The Wiley Trading Guide®
Table of Contents
Introduction
Chapter 1: Financial markets as complex adaptive systems
Straight lines and curvy bits
Introducing chaos theory
Chaos theory and financial markets
Complex adaptive systems
The behavioural spectrum
Points of agreement
Introducing CAS analysis
Chapter 2: Planning your trade to success
Who needs a trading plan?
‘I am on my own, therefore I don’t need a trading
plan!’
‘Creating a trading plan is a waste of time’
‘Trading plans need to be flawless’
‘Only businesses need a plan’
‘My trading plan is written in my head and known by
my heart’
Personal trading plan: your trading edge
Focus and direction
Drive and motivation
Comprehensive study and strategy
Personal creativity
Results
A smart personal trading plan
Keep it simple: start with a vision
Choose an approach that suits your personality
Manage your risk and money
Establish your trading system
Come to terms with your mindset
Become a smart trader
Final thoughts
Chapter 3: Lies my broker told me
Time in the market versus timing
Volatility argument
Random market argument
Best days argument
Dollar cost averaging argument
Good stocks always get better
Final thoughts
Chapter 4: Devising a trading strategy
Aim for consistency
Keep it simple
Decisions, decisions
The entire trading process
Introduction to trading strategies
Following trends
Peaks and troughs
Moving averages
Trend alignment
Trading strategy structure
Final thoughts
Chapter 5: The pursuit of profit
Understanding price action
Market structure
Key characteristics of trading opportunities
High probability
Large price movements
Trading template
Specific trade setups
Retracement entry
Final thoughts
Chapter 6: Getting the edge using intermarket technical analysis
Asset sectors defined
Factors linking markets
Implications and premises of intermarket technical analysis
Concept of correlations
Concepts of rotation, leading and lagging markets
Concept of confirmation and divergences
Graphical representation of relationships
Linkages between asset classes
Interest rate markets: UK 10-year bonds versus US 10year bonds
Nikkei Dow Jones stock index versus US stock markets
(S&P 500)
US versus British stock markets: comparing other main
markets
European energy sector versus Australian energy sector
Gold versus the US dollar
Bonds versus stocks
Summary of methodology
Linkages within asset classes
Australian/US dollar versus the US dollar/euro
exchange rates: overlay
Silver versus gold: ratio chart
Three-year and 10-year bond futures: use of spread
charts
Sector versus sector: use of ratio/relative strength charts
USD gold versus Lihir Gold Limited
Sector versus stock: use of relative strength charts
The best times to use intermarket analysis
Caveats: the times not to use
Final thoughts
Chapter 7: ETF power trading strategies
Risk/reward profile
Capture ‘unavailable’ profits
Diversification
Dividends plus
Forget stock selection
Global diversification
Hot markets
ETF limitations
Market and index behaviour
Dividend hop
Index ETF
Multi-index ETF
ETF sector index
Swiss roll
ETF index, multicountry
ETF management strategy
Capital profit
Capital accumulation
Chapter 8: Sustained profitable trading
What is sustained profitable trading?
Why does sustained profitable trading elude most people?
What is trading?
Objective pattern recognition
Developing an ‘edge’ over the market
‘Edge’ thinking
Societal paradigm versus market paradigm
Transitioning to a market mindset
Transition steps
Am I there yet?
Chapter 9: Trading chicks are doing it for themselves!
And now …
Male? Female? What’s the difference?
The brain
Chemistry 101
So, let’s look at the facts
Gender-specific challenges
Specific male challenges
Specific female challenges
The solutions
Don’t let ego get the better of you
Keep your cool
Sprinkle lies sparingly
So what now?
Chapter 10: With the click of a mouse
Can computers enhance
investment returns?
How are computers used for investing?
Setting up your office
The virtual investing office
Analysis software
Daily trading signals
Company health check
Charting tools
Latest news, views and video updates
Investment newsletters
Daily market updates
The essence of computer analysis
Simple line charts
Overlays
Volume
Moving averages
Bollinger bands
Chapter 11: Combining analysis methods
Why combine?
Fundamental analysis
Technical analysis
Charting
Technical indicators
Creating watchlists
Experts’ picks
The internet
Broker recommendations
Summary
JB trading strategy
Rising trend
Oversold ‘alert’ signal
Volatility indicators
Chapter 12: The psychology of success
Taking control of your life
Taking control of your trading
Remaking the event
Remaking the day
Confidence
Concentration
Calmness
Consistency
Problem-solving
The investigation of the self
Final thoughts
Chapter 13: Mentality matters
‘Ulcers in Executive Monkeys’ and your trading
‘Grasshopper’ and your trading
Chapter 14: Of motorbikes and trading types
(No) Fear
Confidence
Focus
Goal-setting
Dealing with stress
Dealing with mind clutter
The Zen of it all
Final thoughts
Chapter 15: Forex strategies and tactics
Strategic analysis: how to make investment decisions
Supply and demand
Central banking simplified
Interest rates
Fundamental analysis of the United States
Tactical analysis: how to create tactical plans
Go with the flow
The force in forex
The right stuff
Appropriate risk tolerance
Stop it
The price is right
Measuring momentum
Tactical technique
Hit the road, Jack
Summary
Chapter 16: The risky business of forex
Understanding risk
Calculating pips and lots
Managing risk
Equal fixed dollar allocation
Equal per cent dollar allocation
Fixed dollar risk allocation
Fixed percentage risk allocation
The majors
Margins magnified
Final thoughts
Chapter 17: Stepping into futures
A brief history
Forward contracts
The Chicago Board of Trade and Chicago Mercantile
Exchange
The evolution of futures contracts
Standardised contracts
Modern-day futures contracts
Offsetting
Taking delivery
The role of the clearing house as central counterparty
Clearing house margin requirements
Participants in the futures markets
Hedgers
Speculators
Minimum price changes and daily price limits
Minimum price moves (ticks)
Maximum daily price limits
Position limits
A typical futures contract
Monthly expiry and rollover
Leverage
Trading futures contracts
Choice of broker
Hardware, software and data providers
Order types
Placing an order
Trade examples
Final thoughts
First published 2010 by John Wiley & Sons Australia, Ltd
42 McDougall Street, Milton Qld 4064Office also in
Melbourne
Typeset in Adobe Caslon 11.5/14.2
© John Wiley & Sons Australia 2010
The moral rights of the authors have been asserted
National Library of Australia Cataloguing-in-Publication data:
Title: The Wiley trading guide edited by Kristen Hammond.
ISBN: 9781742469874 (hbk.)
Notes: Includes index.
Subjects: Investment analysis. Stock exchanges. Speculation.
Futures market. Money market.
Other Authors/Contributors: Hammond, Kristen.
Dewey Number: 332.6
All rights reserved. Except as permitted under the Australian
Copyright Act 1968 (for example, a fair dealing for the
purposes of study, research, criticism or review), no part of
this book may be reproduced, stored in a retrieval system,
communicated or transmitted in any form or by any means
without prior written permission. All enquiries should be
made to the publisher at the address above.
Cover design by Rob Cowpe
Image on p. 286 © iStockphoto.com/stockcam.Image on p.
287 © iStockphoto.com/bluestocking.
Screenshots in chapter 15: The DealBook® 360 screen
captures were used with permission from GFT. GFT and John
Wiley & Sons Australia are separate and independent
companies. GFT’s DealBook® 360 trading software is offered
as a free service to GFT customers. GFT is not responsible for
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substantial risk of loss with or without the use of GFT’s
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Disclaimer
The material in this publication is of the nature of general
comment only, and does not represent professional advice. It
is not intended to provide specific guidance for particular
circumstances and it should not be relied on as the basis for
any decision to take action or not take action on any matter
which it covers. Readers should obtain professional advice
where appropriate, before making any such decision. To the
maximum extent permitted by law, the authors and publisher
disclaim all responsibility and liability to any person, arising
directly or indirectly from any person taking or not taking
action based upon the information in this publication.
About the authors
Louise Bedford
Louise Bedford <www.tradingsecrets.com.au> is one of Australia’s most
compelling speakers on the sharemarket, as well as being a share trader for
nearly 20 years. With degrees in psychology and business, she’s done the
hard yards in the sharemarket. You will adore Louise’s warm and
approachable style, whether you are a professional trader or a complete
amateur.
As Australia’s bestselling author on the sharemarket for nearly a decade, she
has been quoted in more Australian share-trading books than any other trader.
Her trading books Trading Secrets, Charting Secrets, The Secret of
Candlestick Charting and The Secret of Writing Options, as well as
her presentations, are not about vague concepts that don’t work in the real
world. They are about incredibly practical, timesaving strategies that you can
implement in order to become an extremely successful trader.
If you’ve trained with another sharemarket trainer, the chances are that
they’ve got a dog-eared, highlighted copy of one of Louise’s books in pride
of place in their bookcase.
If you genuinely want to become an ultra-versatile trader and develop an
incredible lifestyle, you need a trading plan. Just go to Louise’s website and
register your details. As a gift, she’ll email you your very own ‘Trading Plan
Template’ straight away. It will help you work through all of the vital issues
that need to be included in a sophisticated trading plan to give you an edge in
the sharemarket.
Jim Berg
Jim Berg, author of The Share Trader’s Handbook, The Stock Trading
Handbook (e-book) and Shares to Buy & When, is a former broker, private
trader and lecturer with over 20 years’ experience in the investment industry.
He has appeared on Sky Business TV, CNBC Asia and Market Wrap and is a
regular guest speaker at such institutions as the Australian Securities
Exchange (ASX), the Sydney Futures Exchange (SFE) and the Australian
Technical Analysts Association (ATAA) and at Traders Expos at capital
cities throughout Australia. In Brisbane in October 2007 he was billed at the
ATAA ‘Pathways to Trading Excellence’ Conference as one of the 10 ‘most
respected trading professionals in the world’. Using his commonsense
approach, Jim Berg won the Personal Investor magazine’s trading
competition in 2002 — during a severe bear market that lasted three years.
In his December 2007 Sharetradingeducation.com report ‘Crash vs Bear
Market’ Jim detailed his technical analysis of the warning signals weeks
ahead of the January/February 2008 freefalls.
His articles have been published in the ASX newsletter Shares, Personal
Investor, Your Trading Edge and Stocks and Commodities in the US.
Further information is available at <www.sharetradingeducation.com.au>.
Guy Bower
Guy Bower is the Head of Training and Development at Propex Derivatives,
a proprietary trading company specialising in high-frequency futures and
equity trading. He is also an active spread trader in US futures.
He has worked in Australia and overseas and has experience in futures,
options, funds management and trading education.
Guy is the author of several books including Options: A Guide for
Australian Investors and Traders and Hedging: Simple Strategies for
Protecting Profits. He was also profiled in the book Bullseye: Top Trader
Thinking by Matt and Sari Kirk.
His website is <www.guybower.com>.
Kel Butcher
Kel Butcher is a financial markets trader with over 20 years’ experi-ence
trading equities, futures, options, forex and CFDs. Kel’s favourite, though, is
the futures market where the ‘pure’ nature of a supply-and-demand-driven
market, coupled with high liquidity, allows the application of wellresearched mechanical trading systems. The use of electronic platforms
allows many of these systems to be ‘auto-traded’, further reducing any
emotional attachment to the trading process. He is a regular contributor to
Your Trading Edge magazine and contributed to Give Your Trading the Edge
— published by Wrightbooks in partnership with Your Trading Edge
magazine. Kel is also the author of the Wrightbooks titles A Step-by-Step
Guide to Buying and Selling Shares Online and 20 Most Common Trading
Mistakes and How You Can Avoid Them. Kel is director of KD Trading
Systems <www.kdtradingsystems.com>, specialising in providing futures
and forex trading systems that work and deliver positive returns to traders.
He is also a mentor and trading coach to a number of both private and
corporate investors.
Davin Clarke
Davin Clarke is a full-time professional day trader who has been trading full
time for over 10 years. Davin is passionate about trading and his consistent
results year after year speak for themselves. He is an active intraday trader
who trades both equities and various futures markets, including the European
and Asian markets. In 2005–07 Davin’s equities trading turnover averaged
A$300 million per annum. Since 2008 Davin has specialised in trading on
the futures markets in Asia, the US and Europe.
Davin has developed a keen understanding of how the market moves and how
market psychology affects price through many, many hours watching and
trading the markets live. The ability to accurately read market dynamics is
invaluable to his success and he combines this skill with his own unique
trading style.
Davin regularly posts articles and showcases his trades on his blog
<www.trade4edge.com>. He is a regular presenter at the Australian
Technical Analysts Association and several other trading clubs. He is also
featured in Eva Diaz’s book Real Traders, Real Lives, Real Money (2006)
and more recently in Kel Butcher’s book 20 Most Common Trading
Mistakes and How You Can Avoid Them, both published by John Wiley &
Sons.
Daryl Guppy
Daryl Guppy is founder and director of Guppytraders.com Pty Ltd.
Guppytraders.com is an international financial market education and training
organisation with offices in Darwin, Singapore and Beijing. Guppy is a
regular CNBC Asia Squawk Box technical analyst commentator, often known
as ‘the chart man’. He is recognised globally for the quality of his analysis
and has a weekly CNBC.com column: Charting Asia.
Guppy actively trades equities and associated derivatives markets, including
CFDs. He is the author of The 36 Strategies of the Chinese for Financial
Traders, Trend Trading and seven other trading books. He has developed
several leading technical indicators used by traders in stock, derivative and
currency markets. His indicators are included in MetaStock, OmniTrader,
Guppytraders Essentials and other charting programs.
Guppy is a regular contributor to financial magazines and media in
Singapore, Malaysia, China, Australia and the US. He is a weekly columnist
in Singapore’s TheEdge, China Daily and Shanghai Security News. He
oversees the production of weekly analysis and trading newsletters for the
Singapore/Malaysia and Australian markets. He is recognised as a leading
expert on China markets. He is in demand as a speaker in Asia, China,
Europe and Australia, speaking in more than 17 countries.
Alan Hull
Alan Hull is a second-generation share trader, fund manager, businessman,
writer, mathematician and IT expert. He is the bestselling author of Blue
Chip Investing — the business of making money on the Australian stock
market and Active Investing — a complete answer, now in its 10th year of
publication. Alan has also managed tens of millions of dollars of other
people’s retirement funds, his performance consistently beating all the major
ASX market averages.
Alan speaks extensively throughout Australia for organisations such as the
Australian Securities Exchange, the Australian Investors Association, the
Australian Technical Analysts Association, Investment Expo and Traders
Expo. His books, articles and newsletters are published and widely read
throughout Australia and overseas.
While ant colonies, the human brain and even entire civilisations have been
recognised and studied as complex adaptive systems, the research into
financial markets as complex adaptive systems is still very much in its
infancy. However, in his relatively brief but comprehensive discussion in this
book, Alan offers what is probably the first complete explanation linking the
sciences of chaos theory and complex adaptive systems to the financial
markets. Furthermore, it is written in very easy to understand terminology,
and Alan concludes by showing how you can profit from this newfound
understanding.
Glen Larson
Glen Larson is president of Genesis Financial Technologies Inc and
TradeNavigator.com. Glen earned his Bachelor of Science in Chemical
Engineering in 1982 and completed graduate work in Electrical Engineering
following his degree.
Upon graduating from college he worked for various industry giants in the
semiconductor industry. His speciality was managing the Device Physics
Analysis departments. He has managed engineering departments for National
Semiconductor, Phillips Electronics and United Technologies. Glen later
applied his engineering and mathematical skills to programming the initial
Trade Navigator platform, later forming Genesis Financial Technologies Inc.
He has over 25 years of trading and programming experience. During these
25-plus years he has participated in seminars across the globe, from Russia
to Europe, South America, Australia, Singapore and India. In addition he has
been fortunate to develop partnerships and friendships with many worldrenowned traders and major financial institutions and brokerages. These
unique relationships, partnerships and global experiences along with his
engineering background have allowed Glen to identify trading edges that
have been built into the Trade Navigator platform.
Wayne McDonell
Wayne McDonell is the chief currency coach at FX Bootcamp
<www.fxbootcamp.com>, a live forex training organisation that teaches
traders how to develop conservative trade plans based on technical and
fundamental analysis, as well as addressing the psychological aspects of
being a trader, all in real time. Each trading session has a coach to provide
live market commentary and analysis and to answer questions; members can
see their charts and ask them questions while the market is moving.
Mr McDonell is a popular speaker at forex conferences around the world,
having won ‘Best of Show’ awards for the 2009 Traders Expo in New York
and the 2007 Forex Trading Expo in Las Vegas. Online, his forex training
videos are syndicated by FXstreet.com, DailyFX.com, MSN.com and Yahoo
Finance, among others, and have been viewed over 1 000 000 times. He has
conducted monthly ‘Trade Non-Farm Payrolls Live’ webinars since 2006
and they have attracted as many as 1200 traders each.
As a regular contributor to the media in regards to currency trading, Mr
McDonell has been interviewed by Bloomberg Television, The Wall Street
Journal, Fox Business Television and others. Each Monday he is the featured
guest on Forex Television’s ‘PM Exchange’, and in each issue of Your
Trading Edge magazine, distributed throughout Australia and the United
Kingdom, he writes the forex column Currency Corner. He has written ‘how
to’ articles for The Forex Journal, Traders Journal, Currency Trader and
Futures magazine. Other notoriety includes Inc Magazine, TechWeek,
Information Week and The National Post, as well as non-English
publications in Spain, Germany, Japan, Korea and China.
The FX Bootcamp Guide to Strategic & Tactical FOREX Trading (John
Wiley & Sons) is highly acclaimed and a bestseller in the foreign exchange
category of Amazon.com. It was featured as the ‘Book of the Month’ on
MoneyShow.com, as well as in Your Trading Edge and Futures magazines.
FX Bootcamp is a member of the National Futures Association and is
registered as a commodities trading adviser as well as an introducing broker.
Mr McDonell also has a Series 3 licence.
Stuart McPhee
A graduate of the Royal Military College, Duntroon and a private trader
since 1996, Stuart McPhee is the author of Trading in a Nutshell, 3rd
edition.
He is a highly sought after public speaker on trading and regularly presents
trading workshops in Southeast Asia. He has also presented at the ASX, the
ATAA and at trading expos throughout Australia, and in New Zealand,
Singapore, Malaysia, Vietnam, China, India, Thailand and the US.
Stuart has a Graduate Diploma in Applied Finance and Investment from the
Financial Services Institute of Australasia and truly understands the
importance of you finding a trading plan and approach that is right for you.
Stuart advises that, ‘Trading is like any other profession. You need to learn
the basics, then develop and hone your skills through application. However,
you are only going to succeed if you commit yourself to the task, as you need
to develop a professional, disciplined and consistent approach towards your
trading.’
An excellent motivator and teacher and technically competent, Stuart, through
his honest and clear style, has helped thousands of people with their trading.
Follow live and learn from Stuart’s own personal trades at
<www.tradingasxshares.com> with regular video updates and commentary.
Justine Pollard
Justine Pollard is one of the ‘Alices’ who has conquered the wonderland of
the stock market. She lives to share the bountiful experiences and wisdom
she continues to accumulate, touching the lives of traders and helping them
discover the smarter way to trade.
As a successful trader and sought-after trading mentor, Justine is willing to
share her years of trading education and experience. She has developed
various training products and packages to help other traders become
profitable. The courses and personal tutorials have been packaged into
training packs to suit different levels of traders.
Justine is the author of the top-10 bestselling finance book Smart Trading
Plans. If you need comprehensive details about what is discussed in
formulating your personal trading plan, Smart Trading Plans is just the right
book for you. The book is a step-by-step guide to developing and
implementing your own personal trading plan to increase your chances of
success in the market. When you purchase the book you also get access to a
free trading plan template and free position sizing calculator to work through
as you read the book.
Visit <www.smarttrading.com.au> to find out more and download your free
special report with Justine’s Top 10 Tips to Smarter Trading.
Peter Pontikis
Peter Pontikis is a Brisbane-based alternative investments management
specialist and has close to three decades of investment and financial markets
experience. A senior fellow of Finsia (the Financial Services Institute of
Australasia), he sits on its national policy advisory council. As a CPA
(Fellow) of CPA Australia, he recently stepped down from its finance and
treasury Centre of Excellence
committee. He is also a director and the immediate past treasurer of the
International Federation of Technical Analysts (IFTA).
Peter’s previous roles include Head of Trading & Research for an Australian
hedge fund and Senior Financial Markets Strategist for Westpac Investment
Bank, and until recently he was the Group Treasury Strategist for Suncorp.
Until the mid-2000s he also ran a consultancy advising Asian central banks
and fund managers. He has authored several books on foreign exchange and
trading in financial markets.
Peter also has two degrees in his other passions: art and literature.
Tom Scollon
Tom Scollon is a Melbourne University commerce graduate and has had a
long and successful business career, including 10 years with BHP in
international marketing. His various roles have exposed him to a wide
variety of business sectors with significant experience in raw materials,
major construction projects, IT and finance. He has held a number of general
management, CEO and chairman roles. Despite a busy corporate life he has
been an active and successful investor for some 20 years. He is author of
Fair Share and guest contributor to several other investment books. He is
chief analyst for <www.sharesbulletin.com.au> and chief editor of ‘Trading
Tutors’ at <www.hubbinvestor.com>. He also presents at many investment
expos and is guest commentator on a number of radio and TV spots.
Dr Harry Stanton
Dr Harry Stanton is a Fellow of the Australian Society of Hypnosis, a
Fellow of the American Society of Clinical Hypnosis and a Member of the
Australian Psychological Society. He has had over 30 years’ experience in
the practice of clinical psychology and hypnotherapy, writing extensively on
these subjects in academic journals. He is a consultant on the application of
psychology to a wide range of practical activities. In his private practice as a
clinical psychologist he helps clients with numerous issues, including
overcoming problems with investing and trading the financial markets.
The basis of his work is self-empowerment, morale-building and
performance enhancement, helping people to manage their lives more
successfully by overcoming the obstacles they create within their own minds.
Dr Stanton is frequently consulted by the business community on how they
might apply psychological principles to improve performance. In addition to
keynoting conferences, he conducts workshops, both internationally and in
Australia, on confidence-building, the psychology of investing and trading,
self-motivation, motivating others, the effective use of time, persuasive
communication, problem-solving, decision-making, coping with stress and
managing people. As a sports psychologist, Dr Stanton works with both
individuals and teams desirous of improving their performance in golf,
bowls, football, rowing, basketball, swimming and rowing.
He is the author of well over 250 articles and nine books, including The
Success Factor: Succeeding in Business and in Life and Let the Trade Wins
Flow: Psychology for Super Traders.
In addition he has, together with traders Louise Bedford and Chris Tate,
recorded a double CD entitled Psychology Secrets, which describes the 10
most common mistakes made by stock market traders and how they might be
overcome. Also with Louise Bedford, he has a CD entitled Relaxation for
Traders.
Gary Stone
Gary Stone is the founder and managing director of Share Wealth Systems
<www.sharewealthsystems.com>, a provider of mechanical trading systems
to private investors. Share Wealth Systems, based in Melbourne, gained its
first client in 1995 and has since educated and coached private investors to
manage their own equity portfolios by using mechanical trading systems.
Gary has a Bachelor of Science majoring in computer science and
mathematics. He started trading in 1990 and has completed thousands of
mechanical trades in equities and CFDs using the same mechanical systems
that his clients use. Share Wealth Systems currently provides two mechanical
systems, one for medium-term trading, SPA3, and another for long-term
trading, Intelledgence. Gary is always conducting research on the markets
and is currently working on an ETF mechanical system and on preparing
SPA3 for other exchanges, particularly the Nasdaq.
Chris Tate
Chris Tate is a trading veteran of 30 years and one of the first people to ever
release a share-trading book in Australia. An old pro of the industry, Chris
has been on all sides of the trading world, from broking to money manager to
private trader. When he first started trading, exchanges still had trading
floors and settling of trades involved the physical transfer of share
certificates. He has had an extraordinary impact on thousands of traders.
Best-selling author of The Art of Trading and The Art of Options Trading in
Australia, his brutally honest approach and meticulous pursuit of excellence
qualify him as Australia’s foremost derivatives trading expert, and
exceptional traders all around the world quote his market comments.
Chris has seen all types of markets and traded every instrument available,
and has profited in every one of them. He is in constant demand for his
keynote speaking skills due to the outrageous success of his presentations for
every major share-trading exchange in Australia. Originally trained as a
research scientist, Chris brings an intellectual rigor to the markets that is
generally missing in much of the fluff-and-bubble world of advising and
education.
Leon Wilson
Leon Wilson has traded just about every market accessible over a span of 20
years, from shares, warrants, CFDs, indices, commodities and futures to
forex. In more recent times Leon retreated to the quiet life in rural Tasmania
for reasons of health and wellbeing, where he now primarily focuses on
international markets from the serenity of his home in the Tasmanian
countryside. He is still accompanied by his faithful old Jack Russel who has
been at his side since trade one.
Leon is one of only a select few Australian traders to be published in the US
Stock’s & Commodities magazine (July 2006) and he contributed the feature
article in the same magazine in January 2008, where he first introduced then
expanded on the techniques originally discussed in Breakthrough Trading.
These methods have since been adopted by numerous trading software
programs on both the domestic and international scene.
Leon is the author of The Business of Share Trading: From Starting Out to
Cashing In On Trading the Australian Market (2003), The Next Step to
Share Trading Success (2005) and Breakthrough Trading: Revolutionary
Thinking in Relative Analysis (2006), all published by John Wiley & Sons.
Preface
In The Wiley Trading Guide you will find contributions from 17 of the finest
traders and trading educators operating across the globe today.
Their methods are many and varied, but each trader we chose to include in
this book has found success through continuous education, technique
development and mastery of every trader’s own worst enemy — themselves.
They bear proof that financial freedom through trading is possible, despite
the markets being challenging and ever-changing.
This book offers insights into each author’s own trading methods and
interests, providing inspiration and information to any trader wishing to raise
their knowledge to the next level. Equities, derivatives, currencies and
commodities are all featured; trading strategies, psychology and plans are
addressed; and analysis methods are considered with a fresh perspective.
For a trader, defining success is simple: consistently trading profitably. But
aspiring to this goal is a venture with a destination never definitively
reached; trading is the ultimate infinite journey. We feel privileged to be able
to share the experiences of these skilled and inspiring traders with you, and
sincerely hope that The Wiley Trading Guide becomes a source of
inspiration and guidance for you on your own trading journey.
John Wiley & Sons
June 2010
Chapter 1: Financial markets as
complex adaptive systems
Using the right tactics at the right time
Alan Hull
As most modern-day traders will attest, there is an overwhelming array of
choices when it comes to the different trading techniques and tactics that one
can employ when dealing with financial markets. In fact this ‘compilation’
book is testament to this recent trend with about 20 acknowledged experts all
offering up their different strategies on how to take profits from the markets.
And indeed I make my own contribution to this wide array of choices by
offering Australian equity traders and investors three different investment
newsletter services.
Some traders will search through this plethora of trading systems and
philosophies trying to filter out what works as opposed to what doesn’t
work. But alas, this approach will only lead to more frustration as you will
inevitably discover that there is some validity to just about every technique
ever invented. The reality is that success or failure of virtually all systems is
largely dependent on the prevailing broad market conditions. And these
conditions change over time, therefore the effectiveness of any trading system
will fluctuate accordingly.
So what we really need to do is take a step back for a moment and try to get a
handle on how the broad market behaves. Because if we can better
understand how the broader market works then it logically follows that we
should know which are the most suitable trading and investing tactics to
apply at what time. Simple … well, not quite.
Now we’re striving to comprehend the real nature of financial markets, and
this is the crux of this discussion. And while I’d like to say that it is a simple
matter to understand the underlying nature of financial markets, unfortunately
we are about to enter the world of chaos theory and complex adaptive
systems. But fear not, as I will make every effort to maintain clarity when
dealing with these somewhat esoteric topics. And so let’s start at the simplest
point: the beginning.
Straight lines and curvy bits
The word linear essentially means straight line or straight line progression,
and in order to simplify everything we see and observe mankind has a
profound tendency to view the world from a linear perspective. The main
reason we want everything to be linear, or to progress in a straight line, is so
we can both easily understand it and predict what it is likely to do in the
future.
In more recent times, thanks largely to the computational power of modern
computers, we have also pretty much mastered the ability to get our heads
around curvy things as well. Of course, this is largely on the proviso that they
are either constantly curvy or consistently changing, such as the case of an
exponential curve like the one pictured in figure 1.1.
We can even project lines and curvy things into the future with a reasonably
high degree of accuracy and determine if, when and where they’re likely to
intersect. Although there is one proviso: that there aren’t too many variables
to consider.
Figure 1.1: exponential curve
But there’s another problem that even the scientific community doesn’t like to
talk about and that’s the possibility of things changing but not doing so in a
consistent way. In other words, the rate of change is not constant. It’s bad
enough that something can be ‘dynamic’ rather than ‘static’ (thus rendering
statistical analysis and the bell curve largely useless), but when the rate of
change itself isn’t linear or at least constant then everyone starts to get really
scared. This is known as non-periodic behaviour, as shown in figure 1.2.
Figure 1.2: non-periodic behaviour
Source: Does God Play Dice? The New Mathematics of Chaos, Ian Stewart, Blackwell UK, 1989,
p. 141.
But let’s sidetrack for a moment and look at the idea of a system being
dynamic as opposed to static. Take the average life expectancy of the
Australian population, for example. If you wanted to know the average
number of years we’re all expected to live then you would most likely use
data available from the past 10 years or so:
But what about using recorded deaths from the last 100 years instead of just
the past 10? Surely this larger sample of data will give us a more accurate
and reliable answer:
Put simply, no … because over this expanse of time factors that impact our
lifespan such as our diet and medical advances have changed significantly,
making this sample period non-static and invalidating any averages taken. So
let’s go to the other extreme now and just use some very recent data. This
should definitely give us the most up-to-date and accurate answer possible:
But unfortunately we now have the problem of insufficient data to work with.
Thus any sample of data that we subject to statistical analysis must be from a
static system or a representative snapshot that allows for the dynamic nature
of a system. Hence using the average lifespan of Australians over the past 10
years to reflect today’s average is in fact a snapshot approach and a
compromise of sorts.
This is a pity because everyone held out so much hope that statistical
analysis was a universal solution for problems of randomisation. So the
stock market, like other irregular phenomena, gets labelled as being
unpredictable and that’s that. Just like weather patterns and the human heart,
the stock market has too many variables and is a dynamic system that’s not
always linear by nature. Hence figure 1.3 shows how the Australian stock
market index, the All Ords, is forever changing its behaviour.
Figure 1.3: the All Ords
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
Thus if we can’t get our heads around it then it’s random or so close to
random it doesn’t matter. Another neat way of dismissing things we can’t
fully comprehend and/or predict is by calling it noise, interference or
turbulence. Thus an engineer working in fluid dynamics will most likely
attempt to eliminate turbulent flow rather than try to understand it.
Introducing chaos theory
So you can imagine everyone’s excitement about chaos theory when it first
appeared back in the early ’60s, because it went a long way towards
understanding what had previously appeared to be random phenomena. Well,
actually, it was largely dismissed by the broader scientific community at the
time as a stream of pure mathematics without any real-world application.
Hence it was just a good excuse not to work on more practical stuff such as
how to eliminate turbulence.
The pioneer in the field of chaos theory was Edward Lorenz, a meteorologist
trying to simulate weather patterns. At the beginning of the 1960s Edward
had developed a set of 12 mathematical equations that he used to model realworld weather conditions, using a very early and (by current standards) very
primitive computer system, such as that shown in figure 1.4.
Figure 1.4: early computer system
Source: © Getty Images/SuperStock.
Like most experimenters Edward would often repeat the same simulations
over and over again to verify previous results. But on one occasion he had
reason to pause a simulation that he had performed previously. To resume the
process, Edward took a series of numbers from his latest printout and used
them to re-seed his equations in order to continue from where he’d left off.
However, much to Edward’s surprise, the results of this ‘interrupted’
simulation varied dramatically from his previous results. On close
examination he discovered that the computer was internally using numbers to
six significant decimal places while his printout only gave him numbers to
three significant decimal places. Hence a number that the CPU saw as
0.152131 would be printed out as 0.152, giving a very minor discrepancy of
just 131 millionths of one unit.
But this was enough deviation to cause massive variations in the output of
Edward’s weather simulations. This ‘sensitive dependence on initial
conditions’ became known as the butterfly effect, where the output of a
system can vary dramatically with just very minute changes in the starting
conditions, comparable in magnitude to the flapping of a butterfly’s wings.
The flapping of a single butterfly’s wing today produces a tiny
change in the state of the atmosphere. But over a period of time, the
atmosphere actually does diverge from what it previously would have
done. So, in a month’s time, a tornado that would have devastated the
Indonesian coast doesn’t happen. Or maybe one that wasn’t going to
happen, does.1
This discovery and the work that followed led Edward Lorenz into the
exciting new world of what is now known as chaos theory. While there is no
commonly acknowledged fixed definition of what constitutes a chaotic
system, it is generally accepted that the following conditions must be met:
• the system must be highly dependent on initial conditions
• the system must employ at least two or more interacting variables
• the initial conditions must be at least partially dependent on output.
A good example of a chaotic system is the operation of a roulette wheel (see
figure 1.5, overleaf), which is probably best understood by analysing the
process step by step:
• An operator picks up a ball from a roulette wheel which he or she then
spins (the starting position of the wheel is dependent on where the ball
landed after the previous operation — initial condition is dependent on the
previous outcome).
• He or she then sets the ball rotating in the opposite direction (the wheel is
the first variable while the ball represents the second variable).
• The ball eventually loses enough energy to drop into the spinning wheel
(the outcome is extremely sensitive to the interaction of the two variables).
Figure 1.5: roulette wheel
Source: © Neda, 2010. Used under license from Shutterstock.com.
Roulette is an excellent example of a two-variable chaotic system which
would in fact be predictable to a degree if a machine was used as the
operator. It is actually the human operator that provides the random factor,
but because the system is chaotic it can’t be manipulated to any practical
degree. Hence virtually all games of chance employ mechanisms or
processes of a chaotic nature.
One of the other principal discoveries that Edward went on to make was that
systems or models of systems behaving in a chaotic state produced repeating
patterns that could be observed if the outputs were mapped in two
dimensions, commonly referred to as ‘phase space’ by Chaoticians. Note that
these repeating patterns were similar in form but never precisely identical.
Hence the Lorenz attractor, seen to the left of a typical price chart in figure
1.6.
Figure 1.6: Lorenz attractor and typical price chart
Chaos theory and financial markets
Of course any chart that shows the change in price with respect to time is in
fact a two-dimensional map, and if the stock market is a chaotic system of
sorts then anyone looking at price charts should observe nearly identical
repetitive patterns. So here’s the bit where it gets interesting and we make the
jump back to financial markets.
Introducing Benoit Mandelbrot, a mathematician working on a think-tank
project for IBM during the early 1960s, primarily to solve the problem of
noise on data transmission lines. However, Benoit was also directed to
investigate the nature of financial markets, I believe by the then CEO,
obviously in the hope of being able to capitalise on any discoveries and/or
developments that he might make.
Benoit chose to study the price of cotton because he could obtain continuous
data going all the way back to 1900. When he analysed the fluctuations in the
price of cotton covering over half a century of market behaviour he made the
following observation:
The numbers that produced aberrations from the point of view of
normal distribution produced symmetry from the point of view of
scaling. Each particular price change was random and
unpredictable. But the sequence of changes was independent of
scale: curves for daily price changes and monthly price changes
were nearly identical. Incredibly, analysed Mandelbrot’s way, the
degree of variation had remained constant over a tumultuous sixtyyear period that saw two World Wars and a depression.2
Thus Benoit both identified a repeating pattern in the price activity and also
observed that it was nested, thus occurring at different levels of scaling.
Furthermore, he confirmed the hopelessness of employing statistical analysis
to study non-linear dynamical systems such that financial markets are. Hence
our earlier discussion on the use of statistical analysis and how it is a
compromise when applied to any type of dynamic system.
There are two key points worth noting at this juncture. The first is that
Benoit’s research should have placed a very serious question mark over the
use of modern portfolio theory. Modern portfolio theory is a statistically
based portfolio management system that assumes price deviations follow a
normal distribution curve … which they don’t.
Here’s the scary bit: it remains the most widely employed portfolio
management approach in use today by fund managers around the world.
Although it is terribly complicated and impressive, it simply just doesn’t
work. Hence if you follow financial news when markets experience a sharp
correction you will no doubt have read a quote similar to this: ‘According to
our risk analysis models there was no possible way anyone could have
predicted what was going to happen’. Straightaway you know their ‘models’
employ the normal distribution (or bell) curve, shown in figure 1.7.
However — and here’s the second point — Benoit did state that markets
were fractal in nature to some degree because he observed self-similar
patterns occurring at different levels of magnification. Hence if you compare
the weekly and monthly charts of the All Ordinaries in figure 1.8 you can see
that the correction we experienced in 2007–08 wasn’t entirely unpredictable
when viewed from a fractal perspective. These two charts of the All
Ordinaries index are very nearly identical even though they cover two
entirely different time frames.
Figure 1.7: normal distribution (or bell) curve
Figure 1.8: All Ordinaries index charts
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
And just in concluding this part of our discussion, Benoit had independently
made observations that closely paralleled those of a famous technical analyst
(read: chartist) by the name of Ralph Elliott, father of the Elliott wave
principle (EWP). EWP in its simplest form suggests that financial markets
move up and down in a
series of wave movements that can be quantified (shown in figure 1.9).
Figure 1.9: Elliott wave principle
Elliott’s basic concept is that price activity moves up in five waves (1–5)
and then down in three waves (a–c). Waves 1, 3, 5 and b are said to be
impulsive (upward) waves whereas waves 2, 4, a and c are referred to as
corrective (down) waves.
Elliott waves are nested (as seen in the chart of Timbercorp, figure 1.10) and
therefore are self-similar patterns occurring at different levels of
magnification; sound familiar?
Unfortunately Ralph (and his followers, commonly referred to as
Elliotticians) promoted EWP as a universal solution to understanding
financial markets and have therefore been largely ignored (and refuted) by
the wider investment community. Because, as we’re about to explore,
techniques such as Elliott wave analysis are valid some of the time … but not
all of the time.
Figure 1.10: Timbercorp chart showing Elliott waves
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
Complex adaptive systems
Hence, the next problem we face in trying to understand the basic nature of
financial markets is that while they seem to behave in a chaotic manner some
of the time, they don’t behave that way all of the time. Put simply, there isn’t
a discrete solution to understanding financial markets as they appear to be
constantly changing and adapting to their external circumstances (as shown in
figure 1.11, overleaf).
So while this discussion has come a long way in explaining the nature of the
curvy bits (chaotic behaviour), we still have to figure out why the markets
switch between making curvy bits and straight lines. Fortunately, one of the
latest developments in the field of chaos theory is now able to proffer an
answer to this dilemma with the introduction of what are commonly referred
to as ‘complex adaptive systems’.
Figure 1.11: the All Ords changing its behaviour
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
Put simply, a complex adaptive system (CAS) is a structure or process that is
made up of independent yet freely interacting agents that react and adapt
either to external information and/or information feeding back from the
system itself. Well, I suppose it’s not really all that simple, so maybe it
would be more helpful if I explain it with the aid of a diagram (figure 1.12).
Figure 1.12: complex adaptive system
Common examples of complex adaptive systems include motor vehicle
traffic, ant colonies, the ecosystem and even the human brain. And, getting
back to our knitting, financial markets are also considered to be a type of
complex adaptive system where we can make the following substitutions in
our generic diagram:
(Note that this is a highly simplistic representation of financial markets as
complex adaptive systems, as we could include many more relevant
influences and external variables.)
Hence the stock market as a complex adaptive system would look something
like figure 1.13.
Figure 1.13: the stock market as a complex adaptive system
Market participants react to a combination of both external stimuli, such as
company information, and feedback from the market itself, via price activity.
When market participants are being strongly influenced by price activity (that
is, internal feedback), the market is sentiment driven and behaves largely in a
chaotic manner.
But when external influences are the principal motivating force the market
moves away from this excited state, near the edge of chaos, and tends to
behave in a more rational and predictable manner, very much in line with
fundamental factors. Hence complex adaptive systems operate in a range,
with chaos at one extreme and equilibrium at the other, and it is this
movement up and down a sort of behavioural spectrum that we need to delve
deeper into.
The behavioural spectrum
In order to do this let’s go back to our chart of the All Ordinaries index
showing the stock market operating at two distinctly different points on the
behavioural spectrum. Going back to the beginning of the period shown
would put us somewhere in the early stages of the 1980s stock market boom
that began in 1982 (figure 1.14).
Figure 1.14: the All Ords changing its behaviour — we are in 1984–85
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
At this point the market has already enjoyed a good rally and is just getting
set for another run up. Anyone who has owned shares for the past year or so
is probably doing fairly well and would have a pretty good feeling about
their stock market investments, thanks largely to the price of their holdings.
We can highlight this phenomenon using the right-hand side of our CAS
diagram (figure 1.15).
Figure 1.15: stock market CAS — price feedback loop
So while external factors such as company fundamentals are still worthy of
consideration, there is no doubt the feedback from price activity is making
market participants feel good. Of course they start to talk about how well
they’re doing to their friends and the media plays its role in talking things up
as well. Now we see the market experience another rally and the stock
market, as a complex adaptive system, becomes even more lopsided in
favour of price feedback (figure 1.16).
Figure 1.16: the All Ords changing its behaviour — we are in 1985–86
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
Anyone and everyone who owns shares is now doing very well and the stock
market is being touted as the place to be. Mind you, investors aren’t talking
about the financial wellbeing of the companies that they have an interest in so
much as they’re just bragging about the increase in the price of their shares.
Hence investors become far less concerned about fundamental factors and
totally preoccupied with price behaviour. And so the stock market as a
complex adaptive system has now well and truly shifted towards the chaotic
end of the spectrum where the whole process is driven primarily by price
feedback and there is little to no external influence governing investor
behaviour. Thus we find ourselves in an accelerating positive feedback loop
(figure 1.17).
Figure 1.17: the All Ords changing its behaviour — we are in 1987
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
Of course the system inevitably collapses as it can’t be sustained forever
without the constant input of more and more energy (read: money); see figure
1.18.
Figure 1.18: the All Ords changing its behaviour — we are in 1987–88
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
Note too that when the market moves up to the chaotic end of the spectrum
that output and input become powerfully linked; investors wake up each
morning and react to price activity from the day before and what overseas
markets have done overnight. This is very much in keeping with one of the
basic requirements of a chaotic system, where initial conditions are at least
partially dependent on previous system outcomes: see our earlier discussion
on chaos theory.
During this phase, where market participants are far more concerned with
price activity than external factors, the market is said to be sentiment driven
and you will note at times like these that share prices tend to move in unison.
So when you look at intraday prices you will see that they are either all
moving up together or down together … hence your trading screen will be
predominantly green or red but rarely an even mixture of both.
So now we move through the corrective or transitional phase, where price
activity is usually both volatile and essentially sideways (figure 1.19,
overleaf). At this point investors and traders are licking their wounds and the
market will usually stay both nervous and uncommitted.
Figure 1.19: the All Ords changing its behaviour — we are in 1989–90
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
It is well worth noting during this transitional period that the market is a very
dangerous place to be and the adage ‘cash is king’ is very much applicable.
Hence there are times when it pays not to be in the market at all as your
exposure to market risk will completely overshadow the potential rewards.
Of course, as with all things, the market won’t stay in this state forever and it
will eventually begin to trend again, just as the All Ordinaries did from the
early 1990s (figure 1.20).
But something very significant happens as the market moves out of the
transitional phase and into its next trending phase: it’s completely changed its
personality. Rather than galloping along at an unsustainable rate of about 25
per cent per annum as it did during the 1980s boom, it’s now rising at a far
more sustainable rate of about 9 per cent per annum. In this somewhat
pristine example I’m using, the shift from the chaotic end of the spectrum to a
more subdued and rational state is well defined: hence the thin vertical line
down the middle of the chart.
Figure 1.20: the All Ords changing its behaviour — we are in 1996
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
Of course it’s no surprise that the high-flying speculators have all had their
fingers burnt and have left the market in the hands of the more fundamentally
motivated (and usually longer-term) investors. And so we can revisit our
stock market CAS diagram, which now operates in favour of external factors
where value investors rule the day (figure 1.21).
Figure 1.21: stock market CAS — external factors
Value investors care little about the price of their shares but a great deal
about the underlying fundamentals and macro-economic factors. In fact this
group of market participants will actually buy more shares when the market
drops and sell them when they go too high, providing negative feedback as
opposed to the positive feedback that we saw earlier during the boom phase.
So let’s now take a really big step back and look at nearly a quarter of a
century of market behaviour via the All Ordinaries index, shown in figure
1.22. You will note that the market appears to switch between rational and
irrational states, an attribute that makes sense according to our discussion on
investor behaviour: speculation followed by a rational period, followed by
speculation, and so on.
Figure 1.22: All Ordinaries index 1984–2007
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
You will also note that the rational period lasted a great deal longer than
either of the boom phases and this also makes sense given that it takes far
less energy to sustain a 9 per cent per annum trend, driven by underlying
fundamentals, than a 25 per cent per annum rise during a boom phase.
Furthermore, in this diagram I’ve defined the boom phases using what
chartists refer to as speed/resistance fans.
And this leads me back to the behavioural spectrum, where we have chaos at
one extreme and equilibrium at the other, shown in figure 1.23. However, a
trading channel, which defines a rational market period, falls in the middle of
the spectrum and therefore we need to complete the picture by defining what
the market would look like if it were moving towards equilibrium. And if
you haven’t already figured it out, a market that is collapsing into a point of
agreement will form a triangle.
Figure 1.23: behavioural spectrum
Points of agreement
Over time buyers who think the market is undervalued will buy it up while
sellers who think it is overvalued will sell it down. Gradually, as price
activity rises and falls, these two groups act on their judgement by buying or
selling and leaving the market, causing it to narrow down into what chartists
call a point of agreement (POA). Eventually all of those who are left in the
market obviously agree that it is fairly priced and act on this view by neither
buying nor selling their holdings. A good example of this process is seen in
the chart of Newcrest Mining (figure 1.24, overleaf), where the price activity
appears to be narrowing down over time to about $25.
Figure 1.24: Newcrest Mining
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
While the broad market is rarely seen collapsing into a point of agreement,
POAs play quite a significant role in technical analysis and are therefore
worthy of a thorough explanation. A market can only exist when there is
agreement on the sale price (in order for a transaction to take place) and
disagreement on the current or future value of the product being traded. When
there is agreement on value there is no market. Disagreement on value is
usually created because of the difference in people’s perspectives or
opinions. This point is illustrated well in example one.
Example one
An individual places lesser value on a tomato if they own a vegetable garden than the neighbour
who has a dinner party in three hours and wants to make tomato soup. Supply and demand create
disagreement in value. The person who owns the vegetable patch has had a win situation if he or
she sells the tomatoes to a neighbour for 30¢ each. The neighbour has also had a win situation if the
only alternative is to buy the tomatoes from the local convenience store for 50¢ each. Win–win
situations can and do happen in markets. It’s not a case of someone must lose in order for another
party to have a win.
In any working market, such as the stock market, agreement on value is short
term or the market will cease to exist, hence the $50-note scenario in
example two. When there is agreement in the stock market it usually indicates
that a breakout is about to occur. Thus you will find many of the techniques
that chartists employ are designed to identify points of agreement so they can
anticipate the impending breakout.
Example two
There is general agreement that a $50 note has a value of $50. Because of this agreement in value
it would be impossible to sell a $50 note for $60. Likewise, the owner of the $50 note would not be
a seller at $40. Hence we cannot create a market for a $50 note.
So you can see how the stock market as a complex adaptive system moves up
and down the behavioural spectrum, never quite reaching its limits nor
remaining close to either extreme for very long. Furthermore, we can identify
where we are on this spectrum by defining the basic shape of the market
progression as a speed/resistance fan, channel or triangle. Well, that’s all
very New Age thinking and makes for interesting reading if you’re into that
kind of stuff, but does it have any practical application?
Introducing CAS analysis
Of course this newfound understanding has very significant practical
application as we now know that all the investment styles and trading
techniques that we’ve ever come across probably have some merit, on the
proviso that we apply them at the right time. Hence the importance of
applying what I call ‘CAS analysis’ to the broad market, where CAS
analysis is the act of determining where we are on the behavioural spectrum.
To demonstrate my point let’s revisit our 1980s stock market boom (figure
1.25, overleaf). Once again please imagine you’re back in the 1980s and
trying to make the most of the bull run.
Figure 1.25: the All Ords changing its behaviour — we are in 1986–87
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
During this time anyone that was attempting to employ fundamental analysis
would have found that the market was taking very little heed of such facts and
information. Hence at this time any reliance on fundamental analysis would
have proven largely futile. But as the market was sentiment driven I would
have been keen to own the market darlings of the day and probably any share
(or rather company) that was capturing the media’s interest.
Hence, getting investors’ attention during boom times usually equates to
getting their money. Let me give you some real-world examples of this: Bond
Corporation in the 1980s or the very popular Fortescue Metals from the more
recent boom. Of course these are also volatile times and so traders should
employ wide stop-losses to allow for this and simply seek out the most
aggressive trends they can find. And as we discussed earlier, trading tactics
such as the Elliott wave principle will work well in this highly bullish
climate.
Also, shopping for hot stocks in hot sectors is definitely the go, as is staying
abreast of the financial press and investigating any and all rumours you hear.
In other words, this is the time to follow the crowd and contrarianism is
definitely out. Of course, I’ve already covered what to do during transitional
periods (figure 1.26) as my primary suggestion is to move to cash when
markets are in this dangerous and frightened phase. The market is still largely
sentiment driven but fear usually carries far more sway than greed during
these times.
Figure 1.26: the All Ords changing its behaviour — we are in 1989–90
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
Once the market has settled down and begins to trend again (figure 1.27),
don’t fall for the trap of using the same tactics that you employed during the
preceding boom; they won’t work. Now we have to switch gears and think
like the Warren Buffetts of the world, because they’re now in control.
Figure 1.27: the All Ords changing its behaviour — we are in 1996
So it’s time to apply fundamental analysis along with ‘channel’ trading
techniques such as the MACD indicator, momentum oscillators and so on.
Expect the market to rise in a fairly sedate and modest manner where you
will be able to apply reasonably tight stop-loss techniques, given the low
level of volatility. This is a climate where stock picking comes to the fore
and great companies like Cochlear International, with its excellent
fundamentals and future prospects, will shine through (figure 1.28).
Figure 1.28: Cochlear International
Source: Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.
As you can see, the concepts behind and application of CAS analysis don’t
contradict any pre-existing trading and investing techniques or philosophies
but simply provide us with a governing framework. In this way CAS analysis
only serves to complement our existing knowledge and the tools that we use
to trade and invest the markets with.
Furthermore, viewing financial markets as complex adaptive systems could
possibly be our first glimpse of financial markets from a scientific
perspective rather than just through empirical observation. Needless to say I
have touched only lightly on the key aspects of this exciting new field and
there is plenty of room for further development by others who share an
interest in it.
Of course it’s also been a crash course in chaos theory and complex adaptive
systems if you have no prior exposure to these very esoteric subjects. But I
do believe it was worth the effort as having a sound understanding of how the
broad market works is an invaluable skill for any trader or investor. So I
wish you well in the markets and I sincerely hope I have extended your
knowledge in a way that will bring you increased profits in the future.
Sources
1 Stewart, I. (1989). Does God Play Dice? The New Mathematics of Chaos,
Blackwell UK, p. 141.
2 Gleick, J. (1987). Chaos — Making a New Science, Penguin Books USA,
p. 86.
Chapter 2: Planning your trade to
success
Why a personal plan is vital for successful
trading
Justine Pollard
Nothing can prepare you for the reality of trading. It is an unimaginable
roller-coaster of emotions that only becomes apparent once you venture into
the unknown world of the stock market and start trading. It’s a world in
which you have no control, yet you try your hardest to control it.
It’s just like when Alice falls down the rabbit hole into a world of
wonderland. You may think that trading will be a wonderland, but once you
put your real money into the market that wonderland soon changes and the
emotional roller-coaster begins.
Trading is an ever-evolving world of choices, from brokers and software to
a huge range of trading instruments to choose from — shares, contracts for
difference (CFDs), futures, FX, options, the list goes on. Where do you start?
What software should you pick? Which instrument should you trade? What
indicators should you use?
There is no Holy Grail, there is no 100 per cent perfect indicator to tell you
the best time to buy and sell. Yet some traders spend years searching for such
a thing.
However complicated the world of trading has become, more and more
people venture into the business of trading. And who can blame them? They
have heard of success stories such as Warren Buffett and Peter Lynch, who
have made it big in the markets and earned themselves millions of dollars. It
is stories such as these that bring dollar signs to people’s eyes; they flock
blindly into the markets, trying to replicate what these traders are buying, or
trading on tips from the newspaper or newsletters in the hope that they too
can earn a motza.
Unfortunately, though, it does not work as easily as buying and selling the
same shares successful traders bought or sold. What most of these types of
traders fail to consider is the long journey these billionaires took to reach
their present position.
A lot of traders and investors plunge right into their business of trading
without thinking of the value of getting organised through a trading plan.
Down the track, this category of traders and investors will belong to the 80
per cent of traders who fail to make money in the markets (according to an
oft-quoted statistic).
So, in the strange metropolis of trading, how will you find your way? The
secret lies in your personal trading plan. In the trading business you do not
always get what you deserve. You get most of what you have planned.
If you want to trade like a professional, your first step is to take the time to
develop your own trading plan. This chapter outlines the various aspects of
mapping out a personal trading plan. I’ll discuss the following:
• why traders do not take the time to formulate their own personal trading
plan before trading the markets
• the advantages of having a personal trading plan before setting up your
business of trading
• the significant areas that you need to cover in a trading plan.
Who needs a trading plan?
A personal trading plan is a significant step in managing your business of
trading, no matter what kind of trader you intend to be. However, there are
still traders who believe otherwise. They continue to pursue instead what
they perceive to be the fastest route to success by hunting for the secret
formula to secure for themselves success in the market.
Here we examine some of the myths that continually hold traders back from
developing a personal trading plan.
‘I am on my own, therefore I don’t need a trading
plan!’
The concept that you are answerable to no-one but yourself is sometimes
given as a justification for not formulating a trading plan. You manage your
trades on your own, why do you need a trading plan? Anyway, you’re not
liable to anybody should you fail (the likelihood of this happening is high
without a trading plan).
A trading plan is your road map, but some traders argue that taking a trip
alone without it won’t matter at all. They are responsible to nobody but
themselves, they say. If they get lost along the way, they get lost. Who cares?
In such a case, let us hope that they would not have to bother others for funds
for the return ticket home. Investing and trading in the markets may involve
risking a lot of money.
The exercise of creating a personal trading plan assists traders to evaluate all
the crucial aspects of trading, including losses and how to make sound
trading decisions and achieve profitability.
‘Creating a trading plan is a waste of time’
Most people equate a personal trading plan solely with a structured written
document. It is a written document — whether that be handwritten in an
exercise book or typed up on your computer — but it does not have to be a
fancy 100-page document with a minimum of 20 000 words, typed in Times
New Roman font and including all other business plan specifications.
A personal trading plan is a process of formulating strategies and decisionmaking that will evolve through the years of trading the markets. It will be
beneficial to have a blueprint for what you want to achieve, how you are
going to achieve it and how much it will cost you to achieve it.
Creating a personal trading plan need not consume months of your time. It
will take some time to put it all together, but in the process you will realise
your areas of weakness or where you need to spend more time working out
how you will handle specific parts of it, such as exits or position sizing. It
will ensure that you answer all the questions you need to consider before you
start trading.
It is easy to put it off and say you’ll do it later, but it is a lot of information to
carry around in your head. By taking this information out of your head and
writing it down, you are giving your trading perspective, focus and clear
guidelines. Plus, you are relieving your mind of the stress of trying to retain
all that information and allowing more knowledge to come in. It is well
worth the effort and you will feel much more at ease as you move forward
with your trading.
If you think you need assistance, my book Smart Trading Plans is available
from my website <www.smarttrading.com.au>.
‘Trading plans need to be flawless’
Another roadblock that keeps traders from making a trading plan is the idea
that their trading plan needs to be perfect before they can begin trading.
If that is the case, you may never start trading. Nothing will ever be perfect.
Even if you have covered every minute detail in your trading plan, you still
need to expect the unexpected. Something that you have not covered in your
trading plan may overwhelm you in the course of real trading.
That is why your personal trading plan is a dynamic and evolving road map.
There is a need to review and update your trading plan from time to time.
There is flexibility to improve and grow as a trader along with your road
map in the market.
‘Only businesses need a plan’
There are traders who presume that only businesses need a plan. Businesses
in the process of applying for loans are required to furnish a structured
written business plan. Trading is not a business therefore a plan is not
needed, they say. Again, this idea is misleading. You may not need a thirdparty investor to finance your trades but you are your biggest investor.
Mapping out your personal trading plan and seeing it in black and white will
give you a better view of how you are going to manage your trades.
And whether you are open to it or not, trading is a business. When you trade
the markets, you are putting money at risk with the goal of achieving a profit,
just like any small business. So you need to treat it like a business and have a
plan that sets out how you are going to manage it.
‘My trading plan is written in my head and known
by my heart’
Having your trading plan all mapped out in your head and fully known by
your heart is a cool thing. It manifests that you are really into the business of
trading with the totality of your whole being. However, don’t you think it will
be less stressful if you can flip through a page of a notebook or click a mouse
rather than rack the compartments of your brain if you forget a small detail in
your business of trading?
It will be a lot easier to remember things if you put them into writing. You
will also be more organised when you can see your plan in black and white.
You may or may not believe it, but there is a certain dynamism when you
write down your plans. There is even a particular point of view held by
some people that writing down a plan conspires the laws of the universe to
make manifest that plan into becoming real.
If you think your business of trading is better off without a plan, think again.
If you need more convincing, the next section will deal with the advantages
of having a personal trading plan.
Personal trading plan: your trading edge
While there will always be traders who trade the markets blindly, without a
clearly defined trading plan, there is clear proof and statistics that show the
successful traders are those who have taken the time to develop their
personal trading plan and have a map to guide them in the markets.
In this next section you will discover the key advantages of having a personal
trading plan, and how it will give you the clear focus you need to be
successful in the markets.
Focus and direction
A personal trading plan provides focus and direction. As you take the time to
develop your personal trading plan, you will have a vision of what direction
your business of trading is going to take.
How do you see your business of trading a few years from now? A personal
trading plan will encourage you to stay focused in that direction day after
day. Without a trading plan you may end up trying every option available to
you and experimenting until you realise you are taking steps that lead
nowhere.
The first part of your trading plan is all about establishing why you want to
trade the markets. It is this vision that will provide you with an overall
direction and focus.
Drive and motivation
A personal trading plan gives you drive and motivation. As you map out your
trading plan step by step, you will be nurturing within you the drive to work
harder. The plan will become motivational because it allows you to consider
all the possibilities of your business of trading and develop strategies to
handle these.
When you have finally engaged in the world of trading, your personal trading
plan will guide you with the answers and be one of your sources for your
motivation and drive.
Remember, trading is a serious business and the excitement will wear off
when you hit that first cluster of losses. During these times you can go back
and browse through your trading plan and get the motivation you need to go
on.
Comprehensive study and strategy
The research and brainstorming you will be conducting in the process of
formulating your trading plan will allow you to know every angle of the
business of trading. The comprehensive study will allow you to consider the
various areas you need to know.
Then when the reality of trading hits you, you will not be groping in the dark
anymore. You will have a plan that you can follow. You cannot plan for
everything, as you will not be aware of all the possibilities until they occur.
But when a situation arises, you reassess, plan how you will handle it if it
occurs again and update your trading plan with this new strategy. It is
important that you consider incorporating contingency plans in your personal
trading plan as you make your cohesive strategy for the unexpected in the
market.
One of the keys to success is knowing how to respond to the unexpected. You
need to consider everything that could possibly go wrong in your business of
trading and determine how you will respond to each situation by having a
contingency plan to protect you. What if your computer crashes or is stolen?
What if your broker’s website goes down and you can’t place a trade? What
if your internet connection or means of communication to your broker is cut
off? What if a severe price shock or market crash occurs? How will you
respond in these situations?
There is no doubt that any trader who does not have a back-up plan will be
panicking the minute these unexpected events occur.
Personal creativity
The only way you can be successful in the markets is to develop a trading
plan that suits your personality. It is up to you to lay the foundations yourself
and develop your plan to blend with your lifestyle and personality.
Making a personal trading plan enhances your personal creativity. Because
you are involved in the making of your trading plan, you instil your own
personality and creativity into the plan. Keeping in mind the important areas
to be covered in a good trading plan, which will be discussed in the
subsequent sections, you can incorporate your own ingenuity and boost your
confidence in the process.
Results
Becoming a consistently profitable trader requires time and discipline. You
must make the effort to complete your trading plan and follow it carefully
once it is finished. The market rewards traders who put in the effort to
complete their personal trading plans and have the discipline to follow them.
Trading is psychological. A trader’s mindset is a crucial element of
becoming a successful trader. Formulating a personal trading plan is the first
step a trader can take that will increase his or her chances of success in the
markets.
Make the right choice and see the bigger picture. If you are willing to invest
your money in trading, try investing your time and energy in the very first
crucial step you need to take before you trade: developing your own trading
plan.
The next section will provide you with an overview of what needs to be
included in your personal trading plan so that you can ensure you have all the
bases covered and it suits your lifestyle and personality.
A smart personal trading plan
The foregoing discussion has enumerated the advantages of having a trading
plan before trading the markets. Knowing that a personal trading plan is a
must is one thing. However, knowing what constitutes a good personal
trading plan that covers the inevitable hits and misses in the business of
trading is another story.
You will work well with your trading plan if it suits your personality and
lifestyle. A trading plan that works for others may not work for you. Each
individual has his or her own unique preferences and characteristics. That is
why you need to develop your own trading plan.
Keep it simple: start with a vision
Mapping out your trading plan will be exciting in the beginning. Setting up a
vision for yourself and how you want your business of trading to work can be
fun. Seeing yourself becoming an advanced trader and winning most of your
trades is something you can look forward to enthusiastically. Visualisation is
your first step.
As you go through your personal trading plan, you will begin to realise that
there are a lot of options to consider. And some of these may pose
difficulties. Just do not forget to stick steadfastly to keeping everything as
simple as possible.
Following are the areas that you need to cover initially in your personal
trading plan:
• Goals and objectives. This is the section of your trading plan where you
need to ask yourself significant questions like: why do you want to trade;
what is your trading edge; and what returns would you like to achieve in the
market (keep this as realistic as possible)? This section will help you set
your vision and purposes around why you want to trade. You can review this
section often to motivate yourself with your vision when things become
unclear or you hit that cluster of losses.
• Trading structure. You need to determine the business structure that will fit
your needs and situation. Determining your trading structure will be
beneficial for tax purposes and asset protection. You have a selection that
ranges from becoming a sole trader to setting up a company. You may also
consider seeking professional help from an accountant to decide on the best
business structure to trade through.
• Trading tools. Part of your trading plan is to gauge and select the best
equipment and resources that are easily available to you. Consider the range
of trading tools you need, from computers, charting software, data providers
and sources of information to websites, brokers and more.
• Trading style. In this section of your trading plan you need to consider the
time frame in which you want to trade. You need to weigh the pros and cons
of each trading style. Decide on whether you want short-term trading,
medium-term trading or long-term trading.
• Trading instruments. Choose the kind of instruments you want to trade and
the markets you want to trade. You can select from shares, CFDs, options,
warrants, foreign exchange, futures, indices and more. Online trading has
made it possible for you to trade the global markets as well. You can
concentrate on trading within your own country or you can trade globally.
The choice is yours, and it can be overwhelming. Focus on an instrument that
suits your chosen trading style.
• Trading indicators. There are a lot of trading indicators that you can use in
selecting a good stock and learning all these may be one of the things that
may bog you down. Keep a simple approach and concentrate on the trading
indicators you have decided to use.
Choose an approach that suits your personality
Trading is about developing an approach that you are comfortable with and
that suits your personality and lifestyle. Your personality influences the way
you trade. Each person has a different psychological makeup and different
reasons for wanting to trade the markets. If your approach does not reflect
these things, it is unlikely that you will follow it.
In choosing an approach that fits your lifestyle and personality, map out the
following in your trading plan:
• Trading routine. Establish a routine plan and list the activities you need to
do on a daily, weekly and monthly basis, depending on what kind of trading
system you have chosen. As you go along with your business of trading, you
will be able to organise your schedule and activities.
• Trading performance and analysis. Develop a regular system of analysing
your trading performance after a set period of time or a set series of trades.
Consider your percentage of winning trades to losing trades, your average
hold time in the market, your average win size compared to your average loss
size and your expectancy per dollar you invest in the market. They are all key
statistics that will assist you in understanding how your business of trading is
going and if you need to make any changes to modify and strengthen your
trading plan.
Manage your risk and money
Managing your risk and money will be one of the keys to your success in the
markets. You need to include information in your plan on how you will
determine your position size, your capital allocation and stop-loss methods.
Consider the following in formulating your trading plan:
• Risk and money management. Prepare how you plan to control your risk in
the market. Set strict money management rules for yourself and adhere to
them. The goal is to keep your losses small and your profits much larger.
Take into consideration how much capital you will be investing in the
market. Think of how you are going to allocate your capital. Bear in mind the
number of positions you can handle having open at one time and how you
plan to manage your open-market risk.
• Contingency plan for all worst-case scenarios. You need to expect
the unexpected. Or better yet, you need to be ready for the unexpected worstcase scenarios in your business of trading. Have a back-up plan or strategy
for difficulties like bad internet connections, power outages, market crashes
and more.
Establish your trading system
Your trading system is the method you are going to use to select trades to
open and how you will manage them after that. Your system will include the
signals you will use to enter a trade, such as the setup and trigger criteria,
and, most importantly, your exits.
In your personal trading plan, detail your trading system (or systems if there
are more than one). Include all the aspects of the system, such as the
following.
Entry criteria
Imagine yourself entering the wonderland of the stock market already. As you
get accustomed to the newness of it all, your eyes begin to adjust and you
define the shares you want to own. What are the triggers that you are looking
for to add a share to a watch list or open a trade?
Take the time to study some healthy shares and work out the ideal moment to
enter these shares. Write down the ideal set-up conditions that were present
and the best entry points. This determines your trigger to buy. Doing so will
help you to develop your personal trading rules and document them in your
trading plan.
Exit criteria
While the signals for entering a trade are important, exit management is just
as significant. So ensure you spend time working out how you plan to set
your stop-losses for your particular trading systems.
Stop-losses are a capital preservation tool that traders use to exit trades
when they move against them. To take the emotions out of trading and to
ensure that you limit your losses and protect your capital you need to have a
stop-loss in place on every trade. The goal of a stop-loss is to protect your
capital by keeping your losses small and protecting your profits once a trade
moves your way.
You cannot control the markets or determine how far a stock will rise or fall
and when it will happen. The only thing you can control is how you manage
your risk in the market. If you set a stop-loss, you must follow it. It does not
take much for a small loss to become a large loss. And it can take just one
trade to wipe out your entire profits for the year or possibly more if you fail
to use a stop-loss on a trade.
Stop-losses are the key to your success. Position-sizing your trades by using
an initial stop-loss on a set percentage of your capital will ensure you limit
your losses. Then, as the share goes your way, a trailing profit stop strategy
will allow you to protect your capital and then protect your profits.
Once you select a method that suits you, stick to it. Trading is all about
consistency and following a set of rules — this will ensure your survival in
the market and enable you to make profits. It’s very easy to buy a share, but
exiting the share is the most challenging part. This is the difference between
successful traders and those who fail — successful traders know that the
secret to their success is in the exits.
Come to terms with your mindset
You are the most important part of your trading. It is what goes on inside your
head that will make or break you as a trader. You need to develop selfawareness and understand your motives for trading. Trading is not just about
making money — money will flow from good trading.
As you discipline yourself and consider your mindset, you can include these
areas in your trading plan:
• Personal trading rules. You need to come to terms with your emotions and
mood swings. The reality of trading is an adventure that is tantamount to a
roller-coaster ride in Alice’s wonderland. Include personal rules like:
remember that patience is the key to success; accept small losses as a fact of
life; act like a master trader; never fear success; analyse winners and losers
but never agonise over them; and more.
• Market exposure guidelines. Consider setting up rules on your exposure in
the market after encountering a series of losses. This will give you ample
time and space to re-evaluate your strategy. It will also give you the chance
to muster enough courage and confidence to re-enter the market.
Remember, you are not in control of what happens in the market. However,
you can prepare yourself for whatever comes your way through your road
map and become a profitable trader.
Become a smart trader
Take the time to develop your smart trading plan today. When I say ‘smart’, I
mean that your plan must reflect the following key criteria, many of which we
have discussed already in this chapter; these are part of my philosophy in
trading:
• Simple. Remember to keep your plan simple — it is easy to get bogged
down with too much information in trading and overcomplicate it with too
many rules. I like the ‘kiss’ method: ‘keep it simple, stupid’. For a technical
trader, it should simply be about trading in the direction of the trend and
exiting when the trend changes. But that is always easier said than done,
because emotions often come into play and affect your trading decisions.
• Mindset. As I mentioned earlier, mindset is so important.What goes on
inside your head will make or break you as a trader. You need to understand
your motives for trading.
• Approach. Trading is about developing an approach that suits your
personality and lifestyle. If your approach does not reflect you as a person,
or you don’t feel comfortable with it, it is unlikely that you will follow it.
• Risk and money management. You need to include information in your plan
on how you will manage risk, including determining your position size, your
capital allocation and stop-loss methods.
• Trading system. This is the method you are going to use to trade. It should
include the signals you will use to enter a trade, such as the setup and trigger
criteria, and, most importantly, your exits.
Final thoughts
The cards have been laid on the table. The business of trading is not
something you can pull together in a bluff like you would in a poker game.
Other traders and investors may have gambled their way through the market
without preparation at all. However, you can count on their failure or
mediocrity in the market. The majority of these traders need to overcome the
common misconceptions about preparing a personal trading plan. These
traders need to recognise the substantial contributions of a personal trading
plan. A trading plan is your road map in the market — without it, you will be
lost.
Completing a personal trading plan is not an easy task. You need not do it
alone. You may find yourself a good mentor who will work with you through
the process. Or you can begin with a good book such as Smart Trading
Plans.
Perhaps the world of trading is a wonderland in the beginner’s eyes and a
roller-coaster ride for the advanced trader. No matter where you are at with
your trading, remember that people have been trading markets all over the
world throughout its history with many a tale to tell. But the successful ones
who live on the profits they gained in the market began with a trading plan.
Chapter 3: Lies my broker told me
Time in the market and other financial myths
Chris Tate
Within the world of trading there are a variety of myths that do not hold up to
intellectual scrutiny. These myths have been part of investing folklore for
generations and they roll off the tongue of those on the supply side of
financial markets very easily. Upon first hearing they sound logical and
intuitive and appear to be neat summaries of decades of investing wisdom.
Unfortunately, this is not the case and these myths are anything but logical. In
this chapter I plan to look at the myth of ‘time in the market’ versus ‘timing
the market’. The central tenet of this myth is that the market cannot be timed;
therefore, the only logical thing to do is to remain in the market through all
periods no matter how turbulent or volatile they may be. In looking at this
myth we will also look at two additional issues, which are adjuncts to our
primary myth — dollar cost averaging and survivor bias. All three are
interwoven in such a way as to provide a compelling case for their blind
acceptance but, as we will see, when exposed to scrutiny all are shown to be
little more than fairy stories that have existed without foundation for
generations.
Time in the market versus timing
The concept of time in the market is based around very simple tenets:
• Markets and their component equities suffer from extreme
short-term volatility, which is washed out of the market over
the longer term. This volatility may lead to short-term downturns.
• Markets are random and unpredictable. This is commonly distilled as the
random walk hypothesis and is a cornerstone of the efficient market
hypothesis (EMH). A consequence of these two elements is that no-one can
predict the future but it is always a good time to invest.
• Missing the best days will cost you dearly.
• The market always recovers and, by extension, good stocks always recover.
To sustain their argument, the ‘time in the market’ supporters generally
produce a chart that looks like figure 3.1. This shows the benefit of being
fully invested and the cost of missing certain periods of market growth.
Figure 3.1: example chart showing the effect of missing the best days
I want to deconstruct these arguments individually to establish the lack of
rigor behind each of these statements and to show them as little more than
homespun feel-good statements.
Volatility argument
In many ways this is a specious argument because it confuses trend with
volatility, and this confusion is very common on the advisory side of markets.
You will often hear of market analysts stating that the market has downside
volatility. To avoid perpetuating this confusion I want to examine what
volatility actually is and how it is measured, and then look at the fallacy of
this statement.
The first step towards understanding volatility is to understand the concepts
upon which much of probability theory is based. It is therefore necessary to
understand how prices are distributed from one trading period to the next and
to get a feeling for the likelihood of any given price movement.
Much of the statistics of probability are built upon the assumption that the
trials being conducted are random in nature. This also assumes that markets
display what is known as a normal distribution, which is not strictly correct,
but it serves as a practical assumption for this exercise and avoids the need
to go into depth about the mechanics of skewed distributions.
In studying the probability of markets, we want to know the chance of price
moving a given amount either up or down in a given period. Note I did not
say the chance of it moving up or down, I said the chance of either event
occurring. This might seem like a semantic argument but it goes to the heart
of the problem that commentators have regarding volatility, and that is the
implication that it has a bias. Volatility has no directional bias, and the
reason for this will become apparent shortly.
To get an understanding of how likely movements are we need to know how
price is distributed. We need to calculate how price moves from one time to
the next. To describe any event we need to look at a distribution curve like
figure 3.2 (overleaf), which is the archetypal bell curve that everyone is
familiar with.
Figure 3.2: bell-shaped curve
These curves can be described using two statistical tools: mean and standard
deviation.
If the curve is described as a normal distribution then we can assume that the
curve is symmetrical about the mean. The mean corresponds to the peak of
the graph so we simply locate the value that corresponds with the peak. The
mean can also be easily calculated without much effort. For example, if we
took a week of the closing share price data for BHP and calculated the mean
price we would get the following:
($43.95 + $43.59 + $44.41 + $43.38 + $43.28) ÷ 5 = $43.79.
The average price for this week’s worth of data is $43.79. If we were to plot
BHP prices for this period, we would see that most values would cluster
around this figure. This is what we would expect and what our experience of
share prices tells us. The majority of prices seem to centre on a mean value
and occasionally we get a large move away from that mean value.
The statistic known as standard deviation gives us an idea of how often we
can expect prices to cluster near the mean and, equally importantly, how
often we can expect prices to deviate by large amounts from the mean. The
standard deviation is how quickly prices spread out from the mean.
By definition:
• 68.3 per cent of all outcomes will fall between + or – one standard
deviation from the mean (2/3)
• 95.4 per cent of all outcomes will fall between + or – two standard
deviations from the mean (19/20)
• 99.7 per cent of all outcomes will fall between + or – three standard
deviations from the mean (369/370).
The average price for BHP during the sample period was $43.79 and from
this figure it is possible to work out the spread or standard deviation of
prices for a given period. For example, if I looked at the five-day standard
deviation (41¢) for BHP for this period I would see that 68.3 per cent of
prices fell within one standard deviation of the mean. That is, 68.3 per cent
of all observations were between $44.20 and $43.38. Looking at standard
deviation gives me an idea of the dispersion of prices away from the mean.
In effect, we are looking at the magnitude of price movement over a given
time.
The volatility figure used by most financial commentators and analysts is a
percentage over a given time. If volatility is expressed as a percentage and
standard deviation is a raw number, the question is, how do we get from the
raw score to a percentage?
The answer is simple. The volatility percentage of any given instrument
actually represents one standard deviation for any given period; in most
instances this is an annualised figure so it is based upon a trading year. For
example, if a $5 stock has a volatility of 25 per cent, a price change of one
standard deviation is $1.25 (25 per cent of $5). Therefore in one year of
trading it is probable that on 2 out of every 3 occasions the stock will trade
somewhere between $3.75 and $6.25; that is, + or – one standard deviation.
On 19 out of 20 occasions it will be trading between $2.50 and $7.50; that is,
+ or – two standard deviations. Moreover, on 369 out of 370 cases it will be
trading somewhere between $1.25 and $8.75; that is, + or – three standard
deviations.
Now that we understand what volatility is we can begin to dissect the
argument that markets show a bias in their volatility distributions and that
short-term periods of volatility may lead to downturns.
This argument displays a fundamental misunderstanding of what volatility is;
it also presumes that trend and volatility are linked in some way. This notion
is wrong: volatility has no bias; as we have already seen volatility can be
defined as the speed and magnitude of price movement. It gives no indication
of the direction of this movement.
Consider the chart of the All Ordinaries shown in figure 3.3, which has
volatility charted along the bottom.
Figure 3.3: All Ordinaries index
Chart by MetaStock.
From this chart we can make two observations.
• Periods of relatively high volatility occur at market peaks and troughs. In
the recent pullback the highest level of volatility occurred as the market
rebounded in October 2008. If the theory of high volatility leading to
pullbacks were correct, we
would not see periods of high volatility at both peaks and troughs.
• Price moves through periods of consolidation to trending but at no point is
there a correlation between the relative levels of volatility and these market
phases.
Implications for the trader
The notion of volatility is often confusing for traders because as a concept it
is poorly expressed and it is often confused with trend. As we have seen, the
two are distinct entities. Volatility describes the speed and magnitude of
price movement and trend describes the direction of this movement. This
misunderstanding does not, however, remove the utility of volatility from the
trader. It simply means there is need to be extremely sceptical of talk that
confuses price direction with volatility. If volatility is applied correctly, it is
a useful tool for the trader. For example, it is possible to define volatility in
such a way that the trader avoids extremely volatile markets. Traditionally
traders are told that they need to trade volatile markets because they need
price to move; once again this confuses volatility and trend. However,
volatile markets are often subject to poor price discovery, and high levels of
volatility, irrespective of the current market phase, can dramatically reduce
the position size of the trader, whereas markets that have persistent trends
can display remarkably low volatility.
Random market argument
In many ways this is an irrelevant argument since the aim in trend trading is
not to predict market direction but to be a trend follower. It is also largely
irrelevant from an academic perspective since there is a compelling body of
evidence that markets are not random in their distributions and that prices
display a degree of persistency that cannot be explained by random
distributions.
An extension of this is the collapse in recent years of the efficient market
hypothesis (EMH) because of its central reliance upon the notion of the
rational investor; that is, all investors are equally well informed and will
make decisions that are designed to maximise the financial utility of the
information at hand. According to the EMH, traders are perfect automatons
unburdened by emotion.
Leaving aside the innumerable examples of financial irrationality, the
efficient market hypothesis has largely been undone by the original work of
Amos Tversky and Daniel Kahneman.1 A list of more general texts is given
at the end of this chapter.2
However, the cornerstone of my objection to this point is based upon the
notion that it is always a good time to invest. The issue of predictability and
the nature of price distributions are beyond the limited scope I have within
this chapter. The suggested reading material I have offered will go into this
issue with much greater depth and clarity than is possible here. Suffice to say
my belief is that the notion of predictability is an irrelevant notion and is
designed to distract one away from the central problem with this belief. The
notion in question is whether it is always a good time to invest, and this idea
can be dissected by reference to a longer-term chart of the All Ordinaries
index.
Consider the chart of the All Ordinaries index in figure 3.3. From this chart
several things are obvious:
• Australian indices have a natural upward bias, and this is a point I will
deal with shortly
• there are periods of no or little return as markets move sideways
• there are periods where markets collapse rapidly in value.
These observations can be supplemented by an even more telling
observation. Figure 3.4 shows the value of $1 invested in the All Ordinaries
since 1984. As can be seen, there are extended periods where the value of
your investment goes nowhere.
Figure 3.4: All Ordinaries value of $1
Microsoft Excel screenshot. Used with permission from Microsoft.
Clearly, it is not always a good time to invest because of the simple nature of
market dynamics. There are long periods of stagnant or negative growth
followed by periods of trending.
The reason to be out of the market during these periods can be easily
demonstrated with a simple example.
Imagine two trading systems that are linked to the All Ordinaries index.
Trading system one has no macro filter and simply attempts to ride out
swings in the market, whereas trading system two has a long-term filter that
switches its trading off when it perceives a change in the long-term trend
from bullish to bearish.
Assume that both systems entered the downturn of 2008–09 being long the
market. Both portfolios had a nominal value of $100 000 at the start of the
crisis. As the downturn unfolds, trading system two switches off to preserve
its value and move out of a down-trending market and into cash, whereas
trading system one continues to hold throughout the swing down.
Trading system one endures a maximum drawdown of 54 per cent; that is, the
portfolio value drops from $100 000 to $46 000, whereas trading system two
has preserved its value at $100 000. However, the situation is more
complicated than this because as the market begins to recover trading system
one benefits from this recovery whereas trading system two has to wait until
its macro filter is triggered before re-entering the market. For the sake of
simplicity I have used my macro filter, which triggered again in June 2009.
At this point trading system one would have climbed in value to $58 000 and
trading system two is sitting in cash.
It is as the market begins to recover that the true difference between the two
systems is revealed. Assume that post the recovery both systems return 20
per cent for the rest of their time in the market. Table 3.1 (overleaf)
demonstrates the difference in the returns over time for the two accounts.
As can be seen, the value of preserving your capital is obvious. However,
the true extent of the difference in these returns is not obvious until the returns
are plotted as a graph (figure 3.5, overleaf).
Table 3.1: trading systems compared
Figure 3.5: trading system comparison
Microsoft Excel screenshot. Used with permission from Microsoft.
The key message from this chart is that trading system one does not catch
trading system two if their returns are equal. Due to the nature of this curve,
trading system two will continue to increase this gap.
As a final point it should also be noted that there is a degree of intellectual
dishonesty in the returns quoted by various funds. This dishonesty plays upon
people’s misunderstanding of how performance works. As an example,
consider a fund that has the following performance:
• year one + 100 per cent
• year two – 50 per cent
• average performance = 100 – 50 ÷ 2 = 25 per cent.
I could say that this fund has an average return of 25 per cent per annum, so
that my expectation would be that if I invested $100 000 at the start of year
one, by the end of year two I should have $156 250 in my account. In reality,
I would have $100 000: despite being quoted an average return of 25 per
cent I would have made no money. This happens because in the first year the
account doubles to $200 000 and in the second year it halves, leaving $100
000 in the account.
Implications for traders
The implication for traders here is simple: you need only be in the market
when the market is trending. One of the biggest mistakes I see in traders is the
desire to be in the market when it is not trending or trending down and having
no notion of when these things are occurring. A trading system that is
continually in the market will never match the performance of those systems
that carefully choose the timing of their exposure to trends within the market.
All traders need to design a macro filter that tells them when the market is
trending over the longer term and then orientate their trading in that direction.
Best days argument
At the beginning of the chapter we saw figure 3.1.
Such charts are traditionally given as evidence as to why you should always
be in the market. However, what is shown is only half the picture and is
actually a rather simplistic interpretation of a complex problem.
Trading can be likened to golf in that the player who makes the least number
of catastrophic mistakes wins. We have already touched upon this when we
looked at the difference in returns between two contrasting trading systems.
This comparison gave us an idea of what happens to two portfolios which
have differing periods of exposure to the market and how difficult it is to
recover from a severe loss.
The situation in trading is, however, a little more complex in that returns are
the sum total of good and bad days. In addition, in trading it is the bad days
that matter the most because these are the ones that set us back temporarily,
or, if they are severe enough, permanently. The bad days are the ultimate
arbiter of how our portfolio performs. Therefore, it is only logical to look at
the impact of missing both the best and worst days and see which one has the
greater impact upon our performance.
The argument implied by those who advocate time in the market is that
missing the best days has a greater impact on a portfolio than missing the
worst days. Implied within this is that by missing the best periods you are out
of the market, so that when you mapped missing the best days or the worst
days on a single chart, missing the best days would always have the greatest
impact upon a portfolio; gains are more important than losses when it comes
to determining the overall return in a portfolio. Initially this seems to be very
intuitive: you cannot make any money without a gain and you cannot make a
gain unless you are always in the market.
However, it is necessary to look at the impact missing the worst days has on
portfolio. The charts in figures 3.6, 3.7 and 3.8 look at the impact of missing
days where the market rose or fell by 3 per cent, 4 per cent and 5 per cent
respectively, and the effect of those changes upon overall performance.
Figure 3.6: missing 3 per cent
Microsoft Excel screenshot. Used with permission from Microsoft.
Figure 3.7: missing 4 per cent
Microsoft Excel screenshot. Used with permission from Microsoft.
Figure 3.8: missing 5 per cent
Microsoft Excel screenshot. Used with permission from Microsoft.
In each example, the effect of missing the worst days was more pronounced
and resulted in a greater portfolio performance than not missing the best
days. That is, I make more money if I miss the worst days than if I am in the
market for the best days. Interestingly, I can afford to even miss some of the
best days if I manage to miss the very worst days. This agrees with our
earlier observation that losses have a greater impact upon a portfolio than
gains. This lack of symmetry in gains and losses occurs because of a simple
twist in financial mathematics. A 10 per cent loss cannot be made up by a 10
per cent gain. It requires an 11.1 per cent gain on the remaining equity to
return to parity.
This relationship is given by the equation G = L ÷ (1 – L), where:
• G = percentage gain required to recover
• L = percentage loss incurred.
So if my portfolio lost 20 per cent then it would require the following gain on
remaining equity for me to return to parity: G = 0.2 ÷ (1 – 0.2) = 25 per cent
When values for various losses are plotted, they give the curve shown in
figure 3.9.
Figure 3.9: gain-to-loss recovery chart
Microsoft Excel screenshot. Used with permission from Microsoft.
Implications for the trader
The clear message is that within any trading plan the preservation of capital
is paramount: if you have no money you cannot play. In many ways it does not
matter what the future return is on your portfolio if you have suffered a series
of catastrophic losses. This means that in combination with a macro filter,
which we spoke about earlier, you need to also have a rigorous stop-loss
program in place so that when you are in the market you are able to — as
much as possible — avoid large losses which deplete your trading capital.
Dollar cost averaging argument
Within most financial texts you will find reference to dollar cost averaging
(DCA). References to DCA go back to about 1925 when Robert Montgomery
in his Financial Handbook urged investors to undertake a ‘diversification of
maturity’ strategy, because ‘the constant reinvestment of funds places one in a
position always to take advantage of such price opportunities as arise’.3
This notion took hold in the financial community with little or no challenge.
Some rigor was applied to the concept in 1967 when Cohen, Zinbarg and
Zeikel said, ‘Dollar-cost averaging allows one to buy a greater number of
shares of any stock when the price is down. Dollar-cost averaging is most
helpful in buying growth stocks’.4
This strategy is based once again upon the notion that markets or instruments
cannot be timed and therefore the individual is best to be in the market all the
time and to employ a strategy of regularly investing set amounts of cash. The
argument is that in doing this you smooth out the fluctuations in price and end
up effectively loading up on an investment when its price is low. This has the
impact of lowering your overall entry price.
In theory, it works like table 3.2.
Table 3.2: dollar cost averaging
The average price per share at the end of the period is $1.07, which is lower
than the initial purchase price of $1.25. Such an approach seems logical:
each period a given amount is invested in the portfolio and all the
fluctuations and periods of volatility that are the bane of investors’ lives are
removed.
This concept seems logical and it would seem that the references cited
earlier and all those who support this strategy are correct. It seems intuitively
correct that DCA provided a lower average entry price, a hedge against
volatility and therefore a more stable return to the investor. However,
intuition is a poor yardstick by which to judge matters of money. After all, it
seems intuitively correct that it is not a loss until you sell or that you can
never go broke taking a profit. Unfortunately, intuition is wrong on both of
these counts and it is wrong regarding DCA.
The first serious work on DCA was done in 1979 by George Constantinides
while at the University of Chicago in his paper titled ‘A Note on the
Suboptimality of Dollar-Cost Averaging as an Investment Policy’.5 This is a
rather formal way of saying it doesn’t work and is inferior to lump sum
investing.
The work of Constantinides is similar to some work I did recently on this
topic. I looked at a sequential series of investments into the S&P 500 versus
a single lump sum investment at the beginning of each year. Grinding through
1000 iterations, I found that lump sum investing wins on an end-of-year
valuation 66.9 per cent of the time. The disparity between the two strategies
was even worse when the market was running. Therefore, the question
becomes, do you want to be involved in a strategy that only has the potential
to be of benefit to you 33.1 per cent of the time and that fails miserably when
the market is running hot?
More advanced work was done by John Knight and Lewis Mandell in
Financial Services Review.6 They compared DCA to traditional buy and
hold and what they termed dynamically rebalanced portfolios or actively
traded portfolios. They analysed these approaches across a series of investor
profiles starting with a high degree of risk aversion and working their way to
a low degree of risk aversion. In each instance, DCA underperformed the
alternatives.
Their summary is extremely telling and very well expressed:
Brokerage firms promote Dollar Cost Averaging primarily with two
rationales. First, they argue that returns are augmented because more
shares are purchased when prices are low and fewer when prices are
high. Second, they assert that Dollar Cost Averaging enhances
investor utility by preventing an ill-timed lump sum investment. Our
results do not support either of these contentions.
In conclusion, they state:
Using three separate methods of comparison, we have shown the lack
of any advantage of Dollar Cost Averaging relative to two alternative
investment strategies. Our numerical simulations and empirical
evidence, in consonance with our graphical analysis, both favour the
Optimal Rebalancing and Buy and Hold strategies over Dollar Cost
Averaging.
Optimal Rebalancing and Buy and Hold strategies convincingly
outperform Dollar Cost Averaging on theoretical grounds as well as
on the basis of numerical simulations. Historical evidence also
supports these two strategies, though the empirical differences are not
significant.
Our results strongly imply that the additional cost and effort
associated with Dollar Cost Averaging cannot be justified for any
investor, regardless of degree of risk aversion. With the possible
exception of its promoters, nobody gains from Dollar Cost Averaging.
This raises the question that if DCA is a discredited idea, why do people
hang on to it? Part of the answer undoubtedly lies in that the people involved
in financial markets and the provision of financial advice are largely
remarkably ill informed about the nature of the business world they operate
in. It is easier to give answers that seem intuitively correct rather than to
critically evaluate matters and to go against the tide of opinion. To
paraphrase Socrates, just because everyone thinks it is a good idea does not
mean that it is.
As a further observation, DCA tells us something very interesting about
human nature. People love to get what they perceive to be a bargain; that is,
they like things they consider cheap. For example, if you bought a stock at $1
and it falls to 75¢ then it is logical that you should buy more because if
nothing else has changed the intrinsic value of the stock has gone up by 25
per cent. Contrast this with the situation of having bought a stock at $1 and it
is now trading at $1.25. Sensible, disciplined trading says that you should
pyramid into this stock because it is moving in your favour and you want to
do as much as possible to maximise your return. Yet if I were to conduct a
straw poll of investors my feeling is that the majority would rather buy a
stock that is going down because they perceive it as a bargain as opposed to
buying a stock that is going up because that is perceived as being more
expensive.
Good stocks always get better
Whenever you visit the offices of a stockbroking or financial advisors firm,
you will generally see a long-term chart of the All Ordinaries index that
looks something like the one in figure 3.10.
Figure 3.10: All Ordinaries long-term line chart
Chart by MetaStock.
Such a chart is generally used to illustrate the point that the market always
recovers any lost ground. The implication is that if you buy a share all you
have to do is wait because the market always recovers to a new high.
However, such a philosophy is built upon a degree of intellectual dishonesty.
The index you are viewing may make a new high but this does not mean that
the stocks you are buying will participate in this recovery. The implication
that all shares recover to a new high is a false one and the use of an upwardly
biased index to highlight this point is somewhat lazy.
The reason for this is that indices in Australia have an upward bias due to the
interaction of two correlated factors. Firstly, there is a great deal of churn
within an index — shares that can maintain their places in the index are
retained whereas those that cannot are dumped. The implication is that shares
that are profitable remain in the index while those that are not are removed.
This churning feature is a function of a phenomenon known as survivor bias
and it is well known to anyone who understands testing of natural systems.
Within any given system there will also be what are known as survivors —
these survivors can and do exert an upward bias in any results that the system
generates. Therefore, they have to be compensated for in any interpretation of
the results such a system generates.
For example, when the S&P/ASX 200 index originally listed it had 210
components: the drift beyond 200 was due to the presence of hybrid
instruments such as preference shares. Of those original components, only 54
are retained within the index in their original form. The remainder have
either been dumped from the index, undergone a merger and then been
dumped or they have simply gone bust. Either way they are gone.
The implication is even if you had managed to buy a representative portion of
each share in the index on the day the index began trading, that portfolio
would have been devastated by the attrition within the group. For example,
you would have bought Solution Six Holdings at $10.40 and watched it trade
its way down to 45¢, or bought ERG Limited at $11.45 and watched as it
now sits at around 0.023¢. In addition to this, an extremely large proportion
of your portfolio would have simply ceased to exist.
So unless you continually churned your portfolio to match the changes within
the index, the value of your portfolio would in no way be represented by
figure 3.10.
Implications for traders
As I said earlier, indices in Australia have a profound upward drift because
of survivor bias. This has implications for both the trader and the system
tester. System testers need to account for this issue in their testing. Traders
need to be aware of the difficulty they will face in generating a short selling
system that can be applied to indices.
Final thoughts
Given that we can accept that the notion of time in the market as an
investment strategy is profoundly flawed the question has to be raised as to
why it has persisted for so long. My answer to this is twofold and reflects
both my experience within the advisory community and my observations on
how people make decisions and the limits to their rationality.
Without doubt, the blame for perpetuating these myths lies squarely at the feet
of the advisory community. My interpretation of the reason for this is simply
laziness: these platitudes roll easily off the tongue and, as I said in the
introduction, they sound logical. Within this is also the usual deferment to a
higher authority by advisors, which goes along the lines of if so and so does
it then it must be correct.
Despite the role of the advisory community, the role of the individual and his
or her decision-making needs to also be reviewed. Herbert Simon, one of the
early architects of game theory, postulated the notion of bounded rationality;
that is, responses of each individual are limited by their information,
cognitive ability and time.7 Effectively everyone is handicapped by time,
information and intellectual ability. However, I would extend this statement
to say that people are bounded by rationality but also have the capacity of
unbounded irrationality. Consider the amount of magical thinking that is
evident today. As an extreme example, consider the flat-earth societies that
still exist. It would be presumed that the notion of the earth being flat was an
idea that died out centuries ago but interestingly it persists and the believers
dispute all evidence against their idea. In fact, the more evidence presented
to them the more fervent their belief becomes.
It is this desire to cling to outmoded and discredited ideas that is the prime
driver for the persistence of such myths as we have examined. As depressing
as this lack of rationality in people may be, because of its wider implications
for society there is a bright side to this issue: we will never run out of people
to take money off.
Sources
1 Kahneman, D & Tversky, A (1973), ‘On the psychology of prediction,’
Psychological Review, 80, pp. 237–251; Kahneman, D & Tversky, A (1979),
‘Prospect theory: An analysis of decisions under risk,’ Econometrica, 47,
pp. 313–327; Kahneman, D, Knetsch, J L & Thaler, R H (1990),
‘Experimental tests of the endowment effect and the Coase theorem,’ Journal
of Political Economy, 98, pp. 1325–1348; Kahneman, D & Lovallo, D
(1993), ‘Timid choices and bold forecasts: A cognitive perspective on risktaking,’ Management Science, 39, pp. 17–31; Kahneman, D (2003), ‘A
perspective on judgment and choice: Mapping bounded rationality,’
American Psychologist, 58, pp. 697–720.
2 Belsky, G and Gilovich, T (1999), ‘Why Smart People Make Big Money
Mistakes — and How to Correct Them: lessons from the new science of
behavioral economics’; Garber, P M, Famous First Bubbles: The
Fundamentals of Early Manias, Massachusetts Institute of Technology;
Goldberg, J & von Nitzsch, R, Behavioral Finance, Wiley Finance.
3 Montgomery, R H, Financial Handbook, The Roland Press Company
1925.
4 Cohen, J B, Zinbarg, E D & Zeikel, Investment Analysis and Portfolio
Management, Irwin 1977.
5 Constantinides, G M, ‘A Note on the Suboptimality of Dollar-Cost
Averaging as an Investment Policy,’ Journal of Financial and Quantitative
Analysis, June 1979, pp. 443–450.
6 Knight, J R & Mandell, L, ‘Nobody Gains from Dollar Cost Averaging:
Analytical, Numerical, and Empirical Results’, Financial Services Review,
2(1) 1993, pp. 51–61.
7 Simon, H (1957), ‘A Behavioral Model of Rational Choice,’ in Models of
Man, Social and Rational: Mathematical Essays on Rational Human
Behavior in a Social Setting, New York: Wiley.
Chapter 4: Devising a trading
strategy
Why consistency is key
Stuart McPhee
If you have come straight to this chapter first because you seek information
on trading strategies, then I may be about to disappoint you. What is more
important than me giving you some basic strategies is you committing to
finding a simple strategy and sticking to it. Don’t despair and flick to another
chapter, as I will give you some solid guidance towards the end.
The two biggest problems people have with their entry signal is a lack of
consistency and it being too complicated. Let me explore these areas first
before providing some more specific guidance on how to define your entry
setup.
Consistency is one of the most important traits of traders — consistency in
the execution of their trading plan from entry to position sizing to exiting.
I believe that most traders trade randomly. In other words, they will look for
trading opportunities indiscriminately without any process or methodology.
They will stare at a chart and see if something pops up. Even if they have to
stare at it for a few minutes, they will keep looking until they find something.
One trading opportunity might appear because the chart looks similar to one
that was seen in a trading book that someone read on the weekend. Off they
go to find the book and flick through it looking for that chart … there it is,
page 123. The chart they are presently looking at almost resembles the chart
in the book and that author said you should trade it, so they do. Even though
they have never traded that setup before and may not ever again.
This is not consistency, but is a terrible way to look for trades.
Aim for consistency
I always talk to people about my three C words with trading: consistency,
comfort and confidence. Comfort in the level of risk you take with trades,
confidence in yourself, your own ability and your trading plan, and
consistency in your whole approach.
When I look at a chart, I could tell you within a second whether it is a likely
opportunity or not. Why is that?
I know exactly what my strategy is and why I will enter a trade. I know
exactly what it looks like on a chart, because I have seen it thousands of
times.
What I want you to do is commit to mastering one trading setup and then
executing it with great discipline and consistency. Take a mental picture of
what your perfect setup looks like and burn that template into your mind. This
will ensure that when you see a chart that doesn’t match your template, you
are able to eliminate it quickly.
What should your strategy be based upon? Good question. Let me explore
that further in this chapter.
I don’t like to compare trading to gambling, although many people think that
trading is exactly that; however, let me talk about consistency from a casino’s
point of view. Let’s use the example of a roulette wheel.
As the roulette wheel and table include a zero and in some cases also a
double zero (00), the odds are slightly tipped in their favour. The presence of
the green squares on the roulette wheel and on the table are technically the
only house edge; however, that is all they need. The casino has an edge and
they apply that edge with absolute consistency over an extended period of
time.
You need to strive for the same level of consistency where you place the
odds in your favour. Trading randomly and using a variety of different entry
setups does not come close to achieving this. You will end up on a neverending journey of moving from one strategy to another to the next and so
forth.
Being consistent means that when you see a potential trading opportunity that
no longer meets your entry setup, you don’t trade it. It doesn’t matter if it is a
classic break higher from an ascending triangle or the perfect moving
average crossover that you read about on the weekend. If it doesn’t meet your
entry conditions, move on.
I could confidently state that my trading style is boring, mainly due to this
level of consistency; however, I am very comfortable with that tag. I have
always said that trading won’t deliver a great rush of excitement for the
majority. If you want to feel exhilarated, jump out of a plane. Trading won’t
provide it to you.
I know for a lot of people who start out and want to trade stocks, they
struggle with identifying potential trading opportunities. They consider that
there are thousands of stocks listed on the stock exchange and don’t know
where to start. This can be a daunting experience.
One thing that greatly assists me with consistency is using software to filter
out all those stocks that don’t meet my criteria, leaving me with a small list to
manually scan through. This is a great time saver for me but it also greatly
assists with the consistency, as I don’t even look at a chart unless it has met
my conditions.
I think this is one of the most valuable things a piece of software can provide.
Many online trading services offer basic charting functionality, but one of the
tools that separates dedicated trading software from many online services is
the ability to scan through thousands of securities very quickly, therefore
providing you with a small list rather than thousands. I have used
MetaStock™ since 1999 and use it principally for this purpose.
Having said that, some traders don’t need such a tool if they are focusing on
only a few items to trade. For example, forex traders may trade fewer than 10
currency pairs and therefore they don’t necessarily need the ability to sort
through all that data; they can easily look at 10 charts within minutes and
identify any trading opportunities.
Keep it simple
I believe that many people, when starting out, view trading as easy money;
however, it may be the hardest easy money there is! Trading has relatively
straightforward concepts, yet it is amazing how many people make a mess of
it.
Once they realise that it isn’t as easy as they initially thought, they try to
overcomplicate their strategies, believing that a complex solution is
required. Unfortunately, this is often not the case and they end up travelling
down the wrong path.
Unfortunately, some beginners then undertake a ruthless search, even
subconsciously, for the Holy Grail — the method that will guarantee
unbelievable success and/or perfect trades every time. Furthermore, many
traders will dismiss simple entry strategies, because they are convinced that
trading is difficult. Consequently, a simple approach can’t possibly work.
Some of the most effective trading methods have very simple trading rules
and entry criteria, and winning traders often use very simple techniques;
however, they will use them consistently. It could be argued that a poor plan,
with solid risk management rules and used consistently, is going to
outperform a trading approach where you are constantly jumping from one
strategy to another.
Generally, two big problems that traders face are not having a trading plan
or, if they do have one, not following it. There is no need to complicate
things beyond simple comprehension. One thing I have learned about trading
plans is that the easier it is to understand, the more likely you are to follow it.
Decisions, decisions
I have been very fortunate to have travelled extensively over the last few
years and speak to traders from many countries. I am still amazed at how
many traders who have traded for several years still can’t specify precisely
what their entry signal is.
Furthermore, many of these traders will devote a disproportionate amount of
time to the various components of their trading plan. They will spend
countless hours devoted to reading about and seeking different trading
strategies and ignore more important issues such as preparing their mind for
consistent and disciplined trading. This is despite your entry signal being
widely accepted to be the least important decision that needs to be made.
I suspect there are several reasons for this. For example, traders often
dismiss simple strategies as they can’t envisage them possibly working. They
subconsciously want to be right all the time and therefore as soon as they find
evidence that a particular strategy results in a losing trade it is dismissed, or
at the very least it loses appeal. The reason might vary for most traders.
If you are in this boat, my advice to you is simple. Jump ahead of the majority
of traders in the success queue by developing a simple strategy that meets the
time-tested rule of following the trend and then trying it with some real
trading. The keys are that you need to do so with great discipline and
consistency and make sure you set appropriate initial stops and trailing exits.
The entire trading process
Before I get into some basic trading strategies, I would like to address who
traders are and what they do. Good traders develop and follow a robust plan
with great discipline and consistency; this plan will routinely identify highprobability trading opportunities and they will manage their risk
exceptionally well, to include keeping their trades small and cutting their
losing trades quickly.
Traders are professionals — they are very good at what they do. They treat
their trading just like running a business where they make decisions all the
time and follow systems. Apart from discipline, perhaps one of the great
separators between the professional traders and the rest is the amount of time
and resources that the former group allocates to their trading activities and
their methodical preparation.
As Abraham Lincoln, the 16th president of the United States, said, ‘Give me
six hours to chop down a tree and I will spend the first four sharpening the
axe’.
Professional traders have discovered a simple trading plan that is a perfect
fit for them. To guide clients through the process of developing their trading
plan, I always use the model shown in figure 4.1 (overleaf).
Figure 4.1: trading plan model
Some people will use terms other than what appear above (for example,
trading psychology for mindset; risk or money management for money;
trading system for method); however, I like these terms as they are easier to
remember: the three Ms!
For the remainder of this chapter I will explore the method further but, before
I do, I want to touch upon which one is most important. Most will declare the
mindset as the most important, including myself; however, there are numerous
other trains of thought on this.
Some would suggest that it doesn’t matter how disciplined or confident you
are, if you don’t have a robust and simple method, you won’t be successful.
Likewise, if you don’t manage your money by cutting losses and protecting
your capital, it doesn’t matter how good your method is.
From this I conclude that all three are important in their own way, yet I will
not change my opinion on the mindset being by far the most important
ingredient to your success. Yes, you need a simple and sound method and you
most definitely need to manage your money; however, it is your mindset
which makes it all happen and ensures you do things the right way.
There are three key decisions you need to make when trading, and if we think
in these terms and your trading plan answers each question you may have the
makings of a simple yet robust trading plan.
Despite what I listed previously as the three broad areas in your plan, your
trading boils down to the following:
• Under what conditions will you enter a trade?
• How much money will you commit to the trade?
• Under what conditions will you close the trade?
First, under what conditions will you enter a trade? Let me provide a slightly
alternative view to what our trading plan is designed to do. Many would
agree that your trading plan and the method listed therein are designed to get
you into the market. My view is the opposite, as I believe my trading plan is
designed to keep me out of the market.
Let me explain. There are theoretically an infinite number of trading
opportunities every day. The vast majority of these do not fit our trading
style, and therefore our trading plan is constantly telling us not to initiate a
trade. If a potential trading opportunity makes it through your selection
criteria, then it has done so for a very good reason. This is part of
consistency.
The most critical part of the process is when to exit. Notwithstanding the
importance of mindset and cutting losses, from a technical standpoint this
would be the most common problem inexperienced traders have. I mention
this here because it isn’t that traders choose terrible trading strategies, it is
the fact they consistently make a mess of their exits.
By developing a written trading plan, you can clearly define and articulate
the rules you will follow, your money management approach and the various
components of your trading method.
Introduction to trading strategies
I want to provide some simple concepts to provide you with some guidance
and a starting point to work with. The key principles for developing a trading
strategy are keeping it simple and trading with the trend.
As I mentioned earlier, I want you to commit to mastering one trading setup
and then executing it with great discipline and consistency. Take a mental
picture of what your perfect setup looks like on a chart, and burn that
template into your mind.
What does trading with the trend mean and why do I mention it as one of the
key tenets of trading strategies?
A trend is the clear, distinct direction in which a price is tending to move
over a set period of time. Basically, it is an indication of a price’s general
course.
There is no doubt that there are some traders who trade against the trend and
consistently make money. However, they are highly experienced, skilled,
decisive and disciplined, and they generally take greater risks when doing
so. No beginner trader fits this mould.
Therefore, the easiest way to trade is simply with the trend. You are placing
the odds in your favour. Let me explore why this is the case and how we can
develop strategies based on the trend.
Following trends
I believe that trends are the cornerstone of technical analysis. The key tenet is
to consistently trade with the trend, and by extension to not trade against the
trend. Naturally, the trend can be either up or down.
The simple rules associated with trading with the trend are that if something
is trending up, you buy it. If something is trending down, you sell it, don’t buy
it or short it.
Furthermore, you don’t trade unless a trend exists. Many products from
different markets around the world will experience extended periods of
sideways movement; that is, not trend.
There are a number of ways you can identify trends, including identifying
peaks and troughs (aka highs and lows) and using moving averages.
Prices very rarely move in the same direction day after day for weeks and
months at a time. For example, even when a stock’s price increases
significantly over several months, there will still be a few days here and
there during that period on which the price will fall. Despite this, the
underlying trend or direction is up.
When a stock is trending up or down, there will often be small movements
against the overall direction. These small movements are often referred to as
‘noise’; you will also hear them referred to as ‘retracements’ or ‘countertrend rallies’. Unfortunately, noise can sometimes distract from the
underlying trend. Always stay focused on the trend and the overall direction.
Note the chart of Giralia Resources NL (ASX code: GIR) in figure 4.2. Over
a 12-month period it has moved steadily higher but not every day was up. In
fact there were several occasions where the stock slid lower and looked like
returning all of its gains. However, these are the sort of stocks that you want
to buy into and hold while they continue to move higher.
Figure 4.2: chart of Giralia Resources NL (ASX code: GIR)
Chart by MetaStock.
When trading stocks, a simple objective is to buy at one price and then sell
them later at a higher price. In order to do this, we try to identify stocks that
have a high probability of increasing in value.
Stocks that are trending up and have established an uptrend are already
heading in the right direction and are, therefore, potential trading
opportunities. This is one of the simplest, most effective rules and should
underpin your trading methodology.
One of the most critical underlying principles to this approach is that often
prices move a lot further and for longer than most could imagine.
You may have often heard yourself say that a stock is too expensive to
purchase. You think that you have missed the boat; you have missed out on its
run; you will get in too late if you buy now. These feelings are quite common
but are not necessarily well founded.
For example, you may be watching a stock that has moved from $3.00 to
$4.50 over the last few months. Looking at the solid move, you comment that
purchasing now would be foolish. ‘I have missed the boat’, you say to
yourself. ‘I would have loved to have bought them back at $3.00.’
Then, as the stock moves from $4.50 to $5.50 over the next couple of months,
you remark, ‘Well, I have definitely missed the boat now!’ Sadly, the stock
price continues to rise.
Several months later, it is over $7, at which point you concede, ‘Well, I was
wrong the last couple of times but now it has absolutely had its run!’ Worst
case, you check it again in 12 months’ time and it is now at $22.
This happens all the time.
Never ever ever ever underestimate how long and how far a wellestablished trend can go.
Conversely, we can also draw conclusions about stocks that are trending
down. If we want to buy stocks and sell them at a higher price, buying stocks
that are already moving down strongly will not help us achieve our aim. It is
simply a low-probability opportunity.
Finally, another underlying principle of a trend is that it is said to exist until
there is absolute evidence that the direction in which the stock price is
moving has changed. For example, should you identify an uptrend, that
uptrend prevails until a downtrend firmly establishes itself.
Prices go up for one reason: the buyers are being more aggressive than the
sellers. Buyers are attacking the market and there is not enough selling
pressure to hold them back. The opposite is true for prices that go down. For
a price to continue to trend upwards, there must be a continuous flow of new
money. Otherwise, the trend will falter.
Think of the emotions people experience when they buy stocks. Normally,
these include anticipation, a dash of excitement and the hope that the price
will go up. Certainly, they are generally positive feelings.
Similarly, think of the classic emotions associated with the decision to sell
stocks. They are often feelings of fear, panic, frustration, annoyance: not at
all positive. Simply put, there is the worrying anticipation that the price will
fall.
I strongly believe that the emotions that lead a person to buy stocks are not as
strong an influence as the emotions that lead a person to sell stocks. As a
result of the emotions involved, downtrends can be a lot stronger and sharper
than uptrends.
One only needs to think of recent events in world equity markets to witness a
clear demonstration of this. During the period from 2003 to 2007 inclusive,
equity markets climbed strongly and steadily to reach all-time highs.
Throughout 2008 and into the first few months of 2009, they generally
returned all of the gains, and in some cases, more.
So, five steady years to increase strongly in value, yet only 15 months to
return it all. That is characteristic of how quickly prices can fall compared to
going up.
Peaks and troughs
Identifying peaks and troughs is a very precise way of identifying trends;
however, it can also be time consuming. In order to identify peaks and
troughs, you need to be able to identify short-term trends using individual bar
analysis.
A short-term uptrend exists when there are two consecutive days of higher
highs and higher lows, as shown in figure 4.3.
Figure 4.3: short-term uptrend
A short-term downtrend exists when there are two consecutive days of lower
highs and lower lows, as shown in figure 4.4 (overleaf).
Figure 4.4: short-term downtrend
Once you have identified the short-term uptrends and downtrends, you can
identify the medium-term trends using peaks and troughs.
A peak is the highest point between a short-term uptrend and a short-term
downtrend, as shown in figure 4.5.
Figure 4.5: peak
A trough is the lowest point between a short-term downtrend and a shortterm uptrend, as shown in figure 4.6.
Figure 4.6: trough
The final step is identifying the different peaks and troughs along a chart in
order to determine the medium-term trend.
When a stock price exhibits successive higher peaks and higher troughs, it is
in a medium-term uptrend. When a stock price exhibits successive lower
peaks and lower troughs, it is in a medium-term downtrend. These are shown
in figures 4.7 and 4.8.
Figure 4.7: medium-term uptrend
Figure 4.8: medium-term downtrend
With all of that out of the way, how can we develop a simple strategy using
this form of analysis? In simple terms, we want to trade in the direction of the
trend.
How about something like: you want to enter a long position when you have
had successive higher peaks and higher troughs, as a starting point? This
means you are entering into a well-established uptrend.
Precisely where you enter is a matter of opinion. You can wait for a
breakthrough to a new high and therefore past the previous peak, as shown in
the chart of JB Hi-Fi Limited (ASX code: JBH) in figure 4.9. This is my
preferred choice. Or, you could wait for any time when price retraces back
from reaching a peak, as shown in figure 4.10.
Figure 4.9: chart of JB Hi-Fi Limited (ASX code: JBH): passing through
the previous peak
Chart by MetaStock.
Figure 4.10: chart of JB Hi-Fi Limited (ASX code: JBH): retracing back
from the most recent peak
Chart by MetaStock.
Just to reiterate my comments about how long trends can go for: never think
you have missed the opportunity and it can’t go much longer. If it doesn’t go
much longer after you enter, you get out, right? However, you will get into
enough trades that do continue on very well to justify you doing it on a
regular basis.
Moving averages
Another way of identifying trends (and definitely my favourite) is through the
use of moving averages. A moving average is a line on a chart that smoothes
out price action by calculating an average of closing prices over a period of
time and displaying the result on a chart, providing an overall direction for a
set period of time.
Just to recap the basics of a moving average, there are two variables to be
determined when using one. You need to decide firstly on the time period you
are going to use to obtain the average, and secondly, what method of
averaging you are going to use.
For example, to calculate a 40-day simple moving average value for any
given day, the last 40 days’ closing prices are all added up and divided by
40. Figure 4.11 shows a 40-day simple moving average on a chart of Walt
Disney Company (NYSE code: DIS).
Figure 4.11: chart of Walt Disney Company (NYSE code: DIS) with a 40day simple moving average
Chart by MetaStock.
The number of days that make up the time period you use in your moving
average should be based on the type of trend you are interested in identifying.
Bear in mind that there are only five days per trading week and not seven. So
if you are interested in identifying short-term trends, you may consider using
a 10-day or 15-day (two- to three-week) simple moving average.
Other types of moving averages include exponential and weighted moving
averages. These place greater emphasis, or weighting, on more recent data.
In contrast, a simple moving average gives equal consideration to all days
used in the calculation.
The end result is that a 40-day exponential moving average will react more
quickly to changes in direction in price than a 40-day simple moving
average.
One of the commonly held views on the disadvantages of using moving
averages is that they lag behind the price, therefore indicating the trend (or
change in trend) too late, or once the price has already started to move in a
particular direction. By definition, moving averages have no choice.
Look at the chart in figure 4.12 of Macquarie Group Limited (ASX code:
MQG), where you see how the price has sharply reversed. Using a mediumterm moving average (50 days), it takes some time before the moving average
also changes direction and heads up again.
Figure 4.12: chart of Macquarie Group Limited (ASX code: MQG) with
a 50-day simple moving average lagging behind
Chart by MetaStock.
In order to counter or lessen this effect, many traders will use exponential or
weighted moving averages, as those moving averages will react faster to
changes in price direction.
I don’t give much credence to such a view, for two reasons. First, I like to
trade in well-established trends, therefore any delay in indicating the new
trend doesn’t affect me. Second, for any exponential or weighted moving
average you can find, I will be able to find a very similar simple moving
average line — it will just use a different number for the time period.
There are a number of ways to use moving averages in your trading, and I
believe the simplest is to note the recent direction of the indicator and where
the price is in relationship to the moving average.
For example, for an uptrend you want to see the moving average at the righthand edge of the chart heading in a clear upwards direction. Plus, you want
to see the present price above the moving average. Both of these conditions
need to be in place for an uptrend.
The opposite is true for a downtrend. The moving average needs to be
moving down and the price needs to be below the moving average.
Okay, so how can we use moving averages as part of a trading strategy? I
think it is wise to use a couple of moving averages which cover different
time periods. For example, you could use a 20-day simple moving average to
identify the short-term trend and use a 120-day simple moving average to
identify the medium-term trend.
For a long trade, you would want both moving averages to be heading up and
the price to be above both moving averages. The opposite is the case for a
short trade.
An example of this can be seen in figure 4.13 (overleaf), which is a chart of
Google Inc. (Nasdaq code: GOOG).
Figure 4.13: chart of Google Inc. (Nasdaq code: GOOG) with 20-day
and 120-day simple moving averages
Chart by MetaStock.
Another popular use of moving averages is to identify when two moving
averages of different time frames cross each other; that is, physically
intersect on the chart. This may provide an earlier indication of when you
have a new trend commencing. In this case you could use a third moving
average to help identify the longer term trend as well.
An example of this using a 10- and 20-day simple moving average crossover
and a 120-day simple moving average as the longer-term trend can be seen in
figure 4.14, which is also a chart of Google Inc. (Nasdaq code: GOOG).
A simple yet powerful trading rule is to only ever trade in the direction of
your moving averages. This rule will prevent you from buying stocks that are
in well-established downtrends, and therefore greatly improve a lot of
people’s performance right from the outset.
Figure 4.14: chart of Google Inc. (Nasdaq code: GOOG) with 10-day,
20-day and 120-day simple moving averages
Chart by MetaStock.
Trend alignment
Many traders don’t think outside their primary time frame and trend. I want
you to. At the end of the day, we need to take trading setups that present a
high probability of a positive outcome.
In order to consistently enter high-probability opportunities, it is prudent to
not only consider your primary trend, but also the longer-term time frame.
In table 4.1 you can see you have two potential trading opportunities,
labelled Trade A and Trade B. For Trade A, your primary trend is heading in
the right direction, and the longer term trend is also heading in the same
direction. I refer to this as trend alignment. However, for Trade B, while
your primary trend is heading in your direction, the longer term trend is
heading in the opposite direction. Examples of Trade A and B can be seen in
figures 4.15 and 4.16 (overleaf).
Table 4.1: trend alignment
Figure 4.15: chart of Apple Inc. (Nasdaq code: AAPL) with numerous
examples of Trade A
Chart by MetaStock.
Figure 4.16: chart of Boeing Co. (NYSE code: BA) with examples of
Trade B
The Trade B examples in this chart are all short trades, triggered by the price trading below the
short term moving average. However the longer term trend is clearly up — these present low
probability trading opportunities.
Chart by MetaStock.
Trade A is presenting a far higher probability opportunity than Trade B and I
would take the former trade 999 times out of 1000. In fact, I never take Trade
Bs.
Trading strategy structure
Within your plan, you will have to write down the specific rules which
present you with a trading opportunity. When defining these requirements for
trade initiation, traders use terms like signals/triggers and conditions/filters.
A signal (or trigger) will be a single event that generates a trading
opportunity signal for you. Simple examples of this include two moving
averages crossing over, a break higher from an ascending triangle, a
significant candlestick pattern or indicators crossing through relevant
reference lines. This list is theoretically infinite.
However, not all signals present us with high-probability opportunities;
therefore, you don’t trade every single signal. We need a process of
methodically removing all the poor signals, and we do that by using
conditions (or filters).
Conditions are another part of your entry decision. Your conditions will
generally be trend-based, because you want to ensure you only trade with the
trend. You may get several signals when looking at a stock; however, a signal
is not valid unless it is accompanied by your underlying conditions being
present as well.
Simple examples of a condition could be that the price must be trading above
its 30-day simple moving average and must have been doing so for at least
the last five trading days, or you require a certain level of liquidity or
volatility.
The combination of a signal and all filters results in a valid trading
opportunity. Traders only ever enter the market once a signal has been
validated.
So when you develop your own trading strategy, think in terms of your signal
and underlying conditions, and write them down in your trading plan
accordingly.
I firmly believe in keeping the entry requirements simple. I have seen people
with the sort of elaborate entry criteria that I would not even be able to
dream up, let alone comprehend. Whatever your entry requirements,
document them in your trading plan.
Final thoughts
I have only referred to stocks in my work here; however, obviously there are
different types of financial instruments available for us to trade, including
foreign exchange, indices and commodities, and derivatives of them. All
these markets have their own characteristics and best ways of trading them.
Variations in your strategy to trade these other products could include the
periodicity you use to chart prices and identify trends, or the chart patterns
that you may find effective, for example.
The reality is that there are theoretically an infinite number of possible entry
signals or trading strategies. There are many strategies widely available
through books and websites. With the limited space I have here, I have aimed
to provide you with a couple of simple approaches in order to provide you
with a starting point using stocks as a reference. You could massage them a
little to make some changes or to include other analytical approaches like
using chart patterns, indicators or considering support and resistance. These
topics have been equally well covered over the years.
As I mentioned at the beginning, more important than me giving you some
basic strategies is you committing to finding a simple strategy and sticking to
it. You need to have confidence in the strategy (either through testing or
achieving positive results), and the discipline and consistency to stick with
it.
If you don’t take on board anything else that I have suggested (apart from the
most important rule: follow the trend), whatever you do, please keep your
entry signal and conditions simple. Your entry signal is one of the least
important decisions you make, yet people have a natural tendency to make it
unnecessarily complicated.
There is no need to complicate things. One thing I have learned about trading
plans is that the easier they are to understand, the more likely you are to
follow them. My entry signal is very simple and it works for me. One thing I
gain a great deal of confidence from is that my exit signals and position
sizing are robust and solid and ensure the more important ingredients of my
trading success are well managed.
Finally, and above all, I want you to commit to mastering one trading setup
that is simple, follows the time-tested trading rules and is easy to implement.
Then execute it with great discipline and consistency — you might be
surprised at the results.
Chapter 5: The pursuit of profit
How to find lucrative trading opportunities
Davin Clarke
Trading can mean different things to different people. For some, it is the thrill
of speculation and being a part of the action, for others it is having
knowledge about the market and how it moves, and for others still it is the
quest to find a perfect system that never fails.
To me, trading is all about actively investing in a market to make a profit.
This chapter is about how to identify the trading opportunities that will allow
you to achieve this aim. Many traders become engrossed by the myriad
trading indicators, oscillators, lines, systems and predictions, looking for the
golden egg — the strategy that will guarantee success. I simply look to
understand what drives price and use this understanding to enter trades that
have a high probability of making a profit with a minimal level of risk.
So let’s first acknowledge that we are trading to make a profit; that is,
focusing on making a profit from price speculation, dividends aside. In
essence, we are looking to profit from the movement in price. Therefore, it
follows that the key to selecting great trading opportunities is to understand
the price action and how the market forces result in movements in price.
Understanding price action
So let’s start with a synopsis of the market. The market consists of multitudes
of individuals who are all undertaking their own analysis and who have their
own time frame and their own personal risk profile. We are just one of the
market participants and are trading in a changing and evolving crowd of
individuals who are reacting to an ever-changing flow of information.
Sounds like chaos, doesn’t it? However, we know that market price moves in
patterns: it ebbs and flows. If we understand the psychology behind what
drives those market participants to buy or sell, we can apply this
understanding to identify times when price action is likely to occur.
The following discussion may seem a little basic to our more experienced
traders; however, it is essential to understanding the trading setups I will
outline later in this chapter. So for the more experienced traders, read on and
use this analysis to cement your understanding of price action.
There are two undisputable facts that occur in the market:
• price
• volume.
Price occurs when a buyer and seller agree to exchange a marketable security
for an agreed consideration; that is, the price at which they bought and sold.
Volume is the amount of the security they agreed to exchange.
This is a simple concept that is often lost in the masses of information and
analysis tools available to traders. All the indicators, oscillators, trend lines,
moving averages and other charting tools are simply derivatives of either
price or volume or a combination of both. They can be useful to support your
trading decisions; however, they cannot substitute for quality price analysis.
The stock markets, futures markets, currency markets and indeed just about
any other market around the world operate within the same premise. In a
system whereby buyers and sellers are able to compete with each other in
order to execute a transaction, the price is determined by market forces. It is
in fact the buyers and sellers who create these market forces.
In simple terms, if there are more buyers who are willing to initiate a
transaction by meeting the sellers’ demands (that is, the ask price), then the
price of that commodity will go up. This situation, in which buyers are
prepared to meet the sellers’ price in order to buy, translates into buying
demand for a particular commodity and results in an increase in price for that
commodity. This applies to any market, not just financial markets, throughout
the world. For example, you may believe that a particular stock has fantastic
earnings, great potential and is underpriced. And maybe it is. However, the
only way that stock is going to increase in price is if there are buyers who
are willing to initiate a transaction by paying a higher price. We need a
constant supply of new buyers willing to initiate transactions at increasing
prices to result in a price increase.
Conversely, if there is selling pressure in the market created by sellers who
are willing to initiate a sale by meeting the bid price of the buyers, then the
price will fall.
Market structure
I think of this buying and selling pressure as buyers and sellers in control of
the market. When buyers are initiating trades, they are in control and creating
an upward price movement. When this price movement moves in ebbs and
flows, but continues in an overall upward direction, we see the creation of an
upward trend in the price. Buyers are continuing to initiate trades and push
the price higher; however, during this time they experience short periods in
which the sellers may start to initiate trades and cause a temporary fall in the
price.
Conversely, when sellers are initiating trades, they are in control and
creating a downward movement in the price. When this price movement goes
in ebbs and flows but continues in an overall downward direction we see the
creation of a downward trend in the price. Sellers are continuing to initiate
trades and push the price lower; however, during this time they experience
short periods in which the buyers may start to initiate trades and cause a
temporary increase in the price.
When there is no particular strength in either the buyers or the sellers, the
market reaches a state of equilibrium. This does not mean that the price does
not move at all, but over time it tends to oscillate between price points
creating a sideways movement on the chart.
Understanding these market structures will assist you in determining a likely
future price direction. Once you establish the overall structure of the market,
you can also look to the speed or momentum with which price is changing
and the volume of securities traded to further enhance your analysis. I will be
discussing how to do this later in the chapter as I outline specific trading
setups.
Key characteristics of trading
opportunities
We know that we are looking to anticipate movement in price in order to
generate a profit. It therefore follows that we are looking to identify trading
opportunities with two key characteristics:
• a high probability of price movement in the direction we anticipate
• a large movement in price (which will result in a bigger profit).
High probability
Our understanding of market structure and the underlying psychology of
market participants allows us to identify high-probability trading
opportunities. We are looking to identify areas when either buyers are
looking to take action and initiate trades at a higher price, or sellers are
looking to take action and initiate trades at a lower price. We know that
during an uptrend the buyers are in control of the market, and although the
price trend is likely to experience short falls in price as sellers temporarily
take control, we also know that when we see buyers moving back into the
market the price has a high probability of continuing to increase.
The market moves between periods of uptrend, consolidation and downtrend.
Price analysis is necessary to help you identify which market structure is
prevalent to guide your trading decision. We are interested in identifying the
market trends and then identifying optimal positions within that trend in
which to initiate our trade.
We are also looking for opportunities in the market when the momentum is
changing from buyers to sellers, or vice versa. This is a time in which market
participants are compelled to act as the market is changing. In particular, a
change from sellers to buyers (or vice versa) that incorporates a period of
consolidation provides an excellent high-probability trading opportunity.
Why? Let me use an example to illustrate.
Imagine the market you are trading has experienced a downtrend. Sellers are
in control of the market; they have been accepting lower prices in order to
exit the market (or enter a short position in expectation of further falls).
Finally, the sellers are exhausted and there are no more sellers willing to
accept further falls in price. The market is in a period of equilibrium. There
are price fluctuations but neither the buyers nor sellers are able to move the
market into a new trend. This period creates a base for the market to
commence a new trend. Generally, the longer this base develops, the stronger
the new trend will be. It allows the market to flush out the last of the sellers
who might otherwise push price lower.
Large price movements
As discussed earlier in this chapter, price movements occur when either
buyers are prepared to initiate a trade by accepting a higher price to enter a
transaction, or sellers are prepared to initiate a trade by accepting a lower
price to exit a trading position (or enter a short position). These buyers and
sellers are individuals who are all subject to the usual array of human
emotions and reactions, many of which are heightened during trading. After
all, we are risking our hard-earned money through speculation, which carries
with it an inherent level of stress. If this level of stress rises, we may be
compelled to act contrary to our initial trading plan, or may be forced to act
in the face of significant losses or forgone profits.
Let me explain. Cast your mind back to late 2007. Many stock markets
throughout the world were experiencing massive growth, strong uptrends and
all-time highs, and large gains were being made. Everyone wanted to have a
piece of those profits and buyers had been in control of the market,
continuing to initiate trades by accepting higher and higher prices. Those who
were not in the market were feeling pressure to enter and those already in
were high in confidence due to their trading success. In early 2008 the buyers
started to ease off and we experienced some price falls. Then around
September 2008 the global financial crisis was upon us. Markets worldwide
started to tumble. All those buyers, and particularly those who entered closer
to the all-time-high prices, were starting to lose money, and lots of it. Can
you feel that stress? And then the sellers started to flood the market,
scrambling to exit the market, accepting lower and lower prices to sell. This
put even more stress on the buyers who hadn’t yet sold, who then started to
panic, and we saw more price falls. It is this level of panic in selling that
created such a large movement in the price.
As traders, we are looking to identify moments in the market when buyers or
sellers are likely to feel under pressure to initiate a transaction at the offered
price as this creates movement in price. Particularly, we want to identify
those moments when a large number of buyers or sellers are under pressure
to act as this will result in large movements in price, which feeds off itself,
creating more pressure and further price movements.
This action works just as reliably in reverse. In early 2009 we saw selling
pressure ease off and the market move into a state of equilibrium. The sellers
had been exhausted. With no more sellers willing to initiate a sale at a lower
price, the market prices stabilised somewhat and, although still volatile,
there was no clear trend to the price movement. Then the buyers started to
initiate transactions in the market, creating a price increase. All those who
had sold previously, and particularly those who had sold out at a loss, were
now missing out on the gains being made! This created more buying demand
as they scrambled to get back into the market and we saw strong gains for
most of 2009.
Figure 5.1 is a weekly chart of the Australian market S&P/ASX200
illustrating the preceding discussion.
Figure 5.1: S&P/ASX 200 2007–10
Published by eSignal <www.esignal.com>.
Trading template
I formulate my trading analysis and identification of trading opportunities
within my trading template. It is the framework I use to ensure I am selecting
high-probability trading opportunities.
My trading template is based upon three core principles:
• market structure
• trend
• retracement.
The first step in my analysis is to assess the market structure. I look to the
past price action to determine the overall structure of the market, whether it
is trending or consolidating, and the strength of the trend or length of the
consolidation. This gives me clues into the mindset of the market participants
so that I can determine the most likely next movement in price.
The trading setups I am illustrating in this chapter are based upon a market
structure that includes a consolidation period and the commencement of a
new trend. I am looking to find opportunities where one side of the market
(either buyers or sellers) is in control of the market and driving the price
movement. As outlined previously, this creates a price trend.
Once I have determined that a new trend has formed, I want to enter the
market at an optimal point, at which I minimise my risk and maximise my
profit opportunity. These points occur during retracements in the trend.
Retracements occur after the price has experienced a significant movement in
one direction. To illustrate, let’s assume we are looking at an uptrend. The
buyers are in control, initiating trades and driving price upward by accepting
higher prices from sellers. After this rise, we see some sellers start to push
the market down. This period usually represents profit-taking, whereby some
buyers are exiting the market to secure the profits. However, retracements are
characterised by a fall in price that is a flatter descent than the previous up
move, indicating weak selling and a likely continuation in the uptrend after
this relatively small pause.
We are looking to identify two key elements for our trade setup:
• development of a new trend, characterised by selling or buying exhaustion
followed by a period that moves from equilibrium to the new trend
• a retracement that is shallow and preferably with low volume that gives us
favourable risk/reward parameters.
Sounds easy, doesn’t it! And often it is very simple to identify market
structure, trends and retracements on historical charts. However, we are
traders! We are looking to profit from movements in price and must enter the
market here and now. We have to identify when the odds stack in our favour
at the time the trading opportunity is developing. We do not have the benefit
of hindsight to tell us where the optimal entry point is. So we need to learn to
trust our abilities and enter trades that meet our trading criteria. However,
from my personal experience and observing newer traders, I have found one
of the most difficult aspects in trading is the ability to wait for a setup to
come to you. Patience and timing is also a skill that can set you apart from the
majority who fail. You need to act when setups present themselves, and also
know when not to trade. These skills will dramatically improve your
win/loss ratios and in turn your profitability.
So let’s move on and start to look at some real-time trading setups. I will
analyse each within my trading template, specifying what I am looking for,
how I interpret the interaction of the buyers and sellers and where I identify
the opportunity as it occurs.
Specific trade setups
In this section of the chapter I will discuss how a trade sets up and the
criteria for each of these trades. Each of the setups is based upon the
previous analysis of market-participant behaviour and looking for
opportunities whereby buyers or sellers are under pressure to act.
Retracement entry
The retracement entry is possibly one of the most recognised trading entries
because it is relatively easy to identify and represents a high probability of
success and a low-risk entry point.
For a retracement entry, we are looking for the market to be in a trend (I will
use an uptrend for illustration; however, the discussion is equally valid for a
downtrend). For an uptrend to develop, the buyers must be initiating trades
by accepting the ask price, resulting in an increase in price. At some point the
initial buyers into this uptrend will be temporarily exhausted and some shortterm selling, quite often representing profit-taking, will take place. We want
to see that the angle on the down move is flatter and less severe than the
preceding up move. This will tell us that the selling pressure is not as strong
as the previous buying. We also want to see that the movement down is
ideally between 20 per cent and 40 per cent of the previous up move. Why?
We need to always be considering what our market participants are thinking.
If the sellers are unable to push the price down a significant amount, this tells
us that there are buyers who want to buy into this market and hence the
uptrend is more likely to continue.
Just a quick note to highlight that I use the words ‘more likely’. Trading is all
about finding high-probability entries, with low risk, and then managing those
positions. There will always be examples of setups and trade entries that do
not produce a profit. In fact, failed patterns will often present excellent
trading opportunities in themselves. You are looking to select those entries
with a high probability of success and then effectively manage those
positions.
There are a number of specific entry techniques that can be employed to
initiate a retracement trade. The timing of your entry will be dependent upon
your specific risk and reward parameters. The earlier the trade is placed, the
more risk is taken that the new trend could fail and you need to determine
what level of adverse price action you will allow before the trade is stopped
out. This also means that the reward for a successful trade will be higher than
taking a trade that requires extra price confirmation.
If you enter early, at the first sign of the uptrend continuing, you maximise
your profit potential; however, you have a higher risk that the retracement
may move deeper and/or spike down before the uptrend continues. You are
exposing yourself to the risk of activating your stops before the price trend
continues in the direction of your initial trade. Another option is to enter the
trade when the uptrend in price is more readily visible and you have more
price confirmation for your trade. This will reduce your profit potential as
you are entering at a higher price but also reduce the risk that the pattern will
fail and retest lows.
One of my preferred entry setups is to look for an initial shallow retracement,
followed by a deeper retracement or spike down in price. This second move
takes out traders who have entered early just before the trend re-asserts itself
and provides a high probability that all sellers have been exhausted. I then
look for the retracement to complete testing the top of the retracement zone.
At this point there is often a small reaction back or a mini retracement that I
look to trade off. This is a usual market reaction at a previous resistance
area. I also like to see the price above the 20- and 50-period EMA
(exponential moving average) to show support of a continuing uptrend. If
trading short in a downtrend, I like to see the price trading below the 20- and
50-period EMA to support continuation of the downtrend. I find these setups
provide a high probability of success. They allow for enough price
confirmation of the continuation of the trend and offer good risk and reward
parameters, but they do require patience.
Example one
My illustration of this entry (figure 5.2) is using a three-minute chart on the
DAX (German futures market).
Figure 5.2: DAX intraday 3-minute chart
© 2010 NinjaTrader, LLC.
In the above chart we have an initial downtrend, whereby the sellers are
accepting lower and lower bid prices to exit their positions (or short the
market to trade with the trend). Interesting to note is the increase in volume
as the selling became more severe at around the 18.00–18.15 time frame.
This increase, as indicated on this chart, saw the market exhaust most of the
sellers in a short time (resulting in the large range bars) and this exhaustion
was followed by a short respite in the price fall. The price action following
this large range bar supports our contention that the sellers are nearly
exhausted. You can see the momentum of the sellers is dissipating as the
angle of the price descent flattens out. This is telling us that the urgency of the
sellers is weakening and they are not as willing to accept a lower price to
initiate a transaction. This washout of sellers is soon followed by a change in
the market structure.
Please note that the second very large spike in volume relates to an offmarket transfer that is not reflective of the overall market action.
The second interesting point on this chart is the very lowest price achieved
during this period. The market was still falling overall but had flattened out
considerably and was almost in equilibrium, with both buyers and sellers
initiating trades in the market. Then we see a large range bar with selling to
our low point. Let us consider what is happening here. Most of the sellers in
the market had already exited and the selling pressure had eased. It is then
we see this final washout, where those who had stayed in the market had
finally given up and we see a last burst of selling. This pushes the price into
an oversold area and we immediately see a rejection bar after this selling
which initiates the start of the uptrend.
You can see the uptrend developing and the initial retracement. As discussed
previously, there are a number of different approaches you can take to
determine your entry point based upon your personal risk and reward
parameters. I will zoom in on the entry area (figure 5.3) to illustrate the entry
technique I outlined earlier.
In this chart, you can see the retracement from the trend and then the
continuation of the uptrend. As the price approaches the previous high, or
retracement zone, you can see a mini retracement as the price move hesitates
at the previous resistance. This mini retracement is shallow, indicating very
weak selling, indicating only a pause in buying strength. On the third bar of
this mini retracement we see buying strength near the resistance area with a
lighter-colour candlestick. The price here is also above both the 20- and 50period EMA. My preferred entry is immediately after this bar. I look to enter
just prior to the price breaking through the resistance area as the
breakthrough is often an explosive move that can be difficult to catch in real
time. I want to enter when I can see the buyers starting to take control and
push the price higher by initiating new trades, but also early enough to ensure
there are plenty of buyers left to continue the price move in my direction.
Figure 5.3: DAX intraday 3-minute chart potential entry point
© 2010 NinjaTrader, LLC.
Example two
Figure 5.4 (overleaf) is a 30-minute chart of the June 2010 ES (being the
mini size S&P 500 futures contracts for June 2010). This contract trades both
the day and night session, with the major volume transacted during the US
day session.
You can see an initial uptrend that has been created by buyers accepting
higher ask prices in order to initiate trades and enter their positions. The
market structure then changes as the buying pressure dissipates and the
market moves into a consolidation phase as marked on this chart. This
consolidation phase is characterised by the price moving in a generally
sideways direction as the market control shifts between the buyers and
sellers, with neither group creating enough demand to create a new trend.
Figure 5.4: ES mini 30-minute chart June 2010
© 2010 NinjaTrader, LLC.
Toward the end of the consolidation range, you can see the build-up of
selling pressure prior to the price breaking the support area and continuing to
fall. During the phase of the consolidation range, the sellers are consistently
able to push price down to a support area just below 1212, with the buyers
unable to push price up to the previous highs. Strong selling, signalled by the
large dark candlestick at the end of the consolidation range, breaks support
and sets in place the beginning of a new cycle to the downside.
We are looking for the initial retracement entry for a short position in the new
downtrend. Figure 5.5 zooms in on the potential entry point.
Figure 5.5: June 2010 ES mini 30-minute chart potential entry point
© 2010 NinjaTrader, LLC.
You can see the initial down movement which signals the start of the new
downtrend, which is followed by a rather choppy retracement. This
retracement pattern illustrates the risks I outlined earlier in relation to early
entries.
I have marked on the chart the area at which the price moves down to and
retests the retracement zone. In this particular example, the price pushes
slightly below the previous low before creating the mini retracement that I
am looking for. Once again, the mini retracement is followed by solid selling
which is evidenced by the large dark candlestick immediately after the mini
retracement. I have indicated my preferred entry bar on the chart as the open
of the bar immediately following this show of selling strength.
Example three
Figure 5.6 (overleaf) is a continuation of the previous ES chart as the market
structure changes once again.
Figure 5.6: June 2010 ES mini 30-minute chart continuation
© 2010 NinjaTrader, LLC.
After a very sharp downtrend, we once again see the market move into a
consolidation range. This coincides with a previous support area (that is not
illustrated on the above chart but is visible on a higher time frame).
The uptrend commences after a retest at the 1180 area. This uptrend
experienced some wild swings in price in some very volatile trading
sessions on the initial breakout from the consolidation range (figure 5.7).
A closer look at our retracement area once again shows a movement in price
up to the retracement zone with a mini retracement occurring at this area. As
previously shown, my preferred entry point is when the market indicates
buying strength after this mini retracement. However, in this example we see
very strong buying which breaks through the resistance zone. My only option
is to enter my long position on the following bar which is above the
resistance area. The market will often move in ways that are not perfectly in
line with your setups and expectations and this requires traders to exercise
their skills and experience to adapt to these situations. In this example, I
assessed this trade as a high-probability trade that met most of my entry
criteria and decided to enter on the bar after the breakthrough, as indicated in
figure 5.7.
Figure 5.7: June 2010 ES mini 30-minute chart potential entry point
© 2010 NinjaTrader, LLC.
Final thoughts
Identifying excellent trading opportunities is a skill that is developed through
an understanding of the way in which buyers and sellers interact in the
marketplace. These interactions form patterns and create a market structure
that allows us to assess when areas develop that are likely to be followed by
a significant price movement. One such area is a retracement that forms at the
beginning of a new trend. Fine-tuning your specific entry point after this
retracement will be determined through your personal risk and reward
parameters. In this chapter I have presented one of my preferred entry
techniques, which I have illustrated in the context of the interaction of buyers
and sellers in the market.
Chapter 6: Getting the edge using
intermarket technical analysis
Using other markets’ trends to help you trade
yours
Peter Pontikis
Recent events such as the Asian financial crisis of 1997, the global equity
market declines in 2000–2002 as well as the more recent global bear
markets of 2008 suggest there are deep-seated linkages between the world’s
financial markets, with no country or market able to effectively operate in
isolation.
In this context, intermarket technical analysis increasingly supplements the
traditional styles of fundamental and technical analysis and integrates in a
more holistic way the analysis of market trading risks and opportunities.
This observed phenomenon shows that market events in one asset or market
have implications, through the principles of linkage, contagion and
correlation, for other markets and asset classes. Intermarket technical
analysis can be applied across all asset classes and geographical locations
and gives an additional layer of analytical value that micro-market analysis
does not provide.
In essence, it provides a competitive advantage to the trader or analyst. This
is more so when the target market is not a major or leading market and where
its price action is likely to be driven by the price action in other more major
markets, geographies or even asset classes.
Asset sectors defined
In order to begin to look at the interrelationships of market prices it is most
effective to group markets into like asset classes. ‘Like’ assets (from an
intermarket technical analysis point of view) are defined as assets or markets
with shared price-risk characteristics. Traditionally, the investment
community has grouped markets into currencies (or FX markets), bonds
(interest rate markets) as in figure 6.1, equities (so-called stock markets) and
commodities.
Figure 6.1: positive correlation between UK bond and short-term
interest rates markets
Source: Proview data <www.proview.com.au>.
Of course, these asset classes can be sub-grouped into more specific
segments or sectors characterised by a defining and shared characteristic.
For example, commodities may be sub-categorised into energies, base
metals, precious metals, ‘softs’ (that is, agricultural) and so on. For our
purposes here intermarket analysis will focus on the four broad asset classes
mentioned above, but in real-world practice these should not be regarded as
the only available tradable categories.
Factors linking markets
Since the 1980s it has been observed that all markets to a degree are
interrelated. This has been particularly highlighted in the crises experienced
by global markets in the late 1990s and again in 2008. Our own domestic
equities market does not trade in a vacuum; it is heavily reliant on trends in
overseas equities markets and the bond market (implicitly, the level of
interest rates). Local bonds themselves, in turn, are heavily influenced by the
direction of commodity prices (as surrogates for inflation) and overseas
interest rates — particularly US, European and Japanese interest rate trends.
This influence we also call an intermarket linkage.
Implications and premises of intermarket
technical analysis
Prior to beginning any intermarket analysis work, we must make explicit the
premises of the intermarket analytical methodology that serves as the
theoretical basis and starting point for your own independent research. Here
we shall take intermarket technical analysis to mean: ‘the application of
technical analysis methods to related markets with a view to ascertaining the
related market risks as they may impact on an individual target market price’.
In saying so we also need to make explicit the assumptions we will carry
throughout:
• all markets are interrelated (that is, markets do not move in isolation)
• technical analysis (be it classical graphical and/or mathematical methods)
is the preferred vehicle of price analysis and for investment timing
• heavy emphasis is placed on the more/most liquid/largest of related
markets (often this will be the derivative; (for example, futures) market as
opposed to the underlying physical
• intermarket analysis can be applied to any time frame, but is most likely to
be effective at the day-to-day or greater time scale.
The assertion is, therefore, that all markets — financial or non-financial,
domestic or overseas — are interrelated. More importantly for technical
analysts and traders (for timing purposes), emphasis will be placed on the
larger (by volume) markets as leading indicators of general trend activity
and/or risk for a whole asset class or sub-groups of that asset class.
Concept of correlations
Correlation is a mathematical method of identifying the extent to which two
(or more) markets are related. If the markets are positively correlated, they
will react in a similar way to particular economic events, information or
sector cycles, such as in the case of short- and long-term UK interest rates
shown in figure 6.1, or in the case of a selection of Latin American
currencies, shown in figure 6.2.
These correlations define the intermarket relationship. They are usually
found in markets of the same asset class to begin with, but are not restricted
to individual asset types. Indeed a key aspect (and opportunity) in
intermarket technical analysis is that the prices of different asset classes are
also related. These links do not obviously tell us the reason for the cause of
the relationship but certainly provide us with an initial starting point for
research.
Figure 6.2: positive correlation: US dollar–Chilean Peso and US dollar–
Brazilian real rates
Source: Proview data <www.proview.com.au>.
Warning: spurious correlations (that is, apparently high correlations between
unrelated markets) are the bane of serious traders and technical (and even
fundamental) analysis. Ideally, the correlations should be grounded in
generally accepted economic theory.
Concepts of rotation, leading and lagging
markets
In parallel with the concept of correlation is the concept of leading and
lagging market prices, where the leading market price tends to (but not
necessarily always) turn first.
Implicit in the concept of leading (but not as important) is that the leading
market tends to be the ‘stronger’ and clearer in trend path. This is not a
prerequisite for leading status, though is often a sought-after characteristic.
Theoretically, a market can lead turns in trends without necessarily being the
market with the most cyclicality or trend volatility, as in the case of bonds in
figure 6.3. Of course, the degree of price movement in different asset
markets/prices will differ, even though all asset classes and markets will
respond either negatively or positively to economic events, information or
cycles. Lagging prices and markets tend to follow trend turns and magnitudes
of moves.
Figure 6.3: lagging and leading markets
Source: Proview data <www.proview.com.au>.
Rotation in this context represents the switch of capital from one market into
another — clearly implied when trends turn. Rotation theory is particularly
popular in the field of applied portfolio management and strictly speaking
beyond the scope of this discussion, but we do touch on it towards the end of
this chapter.
Concept of confirmation and divergences
A key concept of intermarket analysis is that like or related markets (and
their prices) should, under normal market trending conditions, move together.
That is, up or down trends in related (or positively correlated) markets
should be observed as occurring simultaneously in the same direction after
taking into account lagging or leading characteristics (if any) of each
respective market. Note that this does not mean trend moves have to occur at
the same time, merely that the trend directions of the related market are the
same. This principle of confirmation will be familiar to those who remember
a key plank in Dow theory.
This confirmation is crucial and necessary if one is to conclude the existence
of bull or bear trends for two (or more) markets, as shown as an example in
figure 6.4 with the euro and $A exchange rates.
Figure 6.4: positively correlated confirming markets
Source: Proview data <www.proview.com.au>.
Note, in the case of negatively correlated markets, the principle is the
reverse; that is, the negatively correlated markets must be observed to be
trending in opposite directions, as shown in figure 6.5.
Figure 6.5: negatively correlated confirming markets
Source: Proview data <www.proview.com.au>.
While we know from our basic technical theory that divergences between
markets occur at many major trend turning points and offer warnings of
changes in trends, the opposite is not true; that is, not all divergences signal
important turning points. The observed relationship occurs most of the time
— but not all of the time. For example, some divergence may exist for a time,
before the non-confirming market moves back into the same direction as the
laggard market (this, though, should be a rare occurrence). In other instances,
it may be possible for market trends to turn simultaneously; thus, there would
be no lag in confirmation of trend turns, and, therefore, no divergences.
There is an added problem that relates to the concept of leading and lagging
markets, as noted above. If, for example, there is a lag between two or more
markets’ trends turning, by definition we will observe divergence. This, by
itself, does not guarantee a trend turn. It merely warns of a possibility of a
trend turn. While it certainly presents a heightened risk of a turn in the
lagging market, this is not the same as a confirmed turn in trend in the lagging
market. The confirmation of a trend turn proper for the lagging market must
come from its own technical conditions — not from the analysis of the
related or leading markets. See figures 6.6 and 6.7 (overleaf).
Figure 6.6: positively correlated diverging markets
Source: Proview data <www.proview.com.au>.
Figure 6.7: negatively correlated diverging markets
Source: Proview data <www.proview.com.au>.
Graphical representation of relationships
There are several ways to graphically represent intermarket relationships.
The main chart methods include outright or ‘overlay’ analysis, relative
strength charts and spread analysis charts.
Outright analysis charts are effectively market charts that are overlaid one on
top of the other and each tracked technically with the view to confirming (or
otherwise) the instance of parallel and thus ‘confirmed’ trends. They are
ideal for tracking divergences of market trends, where, for instance, if one
(leading) market turns against the prior (shared) trend, it may serve as a
warning of likely trend turn in the lagging market. In figure 6.8, you will
notice the CRB market (an American index of commodity prices) tends to
have major peaks and troughs before like peaks and troughs in the $A.
Figure 6.8: positive correlation: CRB versus the Australian/US dollar FX
markets
Source: Proview data <www.proview.com.au>.
Alternatively, relative strength charts (see figure 6.9, overleaf) are graphical
charts where the price of one market is divided into another market. As a
concept it is basically a chart of the ratio of relative performance, expanded
to include the use both as confirming and diverging indicators, and as a
method of analysis in its own right.
Relative strength charts should be used with a degree of caution as they do
not necessarily provide a picture of absolute performance (or risk) of either
market. With this in mind, relative strength charts can still be analysed on
their own like conventional market charts, with the concepts of ranges,
trends, support and resistance, etc. It is an ideal method for supporting the
asset allocation decision; that is, when trying to decide which market/asset to
invest in and which one to ‘switch’ out of.
Figure 6.9: relative strength chart used for range trading purposes
Source: Proview data <www.proview.com.au>.
The relative strength chart can be utilised as much like a mathematical
indicator as a confirming indicator of the underlying target market, as shown
in figure 6.10.
Note that the chart in figure 6.10 shows points of divergence where the
relative strength line turns down before the target market does. The key value
of a relative strength chart is as a leading indicator of the risk to the trend in
an outright target market’s trend — the early warning coming from its
performances against allied or related markets.
Figure 6.10: relative strength chart overlaid with target market trading
chart
Source: Proview data <www.proview.com.au>.
Spread analysis charts, alternatively, are where the price of one market is
subtracted from another. Relative strength charts (aside from currency charts)
are not normally directly tradable, unlike spreads, which are; for example,
the US two-year bond versus 10-year bond yields shown in figure 6.11
(overleaf).
Figure 6.11: the US two-year versus 10-year bond spread market chart
Source: Proview data <www.proview.com.au>.
Spread relationships (and their theoretical tradability) can be everywhere.
Examples include oil–gold, gold–silver, bank bills versus 10-year spread
and so on. The legitimacy of a spread (and its derived analysis) demands
some a priori relationship. In practical terms, for a spread to be of practical
and tradable use, the question has to be asked: are they in the same asset
class or subgroup? As in the case of the relative strength chart, we can
analyse the spread chart on its own merits (and trade it as such) or utilise it
in combination (as a confirming indicator) with one or both ‘legs’ of the
cross. ‘Legs’ is market slang for one of the two markets involved in a spread.
There is an exception to this rule — and it relates to the legitimate valuation
analysis between broad asset classes. For instance, the 10-year bond futures
versus the stock price index futures (see figure 6.12). Such a spread serves
more the purpose of broad technical valuations rather than a tradable cross.
These caveats should not be read as prohibition on an analyst’s research, but,
as in all things, should be bounded by the rule of commonsense, lest effort be
wasted on spurious intermarket relationships.
Figure 6.12: Australian long-term bond trends versus stock market
Source: Proview data <www.proview.com.au>.
Linkages between asset classes
This section is designed to be a mere introduction to possible inter-asset
linkages in the technical analysis of financial and/or commodity markets.
This is not designed to be exhaustive and, if anything, is a somewhat local
market–centric image of what intermarket linkages could be. It helps to have
exposure to economic theory and the assumptions of fundamental analysis as
to what drives a particular market’s price. This is ‘going up stream’ to
analyse the macro-market conditions that ultimately influence our target
market(s) technically.
This will be achieved by first defining the a priori relationship between the
target market and the market it is ‘related’ to. It is then graphically
represented and technical analysis techniques are applied to it with
conclusions drawn.
Some readers will see immediately that definitional distinctions between
domestic and foreign equities seem arbitrary as, theoretically, it can be
argued that they are in the same asset class of ‘equities’ irrespective of
geography. Though it appears somewhat presumptuous, it must be
emphasised that the categorisation of relationship is not so important as
defining the correct causal relationship.
In the case of leading and lagging markets this should not be difficult.
However, in determining intermarket relationships it does not necessarily
have to be of a leading/lagging nature and indeed we must take it further in
considering the possibility of markets ‘influencing’ and needing to ‘confirm’
each other — much like the principle of confirmation found in Dow theory
with respect to trends in sectors, where neither market is necessarily a
leading or lagging market.
Interest rate markets: UK 10-year bonds versus US
10-year bonds
The a priori relationship we define here is that we assume that United
Kingdom 10-year interest rates are influenced and led by like US interest
rates. When we graphically produce an overlay chart (in figure 6.13)
between the two markets it quickly becomes apparent that there is a strong
positive correlation between the two markets. Secondly, there appears no
substantial lag (or lead) between the two markets, as major peaks and
troughs between the two markets seem to occur simultaneously.
On closer inspection, though, there will appear some rare (but important)
divergences to this general observation. And more importantly, in late 2005
US rates appeared to ‘diverge’ from UK rates when the UK gilt market made
new highs, highs which were not confirmed by the US, whose rates, instead,
posted something of a Dow reversal. This is a classic divergence of the US
market warning that the UK market will also likely reverse soon —
something that would not have been picked conventionally using UK-only
market technical analysis.
Figure 6.13: UK 10-year bonds versus US 10-year bonds
Source: Proview data <www.proview.com.au>.
This chart also shows that in the middle of 2006 a ‘spike’ in UK rates was
not confirmed by the US. This quickly led to the downtrend in UK rates
resuming. Also at the end of this chart you will see again that the UK market
bounced off its lows, confirmed by the ostensibly larger US market, also
warning the UK market that any resumption of the UK downtrend in rates will
be appreciably held up (if not reversed) in the absence of the US market
confirming with a new lower low. In this case, we merely used graphical
comparisons to show that UK 10-year bonds cannot move too far away from
the general course of US rates.
Nikkei Dow Jones stock index versus US stock
markets (S&P 500)
Here we take the previous relationship, apply it to, say, Japanese and US
stock markets, but take the relationship to be that the Japanese markets lag or
follow the trends in the ‘main’ US markets. In doing so, we come up with
like results to those shown in figure 6.14 (overleaf). As can be seen from the
last three to four years of activity, the bear market in the S&P 500 index has
had the effect of preventing the Japanese market from sustaining new highs.
Indeed, as the chart shows, significant peaks in the S&P 500 precede like
peaks and troughs in the Nikkei Dow Jones index. The divergences in price
action between the leading (S&P 500) and lagging (Japanese) markets on
both the upside and downside presage large countermoves. At the very least,
major lows and highs occur simultaneously. Clearly there is much
information the S&P 500 can tell us about the fate of the Japanese market
going forward.
Figure 6.14: Japanese stocks versus US stock markets
Source: Proview data <www.proview.com.au>.
We can, of course, use, instead of an overlay chart, a ratio chart, which will
tell us about the relative performance (before currency effects). Note, in
figure 6.15, the use of moving average (familiar technical techniques)
applied in addition to classical graphing techniques.
Figure 6.15: Japanese stock index versus the US stock markets as a
ratio chart
Source: Proview data <www.proview.com.au>.
US versus British stock markets: comparing other
main markets
Intermarket technical analysis can be applied to markets of the largest scale
where the leader or laggard is not necessarily easy to assume — or
statistically justified. In this relationship, which is leading and which lagging
is a contentious theoretical (and applied) question. As technical analysts, we
are not as concerned with causality as to the issue of confirmation and
divergences between the two markets. The fact that they are correlated is
clear from the raw price action. As can be seen in figure 6.16 (overleaf), the
most powerful and long-term trends up (or down) from these two markets
occur when both confirm the move of the other. Hesitance of one market to
follow a particular path almost inevitably holds back the move of the other.
An analogy with the US universe of markets is comparing the S&P 500 with,
say, the Nasdaq or Dow Jones Industrials (market indices which are,
arguably, each main markets in their own right).
Figure 6.16: US versus British stock markets
Source: Proview data <www.proview.com.au>.
European energy sector versus Australian energy
sector
Intermarket technical analysis also highlights the possibility of technical
analysis being applied to sectors that are not necessarily in the same
geographic location, but which share a certain similarity of ‘sector’
classification; see figure 6.17. Some of the correlations and comparisons of
like sectors in different countries are surprisingly similar and, of course, can
also lend themselves to applying confirmation and divergence filters to our
intermarket analysis.
Figure 6.17: European energy stock sector versus the like Australian
energy sector
Source: <www.Reuters.com>.
It is a new and fascinating area of sector intermarket technical analysis,
which lends itself not only to positive correlation studies, but also to
negative/inverse correlation studies with theoretical possibilities of reversal
studies in any leading or lagging inter-relationships between sectors.
Gold versus the US dollar
This relationship is a complex one, for gold has a special if misunderstood
place in the long history of financial markets (in fact it predates it by
thousands of years). That aside, from a purely technical analytical
perspective, the US dollar price of gold is the ratio of gold to US dollars —
no more and no less. On that basis, it is probably of equal, if not more,
importance to view gold as a surrogate for other ‘major’ currencies valued
against the US dollar. See figure 6.18 (overleaf) for the overlay between the
euro/USD exchange rate and the Gold/USD exchange rate.
Figure 6.18: gold/USD price versus the euro/USD FX rate
Source: Proview data <www.proview.com.au>.
As can be seen in the chart, it appears that major peaks and troughs in the
gold/USD price are led by like trend turns in the euro/USD (and its
interpolated precursor). It is then not hard to justify that it is best for
intermarket purposes to conceive of gold less as a metal and more as an
alternative capital market versus the US dollar. By extension it has price
characteristics analogous to the euro currency.
Bonds versus stocks
Understanding the bonds versus stocks relationship, along with the
relationship between commodity prices and bond prices, is a critical plank in
the understanding of intermarket technical analysis. Interest rates are a key
driver of stock valuations, both directly as a competitor market for capital
and also driving (a de facto cost of debt) the aggregate net profit/after
interest expense returns of ordinary shares. The relationship basically holds
that trends (and trend turns) in bonds lead trends in stocks.
This can be seen in general terms and is supported by the chart in figure 6.19.
Falls in interest rates (that is, rises in bond prices) throughout the 1990s and
early 2000s tended to coincide with rises in the stock market (here
represented by the S&P 500). What is interesting during bond bear markets
(that is, rising interest rates) is that the stock market’s usual ascent tends to
stall. Essentially, the relationship says that for stock markets to rise, bonds
must either be rising or at worst consolidating sideways in order that stock
prices normally rise. The key is normally. Given this, it then follows that
divergence would be a warning of a stock reversal, as happened in early
2008 (as shown in the chart in figure 6.19).
Figure 6.19: long-term bonds versus stocks spread market chart
Source: Proview data <www.proview.com.au>.
Summary of methodology
Having reviewed a selection — and by no means an exhaustive range — of
key intermarket relationships it would be useful to summarise the
methodology and main intermarket relationships to which we can apply
technical analysis techniques. These can be summarised as such:
• establish an a priori intermarket relationship
• represent it either as an overlay, as a spread or as a ratio chart or
combination of these that show the expected intermarket relationship
• determine any leading or lagging aspect between compared markets
• apply conventional technical analysis techniques.
Linkages within asset classes
Having reviewed linkages between asset classes, we can, with small changes
to the methodology, apply intermarket analysis to the analysis of markets of
the same asset class. The analysis will look at the intermarket analysis from
the point of view of both trading risk assessment of our target markets and for
trading spreads and market switches.
Here we review some of the many possible combinations of intermarket
analysis within a given type of asset class. The choice of chart types and
possible applicable indicators are little different in methodology to that
which we applied to inter-asset market analysis in the previous section.
Australian/US dollar versus the US dollar/euro
exchange rates: overlay
In this spread (see figure 6.20) we compare the price trends of one market
with another. Trends in the euro/USD chart are almost replicated in the
AUD/USD chart. This shows the central driving fact that trends in the
Australian dollar cannot be analysed adequately in isolation from broader
currency trends. For, in essence, price trends in the US dollar versus world
currencies are the ‘other half’ of the analysis of the process driving the
valuation of Australian currency (versus the US dollar). This overlay chart
shows this in practice and the essential character of intermarket analysis of
currency markets. The application of lagging/leading and Dow reversal
principles of confirmation would be particularly useful in this case.
Figure 6.20: AUD/USD versus euro/USD market chart
Source: Proview data <www.proview.com.au>.
Silver versus gold: ratio chart
In figure 6.21 (overleaf) we have taken the relative price relationship of a
commodity (gold) and compared it with relative trends in another (silver).
The gold–silver spread, as can be seen, trades a reliable range — for which
the opportunities to use oscillators are ideal (in this case the relative strength
indicator (RSI)). Additionally, using the ratio chart in combination with
technical indicators is an ideal methodology to assist in the asset allocation
decision.
Figure 6.21: silver versus gold spread market chart
Source: Proview data <www.proview.com.au>.
Three-year and 10-year bond futures: use of
spread charts
In figure 6.22 we take the price relationship of one market and subtract it
from another, in this case the 10-year contract from the three-year contract,
creating the so-called 3s/10s spread. The spread is an actively traded one.
As can be seen, we have utilised the MACD and the 40-week moving
average to assist in the analysis. There is of course nothing to stop the use of
other indicators.
Sector versus sector: use of ratio/relative strength
charts
Here we have taken the price relationship of one sector and compared trends
of the sector in relation to trends in another sector within the same overall
stock market (see figure 6.22). In this case we analyse relative performance
of consumer discretionary against the consumer staples sector. This sector
versus sector chart clearly shows the serial underperformance of the
discretionary sector relative to consumer staples. Applying a trend filter, for
example, ADX or the slope of a moving average (as shown in figure 6.22),
provides further technical justification to ‘switch’ from one sector to another.
This can be used also as a filtering technique in its own right. Alternatively,
as shown in figure 6.23 (overleaf), traditional techniques such as the RSI can
be utilised to improve the timing of sector switches. (Note: see the
divergence in the relative strength chart and its RSI.)
Figure 6.22: Australian three-year and 10-year bonds spread market
chart
Source: Proview data <www.proview.com.au>.
Figure 6.23: Consumer discretionary versus consumer staples sector
ratio chart
Source: Proview data <www.proview.com.au>.
USD gold versus Lihir Gold Limited
Here we have taken the price relationship of a mining stock and compared
trends of the stock in relation to trends in the underlying commodity it deals
in. In this case we analyse the relationship between the price of gold and a
Papua New Guinea gold miner (Lihir Gold Limited) listed on the Australian
stock exchange in figure 6.24. As the overlay chart suggests, the relationship
is complex. Often there is divergence between the price trend of gold on a
week-to-week basis and the underlying stock. However, what cannot be
denied is that the best trends (from both markets) are when their trends
confirm each other. This is a basic tenet of intermarket analysis. Highly
correlated markets trend the best when their trends are confirming each
other’s move. This confirmation can be done graphically (through eyeball
analysis) or more clinically through the use of various technical indicators
such as the ADX or the slope of a moving average.
Figure 6.24: gold/US dollars versus Lihir Gold Limited chart
Source: Proview data <www.proview.com.au>.
Sector versus stock: use of relative strength charts
Here we have taken the price relationship of a mining sector index and
compared trends of it in relation to trends in a component stock in it (BHP
Billiton) — see figure 6.25 (overleaf). As this is a relative strength chart it
does not make calls on the absolute direction of the mining stock — but its
relative performance versus the index. Using a conventional 40-week moving
average to determine trend, we can apply a familiar oscillator to the
relationship to determine, in effect, relative overbought values and oversold
values of the stock. By extension, the divergence of July 2008 onwards is
clear and warns of a degree of average/below average performances to
come.
Figure 6.25: sector versus stock and the use of relative strength charts
Source: Proview data <www.proview.com.au>.
The best times to use intermarket analysis
Acknowledging the pervasive presence of intermarket relationships, we must
briefly recap the advantages of intermarket analysis to note that conventional
technical analysis is ‘micro-market analysis’ only. It, by definition, analyses
single market prices internally and draws no outside information into its
methodology. Intermarket analysis is, by definition, more outwardly focused.
It acknowledges that no market trades in isolation. That is, other markets
impact market prices either in an immediate or in a delayed sense on our
target market.
As a consequence intermarket technical analysis draws into the price
analysis elements of well-established economic theory and new external
price information previously ignored by micro-technical analysis — but still
from a price perspective only; that is, price and volume dynamics remain the
only elements of study. It draws in the microanalysis of other markets as it
impacts the target market. In doing so we observe that some market trends,
according to theory (and in practice), act as leading or alternately lagging
price movers. This provides the intermarket analyst the added advantage of
timing.
This brings the previous restricted use of technical analysis into a more
holistic scheme of analysis. Intermarket analysis supplements microtechnical analysis and is more integrated into broader economic trends in
play either within or outside the target market’s asset class or both.
Caveats: the times not to use
Now that we have covered, in general terms, the value and some of the
techniques of intermarket analysis, the caveats in the use of this style of
analysis must also be noted. In the first sense we must be cautious to avoid
some of the more obvious dangers in using this form of macro analysis; they
include the following:
• Avoid the use of spurious linkages. By this we mean that an intermarket
relationship must be justifiable based on generally accepted economic or
fundamental principles. A coincident statistical relationship may be just that
— chance — and not, strictly speaking, a repeatable or tradable phenomena
going forward.
• It is implicit in intermarket analysis that the linkages between and within
asset classes may not be stable and not necessarily deterministic in cause and
effect; particularly when a target market is subject to two or more driving
‘macro’ markets.
A way to deal with this problem is to require additional evidence before one
acts on a divergence between markets. This could include:
• an actual technical reversal signal of the target market’s price action
confirms the ‘early warning’ made by the diverging market; for example, a
Dow reversal, before it is acted on
• where divergence occurs, that like divergence in a target market’s own
technical indicators confirms the intermarket ‘early warning’, in order that a
trade be acted upon
• where an intermarket divergence occurs (regardless of the
above two points), that one tightens one’s capital management/
preservation criteria (that is, stop-losses) in lieu of either or both of the
above scenarios eventually occurring (or not).
In each case, it is essential that the target market confirms the early warning
provided by the intermarket analysis. As in the use of mathematic indicators,
the price of the target market is the final arbitrator in any analysis. There is
nothing to stop the analyst adjusting stops or the risk profile of
trades/switches in the light of the technical conditions of ‘allied’ markets; for
instance, adjusting stops upwards on a local long stock trade, should the
Dow Jones Industrials index post a negative reversal signal.
Final thoughts
This chapter has been about guiding — not directing — traders or analysts
into the area of intermarket analysis. There is no single direction, but various
paths by which the trader may wish to take the principles of intermarket
analysis further.
Key aspects to be taken away:
• identify your major target asset classes and markets and how they are
interrelated
• work out which is a leading and lagging market
• work out whether the relationship is a positive and negative correlation
• look for possible confirmation and divergence
• apply your basic technical analysis to the relationships between and within
your markets with a view to enhancing your risk analysis and trading
opportunities
• build on these linkages and respect the chronological framework between
asset classes over the course of the business cycle
• don’t forget there are times to use intermarket analysis and times not to.
As market analysis should no longer be solely focused on your target market,
a market’s price action now should be viewed as the sum of its own
particular and more general environment with all different factors impacting
on a market’s price paths all at the same time. No longer content with the
information contained in one market’s price action, through intermarket
analysis we move to a more unified trading and analytical process that can
only improve the quality of timing and risk assessment of your market’s
opportunities.
Chapter 7: ETF power trading
strategies
Enhancing profits with better trading solutions
Daryl Guppy
Exchange-traded funds (ETFs) are the essential derivative instrument that
came of age in the global financial crisis. Originally seen as a sleepy and
rather boring index-tracking product, they have grown to become a
foundation of properly diversified portfolios. They provide, in a single
trading instrument, instant diversity within your home market. This in itself is
a tremendous advantage for stay-at-home investors.
ETFs also provide global diversity, and this is a feature that creates rocksolid portfolio foundations. The trader is no longer at the mercy of his or her
home market. Adverse moves in your home market can be offset against more
positive moves in US or Asian markets. The ETF opens the door to effective
diversification of risk and risk management.
Using ETFs to develop an investment portfolio produces a beta return. The
portfolio return is the same as the return from the market. If the market
increases by 25 per cent then the ETF will also increase by 25 per cent. That
may be a comfort for investors, but traders are interested in alpha returns.
Traders want to add an extra 5 per cent or 10 per cent or 20 per cent to the
base return available from the market. This is achieved with a range of
specialist trading techniques which use the unique features of the ETF, and
global diversity, to add the extra alpha return.
ETFs have become a $1 trillion global industry. The range of ETFs grows
rapidly, with ETFs that cover well-known indices, sector indices, and
specialist ETFs that bring together particular performance groupings. The
luxury ETF groups together the performance of global brands including
DKNY, Louis Vitton and others. This diversity of ETFs, including reverse
ETFs that short the market, is not yet available in all markets but they point
the way to a more sophisticated approach to investing, trading and managing
risk.
An ETF ‘shadows’ or replicates the performance of a particular market,
index or sector. They’re baskets of stocks that enable you to buy or sell a
portfolio of securities in a single purchase. Unlike mutual and unit trust funds
you can trade ETFs just as you would an individual stock. You can buy and
sell them at intraday prices. This is a liquid market.
The ETF offers investors a diversified way to trade economic sectors, global
financial trends, market events and ‘special situations’. Contracts for
difference (CFDs) are a trader’s instrument and an important innovation.
ETFs are an active investor’s instrument.
Risk/reward profile
If you want to succeed as an investor/trader then it’s important to understand
that it’s not the stock that you buy but the sector that you play that is
important. While the resources sector has enjoyed a bull run, there are many
individual resource stocks that have either underperformed the sector or
moved opposite to the sector rise. Traders who bought one Australian gold
producer watched it fall by 88 per cent while gold increased by 84 per cent
during the same period. This is specific-stock risk at work.
The ETF is a type of ‘fund’ and offers risk diversification that individual
stocks could never offer. If you identify a great global trend to play for a
profit, but pick the wrong stock, you could actually incur major losses,
despite having chosen a winning trend. The individual stocks may be subject
to an earnings disappointment, a liability lawsuit or a financial crisis. The
sector is immune from these individual problems and so the risk is
ameliorated.
It is estimated that more than 50 per cent of any gain an investor realises in
an individual stock is due to the sector it’s in, not the stock itself. A wellfocused ETF allows you to play the sector, theme or global trend that will
generate most of your gain.
Capture ‘unavailable’ profits
I follow many markets as a result of my work with CNBC Asia and CNBC
Europe. Often I come across opportunities in individual stocks like Taiwan
company Han Hai Precision Industry. It manufactures all three of the hot
video-game consoles that dominate the $10 billion worldwide video-gaming
market and the Apple iPhone. It sounds like a great investment but Han Hai
cannot be traded easily from outside Taiwan. I would have to open an
account in Taiwan, and the problems are not worth the trouble for a single
company trade.
The MSCI Taiwan index ETF has Han Hai as its largest holding. Buying the
ETF provided a way to capture profits that were essentially unavailable to us
by any other means. As a bonus, it also provides exposure to the performance
of the entire Taiwan market.
Diversification
ETFs, because of their built-in diversification, are automatically safer to
own than individual shares. With individual stocks it’s possible to buy into
the right trend and still not make any money, because you bought the wrong
stock. It’s possible to have one stock in a hot sector crash and burn because
of problems unique to that company.
The ETF is actually a diversified fund so if you pick the hot sector or hot
market, then you pick up the profits that go with it. You never get burnt just
because one stock failed.
The structure of the ETF means that as stocks are dropped from the index
they are also dropped from the ETF. As stocks are added to the index, they
are added to the ETF. The ETF simply always trades with the leading stocks
in the market that make up the index. The survivor bias works in your favour.
Dividends plus
The ETF also pays the accumulated dividends paid by each of the stocks in
the index. This generates a steady income stream in addition to any capital
gain. This is the foundation of one of the alpha ETF trading strategies.
Forget stock selection
In the US market there is an extensive range of ETFs to select from. The
range is more limited in the other markets. US traders use the ETFs to move
from hot sector to hot sector. We apply the same strategy, but shift between
countries rather than industry sectors.
This is not active trading. The objective is not to capture the very start or the
end of a trend. An ETF is not suitable for trading an index rally, or longer
rallies. The key disadvantage of the ETF is that it offers no leverage. It
replicates the movement of the market. The only additional benefit comes
from the dividend distribution.
Even so, this is a useful investment trading instrument. The chart in figure 7.1
shows a simple exchange-traded fund strategy using STW, which is an
exchange-traded fund on the XJO index. An entry in September 2006 near
$50.61 followed by an exit near $61 in June 2007 delivered a capital gain of
20.53 per cent. It also delivered all of the dividend payments made by all
XJO index companies during the period.
There are ways to improve on the very simple moving average crossover
approach shown here. The objective in this example is to show how the
broad trends in the market can be effectively traded without the need to select
individual stocks.
Figure 7.1: a simple ETF strategy
Chart created by GuppyTraders Essentials using data from Just Data.
Global diversification
There is usually some degree of divergence in the behaviour of the markets.
Some will go up while others move sideways. Some will retreat while
others trend upwards. The objective in this strategy is to move from one
strongly performing market to another. The cost of movement is limited to
simple brokerage fees. There are no serious financial disadvantages imposed
by a ‘redemption’ of funds, nor is there any waiting time.
This is diversification on a global scale made possible by trading a single
series of instruments.
Hot markets
You have to laugh when a politician claims the ‘brakes are off growth’. It is a
very narrow view of the world and our competitors. The brakes are truly off
growth in China, Vietnam, India and other world markets. ETF trading
allows traders to switch into high-performing markets easily. The ETF
structure allows traders to move between the best-performing global
economies, locking in performance and dividends.
The chart in figure 7.2, again made up of indices, shows how this selection
process is applied.
Figure 7.2: Shanghai and XJO indices
Chart created by GuppyTraders Essentials using data from Just Data.
ETF limitations
The ETF market has several limitations. They include:
• Currently you cannot trade short, and reverse ETFs are not yet available in
all markets.
• Liquidity and trading activity can be low. However, generally there is not a
problem in executing orders. Time is not a significant issue, so limited
liquidity is not a large problem.
• ETFs do not offer leverage. If the market moves up 25 per cent then the
ETF value will move up 25 per cent.
• ETFs will duplicate the returns from the market. These are no worse, or no
better, than the market. This is also a key advantage of ETFs when compared
with fund managers, who routinely fail to meet the index benchmark in a
rising market, and who routinely lose more than the benchmark in a falling
market.
Market and index behaviour
One of the most dangerous market myths is that the market always rises over
time. The believers in this myth trot out historical charts that have been
reconstructed from the middle of the 18th century. And sure enough, the longterm trend marches inexorably upwards. Even a crash like those of 1929,
1987 and the tech wreck all become just little blips in this overall magical
rising trend. The message is clear: just buy and hold and the magic carpet of
the market will carry you to undreamt-of riches.
It’s unfortunate that it’s simply not true. It’s so untrue that it should be
labelled as false advertising.
The truth is that the market index always rises, but not the market. The market
index rises because the index only includes winners. This is called survivor
bias. The components of the index change on a regular basis. The Australian
S&P XJO 200 index is rebalanced every quarter by Standard & Poor’s, who
compiles the index. In the quarter ending March 2010 three stocks were
dropped from the index calculation because they were the worst performers.
Three stocks were added because they were better performers.
When you drop the losers and add the winners it’s no wonder that the market
(index) always rises. Blue-chip stocks that fail are obviously not suitable for
the index, so they are dropped. Too bad if you happen to own them for the
long term.
Despite these changes in the membership of the index, the index is still
treated as if it is a single unchanged entity. While it is true the concept of the
index is unchanging it is important to remember that the membership of the
index is always changing to select retrospective winners.
This is survivor bias. It explains why Caterpillar Corp is a member of the
unchanging DOW Jones index, which has a continuous history that started
long before Caterpillar Corp started business. It explains why the index
always rises.
You could track this index performance if you buy every stock within the
index. However, you need to buy and sell regularly to keep your portfolio
components exactly the same as the index. Apart from cost, time and effort,
there is a significant taxation and brokerage impact. The ETF does all this
work, and presents a single instrument with a single buy or sell price set by
the market.
Matching market performance is a better result than that achieved by around
90 per cent of fund and investment managers. In a bull market around 90 per
cent of managers deliver lower returns than that of the market. In a bear
market, around 95 per cent of fund managers lose more than the market falls.
When their management fees are added, the performance results are even
worse.
ETF analysis leads to 16 analysis and trading strategies. They are:
• dividend hop: three strategies
• Swiss roll: three strategies
• yield trading: three strategies
• beta beaters: two strategies
• international: three strategies
• arbitrage: two strategies.
We use five trade management strategies for profit lock in ETF trading. They
are:
• accumulation
• capital profit
• currency boost
• cost averaging
• currency lock.
I discuss dividend hop and Swiss roll trading strategies and the capital profit
trade management strategy in this chapter. The remaining strategies are
discussed in our e-book Profit Without Pain.
Dividend hop
Dividend hop is designed as a trading method to skim the dividends payable
on all the stocks that make up the underlying index. In a rising market it
delivers a capital return and a dividend return. In a falling market the risk is
greater because the strategy may incur a capital loss.
Initiation of the strategy will depend on the direction and nature of the trend
prior to the entry and exit point. The ideal situation is a rising trend or, at
worst, a sideways trend. This ensures that the risk to capital is reduced, and
the dividend yield is captured completely.
ETF dividends have five interesting features:
• The ETF gathers all the dividends paid at different times during the year by
each of the underlying companies in the index. These dividends are
consolidated into a single payment made twice a year. In some instances,
with international ETFs, the payments are made every quarter.
• The second feature impacts on trend behaviour when the ETF goes exdividend. Unlike trading in the underlying company — for instance, a large
bank — there is no significant price reaction when the stock goes exdividend. If we trade a dividend in an individual stock then the risk is a
substantial price drop — and a capital loss — when the stock goes exdividend. When the ETF goes ex-dividend there is usually a very small
impact in price. The pre-existing trend continues to prevail. If this trend is
up, or sideways, it means there is less risk in terms of a reduction of capital.
• The performance of the index, and hence the ETF, is not dependent upon the
performance of an individual company. This means that the existing trend
behaviour of the market is more powerful than the individual behaviour of
any stock as it goes ex-dividend. As the ETF ex-dividend dates do not
coincide with any particular individual event, there is a reduced impact on
trend behaviour due to the ETF going ex-dividend. The market simply does
not care and takes no notice. With an individual stock, the market does care,
and it reacts accordingly.
• The fourth feature is essential for many of the ETF trading strategies.
Buying and selling an ETF incurs the normal brokerage rate. Unlike managed
funds, there are no exit fees or penalties and the ETF is traded under the
same conditions as an ordinary stock.
• The ETF exists in a made-market. The market maker must stand in the
market in the absence of any other trades and the degree of spread is limited
by regulation. An ETF chart may look ‘spotty’ but this does not limit the
ability to trade the ETF.
Dividend hopping is the strategy of buying a stock a few days prior to the
dividend date, then selling it as soon as it goes ex-dividend. The objective is
to simply take the dividend. In many countries this method is subjected to an
additional level of taxation. The implementation of dividend hopping–style
strategies must always take this taxation impact into account.
Index ETF
The index ETF strategy is designed to reduce risk and collect the dividend. It
is an income stream model. The risk is reduced by the trending behaviour of
the ETF and the underlying index.
This is more effective than trading dividends in individual shares. If we tried
to track the individual stocks in the XJO 200 index then we have to track 400
dividend payments a year. The consolidation of dividend payments into two
dividends by the ETF reduces the complexity of trading. Dividend dates are
around 24 June and 21 December each year.
In this example we use a 40-trading-day holding period. Trades completed
inside the 40-day period incur a penalty tax because the 40-day period
includes the ex-dividend date. Depending on the jurisdiction, the minimum
holding period may be larger or smaller.
There are three potential entry points. They are shown on the chart extract in
figure 7.3. The first enters around 40 days prior to the ex-dividend date and
exits on the day of ex-dividend. This is a very defensive strategy. If the index
begins to trend downwards the trade can be abandoned with minimum capital
loss. The dividend payment is lost, but capital is preserved.
Figure 7.3: trading a single ETF dividend period
Chart created by GuppyTraders Essentials using data from Just Data.
The second entry point is balanced either side of the ex-dividend day. The
purpose is to ride an existing trend. This strategy has moderate risk because
trending behaviour before the ex-dividend date is captured and this
behaviour does not have to continue for an extended period after the exdividend date.
The third entry point is just prior to the ex-dividend day and holds the ETF
for the required minimum period. The advantage of this entry is that the preexisting trend is well established and there is a high probability it will
continue. This is the strategy with the highest risk because it relies entirely on
future trend continuation.
This type of dividend collection adds alpha to the ETF. Alpha is a measure
of outperformance of the market and this is achieved by harvesting the
dividends.
Multi-index ETF
The multi-index ETF strategy uses the methods applied to trading a single
ETF, but it creates a calendar spread using the trading of international listed
ETFs. This is dividend hopping, moving from one dividend payment period
to another. The objective is to reap an income return, rather than a capital
return.
The spreadsheet extract in figure 7.4 shows the ex-dividend dates for 14
ETFs. In this particular market the majority of dividend dates are 27
December and 26 June. The last four ETFs are US-based, and they have four
dividend distributions a year.
Implementation of the strategy starts with an assessment of the dividend yield
that applies to each of the ETFs. This is most difficult in period one, period
three and period five, as there are 14 ETFs that go ex-dividend on the same
date. The objective is to identify the ETF with the highest dividend yield.
This type of information is aggregated on the iShares website, or by
independent providers such as <www.XTF.com>.
In the example shown in figure 7.5 we assume that the Hang Seng index ETF
trading as IHK has the highest dividend yield for period one. It also has the
best trend behaviour and meets the conditions for entry that we would apply
if we were trading a single ETF. The trade captures capital gain and a
dividend bonus.
Figure 7.4: ETF ex-dividend dates
Figure 7.5: selecting the best dividend yield
Moving out of December we go to the next ETF dividend period in March.
This applies to the ETFs covering the US market. Of these, in this example,
the IRU ETF, which covers the Russell 2000 index, has the best dividend
yield and trading characteristics. This dividend trading strategy ‘hops’ to the
next most profitable ETF from a dividend yield perspective.
In the third period the trade hops to the StreetTracks ETF, STW, which
covers the Australian market. The fourth period sees a hop to IVV, which
captures the dividend return from the S&P 500. The fifth period hops to the
dividend yield from Japan. A chart summary is shown in figure 7.6.
Figure 7.6: trading multiple international index EFT dividend periods
Chart created by GuppyTraders Essentials using data from Just Data.
Each trade captures the ETF price activity and capital gain, and the dividend
yield from the most successful individual ETF. These four trades capture
capital gain and dividend yield generated by the underlying markets.
ETF sector index
The ETF sector index strategy is simply an application of the international
index strategy applied to ETFs covering individual subsectors in either your
home market or the international market. The key concept is the same — it’s
a spread designed to move into and out of trades as each successive dividend
is declared and distributed. The strategy takes the dividends from the topperforming sector for each period as shown in figure 7.7.
This is not a calendar spread. All the sub-index ETFs go ex-dividend at the
same time. When each dividend period is due, an assessment is made to
locate the best yield in the sub-index ETFs. This is the same strategy as
applied to trading an individual ETF index, but the selection choice is wider.
This captures sector alpha when compared to market index beta.
Outperforming sectors will often also deliver capital gains as well as
dividend income.
Figure 7.7: trading sub-index ETF dividend periods
Chart created by GuppyTraders Essentials using data from Just Data.
Our ETF strategy objective is to use the ETF to obtain alpha performance.
The objective in the trading strategies is to retain the low-risk profile of the
ETF but increase the reward component.
Swiss roll
The Swiss roll strategy is designed to take the cream out of the differences in
momentum behaviour among ETFs. The Swiss roll strategy is based on
performance switching. A Swiss roll is a type of sponge cake baked in a very
shallow rectangular baking tray, and then filled, often with jam, rolled up,
and served in circular slices. It is also called an egg roll, a chocolate log or
a jam roll. There is one essential question we want to answer in this trading
approach: how can we slice the roll in a way that collects the most ‘jam’?
Or, more correctly: how can we time trade entry and exit to collect the most
benefit from our exposure to a variety of ETFs?
This ETF approach is derived from a portfolio management solution
discussed in my book Better Trading, so it’s useful to consider the
foundations. Annual portfolio reviews focus on weeding out the poor
performers in the portfolio. This magnifies the loss in a portfolio, and
reduces the impact of profits. Poor-performing stocks should be cut as soon
as they fall behind rather than when they have reached the bottom.
Additionally, because these reviews are done annually, or semi-annually,
they take a vertical slice through the risk profile of the portfolio at a single
point in time. This does not allow the investor to take full advantage of the
profits that have been available in the previous six or 12 months.
The Swiss roll approach recognises that in any portfolio some stocks will be
performing better than others at any given point in time. Any vertical crosssection captures both good and bad performance.
The Swiss roll approach cuts the risk profile horizontally at multiple time
points rather than vertically at a single time point, as shown in figure 7.8. The
result is that profits are captured fully from each stock in the portfolio.
Losses are cut quickly and have a reduced impact on destroying portfolio
performance. Entry into new positions is based on trend breaks, or trend
continuation, and candidates are selected from a reserve pool of potential
candidates which have desirable features such as high dividend yields.
Figure 7.8: slicing the Swiss roll
The Swiss roll approach retains the integrity of the portfolio and its general
risk profile while collecting profits and cutting losses. The method can also
be applied using a collection of ETFs.
This is active investment management. It is a trading approach applied in
slow motion with positions being held open for months or years.
ETF index, multicountry
This ETF index, multicountry strategy is based on the observation that
markets move in displaced synchronisation. This is most easily seen when
we compare the Shanghai market with the Australian market. The Shanghai
market collapse began in October 2007. The Australian market collapse
began in January 2008. On a global basis the behaviour of markets is similar,
but the market is characterised by leader and laggard behaviour. Some
markets are rising while other markets are falling. The time differences may
be limited. The Shanghai and Australian differences developed over three
months and left a limited window of opportunity.
A classic approach to ETF trading suggests that buying a single ETF
provides greater protection because the ETF automatically includes a level
of diversification that is not easily available using other methods. Classic
thinking believes this spread of stock provides diversity, and hence a
reduced level of risk.
This thinking is extended further, and it is suggested that when the trader
increases the number of ETFs held, then the risk is further diversified. A
trader with ETFs covering the Japanese, Hong Kong, S&P and Australian
indices has a greater diversity than a trader who holds just an S&P 500 ETF.
This may be correct if we assume a diversity of directional behaviour, but
unless actively managed the net result may deliver unexpectedly low returns.
Indiscriminate holding of a diversified country index ETF may mean that the
gains in one market are offset by the losses in another. This type of hedging
approach is suitable for passive funds management, but it does not deliver
alpha returns.
The diagram in figure 7.9 shows three rising markets. The superior return is
15 per cent, but the portfolio return is 9.3 per cent because the superior
return is diminished by the underperforming ETF with a 3 per cent return.
Diversity can provide an average return, but when traded with a Swiss roll
approach diversity provides an enhanced return. The objective is to delete
the losers, or low performers, and capture a slice of the winner’s
performance.
Figure 7.9: diversification
The foundation of this ETF strategy is to capture the capital appreciation
between the entry and exit points in the trade. In this sense it is no different
from a trade in an ordinary stock, shown in figure 7.10, and similar analysis
methods can be applied. The difference in trading the ETF is the relative
stability of the ETF and the diversification of risk when compared to
exposure to a single stock.
Figure 7.10: capturing capital gain from an ETF
Chart created by GuppyTraders Essentials using data from Just Data.
The window of opportunity is widened when we also consider the rate of
growth. Although each market may be rising, they are rising at different rates.
The Swiss roll strategy attempts to capture the capital appreciation from the
market with the highest velocity within the specified time period. The
difference between the Australian ETF and the Japanese ETF over the same
time period in figure 7.11 (overleaf) illustrates the underlying principle.
Figure 7.11: comparative Japanese and Australian index performance
Charts created by GuppyTraders Essentials using data from Just Data.
The objective is to slice the performance across index ETFs in a way that
captures the best capital growth from each segment. The timing of the slice
and the duration of the slice have a significant impact on the results. This
strategy collects the raw capital gains from ETF exposure.
The chart in figure 7.12 illustrates the trading principle. First, markets do not
move together. Second, markets move at different speeds. Third, traders
improve returns by switching ETFs to the index that is outperforming in the
selected period. Identifying this potential outperformance rests on a number
of technical indicator analysis methods. The box shows the period of each
trade. The figures show the comparative returns from each market for the
same period.
Figure 7.12: capturing comparative global outperformance
Charts created by GuppyTraders Essentials using data from Just Data.
Entry and exit points may be based on momentum indicators. Index analysis
can be simpler, or more complex, but the objective is to identify the
preferred entry conditions for trade execution using an ETF. The objective is
to identify increasing momentum and use this as an entry signal. When
momentum begins to decline, the trade is closed and the search begins for a
momentum entry signal being generated in another ETF.
Although the chart extract shows an almost immediate exit and entry
condition, it is more common for several weeks to elapse between closing
one position and opening another. The Swiss roll strategy is not based on
selected exposure to a variety of markets to capture the best performance.
Momentum entry and exit signals must also be combined with an assessment
of the velocity of the rise. A fast rise in a mature market may deliver a 2 per
cent return. A fast rise in an emerging market may deliver a 13 per cent gain.
The Swiss roll strategy trades the fast gain. The objective is to capture the
behaviour — momentum — of the ETF and the velocity — percentage
change.
This strategy is designed to diversify reward by capturing the best behaviour
across multiple markets and time frames. It is a capital growth model. The
risk is reduced by the diverse timing of the trending behaviour of the ETFs
and the underlying indices. The risk is not reduced by diversity of markets.
ETF management strategy
ETFs offer a variety of trading solutions to add to alpha performance. The
management of ETF positions can also add alpha performance to the
portfolio. These strategies are not focused on entry points and conditions.
They are strategies designed to monitor and maximise gains from existing
ETF positions.
There are three factors which need to be included in comparing ETF
performance. They are:
• the capital growth of the position
• the capital and income growth of the position
• this growth expressed in terms of a single currency.
We prefer to chart these as a financial record of performance. This means the
starting point for the calculations is the day the trade is opened. It is the
subsequent financial performance of the trade that is charted rather than the
price activity of the ETF.
Capital profit
The capital growth of a position is calculated on a marked to market basis
and is charted on a spreadsheet. Marked to market shows the value of the
position, based on the closing price of each day, as shown in figure 7.13.
Superficially it looks the same as a line chart of the ETF, but in this case it
measures the growth in capital. Typically the chart starts from a zero line
which is the value of the original position. The marked to market value can
be calculated every day, once a week or once a month. This chart plots the
capital growth on a quarterly basis.
Figure 7.13: ETF capital growth: cash/percentage
The spreadsheet starts with the initial position size. In this example we use
$100 000 as the total position size when the ETF trade is entered. The
development of the position can be calculated in cash terms, or as a
percentage increase. In this example an increase in the value of the position
by $10 000 is the same as a 10 per cent increase in position value. The type
of management message remains the same. We believe a percentage
calculation is a more effective management and comparison tool.
Capital accumulation
Capital growth is enhanced with income and it is the dividend income stream
that is most significant in an ETF strategy. The aggregation of dividend
income may be used to offset fluctuations in the capital value of the position.
In assessing the performance of a position it is important to include the
derived income.
The objective is to clearly establish the current accumulated value of both
capital and income. The relevant question is: if I sell now how much capital
return do I get and how much dividend income do I receive? The answer is
calculated as a percentage return on capital in the original position, as shown
in figure 7.14.
Figure 7.14: ETF capital and income
Chart created by GuppyTraders Essentials using data from Just Data.
Traders may decide to shoot for short-term combined returns of 10 per cent.
This type of calculation is most suited to traders who are pursuing dividend
trading strategies. However, it is also a useful calculation for investors who
are concerned with a fall in the market value of the ETF.
Accurately tracking the accumulated impact of dividend income is an
important tool in managing and comparing the performance of ETF positions.
This is a return on capital calculation.
ETFs are the foundation of modern portfolio strategies but they also offer the
opportunity to outperform your home market.
Chapter 8: Sustained profitable
trading
Transitioning to trading for profit
Gary Stone
Upon entering the financial markets arena, new traders and investors are
inundated with information on virtually every aspect of the markets from an
array of information sources. These range from brokers to chat forums,
newsletter tip sheets, newspaper columns, TV shows and educators, all with
a genuine desire to help people (although the ‘dark side’ will always exist
with scammers and unethical operators). Having chosen a path for engaging
the markets the active investor then embarks on a journey that can take many
years to complete, or, at best, reach a point where they are satisfied firstly
with their level of skill and then with their results and the profitability of
their trading operations.
Somewhere along the journey, often after many frustrations, reading lots of
books, attending many seminars, having lost money and finally realising that
‘something is missing’, the determined trader that desires a different result
comes to the realisation that consistency and objectivity are required to
engage the market and achieve sustained profitability. In this chapter I will
examine the process involved in transitioning to the level of sustained
profitable trading, from whatever point you are now at. My discussions will
focus on trading and investing in stocks (shares) as that is my chosen area of
market specialisation; however, the same process can apply to trading any
instrument.
What is sustained profitable trading?
My definition of sustained profitable trading is along the lines of:
A rising portfolio equity curve resulting from reasonable trading
effort with permissible drawdown values and periods that over a
three- to five-year rolling period continues to outperform a chosen
benchmark index such as the ASX 200 accumulation index or S&P
500 total return index.
The degree of outperformance should be a reasonable amount to compensate
for the additional time and effort required to manage a portfolio compared to
passively investing in an index fund such as the Vanguard Australian shares
index fund (which slightly underperforms the ASX 200 accumulation index
but outperforms the ASX 200 cash index) or the Vanguard 500 index fund in
the US market. The outperformance is suggested to be a minimum of 2 per
cent to 4 per cent compounded per annum over a three- to five-year rolling
period.
For example, if the ASX 200 accumulation index manages a 10 per cent
compounded annual growth return (CAGR) over a three- or five-year period,
sustained profitable trading should produce 12 per cent to 14 per cent
CAGR. A 10 per cent CAGR will produce 61.05 per cent total growth in
capital over five years while 14 per cent CAGR will produce 92.5 per cent
total growth in capital over five years, which is an absolute of 50 per cent
outperformance. Small differences in CAGR produce large differences in
total growth over time. This is the power of compounding. It’s no wonder
that Albert Einstein stated that, ‘The most powerful force in the universe is
compound interest’.
As a general rule, the more time and effort expended the higher the difference
in CAGR should be, meaning that short-term traders should produce higher
returns to compensate for their additional time and effort.
There is another dimension to being profitable that has nothing to do with
money — it has to do with growth of intellectual capital, or personal growth.
While this is difficult to measure and requires desire on the part of the trader
to establish a measuring process, it can be done by keeping a trading journal
and recording one’s growth. Journaling is part of the transition process
discussed in this chapter.
Why does sustained profitable trading
elude most people?
In order to make the transition to profitable trading it is first necessary to
recognise why a great majority of traders and investors continue to
underperform a benchmark index.
A huge number of active investors don’t have a sustained profitable
advantage over the market they are trading. Most have a hit-and-miss
approach that generates the occasional winner coupled with lots of losing
trades. Randomness will ensure the odd winning trade. With no real plan or
concept of the use and application of risk management and money
management these traders stay in loss trades and exit profit trades, they
hesitate when executing thereby entering and exiting too late, or jump the gun
and enter or exit too early, too often. Their buy and sell decisions are based
on a wide variety of ever-changing ideas, technical indicators, tips, whims
and ‘feelings’ about their perceived view of what is happening or will
happen in either the market or the economy. They have no plan, process or
structure to what they are doing. As a result their trading actions are
subjective and inconsistent and their successes are sporadic, while their
losses are consistent.
Further, the following concepts are not fully understood by the majority of
active investors:
• The market contains a seemingly endless number of variables that can and
will confuse, frustrate and anger its participants about why it doesn’t act like
it logically seems it should.
• The market is an unlimited stream of possibilities and opportunities which
occur in different time frames, in different forms and do not make themselves
obvious to participants. This leads to confusion and indecision as
participants are unable to consistently identify and isolate the specific
opportunities on offer.
• The markets are an environment of uncertainty. No-one knows what will
happen next. Despite all the attempts at predicting price and market direction
the market will essentially perform however ‘it’ sees fit. This can be
extremely frustrating and challenging for those with an ingrained need to be
‘right’, to be in control or to know what will happen in their lives in the near
future. Uncertainty generates fear and doubt in people’s minds which leads to
poor decision-making.
• Losses are guaranteed. Losing trades are part and parcel of participating in
the markets. You will have losing trades, and strings of losing trades. No
single trader can be right all the time due to the huge number of variables
involved, all of which cannot be comprehended in any one given moment, let
alone be controlled. Losing and the fear of losing cause poor and irrational
decision-making.
• Active investors place undue significance on the results of individual trade
outcomes, particularly negative ones. Magnification in the mind of previous
negative outcomes causes hesitation, reservation, doubt and fear with
executing the next trade. Magnification of previous positive outcomes causes
too much capital to be placed into ensuing individual trades.
• Human beings are ‘programmed’ to automatically associate the parameters
of their current situation with a similar experience in the past. Over and over
again the market will mimic its past, causing traders to recognise the same
situations in which past winning trades and past losing trades occurred and
react accordingly in the present. The problem is that the same outcomes will
not always occur as occurred in the past. This causes the trader to lose faith
in the market and become more and more confused by its movements.
• The market provides bucket loads of small samples of different types of
outcomes. If not careful the unsuspecting market watcher can use any small
sample to try to prove a notion he or she has about the market that can be
disproved by a large sample of research. Beware the sample of one or two
outcomes and do not base a trading strategy or a change to an existing one on
such a sample.
What is trading?
The terms trading and investing can mean a number of different things to
different people depending on your time frame, style, approach, goals, needs,
methodology, capital base, past investing experience and mindset.
One of the main attractions of the markets is that it is an environment that
allows total freedom of expression. Trading can really be whatever you want
it to be according to the rules of engagement that you choose. This can range
from very short-term intraday trading to ultra long-term semi-active ‘buy and
hold’ strategies that hold shares for several years. It can be difficult or easy
depending on your belief systems. It can be time consuming and laborious or
it can be mechanical and straightforward. It can be relaxed or it can be
stressful. The truth is, as US-based trend follower Ed Seykota says,
‘Everybody gets what they want from the markets’. Successful traders with
an edge over the market have clearly defined what it is they ‘want’ from the
markets and how they intend to achieve the results that they have identified.
In order to achieve success in any field it is necessary to break the required
processes down into small manageable segments and work through them one
step at a time. From the perspective of trading and engaging the markets this
results in a trading plan.
A trading plan requires us to clearly define what trading means to us; this is
our mission or purpose for trading. Next we need to state our trading goals,
which must be both skills-based goals and financial goals. The purpose of
this chapter is to assist you to define your skills goals and then put a process
into place to achieve those goals. Take care of achieving the skills goals and
the financial goals will take care of themselves.
Your financial goals need to be manageable and achievable. To ‘make a lot
of money trading’ is not a clearly defined goal — it is a dream. Our goals
and aspirations need to be realistic, manageable and measurable. A goal to
consistently outperform an index by a stated percentage year on year over a
rolling five-year period, for example, is a realistic, manageable and
measurable goal.
The next segment of the trading plan is ‘how’ you achieve your financial
goals. This is the trading system which defines the criteria that need to be in
place to enter a trade and when to exit a trade. Lastly you need to define how
much capital to risk in each trade and how much to risk towards any given
market strategy depending on the market status. This is called risk
management and money management.
The trading plan is required to support the act of trading. So what is trading?
Trading in its rawest form is a physical act: placing buy and sell orders.
That’s it. However, many people overlook or do not place enough
significance on the fact that a business associated with the financial markets
is psychological in nature as opposed to physical. It is impossible to
physically ‘force’ the market to do something. Singularly, we are unable to
make any market behave the way we want it to behave or think it should
behave. Just because we have decided to buy a particular stock in the belief
that it will rise in price does not mean that it has to cooperate. The range of
variables at work in the market may combine to ensure that the price actually
drops not long after we have entered the trade. No amount of coaxing,
encouragement or attempts to force the price back up will help in this
situation. It is essential that we prepare ourselves mentally for every
combination of variables that the market can and will throw at us and the
ensuing outcomes that it will produce. It doesn’t matter what happens, it is
how you take it that counts. You can’t control the former but you can control
the latter.
Working toward this total emotional detachment from the outcome of
individual trades is another major mental-skills goal in the transitioning
process from being a hit-and-miss trader to one with a sustained profitable
advantage, or ‘edge’ over the market.
Objective pattern recognition
If trading is placing buy and sell orders, what is the immediate prior step to
placing the order? Objectively recognising a pattern of data, that can be price
and/or volume and/or fundamental data, that calls the trader to take the action
of placing the appropriate buy/sell order.
This requires the objective recognition of price patterns in the market. The
patterns need to be unambiguous such that there can be no doubt that the
pattern is in place when it occurs. There can be no debate over the existence
of the pattern which is a signal for the trader to act. If there is doubt as to the
existence of a signal on which to act then the call to action will not be
objective, it will become subjective and open to the trader’s discretion and
interpretation, which provides opportunity for the trader to change his or her
mind in the heat of the moment.
The important part of this process is identifying objective patterns through
research that, on average, produce greater profits on the winning trades and,
on average, smaller losses on the losing trades. This is known as a positive
profit ratio (also called payout ratio). The problem is that the exact same
patterns that produce big juicy profit trades will also generate losing trades
due to the infinite number of variables and interactions that can occur in the
market at any time.
The key to identifying these patterns is to ensure that they are repeatable over
a large sample size. The markets provide sufficient evidence to prove just
about anything when using small sample sizes, so the sample of objective
pattern signals must be large enough for the sample to be valid. Just because
a particular idea works (doesn’t work) over a small sample size in a given
set of market conditions doesn’t mean it can (can’t) deliver consistent profits
over a large data sample across a wide range of varying market conditions
over many years. A large enough sample is typically a minimum of 30
occurrences of the pattern, but should be larger if possible. Objective pattern
recognition plays an important role in the next step, which in turn plays an
important role in the transition process.
Developing an ‘edge’ over the market
A trading edge is a set of unambiguous entry and exit criteria that, when
executed, will deliver profit trades that are sufficiently large enough to cover
your trading costs and loss trades, and deliver you a sufficient return on your
capital and time, over a large sample of trades.
Mathematically, an edge is defined as [(profit ratio + 1) × win rate] – 1. The
result must be greater than zero for an edge to exist and the larger the result
the better the edge, provided that the profit ratio and win rate are based on a
large enough sample. For example, having a win rate of 36.3 per cent, where
the average winner is 2.467 times larger than the average loser net of
brokerage and slippage, doing 9.2 trades a month over 9.28 years and
delivering an annual compounded return of 17 per cent compared to the All
Ords accumulation index of 8.41 per cent and All Ords of 4.12 per cent over
the same period, is an edge. Mathematically the edge is [(2.467 + 1) × 0.363]
– 1 = 0.2585, after brokerage and slippage. This edge was achieved in live
simulated unleveraged stock trading. A break-even edge would have a result
of zero but this edge was above zero at 0.2585. To put this into perspective,
playing double-zero roulette has a positive edge in favour of the casino of
0.0526, and hence is a negative edge for the gambler.
Figure 8.1 shows the portfolio equity curve of this portfolio compared to the
All Ords from January 2001 to May 2010. The edge will only be allowed to
achieve what the market allows it to achieve and will vary over time as
market conditions vary.
Figure 8.1: portfolio equity curve compared to the All Ords
Chart created using Share Wealth Systems software with data from Norgate Investor Services.
Once the trader knows that an edge exists for a given set of objective patterns
and entry/exit criteria combined with position sizing (that is, how much is
placed in each trade), the trader’s paradigm is that of executing trades
according to his or her edge. At the end of the day, trading is a doing word —
to make money we have to trade, not be a market spectator. We don’t make
profit trades sitting on the sidelines trying to discover the perfect entry
system. We make money by taking trades — cutting the losers and maximising
the profit potential of the winners.
The trader’s aim is not to find the best edge; it is to discover an edge that is
positive and profitable over the long term and then to deploy that edge, by
risking capital, to make profits. A trader trades, an analyst analyses, a person
trying to trade that has not yet transitioned
his or her mindset to a trader’s paradigm will make trading errors.
These trading errors will include:
• not taking the signals that occur according to the researched objective
patterns
• taking trades that do not meet the objective patterns
• entering trades too late or too early too often
• exiting trades too late or too early too often
• placing too much or too little capital into individual trades
• not risking allocated trading capital to the market.
The problem for most, though, is that we sabotage ourselves by making these
trading errors through fear of losing, being wrong or missing out and hence
we either do not adhere to the objective patterns or stop following them as
soon as losing trades start occurring.
The trader does not need to be ‘right’ with 100 per cent of trades or even 50
per cent of trades. The fact is that well below perfection is okay to make
money, and lots of it. Indeed, just 40 per cent of trades being profitable is
sufficient to massively outperform the market provided the profit ratio, such
as 2.7, is large enough to more than compensate for the win rate of just 40
per cent. Simple mathematics proves this to us. Execution of that mathematics
has proved this to me personally and many of my customers over many years
now. To have an edge is to have an understanding of what it means not to
have to be right.
Our ambition when seeking an edge over the market is to create the certainty
of achieving sustainable profits in an uncertain environment, and to be
consistently profitable in a range of market conditions over the long term.
Engaging the markets needs to be seen as a marathon and not a sprint. What
we achieve in a week is less important than what we achieve in a month,
which in turn is less important than what we achieve in a year, which is less
important than what we achieve over a five-year period, and so on.
‘Edge’ thinking
Edge thinking means to think in terms of probabilities, in terms of the win
rate and profit ratio of the edge that you execute in the market. The problem
is that our minds are hardwired not to think in terms of probabilities but in
terms of whole numbers.
Evolutionary psychologists argue that the human mind is wired to think in
terms of raw frequencies rather than base rates and probabilities. Asking
about the probability of a single event is routine in today’s world, where we
are inundated with statistical data ranging from batting averages to weather
predictions. But our ancient ancestors had access to little data other than their
own observations, which were accumulating counts of natural frequencies,
such as ‘we had a good hunt three out of the last five times we went to the
north plains’. Evolutionary theorists also argue that the human mind is wired
to count the frequency of whole objects, actions and events rather than parts.
They argue that our ancestors did not break the world into half-bananas or
quarter-tigers and that parsing the world into whole objects remains more
natural for humans today.1
If you’re interested to read further, Weiten’s Psychology Themes &
Variations contains plenty of information on how the human mind handles
decision-making under conditions of uncertainty, and suggests ‘that human
decision making strategies are riddled with errors and biases that yield
surprisingly irrational results’.2
It’s no wonder that active investors that have not transitioned their thinking to
that of a market paradigm battle to make consistent profits.
Societal paradigm versus market paradigm
Partaking in society via academia, business and socially trains our beliefs to
be incongruent with the market, and it is these beliefs that we need to change
in order to become empathetic with how the market behaves. We all obtain a
societal paradigm just from living our lives in modern-day society. Our
societal paradigm is the result of all the experiences that we have lived
through in our lives to date.
Some examples of the shift required to move from societal thinking to
thinking from the market’s perspective are shown in table 8.1 (overleaf).
A market paradigm is a mindset that has the characteristics in the right-hand
side of table 8.1. These might be summarised as follows:
• being empathetic with the market, which means genuinely not being
surprised, hurt, angry or frustrated with how the market moves
• being at peace with all market moves — no struggle, strain or pain to
execute a trade on any signal or with any trading outcome
• believing in the probabilities of your edge
• executing trades precisely that comply with your edge with absolutely no
hesitation and hence flawlessly.
Table 8.1: societal paradigm versus market paradigm
Transitioning to a market mindset
Making the transition to both think and operate in terms of a market paradigm
or mindset requires a conscious desire to want to change that will motivate a
transition process to be embarked upon.
Central to this process is the deployment of an objective ‘probabilistic edge’
in the market, as has been discussed previously. This edge will have to be
totally objective, or mechanical; that is, emanated from the market through
research of market price patterns, not from society. By definition, an edge
that uses the discretion of a relative newcomer to the markets would have
emanated from society as such a person would not yet have acquired a
market mindset.
Totally objective means an edge with totally unambiguous entry and exit
criteria with no bias, no prejudice and no room for debate about whether the
patterns exist or whether or not to enter or exit any trade.
Mechanical trading or trading a well-developed and researched system
should not be confused with ‘black box’ systems whose rules and parameters
are hidden from the trader. A ‘glass box’ system is one whose rules and
parameters are transparent and made known to the user. A mechanical trading
system, preferably a ‘glass box’, is a mandatory tool in the transition process
from societal paradigm to market paradigm as a mechanical system
researched in the environment of the market has a market paradigm inherent
in its DNA.
Transition steps
At a practical level there are a number of steps to work through to complete
the transition process to sustained profitable trading. The objective of the
transition process is not to make money, it is to acquire skills, the mental
skills of a trading paradigm. Batsmen don’t bat in the nets to make runs, they
bat in the nets to acquire the skills necessary to make runs in the heat of the
pressure cauldron of a competitive match situation. Similarly with golfers:
the skills acquisition happens on the driving range in order to score on the
golf course. The steps in the transition process include:
• Identify and use a mechanical system with a positive probabilistic edge.
Besides the definitions and explanations of what a mechanical system is, as
has been described previously, it is important now to understand the role that
it plays. Its market-sourced signals will create a conflict with the trader’s
society-sourced discretion. This conflict is the clash of the titans between the
‘beliefs’ of the market-sourced signals and the society-sourced ‘beliefs’ of
the trader.
• Trade a minimum of 10 trades (20 transactions, one each for buy and sell)
using the mechanical system in a paper-traded or simulated account. The
objective of this phase is to familiarise yourself with the processes of the
system and to become comfortable with its use in a non-pressure
environment. During the paper-trading phase conflict will occur but it will
not be of the magnitude experienced during live trading.
• Write and/or record your trading affirmations during the paper-trading
phase. Write one for reading prior to every trading transaction and record
one in your own voice for listening to whenever you can. There is plenty of
technology around these days to achieve this. Some tips: search the internet
for ideas on trading affirmations and then modify them to your style and
approach to trading. Background music is also preferable; do some research
on binaural beats as background to your self-recorded affirmations. Put that
iPod/iPhone to some beneficial use for improving your trading!
• Trade in the live environment of your chosen market. Trade a minimum of
20 trades (40 transactions). The objective is not to evaluate the mechanical
system because 20 trades will not cover enough market cycles to achieve
this. Nor is it necessarily to make a profit during the 20 trades. The objective
is to create conflict and then allow that conflict to be resolved through
repeated execution of new experiences of a new paradigm and hence to
acquire new skills. During these 20 trades conflict will occur between your
existing societal paradigm and your developing market paradigm. You will
question why many trades are being taken, and make judgement calls to avoid
some buy and sell signals based on your old knowledge base and belief
systems. You will also make trading errors and will not follow the system
flawlessly as you grapple with the application of this market-emanated
mechanical system and your changing mental paradigm. You will experience
sweaty palms and armpits and become irritable as your old belief systems
demand expression and are suppressed by your conscious desire to change
and take on a new you, that of a sustained profitable trader. Each time you
execute according to the market paradigm you energise new beliefs that are
aligned with the new paradigm and de-energise old beliefs aligned to the old
paradigm. This is an integral part of any learning process whether it be
trading or riding a bicycle. Learning is overcoming fears.
• Keep a trading journal and document everything you think, feel, say and do
before every transaction during this transition phase. This will allow you to
consciously observe what you were thinking, feeling, saying and doing
before every transaction that you execute and thus observe your emotional
responses and help you understand the changing nature of your mental state.
In the journal you also need to record your thoughts and emotional responses
to each completed trade, any judgements you might make, and anything you
may do that is outside the rules of the mechanical system. Reflecting on these
observations at a later time will provide valuable insights into where you
were at the start of the journey, and where you are now. Journaling therefore
becomes the measuring process and provides the convincing evidence of the
positive changes and progress you are making.
• Use positive affirmations and positive ‘self talk’ or ‘auto suggestion’. It is
imperative that you read an affirmation before executing every one of the 40
transactions during the transition process. For example, my execution
affirmation recited aloud before every trade for many years was Mark
Douglas’s five fundamental truths and seven principles of consistency. Play a
different recorded affirmation as often as possible when you are driving your
car or going for a walk or run. Affirmations reprogram your subconscious
and help instil new beliefs. If you do make a trading error, document it in
your journal, and remind yourself gently that you won’t do it again. At all
times practise being positive and mindful, as opposed to negative and
critical.
• If necessary repeat the 20 trades and the journal work in combination with
the positive affirmations several times until you have resolved the conflict
between your existing societal paradigm and your developing market
paradigm.
Am I there yet?
Being aware of how you need to think and feel and how you ‘should’ act is
simple and logical enough in theory. Actually practising it in the heat of
market conditions is very difficult to accomplish for the great majority of
active investors. Understanding why it is difficult requires some knowledge
of how your mind works. Changing the way you think to that of a sustained
profitable trader requires desire to start and keep on keeping on and then
effort and hard work to complete the process. In fact, it requires that you retrain your mind to think in terms of how the market conducts itself rather than
the way it is currently trained to think, which is in terms of how your world
around your chosen lifestyle and profession operates with you as the central
focus.
You have to transition from knowing what to do, to doing what you know.
The transition process outlined in this chapter can achieve this for you. I
cannot guarantee that it will work for everybody as the main determining
factor is not the process, it is the desire for any human being to change. Most
that start out on diets or exercise programs don’t persevere because their
desire is not at the level to overcome the force of their existing beliefs
(habits), which will always demand their own expression. In short, existing
habits prevail by justifying their existence through countering thoughts,
feelings, sayings and actions. Mostly, for those that have a desire to change,
existing beliefs are dysfunctional with respect to what they wish to change
from.
Trading is no different. If you have the courage to embark on this process you
will know you are there when you have achieved:
• empathy with the market, which means genuinely not being surprised, hurt,
angry or frustrated with how the market moves
• being at peace with all market moves — no struggle, strain or pain to
execute a trade on any signal or with any trading outcome
• belief in the probabilities of your positive edge regardless of market
movements
• execution of trades that comply with your edge with absolutely no hesitation
and hence flawlessly.
Continue repeating the transition process until these are achieved.
Completing this process will remove psychological trading errors from the
equation and allow you to execute your edge to make profits and evaluate
and/or research new edges to trade.
Sources
1 W Weiten, Psychology:Themes & Variations, Cengage Learning, 2008, p.
334.
2 Ibid. p. 333.
Chapter 9: Trading chicks are
doing it for themselves!
Do women trade as well as blokes?
Louise Bedford
If you’ve been looking for a trading friend to help you become an exceptional
share trader, then you’re in the right place. This may be the most important
chapter you’ve ever read, because I’m on a quest! A quest to create as many
happy, independent, wealthy and skilled female share traders as possible by
providing them with life-changing information for free.
And guys, just because this chapter is focusing on female traders, don’t think
that there’s nothing in here for you. I’m cramming heaps of essential
information into the next few pages, regardless of your gender, so don’t just
skip forward to a chapter you deem to be more relevant. You may just be
missing out on the ingredient essential to drive you on to success. Also, if
you are planning in advance to take offence to something in this chapter, don’t
blame me — blame the improvements in technology! Without the incredible
leaps forward in analytical equipment such as MRIs, we’d all still be in the
dark about the actual neural differences between the genders. But just
because men are different from women doesn’t mean that one is superior to
the other.
Make no mistake — learning about the sharemarket will be one of the most
rewarding skills you can possibly learn. Not just for you, but also for your
entire family. Over the past two decades I’ve been helping people just like
you cut through the clutter of their lives and write winning trading plans that
open up a host of life choices. Choices about whether or not you’d like to
continue working for a boss, or in your own business. Choices about where
you live, the cars you drive and the schools you send your children to. Please
let me explain.
It all started for me around 20 years ago. I went to a seminar about the
sharemarket and I thought to myself, ‘It’s about time I took control’.
Back then I was a national manager for a large multinational company, and I
was flying high. My professional ambitions had finally begun to come true. I
started to trade alongside my job and then, just a few short years later … the
unexpected happened.
Over the course of a few short months, I progressively lost the use of my
arms through an unexplained tendon condition. I found that even simple tasks
such as opening doors had become a day-to-day painful struggle. Dressing,
driving and feeding had now become daily challenges. Because of this, I had
to quit my terrific job. Life was looking bleak indeed.
Actually, I’m completely understating the situation. I felt black most of the
time, unable to picture my future, and certain that the loss of the use of my
arms meant that my hopes of becoming a mother had to be put aside.
I felt like my guts had been ripped out.
I kept fast-forwarding the images of what my life could have been before my
arms stopped working, and everywhere I turned, all I could see was despair.
The little self-respect I had left was eradicated one day when I got trapped in
my own bathroom, unable to escape because I couldn’t get the door open. By
the time my husband found me, I was howling with frustration at the floor,
and shaking all over with fury at my situation.
I found comfort under my doona, and spent long hours with my head buried in
the covers, sleeping, or miserably contemplating my future. Every public
toilet with a door handle became my enemy. Putting on a pair of tight jeans
was a thing of the past as I just couldn’t get my hands to co-ordinate to pull
up the zip. If I was itchy, I’d find a wall to act as a scratching post. If I
needed my seat belt on, I may as well have tried to run up Mount Everest.
As I did my endless physiotherapy lessons at the public pool, I found myself
surrounded by people in a much worse condition than I was. Amputees,
people with brain tumours and people suffering the ravages of cancer — they
all became my friends. We inspired each other, and didn’t allow excuses, as
we struggled for freedom from our bodies that had let us down.
I dug deep, and was able to access a core of strength that I had always known
was there — it’s just that it had seemed to desert me when I needed it most.
Then one day I told my accountant that I couldn’t work and that I was going to
trade full time.
Well, you know how some people just want to kick you when you’re down?
I’m guessing he was just that sort of guy because then — I heard him try to
smother a cackle.
Yes, a cackle!
He said, ‘You can’t be serious! Barely anyone makes it as a full-time trader.
Barely anyone! Especially not you! Look at you — you can’t even type your
orders into the computer’.
That’s all it took. I got angry. Really angry. Here he was, sitting across his
desk from me laughing at me! How dare he!
I got angry. I got even.
I learned how to type with a pen in my mouth. It opened up a whole new
world for me. I could trade shares online, and email my friends. It meant
freedom!
Trading was a terrific diversion to the continual physiotherapist visits.
Instead of being stuck at home and bored, trading allowed me to gain control
over a major aspect of my life and provided a reason for getting out of bed in
the morning.
It occurred to me that there must be many other people who have found
themselves in a situation where they would like to create a regular part-time
or full-time income from their own home. Maybe they have fallen victim to
company downsizing or are finding that they would just like to scale back
their hours working for someone else’s goals and dreams. Others would just
like to give themselves a well-deserved pay rise and develop some control
over their own salary package. Some people would even like to work from
home so that they can become a full-time parent.
If any of this describes your situation, trading may be the answer.
And now …
Over the past couple of years I’ve had great improvement in the condition of
my arms. Every day when I wake up and can move my arms, I feel a surge of
joy run through my body.
Today I am a full-time active private trader and I am thankful that trading has
eliminated the need for me to re-enter the corporate world. I’m also a fulltime mum to two fabulous kids who are benefiting from the time I’m now
able to spend with them every single day.
Oh yeah, and that accountant?
I kept him as my accountant long enough so I could watch him eat his
words. I dropped his services shortly after I made more money than I guessed
he was making per year!
Ha!
Now I’ve got a friendly accountant who applauds my efforts, instead of
dragging me down.
But before I get ahead of myself, if you’d like to read my full story about how
I started trading, and hear about other successful female traders, go to
<www.tradingchicks.com.au>.
For the rest of this chapter I draw heavily on my psychology degree, and I’ll
take you through the main gender differences that can have a real impact on
your trading. You’ll learn about the specific challenges we face as traders,
and I’ll also tell you how to overcome these issues so you’ll become a more
focused, happier and more profitable trader. Tall order? Perhaps — but keep
reading so you won’t miss out on the gems I’m about to share.
Male? Female? What’s the difference?
Well, aside from some of the more obvious physical characteristics that
we’re all familiar with, the two genders evolved very differently.
Evolutionary biologists have come up with explanations for some of these
differences.
Way, way back, when we were busy cooking ‘mammoth on a stick’ and
inventing the wheel, men and women had very different roles. Firstly, the
blokes focused on catching the beasts that would end up on the dining room
floor. (I’m guessing it took a while to invent dining tables? Who knows?)
Guys developed superior goal focus, excellent navigational skills and
amazing physical strength. These men liked to win and see someone else
lose. It reinforced their superiority over other males and enhanced their
chances of breeding success. Still today, many women find that ‘alpha-male
type’ irresistible — perhaps a throwback to earlier, simpler times?
Social conditioning and the brain functions of the Neanderthal male
prevented them from showing outward signs of fear or uncertainty. Their
language skills were not heavily valued. Males spoke only to relay facts
whereas females used words to build relationships. Men competed, and
women cooperated. Males used physical force, women negotiated.
Let’s contrast this with the female of the species. A female’s role was to look
after her children, help them develop into competent adults, and to form
relationships with other members of the community. This ensured that the
village would pull together in an emergency situation. A woman’s thicker
corpus callosum (the nerve cord connecting the left brain with the right brain)
meant that she could juggle several tasks simultaneously. Multi-tasking as she
collected berries and nuts, she could watch the kids, think about redecorating the cave and have a meaningful conversation, all at the same time.
The presence of oestrogen enhanced women’s language skills and equipped
them to use creativity or insight to solve problems. Women were not
expected to hunt or fight.
Fast-forward a few thousand years, and these roles became less specific.
Somewhere along the line we became ‘civilised’. Our roles began to blur,
and in some cases merge, leading to confusion on all sides. For example, in
modern times men who are not sensitive to others’ feelings are scorned by
some women. Perhaps these women are looking to relate to men as they
would to women. However, they don’t realise that the characteristics
common to women — empathy, for example — are less common in males.
Even though generations have passed, neither gender has changed much
emotionally since prehistoric times. Our basic needs have stayed the same,
despite us becoming more sophisticated as a society.
The brain
Much of our behaviour as men and women is derived from the goal to
reproduce. It is quite likely that this phenomenon exhibits itself in the trading
arena. Let’s have a look at the way our brains vary between the genders and
apply this to trading.
Nearly every difference in the brain of a woman, compared to a man, has to
do with functions related to reproduction and child-rearing. A woman’s
anterior cingulated cortex is larger than a man’s. This region is primarily
responsible for risk evaluation and fretting over choices. In life, it may lead
to questions such as, ‘Is this hunk fatherhood material for my potential
children, or is he just spunky eye candy?’ When it comes to trading, women
will worry over a particular trade or strategy more than a man because this
region is more easily activated.
Also, a woman’s prefrontal cortex is larger in comparison to a man’s. This
area, among other things, is the part that stops her from making a fool of
herself in public. (Yes … I know girls … this explains a lot of things about
our spouses, doesn’t it?) In relation to trading, the threat of public ridicule
can be a scary prospect, especially if you are in a trading group or trading
with a human broker, so some women drop the whole idea of trading before
they commence due to this fear.
A woman’s hippocampus is also more developed, which helps her to retain
and replay every detail and humiliating event such as a trade that has ended
badly. The insula is the area of the brain responsible for processing gut
reactions. A woman’s insula is larger than a man’s and can lead to a
disregard for the facts or the chart, which may be suggesting contrary
information. They may avoid executing a trade because it doesn’t ‘feel right’.
These differences in the structure of the brain have meant that it is often the
woman who is responsible for putting on the brakes during an intimate
encounter. They also help explain why women make more cautious traders.
Chemistry 101
There are major chemical differences between males and females. All of
those hormones and neurotransmitters flying around our bodies create a
gender-specific set of emotional responses. One of the most significant
chemicals driving the blokes is testosterone.
Ladies, you’re not exempt from these testosterone-related effects either. We
also have testosterone flowing through our systems, albeit in different
quantities than the blokes. So pay heed to what I’m about to say.
Professor James Dabbs of Georgia State University measured the
testosterone levels of a variety of males in different fields. He reported that
the superior achievers in any endeavour had higher testosterone levels than
lower achievers. In addition, the thrill of achievement actually causes more
testosterone to be produced.
Studies in the primate world have backed these findings. When a chimpanzee
is ‘promoted’ to leader of the pack, his testosterone surges. (I’m guessing
you’re wondering how they measured that? Well, I guess they go around
excitedly collecting chimpanzee urine samples from trees and test them. You
thought your job sucked.)
There is also a correlation between heightened testosterone levels and signs
of aggression.
Neuroscientists John Coates and Joe Herbert took saliva samples from 17
male traders on a London stock trading floor twice daily over the course of
eight days. They found that high-achieving males in the trading field have
heightened testosterone levels. Other studies have backed this up, but they’ve
also suggested that heightened levels of dopamine are also evident.
Dopamine is responsible for calming you down after feeling angry, among
other functions. A further analysis showed that traders who started their days
with elevated testosterone made more money than those who didn’t. One
trader went on a six-day winning streak, making twice as much money each
day as the previous one. Over that period his testosterone levels rose
steadily by some 74 per cent.
‘The popular view is that experienced traders can control their emotions’,
Coates says, ‘but in fact their endocrine systems are on fire’.
However, there is a point of diminishing returns: too much testosterone leads
to too much aggression and reckless decision-making.
So, to maintain terrific results, male or female high achievers probably need
to find a way to dissipate their testosterone. It’s very difficult to punch the
living heck out of the sharemarket, so you’ll need to find another method of
alleviating your aggression levels. Physical exercise is a great alternative.
Taking revenge on your computer screen is not.
So, let’s look at the facts
Firstly, did you know ladies are more profitable with trading than blokes?
Yeah, it’s true. Using account data for over 35 000 households, Barber and
Odean, financial behaviourists and professors of finance from the University
of California, Berkley, analysed the common stock investments of men and
women from February 1991 through January 1997. Men traded 45 per cent
more but earned 1.4 per cent per annum less in comparison to females. These
differences are more pronounced between single men and single women.
Single men traded 67 per cent more than single women and earned 2.3 per
cent per annum less. So it seems that testosterone can be a blessing, but it can
also be a curse.
The guys seem to suffer from overconfidence, overtrading and wanting to
take revenge on the markets. These are endearing qualities when it comes to
getting us out of the caves and into air-conditioned homes, but not necessarily
so effective in the sharemarket. That’s not to say that we ladies don’t have
our own quirks. Sometimes we can be our own worst enemies. We
notoriously doubt ourselves, think that trading may be a male domain and
study so long and hard before beginning to trade we delay our own success.
Take heart though, ladies. You can excel as an effective trader, and develop
the lifestyle you deserve. The statistics, and your very own cautious nature,
are on your side. The rule is not ‘he who trades the most wins’. As women,
we ‘get that’. In a study of 78 000 households, women turned over their
portfolios about 53 per cent annually and men turned their portfolios over 77
per cent annually. And, you guessed it, the women made more than the men.
The 20 per cent of investors who traded most actively earned an average net
annual return 5.5 per cent lower than that of the least active investors.
This effect translated even when comparing the performance of male and
female hedge fund managers. From January 2000 to May 2009, women who
ran hedge funds delivered almost double the investment performance of their
male counterparts. It also appears that women are better in a crisis — at least
the most recent one. In 2008 funds run by female managers were down just
9.6 per cent, compared with a 19 per cent drop for the men.
‘It’s not that women are averse to risk’, notes organisational behaviour
expert Judi McLean Parks, an Olin Business School professor at Washington
University in St Louis. ‘It’s just that they are less likely to take the big one.’
This inherent risk aversion seems to be the key that explains the genderrelated result differences.
Gender-specific challenges
Guys face very different challenges in the markets to the ladies. Let’s have a
look at those challenges here and I’ll reveal some solutions so you can
maximise your probability of becoming a trading dynamo.
Specific male challenges
The difficulties faced by guys in the markets come down to three major
areas:
• dealing with anger
• managing ego
• avoiding overconfidence.
Blokes tend to overestimate their trading abilities, and their ability to
recover from a loss. They feel like superman, but when things don’t work out
they’re likely to strike out to seek revenge.
Specific female challenges
The difficulties women need to overcome in the markets are:
• lack of confidence
• worry that it’s a male domain
• poor management of stress reactions.
The research suggests that when feedback is unequivocal and immediately
available, women are just as confident in their own abilities as men. It was
found, however, that, ‘When such feedback is absent or ambiguous, women
seem to have lower opinions of their abilities and often underestimate [their
sharemarket performance] relative to men’ (Barber and Odean).
Feedback in the stock market is ambiguous. For this reason, women may be
more inclined to await the perfect setup before investing. This could account
for their more moderate trading levels in comparison to males, yet their
higher level of success.
Many women also harbour secret concerns that they won’t be good traders
because it’s something that comes naturally to blokes. Ladies, if you believe
this, I have one word for you: bollocks! Trading doesn’t come naturally to
anyone. Every terrific trader has had to work his or her way to the top.
Ladies tend to react emotionally to stress, talk about it a lot and use theatrical
body language. They are more likely than guys to ‘catastrophise’— which is
psychology-speak for making a mountain out of a molehill.
When dealing with a distressed female trader, it is important to listen in
order to validate her feelings. This shows that you are reciprocating the trust
she is placing in you. Offering solutions at this stage is not necessary or
productive. If you are the spouse of a female trader, please remember this.
Interestingly, statistically speaking women are 3 per cent more intelligent
than men. Although this has nothing to do with how effectively each gender
will trade, I felt compelled to draw your attention to this fact.
The solutions
Regardless of gender, the solutions to the challenges we face lie in increasing
our levels of self-awareness. In this next section, I’d like to address three
approaches that can help you develop self-awareness. Focus on them, learn
from them, and you’ll make more money as a by-product.
Don’t let ego get the better of you
Ah, the dreaded ego bug. Something all good traders seek to avoid. Now that
you’re in the markets, you should feel proud that you’re a real trader. So
many people just talk the talk, but never walk the walk. However, don’t let
your head inflate too much, or you’ll be in for a shock.
Basically, trading with real money is harder than learning about trading.
When we’ve got minimal experience, we’re more likely to overestimate our
potential returns and underestimate the psychological effects of trading.
Because we have a high level of self-belief that is not based on true results,
when we start trading we are likely to apply leverage too early and jump into
trading volatile, inappropriate instruments.
I’ve been trading for two decades. When I started trading I had little
understanding of the risks, and thought I could conquer this new skill within
nanoseconds. (Reality: it took me three years to break even.)
It never occurred to me that I would actually get upset over losing money.
(Reality: in those first three years, on at least two occasions I bawled my
eyes out because I lost money and didn’t ever believe I’d be able to conquer
this new skill.)
I was sure that I’d be able to understand even complicated instruments with
apparent ease and very little work. (Reality: it took me more than five years
of trading before I started dealing in options.) I’ve found that the more I’ve
traded, the more conservative I’ve become, and the more I realise I’m just an
insignificant player in the sharemarket.
Trading provides the best form of personal discovery you can possibly
derive. The key to effective trading is to survive, with your equity intact, for
as long as possible. Profits will come to those who make a concerted effort
to realistically appraise their performance. Take it easy when you’re starting
out, and apply as much discipline as possible. Keep track of your results and
review your trading diary regularly. Consider getting a third party to help act
as a sounding board, or as a mentor.
Remember the power of compounding. Just because you’re taking your time
learning this profession, it doesn’t mean that you’re not going to be
incredibly capable once you’ve paid your dues. It may all happen a lot
sooner than you initially think.
Once you’ve developed your skill and attained a healthy respect for the
power of the market, then you’ll be able to build your equity and trade tricky
instruments. You don’t have to conquer it all in one day. It’s okay to make
mistakes, and to feel your way slowly. This isn’t a race. The best traders
often started in a very humble way, and decided to keep their egos in check
by keeping their expectations in line with their performance.
Keep your cool
We have all heard that it takes a cool emotional detachment to trade
effectively. It’s just that this goal is so damn difficult to achieve.
There is an ancient Japanese proverb that states, ‘A man is like steel — once
he loses his temper, he is useless’. Although this applied to the ancient
samurai, it is just as relevant today as it was then.
When we get angry, a chemical cocktail floods our bodies as we resort to the
primitive fight-or-flight impulse. The limbic area of the brain is activated,
which is one of the most primitive emotional centres, and this increases our
heart rate, preparing us for action. This happens whether the threat is real or
not.
If you’ve been trading for a while, you’ll be familiar with this type of
response. One minute you can be calm and cool, yet after a newsflash that the
All Ords has dropped 100 points or checking a dire-looking intraday chart,
you may feel yourself pump up as your body primes for action. The reaction
to either fear or anger tends to release the same chemicals as we prepare for
decisive action — either to stay and fight, or to run for cover. It doesn’t
matter that our foe is intangible, and that we are not under the physical threat
of a sabre-toothed cat rushing towards us. The effect on our physiology is
identical.
This reaction tends to dispense with logic. When caught in the claws of either
fear or anger, you are no longer a thinking, rational being. All of a sudden
you’re a primitive, vicious animal, with a need for instant gratification. When
faced with this type of emotional surge, your desire to use the more
intellectual parts of your brain is totally out of the question.
The blood flow to the Broca’s area of the brain is curtailed, which makes it
less likely you’ll be able to speak coherently, let alone think clearly.
Breathing becomes shallow and fast. Rather than being a sophisticated trader,
you more resemble a Neanderthal — at the mercy of your limbic system. So,
other than forcing yourself to evolve at the speed of light, what can you do
about this situation?
Stay in control
Self-awareness is the key. Realise how counterproductive anger or fear can
be while trading. Recognise when these symptoms are beginning to take hold.
Develop a circuit-breaker, such as taking a deep, long, slow breath. If the
threat isn’t dire, this can be all it takes to head off a full-blown aggression or
fear attack.
Don’t seek revenge if you have made a loss. Fight your battles with an
opponent with whom you can make eye contact. Physical activity may assist.
Lots of people use the gym as an outlet for energy. Others use sport or martial
arts. Also, following a written trading plan will help you avoid taking
unnecessary risks.
Recognise that after you have had a shock on the markets, your reactions are
likely to flow in one of two directions. Some people feel the fear and stop
trading all together. Others respond with anger that leads them to make
inappropriate decisions and overtrade in an effort to grab back the funds that
the market has snatched.
Consider lowering your position sizes until you are emotionally ready for the
challenges of the market. Also have a think about returning to a broker, rather
than trading online. Evidence suggests that online traders often overtrade, are
overconfident and earn less money than traders using a human broker. Find
coping mechanisms to self-soothe your battered ego and regain your
confidence, and consider them in advance.
While we’re on this topic, do you realise the market can send people a bit
crazy? During 2009 a bunch of usually sane, angry retirees captured and
tortured their funds manager. Did you read about that? Have a look at
<www.greynomadtrading.com.au> for full details.
Sprinkle lies sparingly
We all tell lies, both to ourselves and to those around us. In general, as a
species, we each lie several times a day. As Mark Twain wrote more than
100 years ago, ‘Everybody lies … every day, every hour, awake, asleep, in
his dreams, in his joy, in his mourning. If he keeps his tongue still his hands,
his feet, his eyes, his attitude will convey deception …’
Some of those occasions when we lie involve evading a particular topic,
open deception or trying to preserve someone’s feelings. So why do we do
this and how does this affect us as traders?
Gender
There is even a difference between the way males and females lie.
According to a 2002 study by psychologist Robert S Feldman of the
University of Massachusetts, men are more likely to lie to make themselves
look better whereas women lie to make others feel good about themselves.
Beware of the male broker or trading companion, lest they exaggerate their
positive trading results from an ego-driven need to impress you. And be
careful of the female broker or trading companion who allows you to achieve
less than excellence, because they are trying to soothe you.
Why do we lie so readily? From an evolutionary perspective, it seems that
natural selection has preprogrammed us for this activity. Those best able to
lie had an edge over others, and even though we evolved using social
networks to get ahead, our main need was to spread our genes to future
generations. If lying helped us achieve this goal, then it was deemed a
positive attribute and passed onto subsequent offspring.
The Feldman research confirms that liars are often better able to obtain jobs
and attract members of the opposite gender into relationships. If the
assumptions underlying this research are correct, lying evolved as a
sophisticated form of social manipulation.
The risk of getting caught lying seems extreme. Even in the rhesus monkey
community, deceit regarding food will involve ostracism, torment and
punishment from that society. As a result, humans learned to become selfconscious liars who aim to cover their trail of deception.
Lying to ourselves
Lying to ourselves seems to be a central aspect of this inherited behaviour. If
we can self-soothe by making ourselves feel better about a situation, we’re
more likely to recover emotionally. We take credit for chance occurrences
such as a market boom, convince ourselves that we’re brilliant and
bulletproof traders, and filter any negative input to the contrary. We also
exaggerate our weaknesses, self-deprecate inappropriately, and aim to elicit
sympathy from others by telling them all about how horrible the market has
been to us.
It seems that those who more easily convince themselves of their own lies
make the best liars to others. By selling the story to ourselves, it’s easier to
sell the story to others. We are able to lie more smoothly, persuasively and
convincingly.
As traders, we must seek to limit our own capacity for self-deception. After
years of watching thousands of traders progress and grow, I have found that
the best traders are the ones who maintain an objective mindset. They
examine their results with realistic honesty — not overrating their abilities,
nor overemphasising their flaws. They are stable and balanced in their
approach and self-evaluation. They also don’t rely on others for external
confirmation or flattery. The best traders are self-reliant, and detached when
it comes to reviewing their trading results and personal abilities.
So what now?
We’ve covered a lot of ground about the gender differences that can have an
impact on trading results. The key now is to go forward with a new level of
self-awareness, and focus on developing your mindset. The happiest,
wealthiest and most consistent traders are continually learning and
developing.
The best traders know that ongoing education is essential. To receive a free
copy of my monthly email newsletter and a trading plan template, register
now at <www.tradingsecrets.com.au>.
Chapter 10: With the click of a
mouse
Can computers enhance investment returns?
Tom Scollon
Over the many years I have been an active investor I can say that I have tried
just about everything: shares, CFDs, options, futures and so on. Because of
my background in economics and business management I was naturally
attracted to fundamental analysis; that is, I aimed to understand what might
happen to the sharemarket and therefore stocks by trying to understand what
was happening in world economics, our local economy and our trading
partners’ various sectors of the economy. All that before I even started to
undertake my ‘micro’ analysis; that is, the health of specific companies.
So perhaps you can imagine me late into the night under the miner’s lamp,
with desk piled high with reports, financial statements and analysts’
summaries. There had to be better ways, I mused one dark night as I turned
the light out at 2 am.
One of the shortcomings of fundamental analysis — that is, macro economics
(economies of the world) and micro economics (study of individual
companies) — is that there is such a vast amount of information to plough
through, and even though I was trained in such analysis it was still a daunting
task. My background meant reading analyst publications was a little easier
but I soon found that not even large investment and research houses that had
armies of analysts managed to get either the big or small picture right.
Of course, there are other ways, and one of those is listening to a broker. The
large high-profile brokers based their buy and sell advice on nicely
presented research and overnight reports from overseas markets. There were
so-called ‘full-price’ brokers charging commissions of between 3.5 per cent
and 5 per cent. The discount brokers, I eventually realised, often gave advice
from the seat of their pants, perhaps based on the latest rumour from the local
broker watering hole. And I must admit that after listening to their catch cries
of ‘buy buy buy …’ and my buys went ‘bye bye bye …’ I soon looked for yet
other methods of making money in shares.
And then I discovered technical analysis. Technical analysis employs price
and volume analysis and looks at history to ascertain what path the overall
market, sectors and shares have taken and then might follow in the future.
Now to the uninitiated this can seem a little like looking at the bottom of your
tea cup for some clues as to the fortune that lies ahead for you. Not really.
What I really like about technical analysis is that it is a very objective and
clinical process and it removes the human subjective element to a large
degree.
Now, that’s not to say it gets it right all the time: that’s not possible, as
everyone would be onto this infallible methodology. And of course by
definition there have to be losers as well as winners! Many reject technical
analysis as it is not seen to be the professional style of analysis like
fundamental analysis. My view is this is intellectual snobbery. Many also
reject it as it does not prove to be the ‘silver bullet’. But nor is fundamental
analysis the silver bullet. One needs to be merely aware of the pros and cons
of both and use them accordingly.
In my years of investing, the ‘fundamental’ and ‘technical’ camps have been
markedly divided, but the good news is that the two worlds have come
together. Fundamental data was seen to be the domain of the analysts in large
brokers but computers have changed that. ‘Technical’ analysis has been quite
accessible to retail investors but it is only in recent years that fundamental
analysis has become so easily accessed by common people like you and me.
This is what I am here to talk about.
As well as having a thirst for making money with shares, I also had a drive to
become time efficient in the process. So as computers appeared on the scene
I delved into this new phenomenon with great gusto. Despite my training in
economics and accounting my leanings were and still are toward technical
analysis. Having got that off my chest I can say I will be equally fair in this
chapter to both camps! Although I will also confess up front that I may even
try to persuade you a little to look at technical analysis, as it does have many
great advantages over fundamental — even though it is regarded as being a
little ‘low brow’ — by — you guessed it — the ‘high brow’. But in a recent
visit to my GP he handed me a chart of my blood pressure readings over the
last two years. Even my GP is using charts!
One of the other paradigm developments with computerised investing was
the advent of online investing. Hallelujah. And can I get something else off
my chest while I am at it: no longer did I have to listen to a broker coercing
(although they would claim never to do that) me to buy or sell. Even now I
listen to no-one when it comes to investing — no Saturday night party advice,
no newspapers or magazines, no financial pay TV channels. Nothing. All of
this I have learnt from the school of hard knocks. Not only can I and do I
make better decisions, I do it in less time!
Can computers enhance
investment returns?
Sure they can, but it is no lay-down misère. But if used effectively,
computerised analysis can save you a lot of time and produce sharper results.
I am not aware of any research into the comparative performance of
computer users versus non-computer users. I suspect that a sharp investor
becomes even sharper and a sloppy, frenetic investor just gets worse.
The ‘digital age’ means there is a plethora of data available. This in itself
can create a problem that didn’t exist 20 years ago: too much information! So
one is faced with the challenge of being discerning.
The key in my view is to keep it simple — yes, you have heard it before,
‘KISS’!
Of course finding the simple solution along the road to wealth creation takes
a little groundwork initially. But my point here is that after you have
researched what tools are available, stick with these and apply them with
discipline. Decide on the methodology you are going to use and document
your approach, your routine, your discipline. This includes such elements as:
when will you do your review of the markets? Daily? Weekly? Monthly?
This will vary from one individual to another. What will be the triggers for
buying and for selling? The essential prerequisite is that you follow your
methodology with discipline.
How are computers used for investing?
Basically you can employ computers in three ways. Firstly is in analysis.
That is, computers can make the process of analysis extremely efficient and
thus time effective. Secondly, you can place trades online almost no matter
where you are. And thirdly you can manage your positions very effectively.
Let’s look first at analysis.
Most brokers have some form of analysis of shares on their websites. These
are a good place to start but they are generally basic and as you are one of
maybe several thousand using the website it can be very slow at any point in
time. And it is Sod’s Law that it will grind to a halt exactly when you are
doing some crucial analysis before you place the juiciest of all trades. From
my experience in reviewing many of these sites my blunt conclusion is that
they are developed by code-cutters/operational people rather than by
investors for investors, and so they are generally not as user-friendly as the
dedicated software packages. Broker online sites generally have limited
analysis, and while this may be fine when starting out, once you have
developed a large portfolio they lack the smart functionality that proprietary
packages offer.
I will talk a little more in detail about analysis later in this chapter.
Placing buys and sells using online platforms is a very efficient way of doing
it yourself. When choosing an online broker there are a number of
considerations:
• Is the platform user-friendly?
• Is it fast enough so that the likelihood of a failure at a very crucial time is
minimal? I have witnessed websites go into meltdown when everyone is
heading for the exits. You of course don’t want to find yourself in such a
situation of panic-selling but it can happen.
• Does it offer the option of placing phone orders if the site fails? The option
of placing phone trades could be a method you may wish to exercise initially
until you want to or have the confidence to go solo online.
• What functionality does the site offer and do you find it useful and userfriendly?
Managing positions is the third main benefit of computerised investing. And
it is probably the most important. My view is that we make money in shares
not so much by the stocks we buy but rather the stocks we sell. And it is thus
crucial that your online broker site offers the ability to manage your
positions.
If you are a long-term, ‘buy and hold’ investor perhaps daily monitoring is
not so critical. But for active investors this is a must and in any case there is
little effort and time involved. When I am in my most active investing phase I
am looking for a broker website that enables me to easily monitor my
positions. I want to see profit/loss by stock, ideally for the day but also since
the date of purchase. I also need to see the totals by portfolio. And I want to
see all of this in both dollars and percentage. I would not use an online
broker that does not provide such functionality.
When actively investing I spread my investing over two brokers. If one
broker site fails I can still open/close positions. I make known to each broker
that I am using more than one broker for redundancy reasons and it is also a
good way of ensuring they do not take you for granted. In each case, even
though I am trading online I have an account manager and their direct lines to
use should the site fail.
As an aside, I do a daily balance sheet on a spreadsheet and so I want the
websites to provide me with accurate detail at the close of the market. So by
4.15 pm I am all done and dusted: within minutes I have consolidated all my
positions for the day into one spreadsheet and I have left my trading office
for a coffee.
Setting up your office
I am going to focus here on a traditional-style office and then talk in the next
section about how you might set up your ‘virtual’ office.
The ideal is to have a dedicated office, or at least an area where you can
quietly operate without interruption. If you work from home then aim for an
environment where interruptions are few. The distractions will in the main be
initiated by you rather than others! Beware.
I use two laptops and one desktop computer with a number of screens. I use
laptops so when I travel I can take my ‘office’ with me. When back at my
‘base office’ I hook up larger screens to the laptops as it makes analysis so
much easier.
Do not go out and buy the perfect office immediately. You add to your
resources as you earn it. I have seen many lash out on course after course,
software programs galore and computers in abundance and then fail when it
is time to make money. In the meantime a lot of money has been burnt.
I use the desktop computer for the real hard grunt and also for doing other
office/business activities. When trading back at base I run my software
analysis on one system and at least two online broker systems on each of the
two laptops. I replicate all of my systems — analysis and online broker
platforms — on at least one other computer so if some gremlin gets past me I
am not disadvantaged and can still operate seamlessly from another
computer.
I also strip back each machine once or twice a year. I format all hard drives
as this will ensure the systems are operating at maximum capacity. You will
be amazed at the difference this makes to reliability. It is just as you would
do to your car to keep it running in tip-top condition!
It is also important to have a good internet provider, a decent speed and a
reliable connection that does not drop out!
Perhaps on a less important note is to have a well laid out work space with
good lighting. Liken yourself to a pilot in the cockpit: everything at your
fingertips and all in ‘fit for flight’ condition.
On the subject of choosing an online broker, do not be entirely swayed by the
brokerage fees. The cost of placing trades is tiny — maybe 0.1 per cent —
and this is minuscule compared to what the standard brokerage was some
years ago. It is just as important to look at the functionality of the broker’s
website and to ensure that it meets your needs. My focus is getting my
investment decision right rather than chasing the cheapest brokerage.
The one feature I could not live without when investing is market depth. And
it is beneficial to spend a little time considering why this might be useful.
Market depth lists buyers on the left-hand side of the screen and sellers on
the right. It shows what each buyer and seller wants to offer: quantity and
price. It is not compulsory for buyers and sellers to actually appear onscreen; they can stay off-screen and come and hit buyers and sellers at will.
Market depth will give me a sense of the weight of buying and selling.
Some broker sites do this well, others poorly, so again, research your sites
before you commit.
The virtual investing office
You may consider that having an office that goes with you anywhere is just
not necessary for investing. If you are investing for the long term then sure,
you can go the library at night and place buys and sells via your broker
website.
But the truth is that the new generation of investors is used to everything ‘to
go’ or ‘on the run’ and that is often the only thing they do know. So they are
used to using their mobile phones instead of going to a bank; they don’t even
know what Yellow Pages is; they would not know a broker if they saw one.
One lifestyle phenomenon in recent years has been shift-working, hot-desking
and telecommuting. All of these have changed work styles and the traditional
desk or office-bound job is more a rarity than ever. This means as an
employee you can’t use the boss’s office and computer to browse for
investment opportunities during the day. So many investors have to be
resourceful and disciplined and open up their laptop during the day to log on
to place their positions.
The new generations — X, Y, Z, and so on — are the early adopters and the
baby boomers are often the resistors toward new technology, but they
eventually capitulate after years of protest. I have embraced new technology
— and still fall for the latest gizmo — as that way the leap into the next
iteration of technology is not so painful.
So it is worthwhile to consider the tools and options available for both the
desk-bound and the road warrior.
Let’s look at hardware. Firstly, let’s consider the trusty notebook computer:
these truly have come down considerably in size, with functionality rising
exponentially. I have found that one needs to limit the weight to a 1 kg
notebook, so with accessories that may bring the weight to 2 kg total. It may
not seem a massive weight to carry but if you lug it around every day you
will know about it. Sometimes when travelling I carry two notebooks — for
various reasons — so that weight does add up.
The trade-off with weight is that the smaller notebooks are, the less ‘grunt’
they have. So opening up websites — especially if using wireless broadband
— can be very tedious indeed. At the time of writing net books were very
much in vogue, but my experience with them is that they tend to be just too
slow for running a number of applications at the same time.
Generally I am trying to run two broker websites — one is live streaming
and the other refreshes on demand — and I also run at least one analysis
program. And on top of that, like most people I will run an email program
and maybe one or two other programs such as word processing. You might
say you only need one broker website at any one time; so be it, but deduct
one website from the above and it is still quite demanding on a small
notebook. So be careful in your choice and do your research carefully.
The other option to access your broker website is via your mobile phone, but
in my experience most broker sites are not well developed for use on
mobiles. The average screen size is just too small and tedious to use. There
is one exception and I am hesitant to ‘name names’, but the iPhone has a great
size screen and is generally fast enough for most websites.
Some websites are just far too slow and a sheer grind when used on a
wireless platform so check out which one will work for you.
The next component you will need is a modem to provide you with a decent
broadband connection. You may be able to ‘tether’ your mobile to your
notebook for it to act as a modem; the other alternative is to purchase a USB
modem which plugs directly into your notebook, and these work seamlessly.
Before you decide on one of these it is again critical to do your research into
the various carrier options. Here you will find yourself trading speed,
reliability and cost as the key factors. Remind yourself when you are making
this decision that you will find a slow connection very tedious. It is smarter
to trial a low-subscription version before you commit to a long-term plan.
The signal strength on a mobile phone from that carrier will be a guide. And
if you don’t have a sim card for the carriers it would be useful to borrow one
from a friend and trial it where you will spend most of your time. Remember,
you will live with the outcome of your decision for a long time.
Around most cities there are some ‘hot spots’ or wi-fi hubs, but these are
surprisingly rare in comparison to what is available in Asian cities. Many
local libraries and coffee chains have free wi-fi and it may be worthwhile to
plan your day to be in the vicinity of one of these when you wish to place
some buys and sells.
There are numerous websites that provide market data, and generally where
this is 20-minute delayed data these websites are free. But also generally not
so fast. Nevertheless, you can be in touch with broad movements in the
markets.
There are a number of platforms that have been developed as ‘apps’ for the
iPhone and one of these in Australia is the WebIress platform. You sign up to
the platform via one of a small number of brokers — there’s a very limited
choice for mobiles. These brokers adapt the platform to their perceived
client needs. At the time of writing one broker platform adaption I tried
worked quite well and the other was in my view quite inadequate. Do your
research and you will see what I am talking about.
Analysis software
Because tens of thousands of users can be on the website at any one time they
can grind to a halt. For mine I would not compromise so I do my critical
analysis offline using dedicated software. Analysis is the most important part
of the chain of events leading up to placing a trade and it is the area I place
most emphasis on, and thus I ensure I have the right tools.
Major online brokers are mass-market focused and by definition that means
retail investors. There’s nothing wrong with that but the tools available are
not what you would call sophisticated, and I believe an active self-directed
investor needs better tools. These tools are available and these platforms
have come a long way in the last few years, and, more importantly for you, so
has price. In fact, some are free!
The one I am going to look at in detail here is Hubb Investor: it is free and
has a wide offering with some outstanding features. Before I espouse these
benefits I will declare that I am an analyst/editor for Hubb. But I have been
using investment software now for 20 years and I think I can say I was one of
the pioneer users here in Australia. Because of my avid interest in computers
and software back then and my thirst for market analysis techniques I
searched high and low for software both locally and from overseas. As each
new product hit the markets here or in the US — who were the leaders at the
time — I acquired the software and pulled it apart, turned it inside out and
studied in detail all the functionality. So I can make some claim about my
credentials for evaluating software.
Hubb Investor is available at <www.hubbinvestor.com>. There are more
advanced versions but in my view the free software packs a real punch and
will provide a multitude of investment market data in one software package.
The software provides data for not just Australia but also the US and UK
stock markets.
Take a look at figure 10.1, or better still go to the website and download the
software as it will make it so much easier to follow what I am saying here.
Figure 10.1: screen shot of Hubb Now: sign up
© HUBB Financial Group.
On the left-hand side you will see ‘free sign up’ — click here and follow the
prompts. It should only take a few minutes to download.
Let me explain step by step some of the elements of the computerised
analysis that are available in this software.
Daily trading signals
This section of the software provides a list of precomputed computer scans
that satisfy designated criteria for ‘healthy’ stocks. Now you can’t expect all
these will be guaranteed winners but they are a short list and will save you a
lot time going through several hundred stocks daily.
You can click on any stock and it will bring up the stock on a chart. The chart
enables you to view what the stock price has been doing. You can then look
at each company using both a technical and fundamental analysis approach.
Company health check
This section provides you with financial data on all listed companies, such
as market capitalisation, annual profit, dividend and yield. The software also
gives you an overall health rating for each stock.
Sure, you can find this data by searching on the internet or going to a broker
website but using Hubb Investor the data is available within seconds and the
complete range of data is here in this one program. This functionality arms
you with an abundance of information and saves you a huge amount of time.
We are all time poor these days!
Charting tools
The software provides you with a wide range of technical analysis tools such
as moving averages and Bollinger bands as well as drawing tools. I will go
into these in a little more detail later.
Latest news, views and video updates
Again, you can search for this material on the internet but this is very time
consuming and it is just so much easier having all of this in one location. You
can look up the latest information on specific stocks before you decide on
your investments.
Investment newsletters
These free online newsletters will keep you abreast of investment trends and
analysis techniques — analysis written by analysts who are experienced in
the markets.
Daily market updates
At regular intervals throughout the day there are succinct market wraps that
will keep you informed with the latest breaking news. You will have a sense
you are in touch with the market and making informed decisions.
The essence of computer analysis
The previous section is what I would call a general outline of some of the
tools available in computerised analysis. I would now like to focus on how
one might use some of these tools to indicate times to buy and times to sell.
There are hundreds of technical analysis indicators. In my days of
researching computerised software I came to believe that there were far too
many, and many doing much the same thing. Yet individual investors always
seek more and more indicators. They are looking for the Holy Grail. But it
does not exist.
To me, successful investing is best carried out one step at a time. It is about
having a goal and working toward that goal steadily, unwaveringly and with
discipline.
Simple line charts
I like a plain line chart and I believe often the simpler the chart the more
informative it can be. Take a look at the BHP Billiton chart in figure 10.2, for
example.
Figure 10.2: BHP Billiton
© HUBB Financial Group.
I can see from the chart BHP has had a strong run from the low back in
November 2008. Even though BHP is a great stock to hold, if I did not hold it
at the high point in the chart I would not buy it now as it has climbed solidly
for over 18 months. And one thing we know about the markets is that they
always pull back, and generally this is after a major and unabated run. So just
from looking at the chart I would conclude buying at this point is buying it at
a high point of risk. This is not rocket science yet there will be unsuspecting
buyers out there buying BHP as it is heading south.
You can experiment with the other forms of charts available in the software
such as bar, candlestick and point and figure. Some of these may work well
for you but keep it simple as that way you are more likely to be successful in
your discipline.
Overlays
A line chart can also be useful for comparing one sector or stock against
another. In figure 10.3 I am considering Telstra performance against the
overall market as shown by the XAO. We can simply see this in an overlay
chart. Telstra is the light line and we can easily see from this pictorial
overlay that since March last year Telstra had drifted south while the overall
market has made solid gains.
Figure 10.3: Telstra performance against the All Ords
© HUBB Financial Group.
Volume
Volume is a very useful indicator and tells us what the big players are doing
because at the end of the day retail investors don’t consistently influence
market direction.
In figure 10.4 we can see Rio Tinto falling and volume rising — yes, major
institutions are selling down. This may be only lightening their positions but
it is enough to make the stock fall — until they have done all the selling they
want to do!
Figure 10.4: Rio Tinto
© HUBB Financial Group.
OBV (on balance volume) is a special volume tool; you can find out how it is
calculated in Hubb Investor. But it can highlight divergences and we can see
an example in the OBV chart of RMD, shown in figure 10.5 (overleaf).
You can see where price went higher but OBV stayed the same, a sure
indicator a share price is going to fall. The inverse can happen when price
falls but buying continues; this will push a price higher.
Figure 10.5: RMD
© HUBB Financial Group.
Moving averages
Moving averages are what you might describe as the oldest trick in the book.
They are even used by institutions that pretend not to look at such esoteric
topics as they are pure-bred fundamental investors!
Figure 10.6 shows a 200-day moving average for the All Ordinaries, which
is one of the key indicators for any market.
Figure 10.6: 200-day moving average
© HUBB Financial Group.
It is often used by investors as a buy signal and/or sell signal. So in this
example one might buy when price crosses over the moving average, as it did
last June, and sell if it was to cross below the moving average at some time
in the future.
The number of days one uses in a moving average is entirely personal. But
bear in mind the lower the number of days, the more often you will be in and
out of the market!
Moving averages may seem overly simplistic but if you follow them
consistently and with discipline then it can be a simple way of making
money.
The 200-week moving average (figure 10.7) is often used as a litmus test of
the health of a market. At the time of writing there was conjecture as to
whether the run-up we have see in the market over the last year has been a
false dawn, as many analysts believe the market is failing at the 200-week
moving average — a crucial test!
Figure 10.7: 200-week moving average
© HUBB Financial Group.
Bollinger bands
Bollinger bands are a part of my daily arsenal of analysis tools. They
indicate to me the extent of volatility in the market. Sometimes we may want
to stay away from a market when volatility is high, or we may wish to
employ a strategy whereby we can take advantage of volatility.
When the bands widen this indicates a period of volatility, and I have marked
one such example in figure 10.8. You will note the Bollinger bands move
within a band of the All Ordinaries. The period I have marked was one of
great volatility, as designated by the vertical line.
Figure 10.8: Bollinger bands
© HUBB Financial Group.
One of the very simple applications I employ for Bollinger bands is to look
at overbought and oversold positions. Take a look at the chart for Adelaide
Brighton (ABC) in figure 10.9.
You can see overbought and oversold positions — where the market
eventually corrects itself. By looking at such a chart you can avoid buying
when a stock is in an overbought zone.
Figure 10.9: Adelaide Brighton
© HUBB Financial Group.
This chapter was intended to show what tools are available today to make
your investing that much easier. If you take advantage of them then they will
not only save you time but enhance your sharemarket returns and, perhaps
more importantly, allow you to avoid any nasty surprises.
Chapter 11: Combining analysis
methods
How to get the best of both worlds
Jim Berg
The long-running battle between fundamental and technical analysis is
counterproductive to both disciplines. Traders often focus on only one
technique and miss out on the strengths of the other method. Fundamental
analysis is a good way to identify healthy companies that have the potential
to outperform over the next 12 months. It is not a good way to trade. Healthy
companies can fall in price for months. Professional analysts and financial
planners, supported by the media, chorus the myth ‘time in the market is more
important than timing’. This means every few years their followers will need
to ‘wear’ the pain of a declining portfolio. Purchasing equity in healthy
companies when their share price is in a rising trend will eliminate the pain.
Combining fundamental and technical analysis is commonsense.
Why combine?
Combining the two methods of analysis gives traders the advantage of using
the strengths of both disciplines. The fundamental analyst uses balance sheet
analysis and profit and loss fundamentals to determine the strength of a
company. Dividends, yield, earnings growth, price/earnings ratio, net asset
value and other criteria are examined to determine the company’s relative
health. All are important measures and give the researcher vital information,
but if you trade any one of these criteria on its own you would likely lose
your money. Back-test each indicator over the last five years and you would
find a success rate of less than 30 per cent. Not many private traders can
survive with a system producing this level of success. Grouping a number of
these criteria together, having them all present at the same time and
conducting the same back-test would result in a success rate of closer to 50
per cent. This is a success rate which, coupled with proper money
management, could enable a trader to make a lot of money. The analyst/trader
would reason that if a set group of criteria worked historically then the
probability is they will work in the next time frame, in real time. The analyst
is working with probabilities and is not predicting the future. An example of
grouping fundamental criteria would be to look for shares with a
price/earnings ratio of less than 25 per cent, a dividend yield of greater than
4 per cent and an earnings per share growth of greater than 8 per cent.
Technical analysts use chart patterns and technical indicators as their
criteria. Technical indicators are mathematical formulas that use price and
volume relationships to help traders determine the probable direction of a
securities price. There are a number of good indicators, but each one, traded
individually, would lose money. Back-test each indicator and you would
likely find a success rate of less than 40 per cent. Group chart patterns and
indicators together and your success rate will increase to 60 per cent and
higher. I call this grouping together of fundamental criteria and technical
indicators ‘weight of evidence’. It ensures I will never take a trade without
considerable evidence and a high probability of success. If a set group of
chart patterns and indicators worked historically, then the probability is they
will work in the next time frame, in real time. As with fundamental analysis,
we are not predicting the future but are working with probabilities.
Let’s look at two of the main problems with fundamental analysis. The first is
the large number of shares recommended. Top research analysts have a
success rate of around 50 per cent. With good money management and a
profit/loss ratio of 2:1 or higher, a trader could make money following a
research analyst’s advice. Most private traders have limited funds to invest
so there are usually too many shares recommended to purchase them all. So
an elimination process begins in an attempt to reduce the number of shares to
a manageable level. Without discipline, this process can turn into guesswork.
The research analyst can have a good success rate of 50 per cent, be quick to
cut losses, let profits run and trade successfully. The undisciplined trader,
following this analyst, could be left holding a large number of
underperforming shares the analyst was quick to cut from his or her portfolio.
The second problem with fundamental analysis is timing. Fundamentalists
don’t like to talk about this too much. Timing? Their response is likely to be,
‘Let’s look at it in three to five years’. Their favourite recommendation is not
to buy but to accumulate. This means buy some now but be prepared for the
shares to fall and you can accumulate more later. This is a calculated attempt
to turn a negative, timing, into the positive of being able to average down. It
actually adds the further negative of buying in a falling market.
Technical analysis helps the trader with both these problems. A disciplined,
mechanical trading system using chart patterns and technical indicators
assists the trader in choosing which shares should be considered for their
portfolio. Technical analysis’ s greatest strength is in timing. Fundamental
analysis plays an important part in helping the investor choose what to buy.
Technical analysis also plays an important part in helping the investor choose
what shares to buy, and also when to buy them. Combining the strengths of
two disciplines is a commonsense approach to investing.
Fundamental analysis
Fundamental analysis involves analysing the underlying forces that affect the
wellbeing of the economy, industry groups and companies. Top-down
analysis starts with an analysis of global and local economic conditions that
could affect corporate performance.
Economic factors that might impact on a company’s success include interest
rates, exchange rates, employment levels, inflation and the rate of economic
growth. Top-down analysis then works down from industry sectors to
specific companies.
Depending on the expectations for the economy, certain sectors are likely to
benefit more than others. An investor can narrow the field to those sectors
that are best suited to benefit from the current or future economic
environment. The individual company is important but its industry group
often exerts just as much, or more, influence on the stock price. When stocks
move, they usually move as groups.
This depth of analysis is most often carried out by professionals such as
broker analysts and prominent newsletters. The average private investor
would get this big-picture (macro) view of global and local economic health
from various media sources such as financial magazines, TV, newspapers and
newsletters. The present state of economic health could then influence the
level at which an investor adds securities to his or her portfolio.
At the company level, fundamental analysis may involve examination of
financial data, management, business concept and competition. Most often,
the aim of company analysis is to derive a stock’s current fair value and
forecast future value. If fair value is not equal to the current stock price,
fundamental analysts believe that the stock is either over- or undervalued and
the market price will ultimately gravitate towards fair value.
By believing that prices do not accurately reflect all available information,
fundamental analysts look to capitalise on perceived price discrepancies.
Most private investors focus on a company’s financial data and ‘ratio
analysis’. A company’s vital statistics and financial performance are used to
determine the financial health of a company and to then compare it to other
companies.
Some of the more popular ratios are found by dividing the stock price by a
key value driver.
Following is a list of potential inputs into the financial analysis of a
company:
• market cap
• sector
• subindustry sector
• net profit margin
• PEG ratio
• earnings per share
• earnings per share growth
• net tangible assets
• cash flow
• return on equity
• return on assets
• price/earnings ratio
• dividend yield.
This financial information could help an investor determine whether a
company is healthy and low risk and how it compares to other companies.
As part of the analysis process, it is important to remember that all
information is relative. Usually, companies are compared with other
companies in the same sector. For example, a media share (Fairfax) would
be compared to another media share (Rural Press), not to a retailing company
(Coles Myer).
My objective is to find fundamentally healthy, low-risk companies and profit
from future price movements using technical analysis to time entry and exit
levels.
Fundamental analysis can be a valuable tool, but it should be approached
with caution. Research written by an analyst who is selling advice is stating
an opinion and often has some sort of bias.
As investors, we are putting our faith in company accountants and auditors to
present accurate figures reflecting the true state of a company’s financial
position. It is important to keep in mind that corporate statements and press
releases offer valuable information but they are delivered with the intention
of presenting the company in a favourable aspect.
Like every other analysis tool, investors need to take the good aspects of
fundamental analysis and combine them with the good aspects of other forms
of analysis to make commonsense investment decisions.
Technical analysis
Technical analysis is often described as the study of price and volume for the
purpose of predicting future price action. This is a myth. It is not possible to
predict the future, and beginning investors could start at a disadvantage and
waste valuable time attempting to develop a trading system that can predict
the future.
I believe technical analysis is about probabilities and weight of evidence.
Here’s an example. Let’s say you read about a chart pattern and you believe
that it could be profitably traded. You scroll through hundreds of charts,
checking two years of history, and determine the pattern has a 25 per cent
success rate. While you are doing this back-testing you discover another
chart pattern that, when both are present, raises the success rate to 35 per
cent.
After studying and testing technical indicators you find one that fits the two
chart patterns and results in a success rate of 45 per cent. Trading only
healthy, low-risk companies that meet specific fundamental criteria raises the
success rate to 55 per cent.
Trading only shares in a rising trend might raise the success rate to 65 per
cent. This is trading with weight of evidence. Trade any one of these criteria
alone and you would likely lose your money. Group them together and you
have weight of evidence with positive historical results. Test the group in
real time and determine its success and develop a complete trading plan.
When you commence trading your system you are not attempting to predict a
future increase in price. You are trading probabilities and reacting to price
changes.
If your system worked with historical and real-time testing then the
probability is it will work in the future, in real time. With disciplined risk
management rules and a 2:1 profit/loss ratio, a system with a 50 per cent
success rate should make a lot of money. A 2:1 profit/loss ratio means that
for every $1 you lose on bad trades you make $2 on the good trades.
I separate technical analysis into two parts: charting and technical indicators.
Charting
Charting is ‘old school’ analysis. Its practice goes back hundreds of years,
long before computers introduced charting and technical indicators to the
masses. Charting provides us with a historical perspective, a picture of price
action. A study of that price action can help investors judge the strength of
buyers and sellers, identify and time attractive trades and assist with entry
and exit levels. Many mechanical system traders shun charting because of its
subjective nature, as people often see what they want to see in a chart.
Charting tools are a small but important part of my weight-of-evidence
analysis. The charting tools that I use are trendlines, support/resistance
levels and reversal patterns.
The subjectivity of charting means there are many different ways to use, view
and analyse the various charting tools. There is no right or wrong; ‘right’ is
what works. I do not suggest that my way is the right way, only that it is right
for me.
Technical indicators
Technical indicators are mathematical formulas that use price and volume in
their calculation. Gauging the probable direction of the next move is done by
grouping indicators together and testing them over previous price action.
Computers have played a major role in ‘new school’ analysis where some
investors develop purely mechanical trading systems with technical
indicators.
A chart shows previous price activity. At the end of the day, information on
the open, high, low, close and volume is added to the chart. Over the course
of time the chart becomes a picture that can be analysed. The same
information that is visible on the chart, and the relationships, is used in
technical indicators to measure the internal strength of that specific market.
The result is another picture that can be analysed and compared to the
original. Similarities and differences give the analyst clues as to the next
probable direction of prices.
Analysts are attempting to shift the odds in their favour by studying the
market and trading a security that has a high probability of moving in a
specific direction, based on historical and real-time testing.
Creating watchlists
Beginning investors often have difficulty reducing the market to a manageable
number of shares to follow. Searching for trading opportunities by scrolling
through hundreds of shares on a daily basis is a waste of precious time, and
time management is a very important part of trading.
The average share portfolio comprises eight to 12 shares. It is not necessary
to have extensive lists of shares when only one or two replacements are
needed to complete a portfolio.
There are a number of different ways to create valuable lists of shares to
watch for entry and exit signals.
Experts’ picks
The beginning of each calendar year brings out numerous share ‘lists’. The
headlines scream ‘This Year’s Hottest Stocks’, ‘Experts’ 2010 Picks’ and
‘Beat the Index in 2010’. Brokers, newsletters and magazines each publish
lists of companies that have the potential to produce excellent returns over
the next 12 months. Considerable time and effort in research is expended to
produce these lists and many of the companies could indeed be the ‘hottest’
performers. A recommended ‘list’, as a portfolio, could also produce
acceptable returns. For example, one ‘experts’ picks’ list for 2005 returned
15.1 per cent growth plus an estimated 3.12 per cent dividend yield for the
calendar year, compared to the S&P/ASX 200 index return of 16.1 per cent
growth. Many investors would be very pleased with this portfolio
performance, but it is important to remember the purpose of watchlists is to
group quality companies together and to save time. Professional analysts,
brokers, financial journalists and software packages are valuable sources of
information on quality companies. Traders should respect the experts’ picks
but should not trust that the selections would be ‘right’ for their portfolio at
this point in time. Here is an example:
The ‘experts’ picks’ list for 2005 contained 26 companies and the average
investor’s portfolio would comprise considerably fewer companies, let’s say
10, for example. Which 10 should the investor purchase and what are the
chances they will get a portfolio that underperforms? Fourteen companies
underperformed the average return of 15.1 per cent. Seven returned negative
results. The bottom eight returned –22.1 per cent. The bottom 16 returned –
5.6 per cent. Random selection, even from experts’ picks, could be risky
trading.
Quality watchlists save time but further analysis is needed to determine
which companies meet the stringent criteria necessary to be included in a
portfolio at this point in time.
The internet
Here are several ways to use the internet to create watchlists.
In Australia the S&P/ASX equity indices are managed and maintained by
Standard & Poor’s. The following lists can be created
from the site <www.asx.com.au/products/indices/types/capitalis ation.htm>:
• S&P/ASX 200 (by individual industry sector). Benchmark for the
Australian equity market. It addresses the needs of investment managers to
benchmark against a portfolio characterised by sufficient size and liquidity.
The S&P/ASX 200 comprises the S&P/ASX 100 plus an additional 100
stocks. It forms the basis for the SPI 200 and the ASX mini200 futures
contract, and the StreetTracks S&P/ASX 200 exchange-traded fund.
• S&P/ASX 300 (by individual industry sector). ASX 200 plus an additional
100 small-cap stocks. It does not always contain 300 companies.
• S&P/ASX 20. Twenty largest stocks by market capitalisation.
• S&P/ASX 50. Large-cap index for Australia.
• S&P/ASX MidCap 50. Companies within the S&P/ASX 100, but not those
included in the S&P/ASX 50. The index provides a benchmark for large
active managers where the emphasis is on having a portfolio with sufficient
liquidity.
• S&P/ASX 100. Australia’s premier large capitalisation equity index.
• S&P/ASX Small Ordinaries. Companies included in the S&P/ASX 300
index, but not in the S&P/ASX 100 index. This index provides a benchmark
for small-cap investments.
The next source of watchlists is a website using fundamental analysis.
I go to <www.money.ninemsn.com.au>; select ‘Shares’ then ‘Find shares’.
On this page Aspect has nine predefined searches. Also on this page you can
create and save a custom search. You must register to create and save your
own search.
Most private investors focus on a company’s financial data. A company’s
vital statistics and financial performance are used to determine its financial
health and then to compare it to other companies. Some of the more popular
ratios are found by dividing the stock price by a key value driver.
My custom search will scan for companies meeting the following criteria:
• market capitalisation greater than 250 000 000
• price/earnings (P/E) ratio less than 25
• return on equity (ROE) greater than 8 per cent
• net profit margin greater than 1 per cent
• earnings per share growth (EPSG) (one year) display
• earnings per share growth (five years) display.
I only ‘display’ the earnings per share growth as I am looking for greater than
5 per cent growth over one year ‘or’ over the five-year average. When I
download the list to a spreadsheet I can sort the companies by EPSG and
easily eliminate companies that fail to meet the minimum criteria.
I run my custom search quarterly, and in December 2009 my search found
118 companies that met the fundamental criteria. For the complete list of the
118 companies contact me at <www.sharetradingeducation.com>.
To create my custom search:
• There are four fields and an ‘Add’ button:
◊ Category
◊ Field
◊ Criteria
◊ Value.
Market capitalisation greater than 250 000 000:
• Category: company statistics
• Field: market cap
• Criteria: greater than
• Value: 250 000 000.
P/E ratio less than 25:
• Category: value
• Field: P/E ratio
• Criteria: less than
• Value: 25.
Return on equity greater than 8 per cent:
• Category: performance measures
• Field: return on equity
• Criteria: greater than
• Value: .08.
Net profit margin greater than 1 per cent:
• Category: income
• Field: dividend yield
• Criteria: greater than
• Value: .03.
Earnings growth (one year) display:
• Category: growth
• Field: EPS one-year growth
• Criteria: display
• Value: .05.
Earnings growth (five year) display:
• Category: growth
• Field: EPS five-year growth
• Criteria: display
• Value: .05.
Save the scan for future searches.
Broker recommendations
The vast majority of full-service and internet brokers offer company analysis
and recommendations to their paying clients. Also, brokers often manage
several portfolios that clients can monitor on a regular basis.
Summary
Watchlists are shares to monitor. They are not a ‘buy’ list. Newsletters,
magazines, brokers, computer software packages and the internet are all
valuable sources of information that can be used to create a list of companies
to follow. Watchlists are an effective time management tool, reducing the
market to a manageable number of shares meeting specific criteria. Weight of
evidence means that a number of criteria must be met before investing in a
security. Creating good watchlists is the first step to weight of evidence.
JB trading strategy
There is a well worn cliché, ‘If you fail to plan then you’re planning to fail’.
Unfortunately for far too many traders and investors, this is very true. I
cannot emphasise strongly enough the importance of having a trading plan
which, at the very minimum, should list how an investor will:
• evaluate market conditions
• choose investing and trading strategies
• select which share, fund, index, and so on to buy
• detail methods for:
◊ entry and exit conditions
◊ money and risk management, including position sizing
◊ stop-loss calculations
◊ protecting profits
◊ setting profit targets.
Trading plans must be written down, kept in a prominent position and, most
importantly, followed with discipline. Novice traders are often paralysed
when faced with the daunting task of creating a trading system. The investor
needs to determine the type of market and the most suitable time frame to
trade before starting the time-consuming process of reducing the vast amount
of available indicators to a workable number and combining them into a
trading system.
Starting from scratch, creating a trading system will take months, if not years,
to complete.
One of the easiest ways to develop a trading strategy is to ‘borrow’ a system
from another trader. The borrowed system is used as a base to test and
eventually build a trading strategy that suits the investor’s personality and
trading philosophy.
Every trading system has parts that need to be specifically researched, tested
and analysed to create a complete trading strategy.
‘Parts of a trading system’ is the outline I use for creating all trading plans.
Every combination of subjective charting tool, fundamental analysis and
mathematical indicator is manually tested before inclusion.
Parts of a trading system:
• Setup conditions:
◊ share — rising trend
• Timing of entry:
◊ RSI ‘alert’
◊ volatility entry signal
• Stops:
◊ initial — below recent low
◊ trailing — volatility trailing stop
• $ management — position sizing.
Each section’s trading rules are carefully detailed before final testing is
complete. Having a trading plan and the discipline to follow it removes the
guesswork from investing. The trading plan should have a course of action
for every price move in a market.
‘Follow the rules’ becomes a mantra. When trading becomes difficult and
indecision appears, repeat the mantra.
Rising trend
The most important selection criterion for trading a security is a ‘rising
trend’ and this is often overlooked by most fundamental analysts. The market
is littered with quality companies whose share prices are falling. The share
price of a healthy, low-risk company can decline for six months or more. By
combining fundamental and technical analysis we can trade the exact same
companies recommended by the fundamental ‘experts’, but when the share
price is in a rising trend.
The first step is to define a rising trend with a set of rules, keeping in mind
that this is subjective analysis. Subjective analysis does not necessarily mean
inferior analysis. It means that there is not a ‘right’ or ‘wrong’ way to define
trends. Each investor will adopt the rules that suit his or her personality and
investing philosophy. All investors experience ‘emotional swings’, and
specific rules eliminate the influence they have on decision-making so that
investors do not trade what they think or feel.
My rising trend rules are:
• always view the weekly chart
• pivot points must show higher highs and higher lows
• there must be a rising moving average
• the price must close above the moving average.
The close above a moving average and the rising moving average only need
to have occurred in the current week.
A rising trend is intact until each of the last three criteria are no longer
present. For example, there is often a lower high and lower low created,
within the rising trend, while prices remain above a rising moving average.
The highs and lows are based on clearly defined pivot points rather than a
series of weekly ranges. The pivot points must be formed over a minimum of
three weeks. For example, after a high is established, a correction of a
minimum of two weeks’ duration is required before prices move to a new
high. There is an exception to this rule, and that is that:
• prices are above a rising moving average
• there is no correction
• the share price has been rising for three months.
There are dozens of different methods used to confirm this pattern. There is
no suggestion that readers need to follow my rules to be successful. This is
an educational exercise to provide a basis for readers to create their own set
of rules to suit their trading style and circumstances.
Let’s take a look at an example.
Figure 11.1 (overleaf) is a weekly chart over a 14-month period. This fulfils
the first of our criteria. A low in March 2009 and a rise to a high in April at
(A) is a pivot point when the following two weeks have an equal or lower
high and a lower low than the low of the week in which (A) was established.
This low could be created in the first two weeks or any subsequent week. In
this case the low was one week later at (B) and confirms point (A) as a pivot
point.
Figure 11.1: weekly chart
Source: chart created using JB Charts with JB Data.
The close above (A) in May (arrow) confirms point (B) as a pivot point.
This chart now has pivot point higher highs and higher lows. The closing
price above a rising moving average signals a rising trend.
Point (C) is a pivot point when the following two weeks have an equal or
lower high and a lower low than the low of the week in which (C) was
established. This low could be created in the first two weeks or any
subsequent week. In this case both lows are lower and this confirms point
(C) as a pivot point. Point (D) is a pivot point when price closes above point
(C) in July (arrow).
Point (E) is a pivot point when the following two weeks have an equal or
lower high and a lower low than the low of the week in which (E) was
established. This low could be created in the first two weeks or any
subsequent week. In this case both lows are lower and this confirms point
(E) as a pivot point. Point (F) is a pivot point when price closes above point
(E) in late October (arrow).
Point (G) is a pivot point when the following two weeks have an equal or
lower high and a lower low than the low of the week in which (G) was
established. This low could be created in the first two weeks or any
subsequent week. In this case both lows are lower and this confirms point
(G) as a pivot point. Point (H) is a pivot point when price closes above point
(G) in early December (arrow).
Point (I) is a pivot point when the following two weeks have an equal or
lower high and a lower low than the low of the week in which (I) was
established. This low could be created in the first two weeks or any
subsequent week. In this case the low was two weeks later and this confirms
point (I) as a pivot point. Point (J) will be confirmed as a pivot point if there
is a closing price above point (I).
Oversold ‘alert’ signal
When I have identified a security in a rising trend on a weekly chart I switch
to a daily chart and look for temporary oversold conditions. This is done
with another common indicator called the relative strength indicator (RSI).
RSI compares the average of rising price changes to falling price changes,
and I use a seven-day time period. RSI is an oscillator with a number
between 0 and 100, and I put it on the chart in an inner window, as shown in
figure 11.2.
Figure 11.2: technology ETF daily chart
Source: chart created using JB Charts with JB Data.
When the RSI oscillator drops below 31 it indicates the security is
potentially oversold. RSI oversold is not a buy signal but simply ‘alerts’ me
to the possibility that the current correction is finished. This occurred on two
occasions with the oversold ‘alert’ areas shown on the chart. I am now
prepared to buy shares in this security once prices resume rising. I will
always miss the beginning of every move as I will only enter the market after
the security’s price reaches the temporary oversold area and then continues
with the rising trend.
Volatility indicators
Many traders use volatility indicators to help determine a direction, strength
and momentum. One of the most popular volatility indicators is average true
range (ATR). ATR measures volatility by averaging price ranges over a set
time period while taking into account price gaps.
The true range indicator is defined as the greatest of the following for each
period:
• the distance from today’s high to today’s low
• the distance from yesterday’s close to today’s high
• the distance from yesterday’s close to today’s low.
The average true range is the average of the true ranges over the past x
periods, where x is specified by the user. ATR is available in most good
software packages.
The most common analysis of ATR volatility would focus on volatility at
tops and bottoms and during price consolidation and retracements, but
combining ATR in a few simple formulas will help traders target specific
price areas for entry signals, trailing stops and profit-taking opportunities.
My ATR volatility analysis is applied only to securities that are in a rising
trend, as this is the path of least resistance. I want to buy securities that are
rising and sell them when they are no longer in a rising trend.
My entry trigger occurs when the closing price has moved the distance from
the recent low equivalent to two times the average true range of the last 10
days. I have programmed my software package to paint the bars blue once
this criteria is met and to paint the bars red when the closing price has moved
the distance from the recent high equivalent to two times the average true
range of the last 10 days.
Figure 11.3 shows the RSI oversold areas and the corresponding blue bar
volatility entry levels (arrows).
Figure 11.3: technology ETF daily chart
Source: chart created using JB Charts with JB Data.
Here’s an example:
• ATR over the previous 10 days is 45¢
• 2 × 45¢ = 90¢
• the recent low is $20.50
• $20.50 + 90¢ = $21.40.
If the closing price is $21.40 or higher the price bar will turn blue, signalling
a volatility entry.
My initial stop is just under the recent low, but once prices continue to rise I
use a volatility trailing stop. I exit the position after two consecutive closes
below the trailing stop. The stop is two times the ATR subtracted from the
close.
This indicator rises and falls with the level of volatility and higher or lower
closing prices. I never want to lower the trailing stop so adjust the formula to
stay at the highest level reached for a period of 15 days or weeks, depending
on the chart time frame.
Figure 11.4 (overleaf) is a daily chart showing the volatility trailing stop.
Figure 11.4: technology ETF daily chart
Source: chart created using JB Charts with JB Data.
Where to enter and exit a trade are vitally important components of a
successful trading system. Beginning investors often struggle with developing
a disciplined and consistent strategy. Volatility can help investors set specific
entries, trailing stops and profit-taking opportunities. Choosing these points
at random, on what the investor thinks at that moment, is fraught with danger.
Beginning investors might believe they are using commonsense when they are
more likely trading what they feel. If you trade what you feel you will lose
your money as your emotions will rise and fall with the value of your trading
positions. Fear, greed and denial are not the investment tools we want to use
in a disciplined investment strategy. Volatility entries and exits help maintain
the discipline necessary to become a successful investor.
Beginning traders must be aware of the strengths and weaknesses of both
technical and fundamental analysis. Combining the strengths of each
discipline is a commonsense approach to investing that will enable investors
to achieve greater control over their investment portfolios.
Chapter 12: The psychology of
success
Taking control of your trading and your life
Dr Harry Stanton
Charles is making a mess of his trading and his life. His stress level is high
as he responds with anxiety to even the simplest demands made upon him. He
is irritable and oversensitive, sleeping poorly and is bad-tempered with his
wife and children. Nothing they do pleases him, so he is constantly criticising
them. Naturally things are very strained around the house. Also, as one would
expect, Charles is trading very poorly, making bad decisions, losing money
and, accordingly, becomes even more stressed and difficult to live with. He
thinks in negative, miserable ways, seeing the worst possible outcome of
everything he does, so he expects to fail both in his trading and his life more
generally.
Trading is just one aspect of a person’s life but if we do not have our lives
running relatively smoothly we cannot really expect to trade successfully. In
this chapter I shall outline some of the methods I have used to help people
gain more control over their lives. As they gain this control, their trading
performance improves markedly. This improvement, therefore, does not
occur in isolation but as an integral part of a change in the way life is lived.
So let’s look at some of the approaches you can use to make such a change.
Taking control of your life
I think most of us would like to be more in control of our trading. Even more,
we would like to have more control over our lives. After many years of
conducting a therapy practice as a clinical psychologist I believe there is a
way of achieving this control, one that is quite simple though it does require
self-discipline. We need to live one day at a time. I know this sounds so
obvious that it should hardly be worth mentioning but, be that as it may, very
few people actually do live one day at a time. Rather they live in the past,
obsessed with regrets about things they have done and opportunities they
have overlooked or, more commonly, live in the future worrying about things
that will probably never happen. Apparently, the main cause of stress in
people’s lives is worrying about things they fear will happen in the future. A
little experiment will make the futility of this behaviour very clear. Ask
people what it is they are most worried about happening in the next 12
months. Then, after expiry of the 12-month period, ask them whether the thing
about which they were so worried had actually occurred. Probably less than
2 per cent of these things will have actually happened.
So, to gain more control over your life, create the habit of, when you wake in
the morning, accepting the gift of a new start, a new life. Then, think of
something for which you are grateful. This will trigger further pleasant
thoughts, a marked contrast to what most of us do on awakening, when our
first thought is usually something about which we are worried. This blends
into other negative thoughts and we virtually mess up our day before we even
get out of bed.
The next step is to get rid of the things you no longer wish to have in your
life. Imagine you are removing unwanted memories, fears, doubts, worries,
guilts and so on by:
• dumping them down a bottomless chute from which nothing returns
• burning them on a fire
• using quicksand to swallow them forever.
It doesn’t matter what particular imagery you use as long as it makes sense to
you as a means of getting rid of the rubbish with which we usually clog up
our minds.
Then imagine you are going into some place where you feel totally safe,
happy, content and peaceful. This could be somewhere from your childhood,
a make-believe place, a comfortable emptiness, a beach, a garden, a
beautiful room or a warm bed. In this place, show your mind the way you
want your life to be. So, for one day, you can achieve anything. You then start
with a fresh start the next day.
Taking control of your trading
When you wake in the morning, think of it as a new beginning. Think of
something relating to your trading for which you are grateful. Someone, for
example, might have suggested to you a way of analysing charts which led to
useful insights. Then dump losing trades, fears about trading and self-doubt
down the chute or in the quicksand. Finally, in your special place, imagine
yourself analysing a chart, deciding on a trade, and seeing it work out just as
you wanted, producing a substantial profit. Imagining your broker’s statement
showing the credit entry would complete the success scenario.
This is what is so important. Our unconscious mind does not think for itself
but works on what we give it. Too often we give it failure. We think of past
losing trades, and fear taking the present trade in case it is a loser too. Using
the mind control method I’ve outlined here you can change this, encouraging
your unconscious mind to accept success as your usual mode of behaviour.
Remaking the event
Another way of feeding success into your unconscious mind is to use a
technique which I call ‘remaking the event’. Some years ago I was asked to
conduct a couple of sessions for the state women’s basketball team. They had
not won a match in a season and a half so I couldn’t do any worse than that.
Actually, for the final five games, they won three and lost narrowly to the two
top teams. What they felt had helped them most was this ‘remaking the event’
approach.
Previously, after a match and after practice, the women used to sit round and
criticise each other for the mistakes they had made. Instead of this, I had them
spend about 10 minutes after practice, and after a match, sitting quietly and
identifying four good plays and four mistakes. These were not shared with
teammates but, instead, individually they started with one of the good plays
and imagined themselves repeating this play six more times. They did this
with each of the good plays. They then thought of one of the mistakes, wiped
it out of their minds as if they were wiping it off a blackboard, and imagined
themselves, six times, making the play they would have preferred to make. In
this way they fed success, success, success into their unconscious minds.
For traders, it would be useful if, as soon as possible after they did
something well, they repeated this mentally half a dozen times. Conversely,
after they made a mistake, they would do well to wipe it off the blackboard
of their minds and redo it the way they would have preferred to do it. This
approach could be applied very effectively to completed trades but also to
the way in which the trade was managed, particularly as regards entry and
exit.
Remaking the day
To gain increased control over our minds, a simple extension of this
technique can produce very impressive results. Each evening, set aside five
or 10 minutes to reprogram your day. Think of three or four things you did
well during the day. This might be as simple as saying something that made
another person feel good. It could well be thinking back over the successful
management of a trade. Take each of these, one at a time, and repeat each one
six times in your mind. Then think of three or four things you would have
liked to have done differently and go ahead and do them differently in your
imagination.
The procedure can be made more powerful by preparing the mind to accept
suggestion more deeply than would normally be the case. A simple way of
doing this is to imagine you have a scale in your mind, ranging from 10,
which would be the most anxious you could imagine being, to zero, which is
total peace within yourself. Close your eyes and look up into your mind and
you will see a number there. That is where you are at the moment. The higher
the number the more anxious you would be feeling, and the lower the number
the more relaxed you would be. Now the number you see is the number you
feel, so watch as the numbers and your feelings change. If you found the
number seven in your mind, you would see it changing into a six, then a five,
straightening into a four, and curling into a three.
Then, almost before you realise it, you would become aware of a beautiful
white swan, gliding along smoothly, effortless and graceful. The graceful
curve of the swan’s neck could remind you of a two, and, as you mentally
watched the swan, you could imagine its neck straightening out and becoming
a one. As you ‘saw’ the one it would take on the shape of a candle and the
candle flame could be very soothing. The sides of the candle would then
bulge out as it became a zero. This is a level of peace and stillness, the zero
expanding until it became a cocoon of calmness and safety around you. In this
cocoon, which shuts out all distraction, you could rest quietly while you
‘remade your day.’ The cocoon may also be used when you remake a single
event, either to reinforce something positive or remake something negative.
This technique, and others like it, is very helpful to the four very important
factors that contribute to success in any activity you undertake. I call these the
‘four Cs’: confidence, concentration, calmness and consistency. Originally, it
was in the sporting sphere that I combined these factors into a powerful
psychological pattern to improve performance. However, the pattern can be
equally successful for traders.
Confidence
Confidence underlies virtually every successful endeavour in life. We have
to believe we can accomplish whatever goal we have set ourselves. This
means we must condition our minds to success rather than failure. One way
of doing so is to make use of a ‘success videotape’.
Ray is a basketball player. He mentally strings together a succession of
winning plays, imagining clean baskets shot from the floor and from the foul
line, excellent assists and effective blocking of his opponents’ attempts to get
under the basket. He imagines himself performing superbly well under
pressure and winning matches. Ray runs this success videotape through his
mind when he mentally prepares himself for his next match.
This concept may be used for any aspect of a person’s life. When I conduct
seminars and workshops on helping participants live their lives more
positively, I sometimes begin by asking them to remember a success
experience and a failure experience. Normally, they have no trouble thinking
of failures, but many have great difficulty remembering a success. Yet when I
have participants share their experiences, those who were unable to
remember a success listened to others and then said that these things had
happened to them too but they had not really thought of them as successes. In
other words, it seems easier for us to remember the negative, the failures,
rather than the positive, the successes.
Creating a success videotape can overcome this tendency, helping people to
think of themselves in more positive ways.
Traders can use this approach to help them become more confident. When
traders lose confidence in their ability to identify winning trades, it is helpful
for them to access their success videotape. In this way they can bring vividly
alive previous successes, providing a basis for a more confident approach to
the current trade. We are often told to force negative thoughts out of our
minds, or to make our minds a blank. Such advice is well intentioned but
useless as most people cannot do either of these things. However, in addition
to using the success videotape, there is another very simple way to change
negative thinking.
Whenever a negative thought — and for traders this usually involves the fear
of failure — comes to mind, use it as a trigger to think of something positive.
For the trader, this will be related to a successful trade or a profitable
broker’s statement. Whereas the success videotape involves a continuous
loop of positive experiences, this idea of using a negative thought to trigger a
positive one is a stand-alone process. It can be linked effectively to a
procedure I call the ‘jewel box’.
Every time you have a really good, positive experience, or remember
something that gives you great pleasure, think of it as a jewel. You then place
this in a jewel box located in your mind. When a negative thought comes
along that is bothering you, open your jewel box, take out a positive
experience and enjoy thinking about it. Do this and you cannot be beaten.
When something positive comes along, enjoy thinking about it. When
something negative turns up, welcome it as an opportunity to enjoy the fruits
of your jewel box.
By behaving in this way you draw upon the resources of the past. Another
way of doing so is to create a ‘resource state’. This involves remembering a
time in your life when you accomplished something really well. Reactivate
this in your mind, what you would have seen, heard and felt. For traders, you
could think of a winning trade, one in which you did everything right. You
would have made an excellent entry based on a thorough chart analysis,
managed the trade carefully, and exited in a way that produced a big profit.
This is your resource state. As you relive this trade in your mind, link it to a
physical ‘anchor.’ This might be something like pulling an earlobe or
clenching your dominant hand into a fist. Do this several times, making the
link between the success experience that you are imagining and the physical
action. Then, in the future, when preparing to look at the markets in search of
a good trade, pull your earlobe or clench your fist in order to tap into the
resource state and create within yourself a feeling of confidence. The more
you do this the more powerful becomes this means of increasing your selfconfidence.
Concentration
Concentration is the second of the four Cs.
Judy is a tennis player. When she enters the dressing room before a match,
she commences her concentration ritual. As she takes off each of her street
clothes, she is taking off tension, stress, idle thinking. As she puts on her
tennis togs she is putting on strength, skill and power. The final action is to
tighten her shoelaces, this being her way of tightening her concentration, her
total focus on the task at hand.
Similarly, the trader would set up a comparable sequence of actions. John
has a room set aside for his trading activities. This is where he has a desk, a
computer, a printer and a telephone. As he approaches this room, he starts
tightening up his concentration, focusing on the doorway. His focus narrows
further as he enters the room and moves towards his desk. Now his
concentration is upon the computer as he settles himself in his chair. At this
point he creates his ‘concentration bubble’.
A concentration bubble is an area that people can create around themselves
which blocks out all distraction, pressure, stress. One of the ways of
generating such a bubble is to imagine you are breathing out calmness which
creates a wall of calm in front of you. As you continue to breathe out
calmness you create similar walls to your right, left and behind you. You then
add a ceiling of calm or turn your area into a dome or a bubble of some sort.
The walls of the area can be opaque or transparent, whatever you wish, but
they are made of sufficient thickness to block out anything that could impinge
on your feeling of calm and safety. Within this area you are able to
concentrate with an intensity not normally available to you because nothing
will be able to interfere with your focus.
Another way of creating this concentration space is to use the zero-to-10
scale I described earlier. Margaret has trouble concentrating, particularly
upon her trading. To make use of the scale and prepare herself to analyse her
charts, she watches the numbers in her mind change until she reaches the
cocoon of total peacefulness. This insulates Margaret from anything that
might interfere with her state of calm, permitting a total, concentrated focus
upon her trading procedures.
Calmness
The peacefulness of the cocoon is one way of achieving a state of calmness,
the third of the four Cs. Another is to use a relaxation technique that has been
with us for centuries, one that is so simple yet so effective. It involves
watching yourself breathe. This does not mean attempting to alter your breath
in any way but simply becoming interested in the way it flows in and out of
your body. In other words, you become fascinated by the natural flow of your
own breathing, watching it the way you would watch someone else breathing.
By doing so, you will find that quite automatically your breathing will slow
down and become deeper, permitting your mind and body to attain a state of
great calmness.
For many people, this watching of the breath is all they need to do to turn off
tension and stress. For others, who find this technique does not create the
sense of calm they seek, there is an addition that may be more effective. As
you watch your breath flowing in, imagine it is drawing into your mind the
number one. As you breathe out, imagine this number one is going down into
your body centre which is just below your navel. Then draw in the number
two and continue the sequence until you reach 10. If you wish you can do
another set of 10 or as many sets as you wish. Should you lose count, begin
again at one.
Using this approach carries with it three great benefits. Firstly, watching the
breath flowing in and out, without attempting to change the rhythm, is very
relaxing in itself. Secondly, counting has always been seen as a way of
calming oneself. When we are becoming upset, we are often advised to count
to 10 before giving vent to our feelings and perhaps saying something we
would later regret. Thirdly, shifting the mental focus from the mind to the
body centre allows the mind to become more settled, more peaceful.
There are many other ways of creating a sense of calmness, of feeling at
peace with the world, and such a feeling is of immense benefit to the trader.
Attempting to make decisions while upset, anxious or stressed is a sure path
to disaster. However, by calming yourself before making such decisions, you
are more likely to see what is actually before you rather than what you want
to see.
When you are calm, it is easier to detach. That is, rather than being bound up
in the mechanics of chart analysis and trade management, you can separate
yourself from what you are doing. Such separation has been described as
watching yourself trade as if you were over the other side of the room, seeing
this person, you, at your computer making decisions. This detachment is
virtually impossible unless you are feeling calm, otherwise your anxiety and
tension interfere with the process.
Consistency
To put yourself in this state of separation, it is necessary to establish a set
routine. This is true for any activity. Consider Gary, a lawn bowler. Every
time he puts down a bowl he does exactly the same thing, going through the
same set of behaviours in the same order. He picks up his bowl, checks the
bias, estimates the length at which he needs to bowl, focuses on his aiming
point, and delivers the bowl in the same way every time.
When he settles down to trade, he once again goes through the same sequence
of behaviours. He uses the calming technique I’ve outlined previously and,
once he has attained the appropriate level of detachment, he studies his charts
in a set order, always uses the same indicators, and makes his trading
decisions based on this study in the identical way each time. He uses a
mechanical system to provide his entry and exit points.
By so doing he is able to exclude the emotional element that is the downfall
of most traders.
Employment of a mechanical trading system is the best way to achieve the
consistency of approach that is the mark of a successful trader. Without such
a system, we are constantly second-guessing our decisions, changing stoploss positions and worrying about whether we should or shouldn’t take
action during the course of the trade. When we have mechanically set entries
and exits, the three great negative forces of fear, greed and hope are
eliminated. We simply do what the system says to do without vacillating back
and forth. Thus we can achieve the consistency that is the fourth element of
the four Cs. Having a consistent approach to problem-solving can help a lot
too.
Problem-solving
Very large text books have been devoted to problem-solving. Elaborate
business management courses purport to teach this skill. There is, however, a
rather simple model outlined by neuro-linguistic programmers that I have
found to be consistently successful in helping people identify and solve their
problems. In my practice as a clinical psychologist I use this model to
quickly focus on a patient’s needs. Firstly I find out the patient’s present
situation. Then I ascertain how this person would like his or her life to be.
We then explore what stops the patient achieving this, and develop a plan
aimed at making the necessary changes. The final step in the problem-solving
model is to check whether the action plan is actually achieving what the
patient wants.
To gather the information needed for this model, it is necessary to ask a few
key questions. The first of these is: what do you have now? The answer to
this question establishes the patient’s present state. If it was a trader, Debra,
who was consulting me, her answer might be that she was making too many
losing trades and too few winning trades.
The second question is: what do you want to have? This enables me to
ascertain where the patient wants to be. In Debra’s case, this would probably
be that she would want to be on the winning side of the ledger, her winning
trades being considerably more numerous than her losers.
The third question is: what stops you getting what you want? With most
patients, although there may be financial constraints, the main reasons they
are not getting what they want is the attitude they have to life, thinking in
negative ways, filling their minds with what they don’t want rather than what
they do want. For Debra, she might well be paralysed by the memory of past
losses so that when a sound trading opportunity comes up she is unable to
pull the trigger.
Next I ask: what do you need to do to get what you want? This is when I
explore with patients ways they consider likely to solve their problem. Often,
they may have no idea about this so we would look at various approaches
other patients have used to achieve their goals. Debra, in this context, would
perhaps consider using a mechanical trading system if she had not been doing
so in the past. Or she might look at using an advisory service which seemed
to get reasonably good results.
Finally, I would ask: how would you know you are getting what you want?
Patients would establish a set of criteria defining a successful solution to
their problem. In Debra’s case, this might be as clear cut as showing any sort
of trading profit. Or perhaps she would specify a minimum profit figure.
This problem-solving model, and the other psychological techniques I have
outlined earlier in this chapter, all depend upon a person’s willingness to
change the way he or she thinks. This may not be easy, necessitating a deeper
look into ourselves.
The investigation of the self
The investigation of the self involves awareness, motivation, discipline and
direction. Before we can modify our behaviour in any way we need to have
an awareness of what we are actually like. If we are unaware that we are
sabotaging our trading through our fear or greed, there is no chance that we
will be able to overcome those characteristics. However, if we realise that
our fear of losing is preventing us trading profitably, we may be able to do
something about it. Interestingly enough, if we do become sufficiently selfaware, we will probably detect the same fear of failure in other aspects of
our lives.
As I have mentioned earlier, probably the best way of overcoming the fear
aspect in trading is to stick to a proven mechanical system. When the system
indicates an entry point, just do it without second-guessing. When it indicates
an exit point, get out of the trade. For doing something about the more general
fear of failure, a mental technique designed to engender a sense of confidence
can be of great value.
Imagine your mind as a pond with the surface of the water totally still, as if it
was glass. Above the water is the conscious part of your mind, that part you
use when you think, plan, reason and work things out. Below the water is the
unconscious mind, which really only works on the information you feed it.
Imagine you have a small stone, one that you might find washed up on a
beach or, perhaps, a precious stone such as a diamond, a ruby, an emerald or
a sapphire. This is the stone of confidence which you drop into the pond of
your mind. Down and down it sinks until it comes to rest on the floor of the
pond and your mind locks around it. Somewhere deep within you is the warm
glow of confidence spreading to every cell of your mind and body. This
confidence is permanently yours, growing within you every day, every week
and every month. It is a confidence in the person you are, in your value as a
human being, in your talents, strengths and abilities, and in your ability to
change in any way you want to.
Once we are reasonably well aware of what we are like and have, perhaps,
identified some aspect of our personality that is interfering with our
enjoyment of life or, more specifically, our trading performance, then we
need to become self-motivated. This is the drive to make the change or
changes that will enable us to overcome the weaknesses we have identified.
Without the motivation to change, nothing is going to happen. Sometimes
there are outside forces that can influence us in this regard but, usually, we
have to generate from within ourselves the power to get us moving in the
direction of change.
One of the ways of doing so is through using the resource state I mentioned
earlier. This entails mentally going back to a time when you were very
successful at achieving something of value to you. This you revive in
pictures, sounds and feelings, and link to the state with a physical anchor like
clenching your fist.
You can also do it by imagining yourself acting in the way you wish to act. If
you are prone to making rash trading judgements, you might motivate yourself
to be more patient by adding an additional filter to your decision-making.
You might analyse your charts in the evening after the markets have closed,
making your normal quick decision on the action to be taken the next day.
However, before you take this action, the next morning analyse your charts
again without making any reference to the decision of the previous evening. If
you come to the same decision again, it would seem reasonable to take
action. If your morning analysis does not coincide with that of the first
analysis, it would seem prudent to avoid the trade.
This is where self-discipline becomes so important. Without this, we are
unlikely to succeed as traders or to succeed in life more generally. Selfdiscipline is closely related to taking personal responsibility for our actions,
something many of us find very difficult to do. When something goes wrong,
it is always the fault of someone else. That is why a cynic once said that the
main reason for getting married is to have someone to blame. If you make a
losing trade the fault is usually yours and it reveals a real lack of selfdiscipline to blame the broker or the economist for misleading you. After all,
the broker is a salesperson, not an investment expert, and economists have an
abysmal record for predicting sharemarket movements.
Self-discipline means taking more control over the thoughts we allow to
occupy our minds. Apparently we have more than 65 000 thoughts every day,
generated by the random firing of our brain cells. The pursuit of the mental
discipline called mindfulness teaches us to watch this flow of thoughts rather
than becoming involved with them indiscriminately. We can choose to focus
on particular thoughts and make them our own. However, it is all too
common for people to focus on the negative, allowing such thoughts to
establish a dominant place in their minds. Discipline is needed to reject such
thinking and choose to focus on the positive, the helpful and the optimistic.
Exerting self-discipline to control the way we think enables us to select a
mode of thinking which recognises opportunities rather than finds reasons to
close ourselves off from these. It also enables us to more effectively set a
successful future course for ourselves. This is the process of self-direction.
Human beings seem to need a sense of purpose if they are to accomplish
anything worthwhile. In his book Man’s Search for Meaning, Viktor Frankl
maintained that there was no meaning in life other than that we put into it
ourselves. In the therapeutic model he developed, termed logotherapy, he
encouraged people to set goals for themselves each day so they gained a
sense of purpose, and also achieved a sense of satisfaction as they crossed
each of the day’s tasks off their list. In fact it comes back to a point I made
earlier, that taking each day as a fresh start in which you set specific tasks for
yourself is an excellent way of taking more control over your life.
Gavin, a part-time trader, follows this pattern. Each day he sets himself a
learning task such as gaining more information about a technical indicator
such as the moving average convergence divergence. He stays with this goal
until he feels he can use the indicator to help him trade more profitably. He
then sets himself another task, maybe another indicator or going back over
losing trades to identify where he has gone wrong. Irrespective of what goal
he does set for himself, Gavin approaches every day in a focused manner.
Each evening he decides what his goal or goals will be for the following day
and he works on these, in order of importance. So each day he knows exactly
where his energies will be directed. These might be a continuation of what
he has been working on, or something new.
Final thoughts
By using the techniques I have outlined in this chapter the trader will not only
be able to trade more successfully but will be able to enhance many other
areas of his or her life. It would appear that we use relatively little of our
mental power and anything that enables us to use our minds more effectively
is of immense value. I hope that you, the reader, will be able to find at least a
few ideas in this chapter that will be very helpful for the rest of your lives
and enable you to increase your trading profitability.
Chapter 13: Mentality matters
Avoiding the stress trap
Glen Larson
A couple of the biggest challenges for traders are taking losses and
overtrading. I was contemplating these challenges over the last few weeks
and was reminded of a stress and decision-making study.
‘Ulcers in Executive Monkeys’ and your
trading
For those who have attended Larry Williams seminars, you may have heard
him mention the Executive Monkey study and how it relates to trading.
That study has always interested me. It shows me how we can become better
traders and how this relates to our own behaviour as traders. Before moving
ahead, let me explain that monkey study.
In 1958 James Brady and Robert Porter published an article titled ‘Ulcers in
Executive Monkeys’ in Scientific American. The experiment placed two
monkeys in separate cages. These cages were constructed so that both
monkeys were randomly shocked with electrical current. (Before anyone
writes and complains about me not being sensitive, let me assure you that I
do not condone this treatment.) A red light signalled that the shock period
was commencing. One monkey could stop the electrical current for both
monkeys if it pushed a lever. The second monkey had no control over the
electrical shock at all. According to the second monkey’s point of reference,
it was being randomly shocked but had no control over it and had no
decisions to make. The monkey trying to stop the electrical shock (making
decisions) ultimately developed ulcers and died. The monkey not controlling
the shock or making decisions about being shocked (although being randomly
shocked) remained healthy.
I should note that up until that time there was no real proof that anything
besides bacteria or viruses could cause diseases. This was one of the first
experimental results that showed the impact of stress. There were finally
actual ‘numbers’ to describe the effect of decisions and stress upon one’s
health.
It’s also interesting to note that some authoritarians then deduced that the act
of making decisions was the source of the stress. They reasoned that since
decision-making caused stress, executives that made these decisions were
under more stress than the general workers. According to this reasoning,
these decision-makers then deserved higher compensation.
This was the general opinion until a study in 1970 by Jay Weiss put a new
light on decision-making and stress. This study was considered a more
complete study that showed under most circumstances making decisions is
actually good for us!
You’re now saying, ‘Wait, I thought you just said that making decisions was
bad for us, bad for our health, stressful?’
I did. However, I learned something new. I gained a better insight into how
you can make decisions as traders and still be healthy, not stressed and
possibly even more profitable.
The main difference between the Brady and the Weiss studies was that the
Weiss monkeys were given a warning alarm that a shock was coming. When
alerted, the monkeys could push a lever that not only prevented the electrical
shock but also silenced the alarm. They were given feedback to their
decisions.
The monkeys involved in the Weiss study were able to cope with the stress
and did not develop the ulcers or declining health that the Brady monkeys
did. The Weiss monkeys learned they could control their situation. The Brady
monkeys, on the other hand, felt little to no control.
What we can conclude from this is that pressure to perform with little to no
feedback or feeling no control was the probable cause of the health problems
that the Brady monkeys developed.
Weiss later repeated the monkey experiment using rats in place of the
monkeys. These animals had to respond approximately every 20 seconds.
These animals developed large stomach ulcers just like the Brady monkeys
did, despite the fact that they were warned.
Weiss varied the experiment by spacing the decisions to one minute or
greater. Weiss found that when the rats had to make fewer decisions, the
number of ulcers the rats developed was reduced.
What can we learn from this as traders?
For me, I learned a lot. Think about it. These studies would suggest that being
in control of the decisions is a good thing if we can reduce the number of
decision points (take time off in between our decisions). How might this
apply to us as traders? First we need to recognise that our trading
environment in many ways is very similar to the conditions created for the
rats and monkeys. We know that a challenge is coming in the next trade
(coming electrical shock). We are making a decision based on our system,
we trade, and we get immediate feedback on our decision. Sometimes we
experience either a positive or a painful result.
Brady’s monkeys didn’t know if their decisions were correct or not. The
Weiss monkeys received close to immediate feedback, quickly confirming the
outcome of their decisions. Remember, the animals that received and acted
upon feedback remained healthy.
We too may be unknowingly creating trading conditions like the Brady stress
study or the Weiss stress study and getting similar outcomes!
What do I mean? Consider these two points.
The Weiss experiments show us that time is a key to controlling stress, along
with getting and following immediate feedback. Brady showed rapid
decisions, little time between decisions and little feedback caused massive
health problems for the animals.
If you’ve been feeling burned out from trading, experiencing stomach acid
problems, feeling overwhelmed or depressed with your trading, you might
just have created these experimental conditions and not even realised it. You
may be experiencing the same results the monkeys did!
So, you have to ask yourself, as a trader, are you creating the Brady study
conditions by:
• high-frequency day trading (in and out of the market all day)
• not following any clear, consistent rules or trading system
• randomly following your gut, randomly overriding your system due to
‘whatever’
• entering a trade and immediately suffering a loss but ignoring your stops
and letting it ride
• suffering losses yet never reviewing your trades
• hoping this trade is in the right place, the right time and guessing
• ignoring money management guidelines and rules.
Do you see how much this trading behaviour looks like the Brady study
where the monkeys developed ulcers and died?
So what would the Weiss study conditions be for a trader? Pretty much the
opposite of what I’ve listed. Yes, I know you probably already know that you
should get a system, trade that system, use stops and review your trades, and
probably reduce the amount of your trades, but are you doing it?
As the saying goes, ‘We know what to do, but are we doing what we know?’
At the end of the day we all need to look at our trading to determine if our
trading conditions are creating a Brady study or a Weiss study. Hopefully
you’ll realise that making trading decisions is great for you under the right
conditions. Under the wrong conditions it could be a setup for failure, stressrelated illness, even possible death.
We will never eliminate losing trades, never eliminate the shocks. We need
to understand that we will continue to experience these ‘electrical shocks’
(losses). But we won’t experience much harm to our systems if we take time
between shocks to monitor ourselves, respond to the feedback we receive
and act accordingly. We can and should apply this to our whole lifestyle, not
just trading.
Remember, being in control and making informed decisions is what makes
healthy rats, monkeys and traders.
Now that you are aware of stress, health and trading, let me add the last
piece to this puzzle.
‘Grasshopper’ and your trading
Previously, I discussed the impact frequent trading has on us and compared it
to the health of test rats. I did some pondering on the subject of why the stress
of frequent decisions was such a big influence. As a result I did some more
research and came across a couple more interesting studies …
Growing up, there was a weekly TV show with David Carradine called
Kung Fu. It captivated my attention and I wouldn’t miss it. For those who are
not old-timers, this is the show where an American orphan is raised in a
Shaolin monastery. During his youth he is constantly referred to as
‘Grasshopper’ by his mentor. He leaves the monastery and begins wandering
the Wild West. It captivated me that no matter what was going on around him,
this Grasshopper was able to remain calm, even while kicking the bad guys’
butts using his mastered (and really cool) kung-fu. How cool would it be to
kick butt and stay calm?
I have often wondered how these monks remain controlled and aware even in
the midst of such chaos. How can anyone remain calm and relaxed in this
world so full of turmoil?
We’ve already learned that the ability to stay calm and not stressed is not
only good for your health but your trading. That is a skill traders would do
well to master.
Science has discovered that the brain emits brainwaves throughout the day.
Various wave frequencies are emitted based on brain activity. In the early
’70s researchers found that people who were relaxed emitted what is called
the alpha wave. They found that if higher amounts of alpha waves were being
produced, the more relaxed and calm the person was
This set off the whole industry of biofeedback training. People started trying
to reach relaxed states by controlling their mind through biofeedback
machines. You probably saw some of the wacky machines and
advertisements. It also created numerous seminars on how to meditate to
reach a calm state.
About this time a group tried having people just lie down on the floor, get
comfortable and do nothing. They found these people were reaching about the
same level of alpha wave production as those trained in using biofeedback
machines.
Isn’t it interesting to note that people who had just laid down on the floor and
did nothing — no meditation and no biofeedback machine — reached that
same alpha state? They also found that the people lying down and doing
nothing achieved the same results as those performing more traditional
meditation as well.
It turns out that the alpha emissions are produced when your eyes are relaxed.
Close your eyes, let your eyes relax and don’t imagine pictures. Doing this
you will begin producing alpha waves a high percentage of the time. This is
why people simply lying on the floor doing nothing produced alpha waves
just as those in standard meditation or those using biofeedback machines.
Now am I saying biofeedback machines or standard meditation are not
valuable or should be eschewed? No, but I do think as traders we can learn
something here to greatly improve our trading.
You have to ask, what is the difference between simply laying down doing
nothing, normal mediation and monk Zen mediation? Since they are achieving
similar results, what do they share in common?
Most standard meditations have to be in a quiet, dark room to shut out any
noise and distractions. Monks, on the other hand, do not shut out the outside
influences. They simply recognise them, but don’t try to change them. They
let them be, they do nothing. People laying down, doing nothing also let
things be. See the commonality?
Researches then thought they were teaching people to produce alpha waves
by biofeedback but were actually just teaching the participants to get
comfortable and do nothing. Standard meditation is teaching people to get
comfortable, breathe deeply, clear the mind and do nothing.
Probably the Zen monks produce alpha waves by just ‘letting it be’;
accepting the world and conditions as they are. Of course they have had
years of training to let it be, but their approach can help you in reaching the
high alpha state.
How then can we use what researchers have learned from studies, monks and
standard meditation to help us with our trading? Here is my opinion from
what I have learned from research, from attending seminars and evaluating
these various meditation methods:
• do nothing
• everything can wait
• just lie there, get comfortable and do nothing at all.
Studies have shown that after weeks of trying various methods, relaxation
can become simpler and quicker through practice of stopping. So that’s the
secret, just stopping. Do nothing.
Researchers found that people were able to relax when they rested their arms
and hands in their laps. When they rested them on the table, it took longer to
relax and some never were able to relax their shoulders and forearms.
Different postures also had different relaxation success rates and it varied
according to the individual. They discovered that once a beneficial posture
has been previously identified by the doer, relaxation is then achieved more
quickly in the future.
These differences are like those who can sleep anywhere and anytime and
those that need dark rooms and no noise, or ambient noise.
That’s why some people are sore and tired from work and trading and others
are not. People who have learned to relax quickly benefit from short and
natural breaks throughout the day.
Now how do you integrate this into your daily work and trading day? How
do you manage the demands of the day and learn how to stop? How can we
start ‘stopping’.
To focus on relaxation is to tackle the problem from the wrong end. I heard
David Brown in a talk share this bit of wisdom:
To stop, you need to feel that you have finished. Feel that there’s
nothing that needs to be done. Relaxation is the natural reward for
finishing. If you don’t finish, you can’t relax.
That’s why the monkeys from the stress test developed bad health. They
never were able to finish. They always had to be looking for the light to
come on. They couldn’t stop.
That’s why day traders have a harder time if they are trading 20 to 30 times a
day. They don’t get to finish and relax in between trades. They can’t stop.
So back to my three ideas to reach a relaxed state:
• do nothing
• everything can wait
• just lie there, get comfortable and do nothing at all.
By recognising everything can wait, you stop. Getting comfortable and taking
time out gets you in a relaxed state. You may not be able to lie down, but you
can shut your eyes, relax your eyes, put your hands in your lap and think of
nothing. Doing this throughout the day will reduce your stress.
Less stress produces clearer thinking, relaxed muscles and more enjoyment
or contentment in life.
My challenge for you is to try the three ideas during your working or trading
day. Leave the trading at your trading desk or trading location. Take time, rest
your hands in your lap, do nothing in your mind and remember everything can
wait for at least five minutes at the beginning and end of each day. It wouldn’t
hurt to listen to the Beatles song ‘Let It Be’ (even sing along, we won’t tell).
Good trading.
Chapter 14: Of motorbikes and
trading types
Exploring the parallels
Guy Bower
I recently began working with Propex Derivatives, a proprietary trading
business. For those that do not know, a proprietary trader trades with the
company’s internal funds and within certain guidelines and limits set by the
management.
While putting together some training material for some new traders, I started
thinking back to my time racing motorcycles.
I started racing after several years of riding road bikes and just being fed up
with those annoying speed limit signs. At first it was just a paid track day
once in a while. A track day is where for a small fee you get to go out on the
track and pretend you are far better at it than you actually are.
Over a short space of time, my interest and involvement grew from just a few
track days here and there to sitting on a complete racing bike and lining up on
the grid.
By the way, there is a great trading-related point to all this, so please read on
…
Back in 1999, I had a very good trading month and within hours of funds
hitting the bank account I paid cash for a brand spanking Suzuki Hayabusa —
at the time the fastest production road bike ever built. Nice!
I obsessed over this thing and rode it every chance I had. I soon realised this
missile was quite dangerous with my limited riding skills so I set about
taking lesson after lesson. The way I thought about it was my bike was at a
certain level and I had to catch up to it. I completed multiple courses run by
the Superbike School, Stay Upright and a couple of others.
I soon realised that as much as I loved the Hayabusa, it was not ideal on the
track — super fast down the straightaways, but terrible around corners given
its size and weight. So I replaced it with a new road-going Suzuki GSXR1000. After modifying it with better brakes, exhaust and suspension as well
as full race fairing, I had a very credible track bike. See figure 14.1 (that’s
me on the left).
Figure 14.1: My Suzuki race bike
This is where I stepped things up and started competition racing. I was still
hooked on doing as many riding courses as there were available. I repeated a
few and then paid for my own personal instructor. I even had personal
instruction from a couple of top-level Australian riders. Brilliant stuff.
At this stage, I also tossed the modified Suzuki and bought a proper racing
bike. This was another Suzuki, the same model in fact, but one that came from
the factory as a full race bike with all the proper trimmings. I wanted to give
myself no excuse for going slow.
Going through the Superbike School courses was a great experience. It
essentially gives you certain things to work on for each track session. For
example, it might be a vision exercise, body positioning or something to do
with throttle control.
The interesting thing was that each little component built on the previous and
in the end I had created an entire plan for riding. I was far from a Mick
Doohan prodigy, but my riding confidence went through the roof, my lap
times fell and all in all I was getting a whole lot more out of the experience. I
also started to experience a new level of focus and concentration.
Almost immediately, I saw the parallels with trading. At the time I was
trading a large options account, but the lessons apply to any type of trading
— and that includes my current role in high-frequency prop trading.
So what are the parallels, you ask? Good question.
(No) Fear
Naturally there were still challenges. Interestingly, I knew all the challenges
were in my head. Take for example the Eastern Creek track in Sydney’s west.
Turn One was a very fast left-hander (205 kph to 210 kph — for me at least).
This was followed by a slow and tight left hairpin that was off-camber, had
noticeable seal lines and an uneven surface. It was where everyone had at
least one spill — including me. It was the corner you’d talk about with the
other guys in the pits between sessions.
Anyhow, the braking point for that left-hand turn would at times psych me
out. I knew the spot at which I should be braking but often fear made me grab
a handful of brakes 3 m to 5 m before it. It was something I would be aware
of on the approach to Turn Two every lap. Sometimes I would nail it.
Sometimes it would nail me.
Have you ever been in front of the trading screen, knowing you should pull
the trigger to either enter or exit, but find a reason not to? I call that ‘Turn
Two at Eastern Creek’.
It’s very easy to keep a fear alive. All you have to do is change your focus
and rationalise. I could have, for example, thought ‘my overall lap time is
improving therefore that little bit does not matter’. In trading that’s like
knowingly making a mistake and thinking ‘at least I came out of the
day/week/month in profit’. That’s pretty much a formula for repeating the
mistake and, who knows, that mistake may be the one that empties your bank
account.
Getting past fear requires awareness and repetition, not ignorance. My Turn
Two was far from perfect, but I was honest with myself and consciously
worked on improvement.
Confidence
A friend that works at an insurance company once told me they ran a survey
where they found more than 80 per cent of people thought their driving skills
were above average. Before taking my riding seriously, I thought I was a
good rider — better than average at least. Looking back, I think I was closer
to average.
Some of my friends thought I was overdoing it when it came to attending
riding courses. I disagreed. As my skill improved so did my confidence.
Then more and more things became second nature. Things that would
previously be in the front of my mind became automatic.
This cleared my mind of clutter and allowed me to focus and the bottom line
was I was riding faster with less effort. Think about all the things that could
be on your mind when coming up to a corner:
• Where do I brake?
• How much do I brake?
• How much front brake, how much back brake?
• When should I turn in?
• How fast do I lean the bike?
• How much lean angle?
• Where should I be on the track?
• What gear should I be in?
• What is my body position?
• Where should I be looking?
• How much throttle should I use and where?
The list is actually longer than this, but you get the point. Imagine how
difficult riding would be if you are thinking of all these things. It can really
slow you down. However, repetition serves to automate these processes. The
effect is a clearer head and faster times.
The parallel with trading is obvious. Regular education is very important. So
is repetition. It’s that repetition that makes something second nature, boosting
confidence and skill.
At Propex, we have a huge focus on using the trading simulators. The new
guys are put on simulators for months and taught how to read volume and
price action. The idea is they learn through practice, practice and more
practice.
In motorcycle racing and trading, there are many things that are best taught by
doing, not by preaching.
Focus
The thing that really stands out at race speed is the need for focus. On a track,
there is no time for thinking about anything other than what is ahead. I would
think of extra thoughts as extra weight, and weight slows you down.
An interesting thing happened on my first ever day of racing. It was Lap One
of Race One at Eastern Creek. Coming around Turn 11 into Turn 12, the final
turn, the rider right in front of me stepped out a little wide and his front
wheel hit the dirt, immediately pulling the bike out from under him. His
helmet hit the ground so hard I even thought I heard it.
A natural reaction is to hope he is okay and of course to think about the
incident itself. The problem there is it would take away focus from what is
important; that is, the next corner and the rest of the race. I put the incident
out of my mind until I came back around and saw he was okay. Then it didn’t
cross my mind again until the end of the day. That is the focus you need for
performing.
The same goes in trading. You need to determine and apply the right amount
of focus for the type of trading you do. For position traders, checking markets
once a day may be enough. For intraday traders, you need your eyes on the
screen and no thinking about shopping, picking up the kids, the phone bill and
so on.
Goal-setting
Goal-setting is important and logical in most pursuits. When it came to
racing, I was inspired by something Valentino Rossi said. It was something
like:
My goal for each lap is a perfect lap. I pick the optimal braking and
turning points for each corner and try to hit it every time. It’s a
challenge I set for myself.
There is a lot of art in motorcycle riding, but there is also a lot of science.
Breaking it down into a science and putting a plan together works. On
practice days, for example, I would literally stick a note to my petrol tank
detailing what I wanted to work on. Each session was different and I’d never
make it too complex. Here’s an example:
When I first thought of the idea of putting notes on my petrol tank, it seemed a
bit silly. Realistically, you don’t have time to sit there and read on your bike
… However, just the process of writing out the note and sticking it there
made it worthwhile. I could have just as easily put the note in my toolbox and
it would still work as the issues were clear in my mind.
From a trading viewpoint, what’s wrong with making small notes and
sticking them next to your PC? A ‘trading translation’ of the above note might
be:
This is hardly a complete trading plan, but that’s not the point. The idea is to
work on a few small issues at a time. Don’t overdo things — keep it simple.
Then regularly change the note. If you’re day trading, perhaps have a new
note every day. ‘Today I will focus on …’
Dealing with stress
A lot of people look to avoid stress, whether it is in trading, sports or
anything else. Those that have read up on trading psychology and related
topics would have read how important it is to reduce stress, or eliminate it
altogether.
That might work for all of those non-human traders, but for the rest of us it is
a touch unrealistic. I think a better approach is embracing stress and being
mindful of how it is affecting you.
There is a great analogy in the book The Trading Athlete by Murphy and
Hirschhorn where they talk about driving through foggy weather. Most of us
in this situation would sit more upright and focus on the road ahead. We feel
uncomfortable or stressed heading through heavy fog but that stress creates
greater focus. This presents a situation where you are less likely to make a
mistake.
It’s the same in road racing and trading. On the track, you feel stress. Your
heart rate goes up — and it happens around the same time as you fire up the
engine and line up at the end of pit lane. That stress feeds your level of focus,
and the more you focus the less chance there is of making mistakes.
In the dealing room I see guys stressed by trading every day. I also see the
same guys extremely focused and consistently profitable.
Now of course there is such a thing as bad stress. Punching holes in walls
doth not a good trader make. On a bike if your stress shows up as aggressive
riding, your lap times will get worse. If your stress means you are tense or
grabbing the grips too hard, you will not be riding well. Good riding has a
lot to do with fluidity and at times letting your body move with the bike.
The similarity in trading is if your stress turns into frustration and that sees
you making silly trades or holding positions when you shouldn’t. In a daytrading context, it might mean pulling trades too quickly or loading up with
your full allocation when the signals to do so are just not there.
Good trading is learning to read the market and letting it tell you how to
position yourself. To do this does not require elimination of stress, but a
mindfulness of how stress may be affecting you.
Dealing with mind clutter
Sometimes we can just think too much. That old internal dialogue can get
rather noisy, particularly when your P&L does not look the best (or you’ve
just stuffed up a few laps).
Perhaps it would be nice to be one of those people that are just born happy
and are always happy; the fact is, however, that most of us are not that way.
We can have destructive thoughts. We can focus on the negatives a little too
much.
My approach with riding was to complete my analysis while off the bike and
think of these things as little as possible while on a fast lap. Having too many
things going on in your head will slow you down and increase the risk of bad
decisions.
In the eBook The Principals and Psychology of Day Trading author George
Slezak says, ‘Remember the power of a position. Never make a market
judgement when you have a position’. Perfectly said!
A great drill we have for day trading is to print out an intraday chart in the
morning, mark your levels on it and map out what you would expect a
bullish, bearish and neutral day to look like. With that you can build a plan
for the day ahead depending on how the market plays out.
It’s not a drill in trying to forecast the market. It’s designed to have you think
about possible scenarios and subsequent actions before your mind is biased
by a position you have.
A properly planned day means making fewer decisions while in a trade and
overall trading with more discipline.
Back on the bike — that internal dialogue and rash decision-making was hard
to stop. In fact, it was a constant effort. My trick to dealing with it was to
have a song — a relaxing song — in my head. I won’t go so far as to tell you
which song, but I’m sure you get the idea. In a way, having a song in my head
was a distraction from distracting thoughts. It worked. Perhaps something
like this can work in your trading.
The Zen of it all
The biggest improvement in my lap time came during an instructional day. I
remember the lap well. Without looking at my timer, I would have guessed it
was a slower lap than normal. I was relaxed and almost out of body. It was a
weird combination of focus and detachment.
For some time I had been stuck at a certain lap time and I just could not get
below it. After this particular lap, I looked down at my timer and saw I was
two seconds faster. Two seconds was a really big jump. I immediately came
into the pits to think about what happened and I realised that it was the
detachment. I was relaxed and in the moment.
There is an interesting paradox in trading. I’ll bet there is not one speculator
that got into the business without the goal of making money, yet we are taught
not to think about the money that is being made or lost.
How do you get around something like that? How can you detach yourself
from the money in your trading account? The answer is not easy. Ed Seykota
in Market Wizards talks about the difference between winning/losing trades
and good/bad trades. A good trade is one that was put on for the right reasons
and the rules were followed. A good trade may well lose money, but if you
follow the rules, it’s a good trade. Strive to make every trade a good trade.
Final thoughts
Both trading and racing are pursuits in excellence. They require focus,
practice and elimination of weaknesses. In a way, it’s no surprise that there
are similarities. I have found it very useful to think of these things side by
side because an improvement in one invariably leads to an improvement in
the other.
There are many things in trading that I consider art but the process involved
in becoming successful is a science because it follows a predetermined set of
rules that you must create for yourself.
Chapter 15: Forex strategies and
tactics
Why and when to trade currencies
Wayne McDonell
The markets are extremely efficient and constantly price in ‘all known
information’. They naturally adapt as traders and investors shape their
opinions. Separating short-term price action from general market forces can
be extremely helpful when trading.
A trader should design a strategy based on the market being traded. Without
knowing the direction of the market, how could you possibly know if you
should create a bullish or bearish strategy? Without strategy, it is impossible
to derive a tactical trade plan.
A trader needs to adapt every entry and exit to the market conditions. If the
market wants to fall, look for opportunities to sell. If the market wants to
rise, be bullish too. It should be your goal to align price action with the
overall market forces and thereby have a greater chance at succeeding.
Strategic analysis: how to make investment
decisions
In this section you will learn:
• how supply and demand work together
• why increased supply lowers currency valuations
• why increased demand raises currency valuations
• what fundamental analysis is
• how central banking works
• which economic reports to watch
• how long-term currency trends are created.
For most participants in the $3 000 000 000-a-day currency market, the true
foreign exchange has little to do with money directly. Sure, they exchange
their local currency for a foreign currency; however, they are doing so to
purchase goods and services in another economy, not to make money on the
currency transition itself, as a trader attempts to do.
For example, if Germany wishes to purchase gold from Australia, it
exchanges euro for Australian dollars and then buys the desired Australian
commodity using its recently purchased local currency. It does this because
Australia does not accept euro as a form of payment. It is similar to a
Canadian tourist visiting the Barossa Valley. They cannot buy the fabulous
shiraz with Canadian dollars; they have to exchange their foreign currency
for Australian dollars before they pop any corks.
In figure 15.1 you will see that the Australian dollar has a high positive
correlation coefficient, as indicated by the thin dark oval, with gold prices.
This shows that as gold prices rose, the Australian dollar valuation increased
versus other major currencies including the Japanese yen and the US dollar.
Speculators like retail forex traders have different intentions; they buy and
sell money in search of making a profit on the transaction itself. This change
of valuation is a direct result of supply and demand on the two currencies
that they are exchanging. So that begs the question: why does money change
value? That is precisely the study of fundamental analysis.
Figure 15.1: intermarket correlation
© Curt Wehrley, FXBootcamp dot com 2010.
Supply and demand
Money only changes value when it crosses an international border. When
foreign money flows into a country for investment or to purchase goods and
services, then the local money is in high demand. If money is leaving an
economy to make investments, build manufacturing factories, purchase
foreign equities, buy foreign bonds, repatriate profits back to the
headquarters of a global conglomerate or buy offshore services, the money
flows out of the local economy. This increases the supply of the currency on
the global market.
For example, if Japan needs to buy wheat from Australia, oil from Canada
and treasuries from Turkey, then the Japanese are selling Japanese yen for
Australian dollars, selling Japanese yen for Canadian dollars and selling
Japanese yen for Turkish lira: selling, selling, selling. They are flooding the
world with their currency and dumping it on the global market. The Japanese
have a lot of yen, but lack enough food, energy and yields to fulfil their
needs.
This flood of yen lowers its value. Imagine that you wanted to buy a widget.
Once at the mall, you soon discover that every store in the mall is selling the
exact widget you need. There are more widgets in the store windows than
potential buyers strolling the halls. Store owners compete for your business
by lowering prices. In theory, the lower prices attract more buyers. This
continues until the price curve has lowered enough for the demand curve to
rise to the point when supply and demand are balanced.
In currency trading you don’t really care where the balance point is. You only
care which direction the curves are going. If supply of the Japanese yen is
high and demand for Australian dollars is high, then buy the AUD/JPY. So
how do you decide which currency to buy and which to sell? Fundamental
analysis of global macro-economic data will help you uncover long-term
trends in the supply/demand equation for foreign currencies.
Fundamental analysis is the study of:
• employment data
• inflationary data
• consumer data
• economic data
• real estate data.
Having studied this data for a given economy, you will have a complete
report card for the health of an economy. More importantly, you can
anticipate the policy decisions that the central bank of the local economy will
employ to manage the health of the economy.
For example, if the economy is weak, it can lower interest rates to entice an
increase in borrowing and spur investment that will eventually strengthen the
economy. Or, if the economy is overheating and inflation is sky-high, the
central bank could raise interest rates to make money more expensive to
borrow or less profitable to invest, thus cooling off the economy.
Luckily, central banking policy changes do not happen very often; perhaps
only every couple of years. This creates long-term trends in the
supply/demand equation as well as the global financial markets and currency
valuations. Therefore, if you can correctly anticipate central banking policy
changes with the careful study of fundamental economic data, you could have
the leading edge on a profitable long-term currency trade.
Central banking simplified
Central bankers have various mandates, depending on the economy they are
overseeing. However, generally speaking, the primary focus of a central
banker is to set economic policies to protect the health of the economy and/or
keep inflation in check. To decide which economic policies are appropriate,
central bankers review a slew of economic data to gauge if the economy is
expanding or contracting and at what rate.
Luckily, this data is available to the general public. Traders, investors,
economists, academics and the common person on Main Street all have
access to the same economic data as the central bankers. It is your job, as a
forex trader, to review this data on an ongoing basis with the overriding goal
of anticipating policy changes made by central bankers.
All this data points to one simple question: is there an appropriate amount of
inflation in the economy? Many central bankers have an inflation target and
set their policies to keep inflation at or near that target rate. Some inflation is
good, as it means the economy is expanding at a controlled rate, companies
are hiring, people have jobs and feel comfortable in their economic situation
to spend money. However, too much inflation means that prices are high for
everything or the purchasing power of the currency is too low. No inflation
means that people and companies are not spending. This could lead to
layoffs, less spending, more layoffs, even less spending and a full economic
crash. A central bank can be ideal if it can manage the economy and hit the
target inflation rate.
Interest rates
One of the most visible tools for managing the inflation-rate target is setting
interest rates. This effectively prices the cost of money. If the central bank
wants to create inflation when the economy is bad, it makes money cheap to
borrow and gives you little reason to keep your money in the bank. If you
borrow or spend your money, demand for goods and services rises, prices
stabilise and the economy expands.
If there is too much inflation, central bankers are likely to raise interest rates
and make money more expensive to borrow and entice you to park your
money in the bank instead of spending it. This takes money out of the
economy and lets it cool off. Central bankers are only likely to do this when
the economy is booming and people are flush with cash and the confidence to
spend it.
Which economy would you like to invest in?
1 The economy that pays you a 1 per cent interest rate, has trouble keeping its
citizens employed, has a falling stock market and a housing market in the
tank?
2 The economy that pays 5 per cent interest rates and has a competitive job
market, rallying stock market and a housing market that is booming?
I’m sure we all want the latter, and the earlier you spot the rising trend the
better, so a study of fundamental data is critically important for currency
traders. This is because of demand. If we all want to invest in economy 2, we
need to first buy its currency and then make our investment of building a
factory, buying a house, investing in the stock market, purchasing a bond,
acquiring a commodity, hiring a service firm or waiting for the currency to
appreciate more. Regardless of our intent, we all need the local currency
first and this high demand drives up the value of the currency. This is what
forex trading is all about because this is how trends are created.
Fundamental analysis of the United States
As mentioned previously, fundamental analysis is the study of the following
data.
Employment data:
• weekly jobless claims
• non-farm payrolls
• ADP employment
• average hourly earnings
• average work week
• unemployment rate
• Challenger job cuts.
Inflationary data:
• producer price index
• consumer price index
• personal consumption expenditures
• import prices.
Consumer data:
• consumer confidence
• personal income
• personal spending
• retail sales
• auto sales
• chain store sales.
Economic output data:
• ISM services
• ISM manufacturing
• industrial production
• capacity utilisation
• durable goods
• gross domestic product.
Real estate data:
• existing home sales
• new home sales
• pending home sales
• building permits
• house starts
• home prices
• Case-Shiller market prices.
My intent isn’t to fill in the blanks for all of these reports, but only to point
you in the right direction. You will find this info published in newspapers, on
the web and reported on television every single day. It’s your job to keep an
eye on the trend in each. Put them all together and ask yourself, ‘How will
the central bankers interpret this data? Will they likely raise, lower or keep
interest rates the same?’
If you foresee the need for central bankers to consider a policy change in the
near future, then you can anticipate a change in the trends found in currency
markets and be ready to spot the change when it happens. Rising interest
rates tend to attract investment and demand for the local currency. Falling
interest rates tend to make investors repatriate their money and thus increase
the supply of the currency globally, thereby lowering its value.
Tactical analysis: how to create tactical
plans
In this section you will learn:
• how to measure market forces
• how to measure price action
• how to measure and adjust for risk
• how to buy low if you are bullish
• how to sell high if you are bearish.
Once you have made a strategic decision to buy or sell a currency based on
sound fundamental analysis of economic data, then you need to look for an
opportunity to enter the trade. A trade plan uses technical analysis to help
you time your trades, either buying low or selling high within your long-term
trend.
A tend is defined by price action. If a trend is bullish, it makes a series of
higher highs and higher lows. If the trend is bearish, it makes a series of
lower highs and lower lows. The key to maximising profits is to:
• strategically decide if you believe the overall trend is bullish or bearish
• tactically enter your trades based on your strategy:
◊ if you are bullish, you want to buy low
◊ if you are bearish, you want to sell high.
As you can see, there are two components to be measured. The first is your
strategic analysis of the overall market. Second is the price action within the
market. Even if the ‘market is up’, prices will fall. This is very important, as
the dips are potentially opportunities for you to buy at favourable prices if
you are a bull.
I believe the secret to success for forex traders is to enter trades in the
direction of their long-term fundamental bias using short-term technical
analysis. This aligns price action with market forces. It is like swimming to
the centre of the river and floating downstream. It is much easier than fighting
the current.
Go with the flow
As a currency trader, the first thing you need to do is define two things:
• the direction of the medium-term market forces
• the direction of short-term price action.
Once market forces and price action have been measured, it is your goal to
identify the opportunity to trade in the path of least resistance. It is my
humble opinion that ‘going long’ in a falling market is less ideal. You can
make money from time to time with such a trading strategy; however, it has
greater risk. Risk is not your friend. The trend is.
Remember that the trend was created from the long-term fundamental
economics and central banking policies of an economy. These fundamentals
do not change quickly. Therefore the trend can be a good friend to be
working with.
Isaac Newton observed, ‘An object in motion tends to stay in motion. An
object at rest tends to stay at rest.’ This holds true for currency valuation
trends. A red-hot economy will not turn ice-cold immediately, unless
something catastrophic occurs and that is unlikely. There will be plenty of
warning signs, such as an inverted yield curve, before the trend starts to bend
and eventually break.
Currency valuations will follow the changes in economic fundamentals,
central banking policy and market trends. As an economy rises, but then stalls
and falls, so will the trend in economic data, then eventually interest rates,
and therefore so will currency valuations.
Traders and investors develop their bias off the economic data. Remember,
the reports come out on a regularly scheduled basis and are reported instantly
by internet and television services. It’s also reported the next day in every
major newspaper on the planet. Traders and investors certainly have access
to the information.
Trader and investor ‘bias’ is derived from ‘all known information’. As new
information enters the arena, bias can change. Sometimes immediately, but
often very slowly. Any individual news report really isn’t that important. It’s
the trend of the reports that matters.
Has the economy been creating jobs? Has the economy been actively
producing goods and services? Are the corporations profitable? Are the
costs of raw materials, energy and food staples within reason? Is inflation at
the consumer level in check? Is the cost of borrowing money acceptable?
These are extremely important questions for all investors and traders to
consider when developing their bias. Trends in the economic data will
provide answers that will likely last for quite a while.
The force in forex
To measure the direction of the market use medium-term moving averages.
For instance, you can use a combination of exponential moving averages
(EMAs) such as:
• 20/60
• 21/55
• 34/89.
Whatever seems to work for you is fine. Test several on a demo account.
FX Bootcamp, my real-time forex advisory and education service, uses the
21/55, as shown in figure 15.2. They are both numbers from the Fibonacci
sequence, as most of our indicator settings like moving averages, MACD
(moving average convergence divergence) and stochastics are. Observe the
angle and separation between these two moving averages:
• a steep angle and large separation will indicate a fast-moving and trending
market
• a shallow angle and narrow separation will indicate a slow and ranging
market.
Why is this knowledge important? Two reasons:
• you can choose the right tools for the job
• you can adjust your risk tolerance.
Figure 15.2: 21 EMA and 55 EMA crossover
Source: GFT’s DealBook® 360 Trading Software.
The right stuff
If the market is trending, use Fibonacci studies to buy dips or sell rallies. If
the market is range-bound use oscillators to buy at support or sell at
resistance.
The reason for this is fairly simple. A market that has a good angle and
separation is trending quickly. You should be confident in the trend’s ability
to continue in the direction it’s moving; making ‘lower lows’ if bearish or
‘higher highs’ if bullish.
For example, in a market that has a 21 EMA that is clearly above the 55
EMA, a technician may conclude that the market is bullish. If the 21/55
EMAs are rising at close to a 45-degree angle, then the trader should be
confident and possibly aggressive in trading with the bullish trend. A trader
who is confident in the bullish market creates trade plans that consist of
buying pullbacks, retracements, dips and other trend-continuation patterns
based on red candles.
Appropriate risk tolerance
Currency traders should adjust their profit targets, trade expectations, lot size
and stop placements based on the current behaviour of the market.
Are you a bull or a bear? If you can’t answer this basic question, don’t pull
the trigger. You should already know this before you even look at a chart;
however, use technical analysis of your charts to confirm trade entries that
agree with your fundamental bias.
Are you aggressive or conservative? If you have established and confirmed
your bias, you need to confirm your confidence in the market. If I am a bull
and the market just turned up, I am often very aggressive in my trading. I
don’t triple my lot size. I am just a little quicker entering a trade, perhaps
using a stochastic cross to enter, not a moving average cross, or enter a
pullback trade with little confirmation it has held. I’m looking for excuses to
get in.
Therefore, if the market is moving quickly, be a little more aggressive.
Remember, an object in motion tends to stay in motion. Do not bet against the
speed of the market. It’s like standing in front of a moving freight train to see
if it can stop in time. Run with the market and hop on the gravy train.
If the speed of the market is slow, the market is more likely to consolidate
and profit potential is diminished. A wise trader should adjust expectations
and risk tolerance. Profit expectations should be set fairly low and
suspicions of a reversal coming should be set fairly high.
For example, if I am a bull and the market is up, but riding on the 55 EMA as
support and the angle/separation of the 21/55 is fairly flat, I can confirm that
I am still bullish, just moderately so. I would not be aggressive. I would be
conservative and would be looking for excuses to not get in. I am almost
‘market-neutral’, but if I had to guess, I would still bet on the long-term
uptrend … but I’d rather not at the moment as the potential for success is low.
Said another way, the conditions are too risky right now.
Professional traders are not afraid of losing money. Only amateurs worry
about that. Professionals expect to make money. Their concern is risk. They
have to consistently make money. Since they have a lot of skill entering
trades profitably, their major focus is really risk management. A professional
trader will often walk away from a trade that ‘could be a winner’ because he
or she is more concerned about the risk. More risk is not better.
No matter if you are an experienced trader or an amateur trader, I am sure
you have observed an interesting phenomenon in trading. Many amateur
traders will watch three potentially profitable trades go by while never
pulling the trigger, then place a trade on the fourth opportunity and then lose.
More experienced traders will have made three profitable trades in a row,
done the exact same trade a fourth time and then lost money. I am certain you
have done either, even likely both; we all have. A professional trader will
make the first three and walk away from the last. Why? For some reason, it
had more risk.
The amateur is totally clueless, so is going to lose regardless. An
experienced trader is great at technical analysis and entered every pullback
flawlessly but did not properly interpret the technical analysis and read the
increase in risk. Is this really a big deal? Yes. The fourth losing trade cost the
experienced trader 40 per cent or more of total profits.
A professional trader correctly saw the increase in risk, traded less and
made a lot more money. An experienced trader is skilled, but not doing much
better than break-even trading. An amateur trader provides profits to the first
two.
Stop it
Every trade has two stops, one for profit and another for loss. You should
always use stop-losses. They are another tool to manage risk. Managing risk
is the key to success. With a stop-loss set, you know exactly how much
money you are putting at risk. You can budget for it.
With a stop-limit put in place at the logical place of reversal, you can analyse
the risk/reward ratio and establish if the trade is worth the effort or risk.
Managing your risk will definitely help you manage greed and fear. You only
trade when profit outweighs the risk associated with your stop placement and
your loss can be tolerated, so what’s the big deal? Develop your bias and
enter trades aligned with it while risking as little as possible. Why get so
emotional about your trading? Attempt to be strategic in your analysis and
tactical in managing your trades.
Without the use of stop-orders, your risk is out of control. Achieving
consistent profitability trading forex without managing risk will be like trying
to put socks on a wild turkey: it’s doubtful that you will succeed, probable
that it will be painful to you and certainly foolish to actually try.
The price is right
When trading, it’s important to remember this key point: prices do rise in a
falling market and prices do fall in a rising market. The goal is to find
opportunities to trade when price action and market forces are aligned. This
means you should try to buy low when the market is bullish and sell high
when the market is bearish. Sounds simple enough, eh?
This begs the question: ‘Once you have determined your market bias, both
fundamentally and technically, how do you decide when to enter the trade?’
Price action is the answer. I attempt to measure price action independently of
what the market is doing. To achieve this, I use moving averages.
In my forex trading, I describe price action as ‘momentum’. My definition of
momentum is the direction of price, at the moment, in relation to the direction
of the market. I first look to my charts to see the direction of the market using
the 21/55 EMAs. I then ask myself, ‘what is price doing at the moment’, and
look to short-term moving averages to find the answer.
Measuring momentum
Momentum is a measurement of price action at this particular moment in
time: what is price doing right now? To measure the momentum of price
action, use a combination of exponential moving averages such as:
• 3/5
• 5/8
• 8/13.
At FX Bootcamp we use 5/8, as shown in figure 15.3. Once again, they are
both Fibonacci numbers. One unique point is that the 8 is a simple moving
average, unlike all our other moving averages, which are exponential moving
averages.
Figure 15.3: 5 EMA and 8 SMA crossover
Source: GFT’s DealBook® 360 Trading Software.
Observe the angle and separation between these two moving averages:
• a steep angle and large separation will indicate that momentum is
increasing
• a shallow angle and narrow separation will indicate that momentum is
decreasing
• consecutive crosses of the moving averages indicates that there is no
momentum.
Tactical technique
So how is momentum useful to a currency trader? It’s a fabulous way to enter
a trade. If you are bullish on the market, then you should use the momentum of
price action as your guide for entry. If momentum falls, as measured by the 5
crossing below the 8, it is not ideal conditions to buy at the moment. Wait.
If you want to buy low in a bullish market, then let price action fall for a
while: it only makes your entry price more favourable and possibly allows
you to place your stop-loss a bit closer if you do enter. A better price with
less risk does sound good, right? Then be patient. Let price fall.
After falling a bit, perhaps to a support area, or a Fibonacci zone, or to a
pivot point, the 5 crosses back above the 8. This crossover indicates that
price action is now rising while you happen to be bullish in the overall
market. You have found the path of least resistance. Price is rising in a rising
market: good job! Now you may be inclined to pop a lot and drop a stop.
You should be able to predict, anticipate and even visualise a trade like this
(shown in figure 15.4) in advance. It’s called a trade plan. You should be
able to say, ‘I’m bullish on this, so I’ll let price fall and then look to buy it. I
wonder where support is …’ You then should start to create a detailed plan
in advance. If you are bullish, and price is falling, but then price hits a major
support area, what do you think could possibly happen? Wouldn’t a bounce
be nice? Yes. It’s exactly what you’d expect. A 5/8 cross up, after a bounce
at support, in a rising market is a wonderful trade plan. If you anticipate it,
then you are in control of your trading.
Figure 15.4: price action aligns with market forces
Source: GFT’s DealBook® 360 Trading Software.
Most amateur traders are not in control of their trading. They observe and
enter trades after the fact and with fundamentally no bias. Their trading is
random and sporadic. Even worse, their trading is late. Taking control of
your trading is supremely important, as traders have no control over the
market and, since they are not market-makers, they have no control over the
outcome of their trades. Traders can only control their trading behaviour.
Without that, trading results are random at best, but since there is no
consistency in an amateur’s trading and they are always late in entering
trades, they are certainly doomed to fail.
Amateur traders enter their trades late and exit their trades early. Without a
trade plan in advance, traders will observe an opportunity well after it has
already occurred and then they enter a trade. They are late. Since price
always pulls back, the latecomer has to endure this pullback. If it is a sizable
retracement, amateur traders exit the position because they can no longer
endure the pain, especially since the pullbacks usually begin soon after they
entered the trade in the first place. Oddly enough, this is about the same time
an experience trader is getting in … right when the novice trader is exiting
for a loss.
Hit the road, Jack
You are in love with your profitable trade. Now that you are +30 pips, you
think it will go to +300 right? Yes, it possibly could. If you are swing
trading: yes. If you are spot trading: no. So it begs the question, what was
your plan?
A spot trader is an intraday trader who primarily uses a 15-minute chart. A
spot trade usually lasts a couple of hours or so. Since the average daily range
for most currencies is 80 to 120 pips +300 pips on your spot trade is very
unlikely. It could eventually get there, but you will have to survive several
pullbacks. I suggest a spot trader should cash out of profitable trades at the
start of the pullback and re-enter at the end. Why risk your profits?
Figure 15.5 shows how you do it. Say you are a bull and the 21/55 crossed
up several hours ago. You had entered a long position when the 5/8 also
crossed up, aligning price action with market forces. Your trade is profitable
and you have moved your stop to break even. After about 15 candles, price
hits a resistance zone. You move your stop to protect some of your profit.
Then you observe that the 5/8 crosses down. You are still a market bull, but
price action has turned bearish for now. You exit your trade for profit and
cancel your stop order. You may or may not re-enter a trade when the 5/8
turns up again, but you have at least an hour to plan that out in advance.
Things could change between now and then. You will make that decision
later. For now, you are a little more confident and a little richer.
Congratulations!
Figure 15.5: as a market bull, cash out when price crosses against you.
Re-enter when price realigns with the market
Source: GFT’s DealBook® 360 Trading Software.
Now enter the trade in your journal and get ready for the next opportunity.
Summary
Strategy is going to help you survive. The first step in developing a strategy
is the careful scrutiny, called fundamental analysis, of all known information.
The purpose of this study is to discern the likely central banking policy of
each economy that you are trading.
Fundamental analysis is a vital step in your trading process because, unlike
other markets, currency traders trade two currencies at once, simultaneously
buying one currency and selling the other. The greatest success will come
from buying the strongest currency relative to others while selling the
weakest currency relative to others.
Relative strength/weakness is very often the outcome of economic
strength/weakness. Economic reports are released to the public on a regular
basis and are freely available to everyone, as well as widely reported by the
media. Central banks, financial institutions, international conglomerates and
hedge funds all study this data to make investment decisions. Their decisions
move the markets; therefore, if you can correctly anticipate their decisions,
you may know which currency to buy and which to sell. Develop your trading
strategy based on fundamental analysis … it’s where trends are born.
Once you have developed a bias for a currency, you need to time your trade
entry and exits. To do so, you should study charts with the simple objective
of buying low and selling high. If you are bullish, you want to buy the dips. If
you are bearish, you want to sell the rallies. Technical analysis, in particular
the study of moving averages to price action from market forces, will help
you tactically implement your strategies.
The medium-term moving averages help you identify the general direction of
the market. If this does not agree with your fundamental bias, don’t trade. If
the market is moving in the direction of your fundamental bias then you must
observe the angle and separation of the two moving averages. If the market is
moving fast, be aggressive with your trade entries. If the market is moving
slowly, be much more conservative. Adjust your risk to the condition of the
market.
The market doesn’t change very often. This is why we use medium-term
moving averages to measure it. However, price rises and falls constantly.
Prices do rise in an extremely bearish market. Prices do fall in an extremely
bullish market. Therefore, it is your goal to observe this divergence of price
action and market forces and attempt to trade when they are realigned.
In conclusion, you may find your trading becomes less chaotic when you sell
into a falling market. Don’t swim against the current. Swim to the middle of
the river and go with the flow. Study the fundamentals to develop bias. Wait
for the market to agree and then enter/exit your trades based on price action
measured with short-term moving averages.
Chapter 16: The risky business of
forex
How to be prepared before you jump right in
Leon Wilson
The world of trading is changing dramatically with forex and futures now
readily accessible to the general public. There is an abundance of forex and
futures brokers now vying for our accounts with the offer of minimal spreads
and commissions. Combine minimal transaction costs with the enticement of
margin-style trading and, like bees to the honey pot, the inexperienced traders
looking for a quick buck with no effort arrive in droves. It’s no different to
the gold-rush days where everybody went to the goldfields looking for their
pass to financial freedom; however, the wealthiest man on the goldfields was
usually the shopkeeper. Nothing has changed over time except the shopkeeper
now has a new profession.
The problem with forex and futures trading for the average person is the total
lack of comprehension of the market they are about to enter. Put politely, as a
good friend of mine often says, the vast majority of those who enter these
markets are unconscious incompetents; in other words, they do not know
what they don’t know therefore they are under the misguided belief that they
are all-knowing simply for no other reason than they have no idea of what
they actually need to know in order to survive. Sadly it’s the truth, hence the
sizeable failure rate. So with this in mind I suggest that if you are not
proficient in basic share trading then these instruments are not for you at this
stage of your trading career. Do not delude yourself: simply changing markets
does not assure you of success; ineptitude is ineptitude regardless of the
market. Margin or leveraged markets merely allow us to lose our capital
with improved efficiency.
If you have chosen to read on then I am going to assume that you already have
a sound trading strategy in place while also having a basic understanding of
the forex markets, so I will not explain the basics beyond our requirements
here. If you have progressed to this point then, unlike our less-experienced
colleagues who think that trading is all about entry signals, you know that
successful trading is defined by risk management, position sizing and capital
allocation as well as having solid entry and exit techniques. From here on I
will focus on the forex market simply for no other reason than it is the most
popular and enticing market to trade at present.
Understanding risk
Before we can fully appreciate the impact of trading a margined instrument at
100:1 such as forex we need to first better understand the risk at hand without
the impact of margins. If our strategy is going to fail then better to do this
early on without being margined to the hilt. The common belief is that
margins amplify gains (which is correct) therefore simply changing markets
turns unprofitable trading into profitable due to increased gain; however,
margins also magnify loss by the same degree so in reality if we are already
unprofitable then our trading account goes from declining to plummeting. If
your trading style consistently produces more losses than gains then the laws
of probability suggest that at some point you will end up broke, just as 90 per
cent of the budding forex traders do in the US, if comments in most forex
journals are anything to go by. While I cannot confirm personally whether
such a high failure rate is accurate, I have no reason to question its validity,
knowing just how difficult forex can be to trade at times based on personal
experience.
In order to help you put risk into perspective, I would like you to study table
16.1. It is based on the accepted market practice of only risking 2 per cent of
total trading capital. Once we can understand the impact of repeated losses
on a conventional account without margin, such as used with shares, then we
are in a better position to more fully understand and therefore manage risk
through capital allocation where margined instruments are involved. What is
often overlooked by many budding traders is just how much we must make up
on our profitable trades to offset our losses, and this is before we even
consider moving into the black. If you can appreciate what is required to
cover your losses, then you can also appreciate why cutting losses early is
critical, especially where margins are concerned. Letting regular losses ride
that are magnified by a margin of 100:1 almost guarantees your demise.
Let’s say I have a conventional $25 000 share trading account. I will use the
accepted practice of maximum 2 per cent risk and 10 per cent allocation (see
table 16.1). For consistency throughout this chapter I will stick with a trading
account of $25 000:
$25 000 × 2% = $500.
Risk per trade = $500.
Position size = $2500.
Table 16.1: return to break even on profitable trades
With a win/loss ratio of 50:50 I am required to generate an average net return
of 20 per cent for each profitable trade just to break even (assuming 10
trades). This is a solid return and beyond the reach of most. If I intend to
produce an average net profit of 10 per cent over the five profitable
transactions then a 32.64 per cent return is required for each profitable trade;
this is seriously good trading which many would not be able to produce with
the required degree of consistency. The reality is that we are unlikely to
produce a 32.64 per cent return consistently over the five profitable trades;
hence this is why very few traders ever go onto making a decent living
beyond the period of a screaming bull market as recently experienced. Now
ask yourself, if success is so hard to achieve and maintain trading traditional
instruments such as shares, then why on earth would I think that by simply
switching instruments from shares to futures or forex that this somehow
swings the pendulum of risk distinctly in my favour? It doesn’t. When it
comes to nails in our trading coffin, we simply go from using a tack hammer
to a sledge hammer. Unfortunately, human nature being what it is, we let
losses run and cut profits short which further compounds the issue, and while
our mind focuses on increased profits through margin our actions remain
unchanged, thereby generating continued loss at margined rates. Until this
mindset is changed, margin instruments and the dream of making big dollars
in the forex market will elude most; therefore, such markets should remain off
limits until we are consistently profitable in a non-margined environment.
Table 16.2 will help you to understand the impact of incurred loss and why
it’s so critical to keep losses to manageable levels. This is critical when
consistent losses are a part of our overall strategy. If losses are a prominent
part of our trading routine then understanding what is required to recover
from them is paramount for survival, especially where forex is concerned.
While I will not discuss all of the values in the table as they are selfexplanatory, it takes a 100 per cent profit just to cover a 50 per cent loss. If
you can keep your losses to less than 5 per cent then you only require a
similar amount in profit next trade to recover; however, once you go beyond
this the likelihood of recovering lost capital becomes highly improbable.
Even the impact of just two or three losses in the magnitude of 20 per cent
basically destroys our potential to trade effectively.
Table 16.2: minimum profit to offset previous loss
Some of you will consider that I have been a bit harsh and am
overemphasizing the impact of loss; however, when it comes to trading, forex
and futures are at the pinnacle of the trading triangle. The vast majority of
traders struggle to achieve a success rate much above 50 per cent in good
conditions so loss is an everyday part of their routine. Wearing loss that is
margined assures accelerated failure unless the individual understands the
impact of losses incurred through margin. Fortunes can be made trading these
instruments by average people; however, the potential for loss is great also,
with more fortunes being lost than made. Better to have the reality check
prior to commencing.
The old adage ‘risk equals return’ is incorrect as it assumes no risk
management technique exists; it should read ‘risk management assists return’.
Calculating pips and lots
The next step is to ensure that we have an understanding of ‘pips’ and ‘lots’.
Many of those who approach the currency market have little or no idea of
what a ‘pip’ even is, much less how to calculate one. First up a pip is the
minimum amount of movement that a currency can experience. Let’s say the
Australian dollar is currently trading at US0.9331¢; a one-pip bullish move
would see the trading price increase to $0.9332. If we happened to be
trading the Japanese yen and the current trading price is US$92.91 and we
again experienced a one-pip bullish move then the trading price would be
$92.92. Due to the significant value defining this particular cross rate the
number of decimal places has decreased from four to two. While most
currency brokers will provide values out to four decimal places, always
check with your broker as this will impact significantly on your risk
management techniques and capital allocation. Some brokers are now
providing five decimal places or fractions of a pip on a number of cross
rates so it pays to be up to date with minimum pips.
Only when we have an understanding of what defines a pip can we begin to
define risk management. Only when we have the ability to define risk
management can we determine lot allocation. So what is lot allocation?
Currency is traded in lots in a similar manner to futures being traded in
contracts. The benefit with currency trading is that we have the ability to
trade in partial lots while futures can only be traded in whole contracts. A
standard lot size for currency is $100 000. There are a number of other
benefits associated with trading currencies over futures but I will not discuss
them here in detail.
So how do I combine this information in order to determine our risk per pip?
(Minimum pip move ÷ trading price) × lot size = pip value
(0.0001 ÷ 0.9331) × $100 000 = $10.7169
Now I am going to show you an anomaly that catches the vast majority of
inexperienced currency traders. Let’s say that our trading price drops to
0.8331¢; how would this impact on our pip value?
(Minimum pip move ÷ trading price) × lot size = pip value
(0.0001 ÷ 0.8331) × $100 000 = $12.0033
When understanding risk, not only must we have an appreciation of risk at the
point of entry but, more importantly, we need to have an appreciation of the
degree of exposure at the point of exit. When risk has a static value such as
we experience when share trading, where loss or gain per cent remains
constant, then risk management simply becomes a process of defining the
value per cent move then applying this to our risk management techniques.
This process changes, however, when risk per cent move or, in our case, per
pip move is not constant. You will notice that the majority of online trading
platforms such as MetaTrader™ will update your account values in unison
with price change. This occurs not for our benefit but for theirs as the brokers
manage their risk often by hedging. While brokers will go to the trouble of
defining risk in conjunction with price change, very few traders have an
acceptable understanding of how price change can impact on exposure. You
must recalculate your risk exposure each time you go to enter a position. For
example, if you miss an entry point and wait for a secondary signal,
recalculate your risk relative to the second entry signal, do not apply your
original values to your second entry setup because exposure per pip is not
constant.
The chart in figure 16.1 (overleaf) is one of a typical entry setup. Price has
moved above my entry line so I have placed a trailing stop below in the same
manner as I would share trading. What I have identified is the degree of risk
by defining the number of pips that exist between the entry line and trailing
stop, in this case 0.0091¢ or 91 pips. While this is good in theory as this is
the difference between my entry and exit points, in reality we are more likely
to enter on or near the close of trade as is done with share trading. If this was
the case then our degree of risk is further increased from 0.0091¢ to 0.0146¢
or 146 pips. The closing price on the day was 0.9279¢.
(0.0001 ÷ 0.9279) × $100 000 = $10.7770
146 × $10.7770 = $1573.4420
Figure 16.1: 20-day high entry point
Source: BullCharts.
Risking $1547.442 with an account of this size based on a single position is
sheer lunacy. The above risk on our account would be unacceptable at 6.29
per cent. Unless you have an extremely high probability strategy at your
disposal then you will go broke if the same principles of risk management
are applied as we would do when share trading, for the reasons already
discussed. Naturally we need to rectify this scenario.
We can deal with this excessive exposure in one of two ways:
• lift our trailing/initial stop
• reduce our lot size.
Lifting our trailing/initial stop is a commonly accepted practice, and while it
will limit additional exposure this technique is not without its flaws.
Excessively tight initial stops often fail to take into account current trending
activity and volatility. Often tight initial stops will choke natural trend
development thereby closing the position prematurely, denying the trader
eventual profits that later develop. With this said there are a number of us
who would prefer to run with a tighter stop rather than reduce position size.
Ultimately it is a personal decision that the individual trader must make, just
one that I do not aspire to personally.
With this in mind, how do we define an initial stop value that will allow us
to trade one lot without exceeding our maximum allocation of $500? This is
actually quite simple and can easily be set up in spreadsheet format, as in
figure 16.2. Again I will assume a bullish setup for ease of calculation:
Entry price – (maximum risk allocation ÷ exposure per pip) = initial stop
placement
($500.00 ÷ $10.7770) = 46.3951 pips (round down to 46)
0.9279 – 46 pips = 0.9233
Our initial stop will sit at $0.9233 but how does this sit against the currency?
Figure 16.2: initial stop by lot allocation
Source: BullCharts.
While our desire may be to trade a full lot size, usually brought about by
greed rather than logic, any experienced trader will quickly tell you that our
initial stop in figure 16.2 is way too close to price action for comfort. It
would be reasonable to conclude that even experiencing normal volatility
this position will be quickly closed and most likely at a loss. Greed tells us
to take the big position with a tight initial stop, and while this approach may
work in strongly trending sharemarkets, currencies are more prone to ranging
fluctuations in price rather than continuously trending. Toss in a strong dose
of volatility and, yes, average traders have done their money before they
know it.
Ideally our strategy should accommodate natural trend behaviour where
practically possible while also limiting exposure to acceptable limits. The
natural progression from here would be to combine our accepted risk
allocation rule of 2 per cent based on our account of $25 000 while
incorporating both entry and exit values. This in turn limits our risk to a
maximum of $500 while encompassing normal price movement; remember, 2
per cent is a maximum not a target. Thankfully most currency brokers will
allow us to trade partial lot sizes up to one lot, usually in increments of 0.1,
so risk through lot size reduction is seldom an issue. Beyond one lot we are
usually required to trade in whole lots. By doing this our strategy through the
application of a suitably positioned trailing/initial stop will accommodate
normal price movement and volatility without fear of being prematurely
evicted from our position. Most traders fail to realise that trailing and initial
stops should be designed to catch movements beyond average. Why on earth
would you want to apply any form of trailing/initial stop that has the potential
to close a perfectly acceptable trade that is performing within the realms of
average? I suggest that if you are unable to handle the risk within the scope of
normal behaviour then trading is probably not for you and currencies are
definitely off limits.
So how do we scale down lot size? We know that each pip movement is
currently worth $10.7770 based on one lot value of $100 000. So far so
good. We also know that our current trailing stop sits 146 pips below the
latest closing price. Yep, right on top of things. Now for the tricky bit: we are
only prepared to risk $500.
$500 ÷ $1573.4420 = 0.3177 (always round down)
In order to trade the position in accordance with our trailing stop thereby
allowing price movement to develop naturally while minimising the
potentially premature closure of our position, we reduce our position from
one lot to 0.3 of a lot (always round down). Yes, I know it sounds wussy;
however, as most of us start off with only limited trading capital it is critical
that we protect this at all costs. The currency market does not offer
warranties or refunds for mistakes and stupidity.
Managing risk
So far I have highlighted how we as traders can define our risk and exposure
relative to our account size and stop position; however, simply having a
basic understanding of the principles so far is not enough to ensure successful
long-term trading. We must take this one step further. Simply defining risk
and capital is not enough to ensure success; more often than not it’s the
manner of how we apply and manage our risk which ultimately determines
whether success or failure awaits us.
For the purposes of our ongoing discussion here I will apply the following
strategy. I have loosely used the basic concept behind the turtles whereby the
occurrence of a 20-day high or low has occurred in order to generate an entry
signal. I have simply used a two times average true range (ATR) trailing stop
for the purposes of position management. This approach is very basic and
has not been optimised in any way in order to suit the forex market or our
discussions here, though I will make a couple of minor adjustments later in
the chapter in order to highlight a point. The reason I have elected to use an
approach similar to the turtles here for discussion purposes is the very low
success rate of the technique. It is usually profitable around 30 per cent to 35
per cent of the time depending on the market being traded and conditions at
the time. By using a very low success rate strategy with only minimal capital
on forex, all things being equal I should be broke with only limited effort by
the end of the chapter.
• Long-side entry: 20-day high.
• Position management: 2 × ATR (21) trailing stop.
• Short-side entry: 20-day low.
• Position management: 2 × ATR (21) trailing stop.
We have many methods available to us when it comes to capital allocation
and risk management; however, the four most common approaches are as
follows:
• Equal fixed dollar allocation: this is where we allocate a specified amount
of our trading capital to each position. With an account of $25 000 we may
decide to allocate $2500 per trade. The degree of risk is not taken into
consideration.
• Equal percentage dollar allocation: this is where we allocate a specified
percentage of our trading capital to each position. With an account of $25
000 we may decide to allocate 10 per cent of our trading capital per trade.
Again the degree of risk is not taken into consideration.
• Fixed dollar risk allocation: now we are starting to get somewhere; this is
where we decide to only risk a predetermined amount of capital per trade.
With our examples here I have been using $500.
• Fixed percentage risk allocation: now we are really cooking with gas.
This is when we define our risk relative to the value of our trading account.
Daryl Guppy advocates using no more than 2 per cent of total trading capital.
This is sound logic that I agree with wholeheartedly. This style of capital
allocation should be stringently adhered to, though from a personal
perspective 2 per cent is a little high for my style of trading where futures
and forex are concerned.
With the methods of capital allocation now highlighted I will look at the
impact of these approaches on our previously mentioned strategy using the 24
most common cross rates available through the MetaTrader™ platform.
These cross rates are readily available on most forex broker websites.
Equal fixed dollar allocation
I know that many less-experienced traders apply this method due largely to
its simplistic nature. This approach is further reinforced as acceptable by
their inability to accurately quantify risk relative to their technique. I know
this because I, like many others, used this method when I first commenced my
trading career: yep, another one of my not-so-brilliant ideas. I’ve had a few
of them in my time. I quickly grew tired of watching my capital disappear
and, like many others, I searched for a better strategy. It took some time
before I began to realise that it was the method of capital allocation that was
doing the damage to my trading capital, not the strategy itself. The technique
was fine; it was the manner of how I applied the capital to my strategy that
was letting me down severely (see table 16.3 and figure 16.3, overleaf).
Table 16.3: 20-day high — 20-day low
Figure 16.3: equal fixed dollar allocation
As you can see, by using one of the most popular methods available for
capital allocation we have managed to steadily lose our capital from day
one. Note that I said popular, not effective! The reality with this method is
that our trading capital is in decline right from the start. What we have
confirmed here is that our technique, which is loosely based on the turtles
methodology, is profitable approximately 37 per cent of the time. This is
consistent with the technique historically; therefore, it’s logical to conclude
that losses have come about from capital mismanagement rather than the
strategy underperforming. With an average trade profit of just $30.16
combined with an average loss of $22.08, we can do nothing but go broke,
especially when a success rate of 37 per cent underpins our strategy. There
are simply not enough surplus funds from our profitable trades to cover our
ongoing losses. With losses affecting our gains by 73.21 per cent, failure is
assured.
Equal per cent dollar allocation
Some of you will say, hang on one minute, Wilson you clown, you have
applied a one-off inflexible amount of trading capital in the previous
example. You applied $2500 per trade regardless of the amount of total
trading capital available, which we smarter traders would not do. If you had
applied, say, 10 per cent of total trading capital to each trade then as your
capital decreases so does your exposure, which in turn decreases position
size thereby also decreasing potential loss. With this in mind a profitable
outcome is far more likely. So here we go again (see table 16.4 and figure
16.4).
Table 16.4: 20-day high — 20-day low
Figure 16.4: equal per cent dollar allocation
What happened here? This can’t be right; no way can I make a loss when I
link position size to total trading capital! Ah, Wilson has made a mistake,
obviously.
Wrong! What we have done here is to simply reduce our capital allocation
per trade relative to the amount of trading capital available within our
trading account. The amount of risk associated with each trade has not been
taken into consideration; therefore, we are going to go broke more slowly —
what a comforting thought! The principle of percentage dollar allocation has
seen a slight improvement in the average profit experienced, returning at
$59.30; however, our losses averaged $43.56. Our losses impacted upon our
profits by 73.08 per cent; this is not good. Again, we are in the same situation
as previously, where our minimal profits are simply insufficient to the point
that our ongoing losses are not covered.
Now think back to our earlier example where I explained how we calculate
risk exposure per lot size. If we are losing excessive capital per trade then
regardless of whether we link this to total trading capital or not, we are going
down the gurgler. Hopefully this is helping you begin to understand the
importance of risk as shown in the previous tables.
Fixed dollar risk allocation
Now let’s have a look at allocating capital relative to risk rather than relative
to total trading capital. There is the common belief that by simply linking
capital allocation to account size without taking the degree of risk exposure
into consideration we are somehow assured of survival, which has been
shown not to be the case.
For the first time I am using risk per trade in preference to capital allocation
per trade. I will continue by risking a fixed amount of $500 per trade for each
cross rate rather than simply allocating capital per trade (see table 16.5 and
figure 16.5).
What a dramatic change in result simply by switching our focus from capital
allocation to acceptable risk management. While the strategy has not altered
in any way in regard to effectiveness, with the profitability rate remaining at
37 per cent, its efficiency has improved dramatically, simply brought about
by us controlling risk. With many cross rates experiencing declines in recent
times our first two methods produced short-side losses of $520.14 and
$1051.29 respectively, when in reality solid profits should have been
generated, while our dollar risk allocation technique produced a healthy
return of $35 213.13 over the identical period. Furthermore, the average
profit has improved significantly, coming in at $754.21, while the average
loss was $330.67. Our losses impacted upon our gains by 43.84 per cent.
Not startling but a vast improvement.
Table 16.5: 20-day high — 20-day low
Figure 16.5: fixed dollar risk allocation
What this highlights for our less-experienced trader is that no matter how
favourable market conditions may be, if incompatible money management
techniques are applied, profitable results will not be forthcoming. Do not kid
yourself on this point; denial will not alter this basic fact, nor will it improve
your end result or your account balance.
Fixed percentage risk allocation
Finally, fixed percentage risk allocation of capital is usually the preferred
method used by most successful traders, including myself, and one that Daryl
Guppy advocates as mentioned previously, and this is done with good
reason. Generally speaking, percentage risk allocation will produce superior
results in most markets and under the majority of conditions (see table 16.6
and figure 16.6). Occasionally the net returns are less than we can experience
when using fixed dollar risk for the simple reason that when things are going
against us and capital is in decline so is risk allocation. Fixed dollar risk
will usually generate the higher return; however, this comes about due to the
static nature of applied risk.
Table 16.6: 20-day high — 20-day low
Figure 16.6: fixed percentage risk allocation
Finally, applying the risk management method of defining risk by 2 per cent
we have again produced a profitable result; however, on this occasion the
method is not as effective as the fixed dollar risk technique. While our shortside trades produced a very similar result we copped a beating where our
long-side trades were concerned. A loss of $6190.06 has put a dent in our
overall result, which is somewhat disappointing; however, this highlights the
point that not all things work at their optimum all of the time. The average
profit was by far the most impressive, returning at $1153.21, while the
average loss experienced was $596.20. The impact of losses on our overall
gains was 51.69 per cent. This has occurred on the back of the beating we
took on the long side; however, with this said, we have remained profitable
though we have sacrificed a sizeable portion of our trading account.
Some of you will go, hah, wouldn’t use this method, look at the drawdown on
trading capital. While this is a fair comment, before conclusions are drawn
compare the results of capital allocation to risk allocation. I have taken a
strategy with a low success rate and applied it to the currency market using
the most basic of exit strategies and managed to turn a loss into a moderate
profit while still only experiencing a success rate of 37 per cent. By all
reasoning I should have gone broke using all four techniques.
The majors
So far I have assessed risk against the 24 cross rates that are usually
provided with most MetaTrader™ platforms; however, it is not necessary to
trade all cross rates in a similar manner to which we would trade shares, for
example. When share trading, for instance, many of us will utilise a single
strategy that we then apply across numerous stocks. When trading currencies,
it’s often more effective to trade just the majors using multiple strategies.
This is a further step in the risk management process. Currency brokers make
their money by the spread between the bid and ask. With the majors, this is
often as low as one pip. This in turn has the potential to put our position into
profit much earlier than when we are trading the minor cross rates whereby
the spread can be out to 10 pips and more. By minimising our exposure to
excessive spreads we enhance the probability of success. In addition to this
we are reasonably well assured of having our orders executed instantly,
therefore slippage does not become an issue on most occasions. If I was to
apply the most efficient risk management technique as identified here to just
the top eight majors, how would our simplistic turtle approach perform? If
we are going to limit our trading to the majors then we could also apply a
more suitable trailing stop. In this situation I will apply a conventional bear
range stop as discussed in my book Breakthrough Trading. In addition to
this, as all instruments tend to fall more quickly than they rise, including the
majors, I will shorten the entry period from a 20-day low to an 11-day low
(see table 16.7 and figure 16.7, on p. 316). Beyond the application of a more
suitable trailing stop and the shortening of the entry periods for a short
position everything remains unchanged. The list of majors will vary
depending on which website you decide to reference or platform you choose
to trade; however, you will generally find the following cross rates are the
most heavily traded:
• EURCHF
• EURJPY
• EURUSD
• GBPEUR
• GBPUSD
• USDAUD
• USDCAD
• USDCHF
• USDJPY.
I trade currencies using the MetaTrader™ platform.
Would you think it reasonable to conclude that while our success rate may
improve slightly due to a more efficient trailing stop our overall return will
be down due to the reduced number of trades being experienced due to
limited exposure?
Table 16.7: 20-day high — 11-day low
Figure 16.7: the majors
Interestingly enough, our success rate dipped slightly down to 34.07 per cent
from 37.01 per cent on average as experienced previously. While this is not a
significant drop it is not a desirable outcome. What is of interest here is that
our degree of loss is basically no different to that of when we applied the
technique to all cross rates. Our average dollar loss was $335.84 while our
best result so far has been –$330.67. In regard to profit our best result so far
has been $1153.21, which we happened to generate using the fixed dollar
risk method. The average profit trading just the majors is the second most
effective returning at $940.03. The impact of losses on our gains was 35.72
per cent, which is by far the most efficient. If we refer back to table 16.2, in
order to survive with a success rate of approximately 30 per cent we need to
generate 46.67 per cent across our profitable trades, which we have
achieved comfortably with an average return of 64.28 per cent. We have
covered our losses and returned a comfortable profit in the process.
None of the equity curves shown here are very pretty, nor are they intended to
be as one cannot expect this to occur when we are applying a strategy that
only experiences a 30-plus percent success rate. Likewise, our trailing stop
selection is nothing to rave about either, with neither stop being refined for
improved strategy efficiency, as this is not the intention nor purpose of this
chapter. I have applied what is popular not necessarily the most suitable.
Margins magnified
Finally, what is now becoming commonplace, no doubt with the aim of
attracting newcomers with minimal capital, is the lure of 400:1 margins.
Where conventional forex trading is concerned the margin rate is usually
100:1; this is generally accepted as industry standard. If I intend to trade one
lot which has a value of $100 000 my broker will quarantine $1000 of my
trading capital in order to cover against any adverse movement. If I am
trading with a margin of 400:1 my broker will quarantine $250 of my trading
capital in order to cover $100 000 worth of currency. If you think about this
for one moment, we have the same exposure with one-quarter of the
insurance. Would you cut your home insurance by 75 per cent just to save a
few dollars or, in this case, attempt to make a few extra bucks by increased
margin? While this may be appealing for some it is a recipe for disaster if
sizeable accounts are involved. First up, margins aim to cover adverse
movement from the brokers’ perspective. The margin is defined by the
amount of capital allocation not the degree of risk exposure as the broker has
no idea of where our trailing stop is positioned; therefore, we as traders need
to be aware that the amount at risk does not exceed the amount covered by the
margin. If we look back to our original example we had a potential risk
exposure of $1573.4420 at 146 pips. The problem here is that our broker has
only quarantined $1000 (100:1) of our trading capital and we are still well
off our trailing stop. If we have insufficient funds in our account then we will
be requested to reinstate the shortfall or the position will be promptly closed.
When I revised the example back to a maximum of $500 risk this reduced our
lot size to 0.3. Again we are still not out of the woods as our broker will
earmark $300 in order to offset any potentially adverse movement. As we
have decided that a $500 loss is within the rules of our strategy we are still
short of covering our broker’s margin by $200.
This highlights the point that we should never trade to the limits of our
account. In typical share trading, where margins do not exist, it is perfectly
acceptable to have full capital allocation to the market when appropriate;
however, forex trading differs. If we are going to apply strategies relative to
general trend behaviour then it is my experience that expected loss relative to
lot size will usually exceed the margin taken by my broker. This is
commonplace when trading forex, and providing we are aware of it this is
not an issue. Because of this I seldom expose any more than 60 per cent of
my total trading capital to the market at any one time. Simply changing from
100:1 to 400:1 does not change this situation. It merely moves the decimal
point, as I will now explain.
Let’s say that I have a much smaller trading account of $500, which is a
relatively common requirement if you want exposure to 400:1. It is a
common belief by many that this is all that is required to commence a
prosperous career in the world of currency trading. Sorry to be the bearer of
bad news here. Surprisingly, many attempt to start with such amounts. The
belief is that the additional exposure will help you grow your capital in the
early stages and once you have a sizeable account the margin reduces back to
100:1. Good in theory but I suspect the concept experiences only limited
success in real life because those with limited capital are usually the ones
with limited experience. The reality is that nothing actually changes from a
trading perspective.
We need to remember that pip values remain unchanged regardless of margin.
Bear in mind, only the lot size can alter pip values. The only thing that
changes is the margin required by our broker in order for us to open the
position. Technically I could open a position, let’s say one mini lot, which is
equivalent to $10 000, with just $25. While this is appealing on the surface
our position only has to drop by 23 pips and I will have received my first
margin call at 0.9256¢, as seen in figure 16.8.
(0.0001 ÷ 0.9279) × $10 000 = $1.0777
$25 ÷ $1.0777 = 23.19 pips (round down to 23)
Figure 16.8: restrictive initial stop based on lot size
Source: BullCharts.
In reality if we are trading a micro account that has a maximum balance of
$500 then ideally we would be looking to limit our risk to $10 per trade,
assuming of course that we have allocated maximum allowable funds to our
account. I will repeat the partial lot calculation for you whereby we simply
divide the allowed risk by the known risk per lot.
(0.0001 ÷ 0.9279) × $10 000 = $1.07770
146 × $10.777 = $157.3442
$10 ÷ $157.3442 = 0.06 (lot size)
As you can see, nothing changes beyond the location of the decimal point. I
will not attempt to elaborate further on how to define risk at 400:1 as I think
you can begin to see the correlation between full-sized accounts and micro
accounts. If you can’t make a reasonable living at 100:1 then greater
exposure will only assist in sinking you further into the mire with equal
efficiency. A margin of 100:1 is ample; however, a number of brokers are
now offering micro lots, which is acceptable if you want to hone your skills
first without exposing too much capital. However, don’t think for one moment
that you will become the next George Soros because trading does not become
easier nor more profitable, our position sizes simply become smaller. All
other facets of trading, including technical and risk management, remain
unchanged. Go Markets offers micro accounts that utilise nano lots
commencing at 0.01 with a lot being $10 000 instead of the usual $100 000.
Final thoughts
Capital commitment and risk exposure is an area in which the seasoned
trader is well versed, while the inexperienced campaigner considers that risk
management is for wimps and those who lack the intestinal fortitude to trade
like real men (and women!). Well, I’m the first to acknowledge that when it
comes to trading, I’m a proper wimp; however, I’ve been toasted by the
market enough over the years — usually through complacency mixed with an
occasional splash of stupidity — to know that I must respect this aspect of
trading at all times. A number of readers may feel that I am reasonably risk
tolerant looking at the earlier charts, which is a fair conclusion to draw on
the surface as my trailing stops often appear some distance from price action
as highlighted earlier in the chapter; however, the position of a trailing stop
does not determine my degree of exposure, it’s the amount of capital that is
allocated to the position that defines my exposure. My trailing stop merely
defines the point of position closure. This is a common mistake made by
many where they consider that the degree of risk is defined by stop placement
when in reality it’s the capital allocated to the position that defines risk.
The following must occur in the order shown here; there can be no argument
on this:
• trend behaviour defines stop placement
• stop placement defines capital allocation
• capital allocation defines risk.
What I have endeavoured to do is to show you that regardless of how good or
bad a strategy may be, it’s the method of how we manage risk that defines the
eventual outcome. Entry and exit signals are important regardless of what
anyone attempts to tell you. Just think of how effective our strategy would be
here if we could lift the success rate to 40 per cent or, better still, 50 per
cent. Alan Hull advocates trading a strategy with a success rate of greater
than 50 per cent and with this I must concur. Develop yourself a timely entry
signal that is reliable more often than not while supporting this with a trailing
stop that takes trend behaviour into consideration.
Often it’s not the strategy that defines our success nor our sheer brilliance, as
we would often like to delude ourselves, but the manner of how we apply our
capital by way of risk management to the instrument in which we choose to
trade. A perfectly acceptable strategy can fail when incorrect capital
allocation and risk techniques are applied. If the basic principles of risk and
capital allocation are not second nature to you then master them first on a
non-leveraged/margined instrument such as shares before delving into the
world of derivatives and margined instruments. Always remember that when
trading currencies, it’s risk management that counts, not capital allocation,
and that increased margin does not imply enhanced gain. Trade all currencies
in the same manner as you would any other instrument relative to your
understanding and strategy while keeping both feet firmly planted on the
ground. A succession of profitable trades from forex trading can see greed
get in the way of logic and discipline. The forex market can produce
significant returns; however, it can take them with equal ferocity, leaving
those who experience this shattered and disillusioned. On the goldfields, all
arrived with high hopes and great aspirations for a better life; however, only
a handful of diggers ever walked away with the reward. The rest managed to
etch out a meagre living, died trying or walked away broken men.
Make sure you know what tools to use, where to dig and how to protect
yourself from potentially fatal risk. The forex market may have the greatest
reward; however, it also has a lethal bite. I’m not attempting to discourage
you from trading forex, just make you aware of the market you are
endeavouring to master. Take the information from this chapter and adapt it
so it may work for you. The only place you will find wealth before work is
in the dictionary, so the task is now before you. Good luck and may the
markets be with you!
Chapter 17: Stepping into futures
An introduction to trading futures
Kel Butcher
Trading commodities and other markets such as equity indices and interest
rate products using futures contracts presents traders with a number of ways
to participate in and profit from a continuing array of opportunities presented
by these global markets. Opportunities to profit always exist for the trader
with a consistent and disciplined approach to his or her trading business. The
futures markets present us with an array of trading and even investing
opportunities across a range of global markets. For those looking to expand
the range and diversity of markets they are trading, transfer their existing
trading skill set to other markets or to spread their risk profile, serious
consideration must be given to trading futures. There are a number of very
significant advantages to trading futures, which will be discussed in this
chapter. Initially, though, it is important to have some understanding of what
futures contracts are, who the major players are and to understand the history
of futures trading and how it has evolved over time.
A brief history
The cyclical and seasonal nature of agricultural production, which often
results in gluts in supply during the harvest season (and cheap prices as a
result) followed by shortages in the winter months (and rising prices), was
the basis for the development of modern-day futures markets. In an attempt to
smooth out the wild price fluctuations that can occur in response to seasonal
supply and demand, both buyers (end-users) and sellers (producers) began to
introduce a method to guarantee delivery of a specified quantity of a product
at a specified price.
Forward contracts
Commodity markets have existed for centuries wherever producers and
consumers traded goods in exchange for cash. While cash began as the most
common form of settling transactions, agreements began to be made between
the counterparties to deliver a commodity at a designated time in the future at
a price agreed on in the present. Payment would be made on receipt of the
agreed quantity of the commodity at the specified quality. These agreements
became known as forward contracts. These contracts meant that the producer,
usually a farmer, could plant his crop knowing that he was guaranteed a
return for his time and investment, and the buyer was assured of receiving the
contracted commodity from the producer. These forward contracts were not
as effective as they first appear, as they were often not honoured by either
party if market conditions, namely price, had changed significantly from
when the contract was first negotiated. If, for example, the price had risen
dramatically due to poor seasonal or climatic conditions, the seller would
back out of the agreement claiming an inability to deliver the contracted
quantity or quality due to the effects of drought, flood or other conditions.
Similarly, in years of overproduction when prices fell, the buyer would back
out as crop prices were now much cheaper on the open market due to an
excess of supply. Other problems with these original forward contracts
included the lack of liquidity, the need for buyers and sellers to firstly locate
each other and then negotiate a contract, the individual nature of each of these
forward contracts and the lack of any formal way of ensuring that these
contracts were honoured. The first recognised organised futures exchange
can be traced to the Dojima Rice Exchange in Osaka, Japan in the 1700s.
The Chicago Board of Trade and Chicago
Mercantile Exchange
In the 1840s in the United States, Chicago began to emerge as the market
centre for grain farmers. Each year at harvest time they would arrive to sell
their grain. In abundant years there would be too few buyers, prices would
be low, and with no way of storing all the excess production, much of it
would be dumped. In the winter time prices would rise due to a lack of
available grain supplies. Privately negotiated forward contracts were agreed
to between buyers and sellers. In 1848 a group of grain merchants decided to
band together and form an organised grain exchange where buyers and sellers
could meet and conduct business at a centralised location. The Chicago
Board of Trade (CBOT) was formed and the first official forward contract
was written on 13 March 1851. In 1865 standardised futures contracts were
introduced. With a formal exchange now in place, the ability to access
product year-round was necessary and storage silos were built to handle the
excess that occurs each year at harvest time. This storage helped to smooth
out the wild fluctuations in price that had occurred previously.
In 1874, inspired by what had occurred in the grain markets, a group of
merchants formed the Chicago Produce Exchange to allow the buying and
selling of futures contracts on other agricultural products. These included
eggs, butter, hides, onions and potatoes. In 1919 the name was changed to the
Chicago Mercantile Exchange (CME). Over the years more contracts were
added, starting with frozen pork bellies in 1961, followed by financial and
currency futures in the 1970s, then interest rate products and equity index
futures and options in the 1980s. These contracts were all traded by open
outcry in a trading ‘pit’ where brokers developed a unique hand-gesture
system to facilitate trade execution.
In the early 1990s as the internet began to expand, exchanges began
introducing electronic trading on some futures contracts in off-exchange
hours. Since then, electronic trading has expanded to include side-by-side
electronic trading, where markets are traded simultaneously in the pit and on
electronic platforms, and more recently the development of contracts that
trade solely on electronic markets, such as the E-mini S&P. Futures trading is
now conducted 24 hours a day, six days per week.
Today CME is the largest futures exchange in the US and among the three
largest futures exchanges in the world along with the Eurex exchange
(established in 1998) and NYSE Euronext Liffe Exchange (previously the
London International Financial Futures Exchange). The futures markets have
far outgrown their agricultural origins. The majority of futures contracts are
now traded electronically via 24-hour online platforms that make them a truly
global marketplace.
The evolution of futures contracts
The initial contracts traded on the CBOT exchange were forward contracts
that still had issues with defaults occurring as discussed previously. To
resolve these non-delivery issues the exchange introduced a system of cash
deposits. Each party involved in a forward contract was required to deposit
a sum of money with a neutral third party to help ensure that both parties
would honour the agreement. If either party defaulted on the deal the other
would receive the cash deposit as reimbursement for any financial loss or
inconvenience.
Standardised contracts
In 1865 standardised contracts were introduced. These specified the quantity
and quality of the commodity being traded as well as the delivery date, but
not the price. They were also interchangeable, which allowed them to change
hands between buyers and sellers many times before the specified delivery
date as prices fluctuated.
Modern-day futures contracts
Present-day futures contracts evolved from these original standardised
forward contracts. While they retain the basic concepts of these original
contracts, they are now very specific contracts that cover a wide range of
markets and related products. The underlying principle and major benefit of
standardised futures contracts is that at contract expiration date the holder of
the contract (the buyer) has the obligation to take delivery under the terms of
the contract, while the seller is required to make delivery.
Offsetting
Because they are interchangeable many people who never intend to either
make or take delivery of the underlying commodity can buy and sell futures
contracts. These traders and speculators buy and sell futures contracts as a
way of making a profit from price fluctuations as market conditions change.
They are taking advantage of a key feature of futures trading: the ability to
eliminate an open position by buying or selling the opposite side of the
existing open position before the expiry date — a process known as
‘offsetting’. Every futures contract has a last trading date whereby all open
positions must be closed out. For both physical-delivery futures contracts
(such as wheat and lean hogs) and cash-settled futures contracts (such as
Eurodollars or E-mini S&P), open positions are closed out by making an
offsetting trade. If you are long wheat, for example, you simply sell the
futures contract, profiting from the difference between the price you paid and
the price you sold at, or accepting the loss if the price has moved against
your open position. You have ‘offset’ your open position. Figure 17.1
displays this offsetting process.
Figure 17.1: offsetting process
Taking delivery
Alternatively, you can take delivery (in the case of physical-delivery
contracts), or have the position closed out by a final mark-to-market cash
adjustment (in the case of cash-settled contracts), which will result in a
credit to your account if you have made a profit, or a debit to your account if
you have incurred a loss. Less than 5 per cent of all futures contracts actually
result in physical delivery. The vast majority of market participants prefer to
close out or offset their open positions prior to expiration date. Some
producers and end-users may choose to take delivery and this will be
discussed later in this chapter.
Definition of a futures contract
A futures contract is a legally binding, standardised agreement to buy or sell a standardised
commodity or financial instrument of specific quality and quantity on a specified future delivery date
at a given location. The only variable is price. Some futures contracts, such as wheat and live cattle,
call for physical delivery, while others, such as Eurodollars and S&P 500, are cash settled.
The role of the clearing house as central
counterparty
In order to handle the ability to offset futures contracts, a method was needed
to match the final buyer with the final seller. Futures exchanges developed
clearing operations to record all transactions and to document transfer and
delivery of futures contracts between buyers and sellers. This clearing
operation assumes the role of third party to every transaction. The clearing
house assumes the role of seller against the original seller and buyer against
the original buyer, and ensures the integrity of all trades. It operates as if the
seller has sold to the clearing house and the buyer has bought from the
clearing house, as the counterparty in every trade. It can do this because the
number of long contracts is always equal to the number of short contracts.
The leveraged nature of futures contracts adds to volatility and can lead to
situations where large losses can be incurred by one party to a transaction,
who may be unable to honour their obligations at the settlement date. For a
market to operate efficiently and effectively, all market participants need to
be assured that all transactions will be honoured, particularly in instances
when prices may have moved significantly. If the buyer and the seller were to
deal directly with each other the need to run credit assessments, set credit
limits and arrange settlement would be a messy, costly and time-consuming
process that would detract from the advantages of a centralised exchange. To
prevent this the clearing house interposes itself between the two
counterparties and guarantees that each trade will be settled as intended in
the contract. This process is called ‘novation’ and means that traders have no
counterparty risk. The clearing house is able to accept the risk through use of
a margin requirement process.
Clearing house margin requirements
The clearing house charges two types of margin: the initial margin when a
trade is opened, and the variation or mark-to-market margin on open
positions. Trading futures allows you to use leverage to control large
positions with a relatively small amount of your own capital. To enter a
trade, only a fraction of the contract’s full value is required. This margin
deposit confers no rights of ownership, it is simply a security bond required
to protect the financial integrity of the market.
Initial margin
The initial margin (also called a performance bond) is a security deposit
required by the clearing house to ensure that traders have sufficient funds to
meet any potential loss from a trade. This is essentially a ‘good faith’ deposit
that you pay to indicate that you will be able to fulfil your contractual
obligations. These initial margin amounts are determined by the futures
exchange and are a function of the volatility of each futures contract, not a set
percentage of the contract value. Brokers are permitted to request higher
margin requirements from private clients, but never less than the minimum
amount set by the exchange. If at any time your account dips below a
specified maintenance level, you will be required to deposit more money to
keep your account up to the initial margin requirement level.
Variation or maintenance margin
Also called mark-to-market margin, this is an amount of the initial margin
that must be maintained for each position before a margin call is generated
and you have to add further funds to your account. At the end of each trading
day your open positions are re-valued at that day’s closing price. The
clearing house will add money to your margin balance if you are in profit,
and deduct money from your margin balance if you are in loss. If the loss is
large enough that the balance in your margin account has fallen below the
maintenance level, a margin call will be issued and you will have to
replenish your account with extra cash, or close out the position.
By way of example, let’s assume that the initial margin on a wheat futures
contract is $1200 and the maintenance margin is $800. When you buy or sell
one wheat futures contract to open a position you will need to have $1200 set
aside in your account for the initial margin. If the price of wheat moves
against you by 10¢ per bushel or $500 per contract, you have violated the
maintenance margin level of $800 ($1200 – $500 = $700) and will need to
add an additional $500 to your account to bring it back to the original
maintenance level of $1200.
A margin call will be triggered when the value of your account drops below
the maintenance level for all your open positions. For example, you have six
open positions with an initial margin requirement of $8000, and a
maintenance margin requirement of $5000. If the value of your account drops
to $4500, you will get a margin call for $3500 to bring your account back to
the initial margin requirement. You can also liquidate positions and thus
eliminate the margin call.
These margin requirements mean that it is highly unlikely that a client will
not be able to fulfil their obligations according to the futures contract. It also
helps ensure the financial integrity of the clearing house, the brokers and the
exchange as a whole, and adds to the appeal of trading futures.
Participants in the futures markets
The range of participants in the futures markets, as in any market, is large and
varied, ranging from small retail traders to large end users and institutional
trading operations. These participants usually fall into two main categories:
hedgers and speculators.
Hedgers
Hedging is essentially buying or selling futures contracts to insure against any
adverse change in the price of a commodity or financial instrument. Hedgers
may be individuals or firms that buy or sell in the futures markets in order to
establish a known price level today for something they intend to buy or sell
for cash at some point in the future. By taking a futures position that is equal
and opposite to their cash position they are attempting to protect themselves
against the risk of an adverse price change occurring as a result of adverse
weather conditions, economic downturn, currency fluctuations and other
variables. There are any number of hedging strategies available.
The underlying principle of any hedging strategy is that the hedger willingly
gives up the opportunity to benefit from any favourable price move in order
to achieve protection against any unfavourable price changes. A corn farmer,
for example, may short sell corn futures to lock in a price for his corn prior
to actually harvesting the corn crop, thus avoiding any downward move in the
price of corn. The downside is that he will forgo any further profit if the
price of corn were to increase. At the same time, an end user of corn such as
an ethanol manufacturer or flour mill may buy corn futures to lock in the price
they will pay for corn, thus avoiding any upward move in the price of corn.
The downside is that they will forgo buying cheaper corn if the price were to
fall.
Similarly, a superannuation fund or pension fund manager who is nervous
about the global economy might short sell S&P 500 and Euro Stoxx 50
futures to offset stock positions held in a global share portfolio instead of
selling the stocks. If share prices fall the fund will have protected its position
by profiting from the fall in the price of the futures contracts.
Speculators
While hedgers use the futures markets to manage risk, speculators enter the
futures markets to accept risk in the pursuit of trading profits. In doing this
they must also be prepared to accept losses as a natural part of the trading
process. Speculators add liquidity and capital to the futures markets and thus
contribute greatly to the process of price discovery. Traders who expect a
market to rise in price will go long by buying a futures contract with the
expectation of selling at a higher price. Those who expect a market to fall in
price will go short by selling a futures contract with the expectation of buying
it back at a lower price. One of the unique characteristics of futures is the
ease with which both long and short trades can be initiated. It is a
characteristic that adds significantly to the appeal of trading futures.
Buy and sell decisions are arrived at through various methods of technical
and fundamental analysis. If a commodity is in short supply, or perceived
short supply, speculative buyers will enter the market causing prices to rise.
If a product or commodity is oversupplied or there is reduced demand for it,
speculative short sellers will enter the market and the price may fall until it
reaches a price where buyers will re-enter the market. This constant
interaction of buyers and sellers is what contributes to price movements as
the supply and demand battle continually plays out in the markets. This
process of price discovery is a constant and continuous one that reflects the
dynamic nature of trading futures. It is a major economic function of futures
trading where the only certainty is that price will change!
Minimum price changes and daily price
limits
In order to give some structure and guidance to the markets, futures
exchanges determine the minimum price movements for individual futures
contracts, and the maximum daily price movement that can occur for some
futures contracts.
Minimum price moves (ticks)
Each futures contract has a minimum amount by which it can move up or
down. These minimum price moves are established by the exchange and vary
with each instrument. These minimum price moves are called ticks. On a
gold futures contract, for example, a tick is 10¢ per ounce, so a one-tick
move on a 100-ounce contract is worth $10 (10¢ per ounce × 100 ounces). In
comparison, a tick on a grain futures contract is 0.0025¢ per bushel. On a
standard 5000 bushel wheat futures contract that equals $12.50 per tick
(5000 bushels × 0.0025¢ per bushel). It is important to know the tick moves
for the futures contracts you trade so you know how a price change will
affect the value of the contract. This information is available from your
futures broker or from the various exchange websites.
Maximum daily price limits
Commodity exchanges also establish maximum daily price limits for futures
contracts. These limit prices are stated in terms of the previous day’s closing
price plus or minus a specified amount in cents or dollars per contract unit.
Once a futures contract has increased or decreased in price by its daily limit
no more trading can take place until the next trading session — this is termed
‘locked limit’. If the daily limit for live cattle futures, for example, is 3¢ per
pound on a 40 000-pound futures contract and the previous day’s settlement
price was 92¢ per pound there cannot be any trading during the current
trading session at any price above 95¢ per pound or below 89¢ per pound.
Price is allowed to increase or decrease within the limit amount each day.
These daily price limits can result in days when it is not possible to exit an
existing futures position because the market is locked limit. This can be
frustrating and costly if the market is moving against you, or extremely
beneficial if the market is moving in the direction of your open position. In
the live cattle example above, the daily 3¢-per-pound limit equates to $1200
per futures contract (3¢ per pound × 40 000 pound contract).
These daily price limits are eliminated during the contract expiry month (also
called the delivery or spot month) for some contracts, allowing price to trade
according to supply and demand and not be artificially curtailed by the
imposition of daily price limits. While daily limits are supposedly imposed
by exchanges to provide order to the market, they are inefficient and
frustrating for speculators as it can be difficult to exit a trade if a market
trades locked limit for consecutive days. It would be far better to have no
limit applied to these markets and let price naturally find its own level. The
professional use of stop-loss orders by traders would ensure positions could
be liquidated much more efficiently.
Position limits
Exchanges and regulators also impose limits on the maximum speculative
position that any one person can have at any one time in any single futures
contract. Maximum position limits are imposed to prevent any one buyer or
seller from being able to influence the price of a market through their buying
and selling activities. These position limits are stated in total number of
contracts or total units of the instrument or commodity.
A typical futures contract
The live cattle futures contract displayed in figure 17.2 shows all the features
we have discussed so far. You can clearly see that this is a contract for the
physical delivery of 40 000 pounds of grade-three steers priced in cents per
pound. The minimum tick move is 0.00025¢ per pound or $10 per contract,
and the daily price limit is 3¢ per pound. This contract is traded side-by-side
on both the Globex electronic platform and in the trading pit during pit hours.
You can also see the contract months, the last trading day and the position
limits.
Monthly expiry and rollover
Futures contracts are traded for specified delivery months. For some
contracts these are every month, while for others it may be every second or
third calendar month. In figure 17.2 you can see that live cattle contract
months are every second calendar month. Each calendar month is given an
alphabetical symbol as shown in table 17.1 (p. 336). The next available
contract month is called the ‘front month’ or ‘nearby month’ while those
further away are referred to as the ‘back months’.
Figure 17.2: live cattle futures contract
Source: Chicago Mercantile Exchange Group.
Table 17.1: delivery month symbols
When placing trades electronically these codes are used to specify the month
you are trading. If, for example, we were to place an order to buy October
live cattle, we would enter LCV followed by the year numeral into our
trading platform.
This monthly expiry of futures contracts gives rise to a process called
‘rollover’. For example, you may be long cotton futures contracts and the
delivery date is approaching for the contract month you have bought. You
believe price will continue to rise and you want to capture more profit on the
trade. To roll over to the next contract month you simply sell out of the
contract month you are holding and buy the same number of contracts in the
next month. This trade is done simultaneously and most brokers charge a
reduced rate for specified rollovers.
Leverage
Futures are traded with the use of leverage, which is a major attraction for
traders and speculators. Trading with the use of leverage enables your money
to work much more efficiently than if you could only use your own capital to
trade with. You are able to control large amounts of a commodity or
instrument for a fraction of its face value, as only a small initial deposit or
margin (as discussed previously) is required to trade. As a result a relatively
small movement in price can produce large profits in relation to this initial
margin. Leverage is, however, a double-edged sword, and small movements
in price against your position will also magnify losses.
The initial margin requirement at the time of writing for the live cattle futures
contract shown in figure 17.2 is $1080, on a contract with a face value of
around $38 000. This means we are able to initiate a position, either long or
short, in this market by lodging just $1080 as margin with our futures broker,
who in turn lodges it with the exchange. A 1¢-per-pound move equates to
$400 per futures contract. If the trade moves in our favour by 1¢ per pound
we have a $400 profit per contract or a 37 per cent return on our initial
margin requirement ($400 profit on $1080). If we had to use all of our own
capital to participate in the trade the return would be just over 1 per cent
($400 profit on $38 000 contract value). Conversely, if the trade had moved
against our position by 1¢ per pound, our losses would be equally magnified.
Through the power of leverage, a 1 per cent move in the price of the futures
contract results in a 37 per cent move in our margin account.
Trading with the use of leverage is enormously beneficial to those who know
and understand the benefits and pitfalls. Used wisely and with prudent money
management and risk management principles in place it can result in
increased profit potential and significant increases in return on capital. Used
incorrectly it can wipe out your trading capital.
Trading futures contracts
Now that we have an understanding of what the futures market is and how it
works, let’s examine the mechanics of placing futures trades.
Choice of broker
Trades can be placed through the use of a broker, who you contact by phone
or email with your order instructions, or you can place them yourself via an
electronic trading platform on your computer. Either way, you will first need
to open an account by completing the necessary paperwork, and depositing
funds into your account for use as margin when you open positions. Brokers
charge a fee for executing trades when you buy and sell futures contracts.
Electronic trading via the internet is considerably cheaper than using a
traditional voice broker, but you need to be confident that you can place
orders competently and quickly yourself. Electronic trading has levelled the
playing field for retail traders as transactions can be executed in a
transparent environment where market makers and floor traders can no longer
use inside knowledge to manipulate price, front run large orders or hold back
small orders.
Hardware, software and data providers
Your choice of computer equipment will depend to a large extent on your
choice of order placement method. Traders using end-of-day data and placing
orders with a voice broker will need much less sophisticated equipment than
those trading short term and firing orders into the market from their own
computer. In order to confidently execute trades via the internet it is essential
to have high-quality equipment and software to ensure fast and efficient
market access and order execution.
A high-speed, reliable internet connection is essential, as is a fast and
reliable computer. Ideally, for short-term and intraday traders this computer
should be dedicated to trading, with another computer used for emails, webbrowsing, data storage, etc. Your trade execution platform that provides live
prices and quotes must also be fast and reliable.
Market analysis, chart studies, system design and back-testing are all carried
out on charting software programs designed specifically for these purposes.
It is essential that this software analysis program be reliable, provide you
with a range of indicators and analysis techniques and allow you to design
and test your own trading strategies across a wide range of markets. My
choice is Trade Navigator from Genesis Financial Technologies. A free 30day trail is available for download at <www.genesisft.com/landing.php?
v=webwisdom>.
Order types
There are some basic order types that all brokers provide and that you need
to be very familiar with when trading futures. There are other more complex
order types, but the ones shown below are the most common ones that the
majority of traders will use. These are:
• market order: an order to buy or sell at the current market price
• stop-entry orders: can be used to enter long trades above the current market
price, or short trades below the current market price
• stop-loss orders: used to exit losing trades
• limit orders: used to enter long trades below the current market price, or
short trades above the current market price. Limit orders are also used to exit
profitable trades at a designated price target
• linked orders: allows us to bracket our orders, using OCO orders so that
our entry order, the stop-loss and the profit target are all placed at the same
time. An OCO order stands for Order Cancels Order and means that once the
trade entry is filled the stop-loss and profit target orders are then activated in
the market. Whichever one of these orders is filled first, the other order is
cancelled.
Orders are placed as either Good Till Cancelled (GTC) or Good For Day
(GFD). GTC orders remain active in the market until you cancel them, while
GFD orders expire at the end of the trading day. Since the advent of
electronic trading it is now important to place orders Good All Markets
(GAM) so that they are working in both the pit hours and on the electronic
market.
Placing an order
Referring back to our live cattle futures contract in figure 17.2, let’s now
look at how we would place an order in this market. Let’s assume that it is
September 2010 and we have decided to go long (buy) on contract. The front
month is therefore October, which has the symbol V. The current price is
94.75¢ per pound and we wish to place a stop-loss 1¢ below this price, and
a profit target 2¢ above. We also want to buy when the price reaches 94.80¢
per pound. Our order therefore is:
‘BUY 1 October 2010 Live Cattle contract at 94.80 On Stop. If filled sell 1
at 93.75 On Stop OCO sell 1 at 95.75 Limit GTC GAM.’
Trade examples
The ability to trade both long and short with relative ease is one of the great
benefits of futures trading. Unlike the sharemarket, where it is often difficult
to short sell shares due to various market rules and regulations, no such
impediments are imposed on the futures market.
Figure 17.3 is an example of short selling wheat in a downtrend. While this
system has taken two short-term trades as shown on the chart, a much longer
term trade could have just as easily been taken.
Figure 17.3: short selling wheat
Source: Trade Navigator © Genesis Financial Technologies, Inc.
Figure 17.4 is an example of trading long in the feeder cattle market. Again,
these are examples of short-term trades, but a longer term trend-following
trade could just as easily have been undertaken.
Figure 17.4: long trades in feeder cattle
Source: Trade Navigator © Genesis Financial Technologies, Inc.
Final thoughts
In summary, there are many benefits to trading futures which informed traders
can use to their advantage. These include:
• leverage to maximise returns from your trading capital
• diversification across a wide range of unrelated and uncorrelated markets
• the ability to trade both long and short
• the fact that markets are driven by ‘real’ supply and demand issues
• order combinations including stop-loss, limit and OCO orders
• the use of electronic trading platforms
• trading on a global market
• the use of mechanised auto-trading systems to execute orders in the markets
• the fact that you are already a commodity consumer — you drink coffee,
wear cotton, drive a car and use bread and corn in a variety of food staples
• the reality that commodity prices will never go to zero, and futures
contracts can’t go bankrupt
• ease, speed and efficiency of order execution.
Futures trading exposes you to a true global economy that, with the use of
robust trading strategies and sound risk management and money management,
can provide great opportunities and returns for the disciplined and consistent
trader. In the words of Michelangelo, ‘The greatest danger for most of us lies
not in setting our aim too high and falling short; but in setting our aim too
low, and achieving our mark’.
Trade well.