicator. Even moving averages are technical indicators. While moving averages can have a useful purpose, they too are often used subjectively to a trader's detriment.

Technical indicators are subjective in nature for a couple of reasons. They all rely on past prices. Also, while they claim to add objectivity, they all have so many settings that it comes down to everyone's individual opinion of how to read them.

It Is All in the Past

As I just mentioned, all technical indicators rely on past prices and apply a mathematical formula, which is supposed to help predict the future move. The past prices are already on the chart in front of you. This is the objective part of the chart. Price is what matters. Once you create a derivative of that price, it is open to interpretation as to what it means.

Some who use indicators say that they remove the noise from the price movement. However, it's that noise that can provide some of the most valuable information to us. We'll get to this later on.

There is some subjectivity in reading a price pattern. Trading will always have some subjectivity. If it did not, the future of all prices would be known to all and there would not be a market. Our job as traders is to keep things as simple and objective as possible, to find the patterns we know. Indicators add just another layer of mystery, and rely on someone else's setting to tell us what is happening.

It Is Still a Matter of Opinion

Indicators rely almost entirely on opinion or how each individual reads the tea leaves of the various indicators. There have been literally hundreds of different oscillators and indicators developed over the years and when most of them have the option to change the settings it makes the choices endless. The simple truth is that they alone do not tell you anything about what is going on in a stock or in the markets. Investors and analysts over the years have developed countless methods to take the measure of the market. In reality, you do not need to measure or guess the market. The answer is in the price and it will tell you what it is going to do if you know how to listen to it.

Subjective analysis is based on what you think is happening. In contrast objective analysis is based on what is happening. Prices are directly observable in the real world and tell us what we need to know. Making decisions on subjective measurements leads to what we at Pristine (recall that I am president of Pristine.com, and may occasionally reference what we do there; please see the preface for more comments about my trading company, Pristine) call “mirage trading.” It almost always leads to failure. A stock can hit its moving average and go down just as often as it might go up. A stock can remain oversold for months at a time. Perhaps you have already made some of these observations.

Take a look at Figure 1.2. You can see a clear divergence in the 14-day RSI, a very popular oscillator. A divergence such as this would tell the trader that since the oscillator is going down, the stock price should follow according to traditional technical analysis. As you can see that simply does not happen. All an oscillator can measure is slower momentum between price points. This does not necessarily mean that prices will change direction any time soon. Momentum can increase and decrease and the trend remain the same for a long time.

Figure 1.2 An RSI Divergence Is Often Meaningless

Chart courtesy of Mastertrader.com.

As we can see in Figure 1.3, using absolute levels for many of the indicators does not work either. In this example the RSI never reaches the levels that would indicate the stock was oversold and should be purchased. The price just kept going up for months. This leads to traders trying different settings until the indicator reaches the buy and sell levels where prices turned in the past assuming that this will predict the turns in the future. As the market environment changes or a different stock is used the indicator doesn't line up any more. This typically leads to a long cycle of constant changes in settings and indicators to find the perfect indicator.

Figure 1.3 Most of This Move Was Missed by the RSI Indicator

Chart courtesy of Mastertrader.com.

Unless there is a very strong trend in place, using oscillators leads traders to buy tops and sell bottoms in stocks. The tools you learn in this book will show you to focus on the price itself. It does not matter if you are a day trader using five-minute charts or a long-term investor looking at weekly ones, all the information you need is in the price bars themselves. Why use anything else? The price is the truth.

You may notice that these conversations can flip back and forth between a stock and the market. That is intentional. The market is just a sum of several stocks. What is taught in this book works across all price patterns on anything that is bought and sold in an open market, with sufficient volume. Stocks, futures, commodities—the market itself—they are all the same.

Another problem with some of the technical systems that traders use is that they may lead the trader to believe with 100 percent conviction that the trader knows what will happen next. These are the ultimate in providing those new to the technical analysis with a false sense of security. Everyone wants to feel secure—to know what will happen next. This is human nature, but this is a major obstacle to succeeding as a technical trader or investor. Methods like Gann Angles, Cycle analysis, and Fibonacci retracements profess to offer precise measurements and predictors of stock movements. This creates a belief for traders that they know what is going to happen and can lead traders to make serious mistakes. If your conviction causes you to over-bet on a particular trade the results can be disastrous. Operating with a false sense of belief can also cause you to stay with a losing trade far too long, rather than exit with a small loss when the market told you your bet was wrong.

APPROACHING THE MARKETS OBJECTIVELY

To succeed at trading and investing you need to develop confidence, patience and discipline. I have found over the years that the key to developing these traits includes, ironically, operating in a state of not knowing what will happen next. This is just the opposite of what the majority of technical analysis techniques are based on. You have to eliminate subjective analysis based on indicators from your day-to-day activities in the market. To do this we need to learn a systematic objective approach to the markets.

At Pristine, we teach traders to recognize two key factors when approaching the markets:

1. A stock is always in one of four stages: we name those stages simply stage one, two, three, and four. All stocks, markets, anything, are always in one of these four stages. This is what I consider to be the first basic truth of trading and investing. Understanding this will always keep you on the right side of a move, and also let you know when it is best to leave a stock alone as it becomes less predictable. This is a basic concept to our method that I will be referring to throughout this book.

2. The stages always come in the same order. Once we know what stage a stock is in, there are very specific strategies used to play the stock, and this process keeps us objective in our trading.

The Four Stages of the Markets

For every stage, there is a correct way to play the stock. There is a direction, and there are certain strategies that can be played that will maximize the movement due to the stage we are in. Once you know what stage you are in, you know how to trade the stock, and you will know what strategy to use on the stock, which will tell you when to enter the position. Simple, objective, clear. Trading against the stage a stock is in accounts for 80 percent of losses.

Is it always easy to tell what stage a stock is in? No, of course not. In hindsight it is. In real time it is sometimes easy, and sometimes more challenging. Subjectivity can never be totally eliminated in technical analysis; you must accept this. But it must be controlled, minimized, and understood.

Here is an important point to remember: When it is not easy to tell what stage a stock as in, you, as a trader, have the right to pass that particular trade. Wait for a better stock, or a better time.

Re-read this paragraph; it is one of the keys to trading in my view.

Winning traders and investors are those who have learned to identify which cycle a stock or market has entered and buys or sells accordingly. You want to buy at the beginning of stage two and sell it before it enters stage three. Again, this is true regardless of whether you are day trading or investing for the long term. Losing traders and investors are those who react emotionally or rely on subjective indicators. Inevitably these individuals will buy late in stage two as the excitement peaks and sell near the end of the fear stage when all hope of an imminent recovery is gone.

Stage One: A Time of Ambivalence

In stage one, the stock is in what I call a state of ambivalence. Nobody really cares much about the stock, and the stock trades back in forth in a range. There is usually very low volume, as there is little interest in the stock. The range is usually very small, as again, no one cares about this stock. Stage one always follows a period of selling, and often this selling can be enough to totally turn off the bulls from trying to buy any more. They are wounded, hurt, out of money, and no longer interested in the stock. Other bulls may be watching, and may soon want to buy, but at the moment, no one is interested as this stock is weak, and no one knows how far it may fall. There are many failed breakout and breakdown attempts, as neither bulls nor bears can find follow-though anymore, as there is just not enough interest. Breakouts always fail, as all the traders that held the stock long on the way down, sell into rallies trying to recoup their money.

Stage Two: The Uptrend

After enough time goes by, many of these sellers exit or give up, and are no longer selling on rallies. All of a sudden, instead of a rally getting slapped down, it holds. Bulls look around and notice there are very few bears left. This attracts the attention of other bulls, and a snowball effect develops. When selling does come, it is just profit taking from the new bulls, and the stock doesn't go as low as it was before. More bulls come in and the next rally goes to new highs when compared to the prior rally. If this process continues, the early bulls are rewarded as the stock continues to set higher highs on rallies, and higher lows on pullbacks. This turns into an actual uptrend and attracts more buyers. This is now stage two, the time of buying: bulls, uptrends, and the emotion is greed. In the beginning this is what drives the price higher, and the beginning of stage two is the sweet spot that traders should strive to hit. You can see this in Figure 1.4.

Figure 1.4 The Power of a Stage Two

Chart courtesy of Mastertrader.com.

Figure 1.5 The Uncertainty of Stage Three Produces a Wide Sideways Pattern

Chart courtesy of Mastertrader.com.

Stage Three: Uncertainty Sets In

Even after stage two has been in place a while, it can continue higher. Never bet that a trend is going to end unless you have good evidence. One of the odds we have in the market is relying on the power of the trend. At some point, new intelligent buying now becomes irrational exuberance. However, sometimes after a reasonable move, traders take profits, and new bulls are not as easy to find. The stock or market cannot find enough buyers on breakouts and they fail. Yet, when things seem weak, potential buyers who missed the move view dips and breakdowns as buy opportunities, and breakdowns do not work. The stock or market goes sideways, in a very sloppy manner in a wide range. The bulls and bears have to battle it out until a victor is found. This is a period of indecision, where prices go sideways, and where unknowing traders try to play breakouts and breakdowns and they lose money, never knowing why.

Stage 4: The Downtrend

The pattern may settle down and simply go higher, which would continue the original stage two. This is known as a pause in stage two, and can be distinguished. We will discuss these two types of bases in more detail later. But sometimes the balance of power changes and, all of a sudden, one of those breakdowns does not find buyers and the price drops. The bulls who have been relying on that base to hold now realize they are in losing positions, and they begin to exit. Again, the snowball starts rolling and selling begets more selling. The rallies stop short of prior rallies, and the declines go lower than the last decline. Selling, fear, good news is bad news, are all the signs of stage four (see Figure 1.6).

Figure 1.6 Stage Four: The Bears Take Control

Chart courtesy of Mastertrader.com.

As fear accelerates, selling increases and begets more selling. This drives prices to the point that even those who swore they would not sell cannot stand the pain and they sell, vowing never to buy another stock again. At some point all sellers, that are ever going to sell, have sold. The stock has run out of sellers and it stops falling. There are no buyers, as the pain has kept old bulls away, and the falling stock has kept new buyers away. So the stock drifts sideways, with no one caring. We are back to ambivalence; we are back to stage one.

This will play out across all time frames. You will see it on intraday charts every day. You will see it on daily and weekly charts.

Observing Trends: Up, Down, or Sideways

The second truth is that throughout these stages, a stock or market can really do one of three things. Go up, go down, or go sideways. When a stock goes sideways, it can trend sideways in a reliable pattern, or it can be sideways in a wild erratic pattern.

Stocks go up in up trends (stage two), where the price movement forms higher peaks at the highs and higher dips at the lows. Stocks go down in down trends (stage four), where the price movement forms lower peaks at the highs and lower dips at the lows. A sideways price pattern will have a series of roughly equal high peaks and low dips and requires a slightly different approach to trading. Knowing which condition exists is a key to consistently making money in the markets. Once we know which stage and trend a stock or market is in at a point in time, we can begin using what prices are telling us to find: high probability price movements.

One of our biggest tools to help spot where we are and how to read what the prices are telling us, are what I call the Pristine Buy Setup and Pristine Sell Setup. As you can see in Figure 1.7, I use candlestick charts to read the price of a stock or index. For analyzing all normal price action on most charts, I do not consider a chart useful unless it uses candlesticks. I will explain why in greater detail in Chapter 2.

Figure 1.7 A Bullish Changing of the Guard Bar Tells Us the Stage Two Uptrend May Be Ready to Resume

Chart courtesy of Mastertrader.com.

For now let's take a look at what this chart is telling us. The big picture of this stock is a bullish stage two, moving up with higher highs and higher lows. The recent pattern shows the stock has been moving down for several bars in a row, but has not violated the stage two pattern. Once we get a reversal of this price action, as long as we have identified that the stock is still in an uptrend, or in the early part of stage two, it is time to buy. We also call this reversal bar the “changing of the guard” (COG).

In Figure 1.8 we can see that a Pristine Sell Setup (PSS) is simply the reverse of this. The big picture of this stock is a bearish stage four, moving down with lower highs and lower lows. The recent pattern shows the stock is moving up for several bars but has not violated stage four. If we looked at the movement as a line it would be pretty much a straight line up. When the price action reverses it is time to sell or short the stock.

Figure 1.8 A Bearish Changing of the Guard Bar Completes This Sell Setup

Chart courtesy of Mastertrader.com.

These setups can be used in any time frame. They can be used to establish short-term swing trades or to time long-term stock purchases. It is an easily recognizable pattern that uses a specific series of candlestick charts. Generally speaking once we get reversals we find out very quickly if we were right or wrong and can react to what the market tells us most of the time. Generally this set up occurs when there has been a countermove due solely to profit taking, and the buying or selling activity of the underlying trend is going to reassert itself. Because we already know that we do not know exactly what is going to happen we can let the price tell us what to do once we place the trade.

There are several beautiful things about this Pristine Buy or Sell Setup you may have noticed. First, we are playing in the direction of the primary trend. Second, we are not chasing high prices, we are getting in right at the maximum pullback. Which leads to the next beautiful thing, we have a larger move to whatever price target may be out there. We also have a place to limit our losses very quickly, because if we are right, that entry bar should be the resumption of the trend. If it does not hold, we will be out quickly.

Take a look at Figure 1.9. The stock opens up and begins an uptrend around 10:30 A.M. Then, at 11:15 A.M., we get a changing of the guard buy setup. After momentum stalls and the stock fades out, we pull back setting up another buy signal and move still higher into the close. The patterns are very precise and easy to recognize.

Figure 1.9 The Uptrend Is Punctuated with Bullish Changing of the Guard Bars

Chart courtesy of Mastertrader.com.

Once we eliminate emotional thinking and subjective analysis we can begin to read what the market is saying. The price is the truth and it is all we need to determine what trading or investing action to take next. We do not need to rely on indicators and tools that are derivatives of price when we can use the price itself. There are no fundamental or technical measurements that will allow you to develop absolute certainty about what is going to happen next. Using the tools you will learn in this book you can tip the odds in your favor but you have to be willing to trade based on probability, not absolute certainty. This allows you to react properly to what does happen and to profit.

IN SUMMARY

The price patterns that form every day and every week are true objective indications of what is actually happening to prices. When stocks are being bought or sold they usually develop very specific patterns that can be learned and identified. Relying on or even considering any of the subjective notions we discussed is only a mirage as they do not involve the truth.