11.30.2008

Two types of buying

I once heard a phrase that stayed with me for years—a man who owned a flower shop said that he had to “buy well to sell well.” Flowers have to be sold quickly, before they wilt. Buying at a low price gives the shop owner more pricing power. If business becomes slow, he can drop his selling price and still be profitable. Buying well—getting a low price—helps him sell well.

As we near the end of our brief discussion of buying, we need to discuss its two main types. One is value buying: “buy low, sell high.” The other is momentum buying: “buy high, sell even higher.”

A value buyer tries to identify value and buy near or below it. He wants to sell when prices become overvalued. To help define value I put two moving averages on a chart and call the space between them the value zone (see Figure 3.11). To help define overvalued and undervalued zones I add channels to my daily and intraday charts. The space above the upper channel line identifies the area of mania, and the space below the lower line the zone of depression.


Figure 3.11 Value Buying


In trading, we do not have the luxury of shooting at a standing target—the target keeps moving. Prices move very fast, but the value zone moves at a much slower rate. The concept of a value zone gives a trader a target that moves a little slower than prices.

We will discuss the tactics of selling using the concept of value in a later chapter, but even a quick look at Figure 3.11 will show that the concept of buying at or below value and selling in the overvalued zone makes logical sense.

Momentum trading calls for a completely different approach to buying and selling. The chart in Figure 3.12 shows how a stock, after spending several months in a narrow trading range, broke above its resistance line and accelerated to the upside. Several weeks later, after a half-hearted pullback that did not even reach its former resistance line, the stock accelerated and went up at an even sharper angle than before.

Here, the time to buy was whenever the stock showed renewed strength by taking out the previous day’s high. But where would you sell?


Figure 3.12 Momentum Buying


In retrospect, that point would have come during the false breakout above $20—but this became clearly visible only several days later. How would you decide when to sell at the right edge? Our next chapter is dedicated to the questions of selling.

The two charts we have just reviewed show that the way we sell will depend on why and how we buy. Are you primarily a value trader or a momentum trader? And how do you make this decision?

This tends to be one of many instances where people make market decisions on the basis of emotions rather than hard facts. We make some of the most important decisions in life this way, and it is not necessarily a bad thing. Some of us are temperamentally drawn to buying low and selling high, suspicious of runaway trends. Others scan the markets, looking for runaway trends, jumping aboard and trying to hop off before a significant reversal.

Only you can decide whether to be a value or a momentum trader. I cannot make this choice for you. Whatever you decide, please keep in mind that having a written plan for buying and selling will put you miles ahead of your competitors. Whatever your method, a person with a plan has a clear advantage in trading.

Remember, your mind is a trading instrument. When it gets clouded in the heat of action, as it often does, the quality of your decisions will deteriorate. Having a written plan will keep you rooted in the cooler, calmer times before the trade, when you were in a much better position to make decisions.

When you come to the market to sell, knowing whether you are a value or a momentum trader and having a written exit plan will give you a terrific advantage over the masses of impulsive traders.

Remember—buy well to sell well!

11.28.2008

How to grade your trades

The goal of trading is to make money, but can you use money to measure the quality of every single trade? I believe that the amount of profit or loss provides only a very crude measurement of a trade’s quality.

The amount of money in your account at the end of a month or a quarter is extremely important for plotting the equity curve. That curve provides an accurate measure of your performance as trader. Money does not provide a good measure of any individual trade because theamount you make or lose in a single trade heavily depends on the trade’s size as well as the market’s current volatility.

The best way to rate your performance in any single trade is to measure the number of points gained or lost against the market’s recent volatility. What has been the normal swing of that market in recent months? What percentage of that swing did you catch in the latest trade? Answering these questions will provide a good measure of your performance in that trade.

What yardstick should we use to rate a trade’s quality? A well-drawn channel on the daily chart serves as an excellent reflection of that market’s recent volatility. Our trade grade will show what percentage of the channel we have managed to capture.

For swing trades, I use a channel around the longer moving average on the daily chart. For day-trades, I use a channel on a 5-minute chart, also centered around the longer moving average.

One of the few scientifically proven facts about the financial markets is that they fluctuate above and below value. As a psychiatrist, Ican say that the market is manic-depressive. When it becomes manic,prices rise above the upper channel line. When it becomes depressed,prices fall below the lower channel line. While prices keep swinging between mania and depression, I rate the quality of each trade by the percentage of the channel it captured.

Channels

A moving average reflects the average consensus of value, but what is the meaning of a channel?

The upper channel line reflects the power of bulls to push prices above the moving average—the average consensus of value. It marks the normal limit of market optimism. The lower channel line reflects the power of bears to push prices below the average consensus of value. It marks the normal limit of market pessimism. A well-drawn channel helps diagnose mania and depression.

Most software programs draw channels according to this formula:

Upper Channel Line = EMA + EMA . Channel Coefficient

Lower Channel Line = EMA . EMA . Channel Coefficient

A well-drawn channel contains the bulk of prices, with only a few extremes poking out. Adjust the coefficient until the channel contains approximately 95 percent of all prices for the past several months. Mathematicians call this the second standard deviation channel. Most software packages make drawing them very easy.

Find proper Channel Coefficients for any market by trial and error. Keep adjusting them until the channel holds approximately 95% of all data, with only the highest tops and the lowest bottoms sticking out. Drawing a channel is like trying on a shirt. Choose the size in which the entire body fits comfortably, with only the wrists and the neck poking out.

Adapted from Come into My Trading Room, by Dr. Alexander Elder,
John Wiley & Sons, Inc., 2002





I measure the channel height—the upper line minus the lower line—on the day of the entry into a trade. If you look at Figure 3.1, you will see that column W tracks the percentage of a channel captured in every trade. This is the most important ranking for every trade. Even if you score 100% on your entry and exit but get a low single-digit or even negative number for your trade grade, the trade is a failure. Not a total failure, of course—as long as you keep good records, you are learning from losing as well as from winning trades.

And what about column X in Figure 3.1? Here I fall back on the old school system and call every trade that captures 30% or more of the channel an A trade. Sometimes there are even A+ trades. Any trade that captures 20% to 30% of a channel gets rated B; 10% to 20%, C; below 10%, a C.; and below zero it becomes a D trade. If you now return to Figure 3.3, showing my Outlook Calendar, you will understand why the labels for some winning trades are colored green (Profit) and others blue (Profit Demerit). It is not enough to make profits—it is just as important to earn a good performance grade.

Grading every entry and exit as well as every trade will lead you to adopt a demanding and tough-minded attitude towards your work. As a private trader, you have no manager. To win, you must become your own manager, and that’s what trade ratings help you accomplish.

If you like the rating system I’ve shown you, you can expand it even further. For example, you may want to add a column to your spreadsheet measuring the cost of your trades—the total cost of commissions, fees, and slippage divided by the gross profit from that trade.

How to grade your entries and exits

The two most basic ratings for every trade are the buy and sell grades, which measure the quality of your buying and selling. Tracking them will help you increase your level of competence in entering or exiting trades, whatever their outcome.

You can measure the quality of your buying and selling by comparing your transaction price to that day’s range. When you buy, you want to trade as close to the low of the day as possible. When you sell, you want to trade as close to the high of the day as possible.



The result is expressed as a percentage: if you buy at the low of the day, your grade is 100%, and if you buy the top tick, your grade is 0. Grades below 25% are poor, above 75% superb, and between 25% and 75% satisfactory.


The result is expressed as a percentage: if you sell at the top tick of the day, your grade is 100%, and if you sell at the bottom tick your grade is 0. Here too, you want to score above 75% for an excellent grade, while anything less than 25% is poor.

Whenever I trade, my goal is to score above 50% on my entries and exits. This means buying below the midpoint of the day and selling above the midpoint.1 A non-trading market analyst said to me once that a person who placed his trades at random would average 50% of the day’s range. Far from it! An entire industry of professional traders makes a living from buying low and selling high. When the insiders and the professionals take the lowest buys and the highest sells, the public is left to buy high and sell low. Grading your entries and exits makes you focus on your executions, and that leads to a better performance over time.

If you now return to Figure 3.1, you will understand the meaning of columns U and V. They grade the quality of my entries into and exits from the trades shown in that spreadsheet. Just keep in mind that in long trades the entry is a buy and the exit a sell, while in short trades the sequence is reversed—first a sell, then a buy.

It may seem like an easy task—to buy in the bottom half of a bar and sell in the upper half—but it is surprisingly hard to accomplish. Psychologically, it is easy to buy high and sell low. Keeping a score of your entries and exits and following their trends to measure your progress makes you a sharper, more demanding, and more successful trader. Knowing that at the end of the day you will have to grade your trade helps restrain you from chasing intraday rallies or selling into intraday declines.

How to Grade Your Performance

A person who trades without measuring and grading his performance is like someone who calls himself a competitive runner but does not own a stopwatch. Only a recreational runner can jog around the block without a stopwatch, to get some exercise and enjoy the scenery. A person who claims to be a competitive runner but has no stopwatch and keeps no records is a joker.


How to Grade Your Performance

Imagine two friends taking a college course. Both have similar abilities and backgrounds, but one takes a test each week, while the other waits for the final. All other factors being equal, which of them is likely to get a higher grade on the exam? The one who waited or the one who took weekly tests?

Most educational systems test students at regular intervals. Testing prompts people to fill the gaps in their knowledge. Students who take tests throughout the year tend to do better on their finals. Frequent tests help improve performance.

The markets keep testing us, only most traders don’t bother to look up their grades. They gloat over profits or trash confirmation slips for losing trades. Neither bragging nor beating yourself up makes you a better trader.

The market grades every trade and posts results on a wall, only most traders have no clue where to look. Some count money, but that’s a very crude measure, which does not compare performance in different markets at different prices. You may take more money from a sloppy trade in a big expensive market than from an elegant entry and exit in a difficult narrow market. Which of them reveals a higher level of skill? Money is important but it doesn’t always provide the best measure of success.

From Come into My Trading Room, by Dr. Alexander Elder,
John Wiley & Sons, Inc., 2002

There is no “recreational trading” in the markets. There is competitive trading and there is losing, and not much else in between. If you are serious about winning—and if you aren’t you shouldn’t be in the markets—you must get yourself a stopwatch before you run another lap.

There are many ways to measure performance. I suggest grading your trades on three scales: your buy grade, your sell grade, and—most importantly—the overall trade grade.

Fred`s method - a chihuahua trade

I learned this method for implementing trading plans from an old friend who came to teach at one of our Traders’ Camps. Fred Schutzman is a CTA (commodity trading advisor), and even though he came to teach, he also liked to sit in on my classes. One day I was showing a trade that was coming together, saying that I was going to place an alert with my electronic broker. I wanted to receive a message when that stock reached a certain predefined level.

“Why don’t you place a small order there instead of an alert?” asked Fred.

It hit me that placing an order and receiving a fill had an entirely different emotional meaning than receiving an e-mail. One more e-mail in the midst of a busy day only added to that day’s clutter. It would be a completely different matter to receive a fill for a few shares of stock. Suppose I was planning to trade a 1,000-share lot and placed an order for 10 shares at the trigger level. Once I owned those 10 shares, I’d have to re-analyze the charts and make a decision—to buy another 990 shares, bringing the trade to its full size, or to sell those 10 shares, taking a tiny loss because my view of that stock has changed.

There is a big difference between looking at a picture of a woman and hugging a real one. There is a difference between reading an e-mail about a potential trade and holding a real position, no matter how small.

I liked Fred’s suggestion very much and implemented it immediately. Years later I came up with a name for this method—a Chihuahua trade. A Chihuahua is a tiny dog, so small you can put it into your pocket, but it is a real dog nonetheless. I met a woman in the Dominican Republic who kept a pack of big dogs for security at her estate. The big dogs slept much of the day, but she also had a few Chihuahuas who were always alert. Whenever they heard someone approaching the fence, they began barking, and then the big dogs would wake up and rush in to investigate.

This is why when I am away from the screen and need to place an alert for some future trade, I prefer to place a Chihuahua-sized order. Recently a friend gave me a present—a photo of a Chihuahua at the feet of a Great Dane. I have the picture on my bookshelf and continue to use trigger orders instead of sterile alerts.

11.27.2008

Marget`s method put it on the wall

In addition to the fairly high-tech diary we just reviewed, I want to give you a low-tech method for keeping track of planned trades.

You may look at a chart and see a beautiful trade starting to come together—only it is not there just yet. You may notice a stock sinking on low volume towards its multiyear support zone. You may say to yourself, “If it comes down a bit more and this support holds, I will buy it.” Sounds like a good plan, but what are the chances of you remembering it three weeks later, when the stock actually does what you expected? By that time you’ll be looking at other stocks and dreaming of other trades, oblivious to the fact that your first pick is doing exactly what you expected it to do. You may notice it only many weeks later, when you accidentally glance at its chart and then it hits you—you missed another fantastic buy!

The best trades come together slowly. You notice them from far away and have to wait for more pieces of the puzzle to emerge before you can pull the trigger and place an order to buy or sell short. Meanwhile, you have to keep an eye on the developing trade.

Years ago I became very impressed by a low-tech system my good friend Margret used for keeping track of her trade ideas. Margret, who died last year, was a terrific trader. I invited her to be interviewed for my book Entries & Exits, but she declined. She was modest, even shy, kept a low profile, lived in the Caribbean, and did not want to draw attention to herself.

“My niece gave me $18,000 to trade for her,” Margret said to me once, “and I turned it into $60,000. Now she thinks I may know what I am doing.” “Your niece is right!” I said.

On one of my first visits to her tropical penthouse I noticed that her desk stood in a niche, the size of a small room, facing out into the hall. That niche had a few shelves with Margret’s books and papers but also several large bulletin boards, with charts pinned to them. Margret explained that whenever she saw a trade starting to come together, she printed out the chart and marked it up with a red pen, showing what the stock had to do in order for her to buy it. Margret pinned those charts to the walls of her trading niche. Whenever she walked to her desk she saw the charts with her own hand-drawn action signals. There was no way this woman, who grew up poor, was going to let a good trade pass her by.

If you decide to implement Margret’s method, be sure to take the charts down from the wall after you enter the trade or decide to pass it up. Make sure the visual records on your wall are fresh and up-to-date.

How to document your trading plan

I believe that the best format for creating a trading plan is similar to the Diary we have just reviewed. When you scan a large number of stocks, you can keep brief notes on the potentially interesting ones in a spreadsheet or on a notepad with three columns: Date, Ticker, and Comment. The idea is to narrow down your search to a few actionable stocks. Once you have a handful of candidates, it is time to work them up and create an action plan for each promising one.

When you find a stock that you think you may want to trade in the days ahead, create a plan for it using the same format as the Diary, shown above. Capture a weekly chart using SnagIt, mark its signals with arrows and lines and write on it. Paste the chart with all the markings into a newly created entry in your Calendar within Outlook. Now capture a daily chart, mark it up, and paste it into the same Outlook entry, below the weekly chart. Name that Calendar entry after the stock and label it as a planned trade so that you can easily recognize it. Save and close your newly created entry.


Figure 3.6 Trading Diary—DB, Entry, Daily Chart

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


Figure 3.7 Trading Diary—DB, Exit, Weekly Chart

The weekly chart shows that the price dropped below the value zone, underneath both moving averages. A severe downspike of the Force Index marks a potential bottom. MACD-Histogram has declined close to the zone where upside reversals tend to occur.



Go to your brokerage house website and place an order or orders for your planned trades. Make sure your broker sends you an alert immediately after your order is filled. Once you know you are in a trade, it is a good idea to place your stop-loss and profit-taking orders using an OCO (one cancels other) order. The exact mechanics of placing orders are outside the scope of this book—this is something you need to discuss with your broker.

Once you have created a plan for trading a stock, add its ticker to your monitoring list in the quote window of the program you use for market analysis. The size of the computer screen limits the size of the quote window, which is actually a good thing. I want to monitor only as many stocks as can fit into a single screen, without dividing my attention between dozens of tickers. I like this window (Figure 3.9) to show the key market indexes, such as the S&P500, as well as separate sections for my long, short, and futures positions. I named the bottom section Monitor, and put there the stocks I am considering trading.


Figure 3.8 Trading Diary—DB, Exit, Daily Chart

The daily chart shows that prices are severely overextended to the downside, having fallen out of their channel. At the same time, there is a bullish notch in Force Index. The bears had a great ride, but all rides must come to an end. The odds of this one continuing are not that good.


I also write down the key trading messages on my charts, especially the price and size of my entry as well as the target and stop. When the markets become active, it is easy to lose track of things. This is why writing on the chart is very helpful, as illustrated in Figure 3.10.

Once you execute your plan and enter a trade, move its Outlook Calendar entry from the day when you made the plan to the day when the trade took place. Update the chart and add an intraday chart if you like. Add a few relevant comments—the size of the trade, the entry grade (we will discuss that in a moment), any comments on the quality of your entry, or the feelings the trade evoked. Change the color of the label from purple (Planned Trade) to yellow (Open Trade), then click Save and Close. The entire process of changing a plan into an entry record should take just a few minutes. Most beginning traders feel out of control and overwhelmed by the markets. This system for creating plans and monitoring trades is a tool that will help you control your trading. When your work becomes better organized, you will be in a much stronger position to take profits from the markets.

Figure 3.9 The Quote Window in My TradeStation


My quote window always tracks the latest prices and the net changes for the day. This is the setup I want to see whenever I open my trading program. It shows all the important data at once: the key indexes, my long and short positions in stocks, my futures positions, and my monitoring list. The chart (truncated in this picture) is on the left, the list on the right. I have set up myTradeStation so that whenever I click a symbol in the quote window on the right, its chart automatically appears in the window on the left.


Figure 3.10 Writing Notes on the Charts in the Quote Window

A. Shows the purchase day and price
B. Reminds me about the target and stop
C. The trade in question

Even a faulty plan is better than no plan at all, as long as you record it. If you keep good records, you will be able to recognize any flaws in your method and fix them. Keep doing this long enough, and you may start running out of mistakes! That’s when your equity curve will be ready to turn up.

11.26.2008

Trading diary - your key to lasting success

People who like to explore and learn always make mistakes. Curious and intelligent people inevitably make errors. Someone who never makes a mistake is a narrow-minded individual who stays in his shell, never does anything new and always repeats himself. Whenever I hire people, I tell them that I expect them to make mistakes—it is a part of their job description! I also tell them that what makes me really angry is when people repeat mistakes.

Making mistakes is a sign of learning and exploring. Repeating mistakes is a sign of laziness, carelessness, or some neurotic problems. There is a nice piece of advice in an old Russian saying: “Do not step on the same rake twice!”

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

A Trading Diary is a pictorial record of your trades (see Figure 3.2). It documents your entries and exits by using charts marked up with arrows, lines, and commentaries. I create a diary entry for every purchase or sale. To make sure my diary is always current and up to date I have a rule—no breakfast until my diary for the previous day is completed. This encourages me to update the diary before the market opens and a new trading day begins.

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

Why a pictorial diary, in addition to the spreadsheet?





Figure 3.2 A Visual Diary


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

In February 2007 a variety of signals which we will discuss later in this book led me to become extremely bearish on the stock market. I went heavily short stocks and index futures, as well as long index puts. When the stock market collapsed, I was loaded with shorts. When my indicators signaled that a bottom was at hand, I spent hours taking profits, covering shorts. The next day, instead of going to the office, I worked from early morning until 2:30 PM documenting the trades I had just closed out. If I had to choose between my profit from catching that swing or having my Diary, I would choose the Diary! I can always make more profits if I continue to use my Diary, but without it profits can quickly turn to losses.

To maintain a Trading Diary, I suggest using two inexpensive and widely available programs. You can add them to whatever programs you already use for market analysis. One of them will help you capture and edit images, while the other will let you store and retrieve your diary records.

The best tool for taking pictures of your charts and making notes on them is a program called SnagIt. It makes it easy to capture images from any charting program, draw and write on them and paste them into your diary. Windows provides a PrintScreen utility for taking screen-shots, but nothing compares to the ease, versatility, and the sheer pleasure of using SnagIt (www.snagit.com). I use it almost daily for updating my Diary or sharing trading ideas with friends. Whenever we shoot each other an e-mail, we tend to send charts captured and marked up with SnagIt instead of writing long messages.

My program of choice for keeping a trading diary is Microsoft Outlook.1 This is a fantastically powerful program, but most people scratch its surface by using it only for e-mail. I’ve come to believe that Outlook is the best program for keeping myself organized, focused, relaxed, and in control—and not only in the markets, but for life in general.2

The instructions for using SnagIt and Outlook are included with both programs. The following comments touch upon just a few features of these programs.

Go to the Calendars tab in Outlook, create a new Calendar, and name it Trading. You can view any Calendar in a daily, weekly, or monthly format. I prefer a monthly format, which serves as a table of contents for all of my trades, both open and closed (see Figure 3.3). Lately, I have begun keeping two calendars—one for regular trades and another for long-term positions which stay open for months or even longer.

1I began keeping my first trading diary years ago in a large notebook. I used to print out black-and-white charts on a dot-matrix printer, cut them out and paste them into the notebook with double-stick tape, then mark up trading signals with colored pens. Years later I graduated to an electronic diary, creating a Word file for every trade. I found both diaries cumbersome to keep, and it was difficult to find something in Word when I wanted to look for an old trade. Finally, Kerry Lovvorn (www.kerrylovvorn.com), a camper who became my co-manager of the Spike group, showed me how to implement my diary using the power of Microsoft Outlook. It put me completely in control of my trading history. Later I met a number of traders who kept their diaries in a program called Lotus Notes.

2If you feel as if your work and paperwork are out of control, there are two books I highly recommend. In Getting Things Done, David Allen teaches a system for bringing simplicity and clarity into your life. In Total Workday Control, Michael Linenberger shows how to implement those principles in Outlook. I have read both books several times, took extensive notes, and implemented many of their recommendations. They had a strong positive impact on my life.


Figure 3.3 A Trading Diary in Outlook
See the description of the meanings of colors in Figure 3.4.

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

Whenever you click on a calendar to create a new record for a trade, Outlook allows you to label that entry. The labels show up in the monthly view, and if you set a system of rules for coloring labels, each of them will carry a message (see Figure 3.4).

Most of my Diary entries include two charts—a weekly and a daily. Depending on the trade, I may also add a monthly or intraday chart. Figures 3.5 and 3.6 show a recent example of a Diary entry.


Figure 3.4 Labeling the Entries in a Trading Diary


A trader without a Diary is like a senile person. The poor man cannot learn anything: you can show him today how to zip his pants, but tomorrow he will forget again. Most losing traders are stuck, repeating the same mistakes over and over again. A Trading Diary helps you break out of that vicious circle. Maintaining and reviewing a Trading Diary will lift you to the level of a thinking and learning human being.

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

Not very.

I hope that by now I have convinced you that it is essential tokeep a Trading Diary. Will you promise to keep one? If so, I’ll open my Outlook again and bring up the exit diary. Take a look at Figures 3.7 and 3.8.

Figure 3.5 Trading Diary—DB, Entry, Weekly Chart


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

You can see that the exit is also graded. Its 45% rating was not that great, but the trade grade was very nice. Taking over $9 profit on 1,000 shares was a good payday. See the note—“keep an eye on it to maybe short again.” The trade does not have to end when you exit a position. There is a lot to review, much to learn, and you can continue to make plans for the future. I hope that this exercise has helped convince you that it is important to keep a Trading Diary. You need to document your successes and failures and learn from both.

11.25.2008

Trader`s spreadsheet-basic accountability

Whenever I talk with traders, it amazes me how few people maintain records of their trades in spreadsheets. Many rely on their brokers, but while your brokerage house is probably very accurate, its statements do not provide the necessary level of information. This is why I recommend using your own spreadsheet.
Basic spreadsheet literacy is highly desirable for traders. If beginners took 10% of the time they spend staring at indicators and invested that time in learning basic Excel, their payoff would be much greater. You do not need to become a spreadsheet expert, but a simple ability to manipulate numbers will give you a much greater degree of control over your trading(Figure 3.1).



Figure 3.1 A Basic Record-Keeping Spreadsheet



The previous figure shows the headings as well as a few lines from my own spreadsheet, with my own trades. The text explains the meaning of every column.

This basic spreadsheet takes just a minute to update after every trade. What you see above is a single tab. In my own spreadsheet I have a tab for every account and a summary tab where I record the value of every account on a weekly basis to track my equity curve.

If you would like a more high-end spreadsheet, I recommend Trader’s Governor, programmed by my old friend James (Mike) McMahon. It calculates risk, evaluates trades, tracks capital, and much more. It is extremely powerful, but takes longer to learn than this simple spreadsheet.

Good records lead to good trading. (On keeping records)

Whenever you put on a trade, you must have two goals. The first, of course, is to make money. The second is to become a better trader. You can reach the first goal in some trades but not in every trade. There is a fair bit of randomness in the markets, and even the best planned trades can go awry. Even a top trader cannot win in every trade—this is a fact of life. On the other hand, becoming a better trader is an essential and very reachable goal for every trade. Whether you win or lose, you must become a better trader at the conclusion of each trade. If you haven’t, the trade has been wasted. All the energy and time you put into analysis, all the risks you took with your money—wasted. You must keep learning from your experience, otherwise you are just playing at being a trader and not being serious. The absence of records exposes a wannabe trader as a dreamer and an impostor.

The best way to learn from your experience is to keep good records.

Keeping good records allows you to transform fleeting experiences into solid memories. Your market analysis and your decisions to buy or sell become deposits in your data bank. You can draw on those memories, re-examine them, and use them to grow into a better trader. Writing your notes makes you focus and use your “extracranial memory.” A human mind has a limited amount of memory that is instantly available (what the computer people call RAM).

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

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

The proof of a successful strategy is growing equity. Seeing your equity grow quarter after quarter and year after year is the true proof of trading prowess. Trading is a hard job. We tend to become a little arrogant and careless after a big win or a string of wins. That’s when, feeling invincible, we start feeding our equity back into the markets.

Any trader, even the worst gambler and loser, will occasionally hit it right and score a profit. A single profit or even a handful of profits does not prove anything or matter in the long run. Even a monkey throwing darts at a stock page can occasionally pick a winner. Our most important challenge is to maintain a positive slope of our equity curve.

For that you need to keep good records.

You need two sets of records. All the numbers relating to your trades must go into a spreadsheet and the visual record of your trades must go into your diary.

11.24.2008

The 6% rule - protection from piranhas

As markets go through stages, rallies give way to declines or trading ranges. Your style of trading may be in tune with the current market stage or out of tune with it. This is why you need to protect yourself from the possibility of a series of losing trades damaging your account.

You may follow the 2% Rule, and even reduce it to 1%. Still, when losses begin to pile up, your account may begin to sink. The natural human tendency is to push harder when things go badly and put on more trades. In fact, a much better response is to step back and take some time off. The 6% Rule forces you to do just that, by capping the maximum monthly loss in your account.

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

Every good trade must begin with this money management question—does the 6% Rule allow me to trade? You know how much you have already lost during the month. You also know how much money you have exposed to the risk of loss in your open trades. Now add up the two and ask—do I have enough available risk left in my account to put on another trade?

If your losses for the current month plus your risk on existing trades expose you to a total risk of 6% of your account equity, you may not put on another trade. When I taught the high school class, risking 1% per trade, the 6% Rule meant we could never have more than six open positions at any given time. The class traded very carefully and never hit the 6% limit.

The 6% Rule

Most traders on a losing streak keep trying to trade their way out of a hole. Losers often think that a successful trade is just around the corner. They keep putting on more and bigger trades, digging themselves ever deeper holes. The sensible thing to do would be to reduce your trading size and then stop and review your system. A trader keeps sharks at bay with the 2% Rule, but still needs protection from the piranhas. The 6% Rule will save you from being nibbled to death.

Whenever the value your account dips 6% below its closing value at the end of last month, stop trading for the rest of this month.

Calculate your equity each day, including cash, cash equivalents, and current market value of all open positions in your account. Stop trading as soon as your equity dips 6% below where it stood on the last day of the previous month. Close all positions that may still be open and spend the rest of the month on the sidelines. Continue to monitor the markets, keep track of your favorite stocks and indicators, paper trade if you wish. Review your trading system.

You may have more than three positions at once if you risk less than 2% per trade. If you risk only 1% of your account equity, you may open 6 positions before maxing out at the 6% limit. The 6% Rule protects your equity, based on last month’s closing value, not taking into account any additional profits you may have made this month.

Whenever you do well, and the value of your account rises by the end of the month, the 6% Rule will allow you to trade a bigger size the following month. If you do poorly and the size of your account shrinks, it will reduce your trading size the next month. The 6% Rule encourages you to increase your size when you’re on a winning streak and stop trading early in a losing streak.

Adapted from Come into My Trading Room, by Dr. Alexander Elder,
John Wiley & Sons, Inc., 2002

positions at any given time. The class traded very carefully and never hit the 6% limit.

The 2% Rule and the 6% Rule provide guidelines for pyramiding— adding to winning positions. If the stock you bought rallies, you can move your stop above breakeven and then you may buy more of the same stock. You must handle each addition as a separate trade and make sure the risk of the new position is no more than 2% of your account equity and your total account risk stays under 6%.

Most traders go through emotional swings, becoming elated at the highs, gloomy at the lows, and losing money to sharks and piranhas across the board. If you want to be a successful trader, the 2% and the 6% Rules will convert your good intentions into the reality of safer trading.

The 2% solution - protection from sharks


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

When beginners first hear about this rule, many misunderstand it. They take it to mean that a person with a $100,000 account may buy only $2,000 worth of a stock. That is completely wrong! This Rule does not limit your position size—it only limits your risk.

Of course, if you are planning to hold your position down to zero, then its maximum size would have to be capped at $2,000. On the other hand, if you do a much more sensible thing and use a stop, your risk per share will decrease, and your permitted size will increase.

• The distance from your entry price to the stop level defines your maximum dollar risk per share.
• The 2% Rule defines your maximum risk for the entire position.
• Knowing the risk per share and the total permitted risk makes it easy to calculate the maximum number of shares you may trade. For example, you may decide to buy a stock at $12.48 and put a stop at $10.98. This means you’ll be risking $1.50 per share. Assuming you have $100,000 in your account, applying the 2% Rule tells you that the maximum permitted risk is $2,000. Dividing this total permitted risk of $2,000 by $1.50 risk per share means you may trade 1,333 shares. You should round this number down to 1,300 or even lower. Keep in mind that your commissions and slippage have to fit under the 2% total risk limit. You may buy a smaller position if you wish, but never go above the 2% limit! We will return to this concept in the chapter on stops and the Iron Triangle.



The 2% Rule

The ability to find good trades does not guarantee success. No amount of research will do you any good unless you protect yourself from the sharks. I’ve seen traders make 20, 30, and (once) even 50 profitable trades in a row, and still end up losing money. When you’re on a winning streak, it’s easy to feel invincible. Then a disastrous loss wipes out all profits and tears into your equity. You need the shark repellent of good money management. The single most important rule is to limit your loss on any trade to a small fraction of your account.

Limit your loss on any trade to 2% of equity in your trading account.

Suppose you’re trading a $50,000 account. You want to buy XYZ stock, currently trading at $20. Your profit target is $26, with a stop at $18. How many shares of XYZ are you allowed to buy? Two percent of $50,000 is $1,000—that is the maximum risk you may accept. Buying at $20 and putting a stop at $18 means you’ll risk $2 per share. Divide the maximum acceptable risk by the risk per share to find how many shares you may buy. Dividing $1,000 by $2 gives you 500 shares. This is the maximum number, in theory. In practice, it has to be lower because you must pay commissions and be prepared to be hit by slippage, all of which must fit under the 2% limit. So, 400 rather than 500 shares are the upper limit for this trade.

Poor beginners often think 2% is too low. Professionals, on the other hand, often say 2% is too high and they try to risk less. Good traders tend to stay well below the 2% limit. Whenever amateurs and professionals are on opposite sides of an argument, you know which side to choose. Try to risk less than 2%—it is simply the maximum permitted level.

Adapted from Come into My Trading Room, by Dr. Alexander Elder,
John Wiley & Sons, Inc., 2002



Two years ago I volunteered to teach a class called “Money and Trading” at a high school near my office. To make the experience more real for the kids, I opened a $40,000 account which we traded in class. I told the kids that if by the end of the school year we lost money, I’d eat the loss. But if we made a profit, I’d donate half of it to their school and divide the other half among the members of the class. Then I laid down the law—the 1% Rule. Since we began trading with $40,000, I told the kids the maximum risk on any trade would be $400. For example, the kids got excited about Nokia and wanted to buy it at $18, with a stop at $16.75 (risking $1.25 per share). The 1% Rule told them we could trade a maximum of 300 shares. As our account grew, the permitted risk grew with it, but it could never exceed 1% of our current capital.

A trader with a larger account may vary the 2% Rule depending on his level of confidence in a trading idea. For example, he may define a small, medium, or large commitment as risking 0.5%, 1%, or 2% of his account. Then he may risk only 0.5% on an average trade, 1% on a more important trade, and reserve the 2% of risk only for the most promising trades.

11.21.2008

Risk control

When the stakes of a game go up, spontaneity and ease go out the window. When the stakes become dangerously high, people become stiff with tension and their performance deteriorates.

The edge that the winners have over losers in the financial markets is very narrow. If you start putting on trades whose size makes you tense, your performance will decline, and you will begin losing. One of the key goals of money management is to put your mind at ease by providing a safety net for your account. Intelligent money management is a reflection of healthy trading psychology. It allows you to concentrate on trading instead of worrying about losses.

Imagine what would happen if you came to my office and I offered you twenty bucks to climb on a conference table, walk its length, and jump off at the far end. You would probably be surprised, laugh, and collect the money. That smile would quickly disappear if I raised my offer to $2,000 but challenged you to walk not on a table but on a sturdy plank as wide as that table, connecting the roofs of two office buildings. Even if the day was very calm and windless, your legs would probably tremble and you would feel extremely tense. Physically, the task would not change, but the new offer would greatly raise your risk. That fear would prevent you from accomplishing your task.

As a trader sinks into worry or fear, he becomes more stiff, less adaptable, and more prone to making bad decisions. When you start playing for stakes outside of your comfort zone, you will begin losing money.

Trading is like walking on a high wire. To feel at ease, to feel playful, adventurous, and ready to explore the nooks and crannies of trading, you need a safety net. If you happen to take a wrong step, stumble and fall, the net will catch you. You’ll suffer no damage—just a minor scrape. Having a safety net will reduce danger and improve your trading performance.

One of the most common problems among traders is fear of pulling the trigger. I’ve heard enough people complain about it to devote an entire chapter in Entries & Exits about how to overcome it. In a nutshell, fear of pulling the trigger is the result of trading too large a size. If you had something like $20 riding on a trade, you would squeeze that trigger fast and hard, without hesitation. A trader afraid of pulling the trigger must take a break from trading and sharply reduce the size of his trades. He can build up that size only slowly and gradually.

The financial markets are infested with loud vendors whose vulgar advertisements imply that making money is easy if only you buy their merchandise. In fact, the market is a very dangerous place, where most traders lose money. An account that has lost half its value is as good as dead. You may fund a new account, but the old one is finished. Most accounts get demolished in one of two ways: by a shark bite or a piranha bite.

A shark bite is a single disastrous loss that mauls the account so badly that it has virtually no chance of recovery. A poor beginner who loses one-third of his equity would have to generate a 50% return on the remaining capital simply to come back to even. The victim of a shark attack almost always loses much more than money. He loses his confidence, becomes fearful, and cannot pull the trigger again. Whatever your trading method and style, you must do everything in your power to protect yourself from a shark bite.

Following the 2% Rule will keep any loss in your account to a relatively small, livable size.

A piranha is an aggressive fish that lives in the rivers of South America. Its main danger comes from the fact that it travels in packs.

A careless bull who stumbles into a piranha-infested river gets reduced to a collection of bones floating downstream. A smart bull would have fled after the first few bites.

The 6% Rule will define a series of losses after which you must exit the markets and wait on the shore.

The two pillars of money management are the 2% and 6% Rules.

Beginners are often fascinated by technical indicators. They tend to spend the bulk of their time looking at charts and trying to recognize patterns. Experienced traders know full well that psychology and money management are just as important. Professionals tend to spend almost as much time calculating money management angles as performing market analysis.

On being kind to yourself

It may seem as if undisciplined traders are having fun, but that is usually a false appearance. Losers can be extremely harsh and shockingly abusive towards themselves. They keep breaking the rules and hitting themselves, breaking and hitting.

For example, a trader finds a stock that he likes and buys it. The stock rallies, but a few days later it stalls and appears ready to reverse. The novice sells at a profit—and feels good about it for about a day. Then the uptrend resumes and the stock shoots up. Now the trader feels a great pain because he is no longer onboard. Had he continued to hold, his profit would have been so much larger. How does he react? Probably by beating himself over the head!

Instead of congratulating himself for having correctly identified the trend and taken some money out of it, he feels disappointed and angry. In his next trade he probably will take greater risks and overstand trend. Afterwards, he will beat himself up for that and then probably get out from the next trade too soon.

This poor guy should be celebrating that he got two out of three right, instead of beating himself up. He was right on the market and right on the entry—but premature on his exit. With two correct decisions out of three resulting in a profit, he is well ahead of the majority of market participants. He should pat himself on the back and then create a good record of his trade, documenting his entry and exit. He should revisit his record in a month and then again in two months, updating his diary with fresh charts. He should celebrate his achievement and take fulladvantage of that trade as a learning experience.

Beating yourself up will not make you a better trader.

Think of another situation: a trader notices an attractive stock, studies it, and makes a mental note to continue to watch it and probably buy. Soon he loses track of that plan. As the joke goes, a “mental note” is not worth the paper on which it is written! A few weeks later he glances at the stock again and sees that it had a big run-up. His pick was right but his attention wavered.

What does the trader do? He kicks himself, as if that would do him any good.

A healthier approach would be to congratulate himself on his superior stock-picking skill. He deserves a pat on the back for finding that wonderful stock. He can probably find another one just as good, and the next time he will be more alert and not miss the signal to buy. He would benefit from fixing his deficient record-keeping. This trader needs a system for documenting his discoveries and keeping them in his view in an actionable form, something that we will discuss later in this book. The fact he found that stock is great—all he needs now is to catch up on the record-keeping.

You need to stop beating yourself up when your trades go awry. You have to celebrate your achievements and soberly take stock of your shortcomings. Keeping good records will help you identify and correct your mistakes, and allow your accomplishments to shine even brighter.

Beginners underestimate the importance of psychology. Your mind is an essential component of your success (or lack thereof). You would not throw your laptop on the floor if it froze on you and caused you to miss some quotes. In the same spirit, please do not hit your poor head when it misses something—treat it kindly and nicely, and it will serve you better! While working on this chapter, I received an e-mail from Nils Gajowiy, a trader and a teacher of traders in Germany:

At a seminar for beginning traders we spoke about the importance of a written trading plan and the negative impact of emotions on trading. Suddenly one of the participants asked: “Can you tell me anything positive about emotions? I keep hearing that they mislead us to take wrong decisions, to deviate from the trading plan, etc. But do they have any positive aspects?”

I kept thinking that positive emotions are a strong motivator which increase our strength in many other areas. We have a saying in Germany, “When you are in love, you can move mountains.” I looked through all my books and saw that nobody has ever written a word about the positive impact of emotions on trading. Do you have any suggestions about that topic? I hope that my earlier comments on treating yourself kindly and celebrating even partial successes will help answer Nils’ question. Let me list several additional points:

• It is better not to trade when you are in foul mood. Remember that even a good trader has only a very narrow edge in the market. Anything that reduces that edge will shift the balance of power against you. Feeling calm, relaxed, and in a pleasant mood is extremely important for your success. If you have a severe toothache or if a problem with a spouse or one of your kids has you very upset, you would be better off taking a break from the markets.
• If you feel stressed or preoccupied, stand aside from the markets
until your personal stress clears up. The markets require you to think and act fast. You need to get into the flow of things and make quick intelligent decisions, without ruminating or worrying. The markets send out a torrent of information which you must process and act upon as swiftly as if riding a surfboard.

• Successful traders love the game more than the profits. On Sundays, with my weekend homework completed and plans for the next week drawn up, it is a pleasure to think of the next day’s opening. A surfer probably has a similar feeling in the evening, knowing he’ll be going to the beach in the morning. This good feeling comes from being prepared. Even if the ocean becomes stormy and tosses my plans out of the water, it can only scrape me a bit but not hurt me!

When I began interviewing people for Entries & Exits, it came as a surprise to me how many men wanted to talk about their love for their wives. One after another talked with great feeling about the trust, support, and encouragement he felt at home. A person with a happy personal life has an advantage, while someone with a stormy personal life finds himself doubly stressed. A person who goes home to a smiling, loving spouse and does not need to spend an ounce of mental energy on figuring out the angles of a tense personal relationship is in a much better position when he or she sits in front of the computer to analyze charts and make decisions.

11.20.2008

On being disciplined

Whenever I run a Traders’ Camp, there are campers who ask for help in acquiring discipline. I sometimes joke about tying people to the palm trees for physical discipline. Jokes aside, the question remains how to maintain discipline after one graduates from a Camp or finishes reading a book. Let us consider several essential points:

• Some traders are destined to fail The markets produce endless temptations. People with a history of poor impulse control are likely to get nothing but grief when they try to trade. Those who are actively drinking or using substances are highly unlikely to succeed as traders. They may have a few lucky trades, but their long-term forecast is grim. I have written about applying the principles of Alcoholics Anonymous to trading in my first book, Trading for a Living. If your drinking, eating, or some other behavior is out of control, you are better off not trading until you resolve your addiction problem. Obsessional nit-pickers or greedy people who cannot tolerate losing a dime are unlikely to do well in trading.
• Keeping records: actions are more important than promises
It is easy to talk about discipline on a weekend, when the markets are closed, but let me see you in front of a live screen when the markets are open. All your promises and good intentions will not amount to a hill of beans—unless you act to implement them. This is why I keep repeating that good records are essential for successful trading. You must write down your trading plans and compare your performance with those notes. We are just about to discuss a simple system of record-keeping. Your ability to follow that system will be an excellent predictor of your success or failure. If you keep good trading records, you will be very likely to succeed. If you fail to keep good records, your chances of successful trading will be slim to none.
• Solitude is essential Many people feel stressed by the markets. They respond by huddling with others, following them, and aping what other people do.

To become a successful trader you must make your own decisions. You will need to insulate yourself from others while you make your trading plans and implement them. This does not mean becoming a hermit—it is a good idea to network with other traders. But you may not talk about your trading plans while you are making and implementing them. Stay alone with your trade, learn all you can, make your own decisions, record your plans, and implement them in silence. You can discuss your trades with the people you trust after those trades are closed—but not a moment sooner. Many people fear solitude, but you need it for trading.

As my late grandfather used to say, “The road to Hell is paved with good intentions.” Even a responsible person can lose his bearings in front of a live screen. It is not enough to promise to be good and disciplined. You need to write down a plan and follow it when you trade.
You need to complete a trading diary after each trade and record the consequences of your actions. It is also important to remember that if your discipline occasionally fails, it is not the end of the world, but a reminder to return to the right track. If you slip up while trying to stay on a diet, it does not mean that you can drop the plan and pig out. Just correct your slip and return to the original plan.

Trading psychology and risk management: your mind as a trading tool

What trading tools do you use? You probably have a computer, some software packages, and databases. You probably visit several trading-related websites and may have a shelf of trading-related books. If you think that these electronic and physical objects are all the tools that support your trading, you overlook a hugely important trading instrument.

YOUR MIND AS A TRADING TOOL

Your mind is a much more important tool than any computer or book.

Your emotions, hopes, and fears have an immediate and lasting impact on how you trade. If your computer freezes while you’re doing your homework or if your Internet connection goes dead in the midst of a busy trading day, you’d immediately recognize those events as severe obstacles to trading. Meanwhile, what goes on inside of your own head has a greater impact on the success or failure of your work than any technology.

Your mind is constantly at work, but it is humanly impossible to process all the signals that enter it from all directions. The input you receive through your eyes and ears is so immense that your mind must do a lot of automatic filtering to save itself from being flooded, overloaded, and shutting down. With a waterfall of sensations coming at you from life in general and from markets in particular, your mind must automatically sort out what to see and what to filter out. Most people are unaware of this filtering process. In fact, what you think are the objective signals from the markets tend to be highly filtered messages.

Once you become aware of this largely unconscious filtering process, you can see that most traders respond not so much to the markets but to the contents of their own heads. When people trade on the basis of their fears and fantasies instead of the reality of the markets, the results are likely to be poor. This explains why so many traders lose money and wash out of the markets.

To illustrate this unconscious filtering process, let us step away from the markets for a moment and take a look at what happens at the highest levels of the government.

The President of the United States has virtually unlimited sources of information—but there is no way one person can process everything available to him. He ends up depending on trusted assistants, such as cabinet ministers, to process the data in their area of expertise and give him their summaries. Those ministers, in turn, depend on their assistants in the narrower areas of expertise to process information and feed it to them. It is a logical system, designed to work well. It fails when the man at the top tells the men below what information he believes is correct. This influences them to serve up the information that confirms his preconceived notions.

For example, think of Iraq—instead of true information percolating up from the field, intelligence agencies were told to look for weapons of mass destruction. As it turned out much later, those did not exist, but overeager agencies produced enough flimsy “evidence” for the President to authorize the invasion. We are still dealing with the consequences of that highly flawed decision-making process.

What can we do as traders to avoid fabricating our own evidence? How can we avoid the trap of buying or selling because we “see” something that we want to see in the markets, when it is not actually there?

Much of this book is dedicated to the recognition of good trading signals. Before we proceed, I want you to recognize the hugely important fact that your mind is a part of the decision-making process. Your fears, wishes, and fantasies have a greater impact on your trading than all moving averages and trendlines combined. You have a great capacity for deluding yourself—but your success depends on seeing the truth.

If your mind is a trading instrument, we will need to set up a system for processing information. Your decision-making process must be transparent and unbiased. Then you will be able to learn from your experience and become a better trader going forward.

The new high-new low index

Most traders pay attention to the key market indexes that are given to them ready-made, such as the Dow, the Nasdaq, and the S&P. There is one additional market indicator that is much more forward-looking. I believe that the New High–New Low Index (NH-NL) is the best leading indicator of the stock market. I look at it every day to confirm my bullish or bearish stance. NH-NL takes a bit more work to construct, although its formula is very simple.

NH-NL = (New Highs) minus (New Lows)

NH-NL is very easy to track by hand, since the raw data is published daily in all major newspapers. For example, yesterday there were 51 new highs in the market and 98 new lows, giving us NH-NL of minus 47. The day earlier we saw 43 new highs and 130 new lows, resulting in NH-NL of minus 87. Plotting these numbers on a day-today basis gives us three lines: New Highs, which I like to plot in green, New Lows, which I plot in red, and daily NH-NL which I plot in some neutral color.

Plotting the weekly NH-NL is a bit more tricky, as you have to decide when your week ends. I used to plot this indicator by adding daily numbers for the past week, but last year switched to plotting weekly NH-NL as a 5-day running total of daily NH-NL.4 For example, as I write this on a Wednesday morning, my weekly NH-NL for the past night sums up the daily NH-NL for Monday and Tuesday of this week, as well as Wednesday, Thursday, and Friday of the previous week.


New High–New Low Index

A stock appears on the list of new highs when it is the strongest it has been in a year. This shows that a herd of eager bulls is chasing its shares. A stock appears on the list of new lows when it is the weakest it has been in a year. It shows that a crowd of aggressive bears is dumping its shares.

The New High–New Low Index tracks the strongest and the weakest stocks on the exchange and compares their numbers. It measures the balance of power between the leaders in strength and the leaders in weakness. This is why NH-NL is a leading indicator of the stock market. The broad indexes, such at the S&P500, tend to follow the trend of NH-NL.


You can visualize the stocks on the New York Stock Exchange as a regiment. If each stock is a soldier, then new highs and new lows are the officers. New highs are the officers who lead the attack up a hill, and the new lows are the officers who are deserting and running downhill. There are no bad soldiers, only bad officers, say military experts. The New High–New Low Index shows whether more officers lead the attack uphill or run downhill.


When NH-NL rises above its centerline, it shows that bullish leadership is stronger. When NH-NL falls below its centerline, it shows that bearish leadership is stronger. If the market rallies to a new high and NHNL rises to a new peak, it shows that bullish leadership is growing and the uptrend is likely to continue. If the market rallies but NH-NL shrinks, it shows that the uptrend is in trouble. A regiment whose officers are deserting is likely to turn and run.

A new low in NH-NL shows that the downtrend is likely to persist. If officers are running faster than their men, the regiment is likely to be routed. If stocks fall but NH-NL turns up, it shows that the officers are no longer running. When officers regain their morale, the whole regiment is likely to rally.

From Trading for a Living, by Dr. Alexander Elder, John Wiley & Sons, Inc., 1993



Surprisingly few software vendors supply the New High and New Low numbers, but even when they do, those numbers alone are not enough. They need to be processed in a manner described above to make them useful for analysts and traders. Some software vendors process their data in strange ways whose logic eludes me. Kerry Lovvorn, my comanager of the Spike group, has spent a great deal of time and energy to develop a proprietary method of locating this data and transferring it into TradeStation. He sends out a nightly NH-NL update to all members of our Spike and Spike Spectator groups, and when he is busy I do it for him.

I like to track NH-NL for all listed stocks on the weekly and daily charts (see Figures 1.3, 1.4, and 1.5). The weekly NH-NL helps identify major tops and bottoms, while the daily chart is useful for shorter-term timing.

Another extremely important feature of this weekly chart is that its bearish divergences signal traders when to sell their long positions and go short. Notice that tops are broader than the bottoms and the signals to sell and go short are less precise than the buy signals near the bottoms.


Figure 1.3 Weekly S&P500 and New High–New Low Index

Green arrows—downspikes. Red arrows—bearish divergences.

This chart tracks the behavior of weekly NH-NL during the 2003–2007 bull market. It has two striking features. The first is that every bottom of any importance is identified by a downspike of NH-NL. When NH-NL spikes several thousand below zero, it identifies the end of a bear market and the beginning of a new bull market. This chart shows only three such occurrences, but one can see more of them on a very long-term chart (not shown). In an ongoing bull market, a weekly downspike below .1,000 (minus one thousand) identifies the end of a downtrend and a great buying opportunity. The upspikes carry no such meaning.


Figure 1.4 Daily S&P500 and New High–New Low Index

Red line—new highs. Green line—new lows. Blue—NH-NL. Green arrows—downspikes.

This chart tracks the behavior of daily NH-NL in 2007. Whenever the daily NH-NL falls below zero, while the bull market is going on, it gives a buy signal. When it becomes negative it marks a brief imbalance in favor of the bears during an overall bull market. That is the time when many people become fearful and bearish, but NH-NL helps counteract their psychological pull. You can see that the daily chart of NH-NL provides excellent buy signals during a bull market but is not too useful for identifying market tops.


Figure 1.5 Daily S&P500 and New High–New Low Index

The box marks the summer 2006 bottom—new lows stayed above new highs for nearly three months. The length of time NH-NL stays below zero provides an important indication of the durability of the uptrend to follow. Strong uptrends grow out of solid bottoms, when NH-NL stays negative for two or three months. If NH-NL spends only a few days below zero, it shows that the bottom is not too solid. Even if it leads to a rally, that rally, built on a poor foundation, is likely to end in a severe break. Another message of these charts is that it pays to keep good notes—a visual diary of your trading and research. You must remember what has gone on before in order to profit in the future.

11.19.2008

One trader`s toolbox

When I put on my first trade ever, the worst possible thing happened. I made money. That lucky break created the delusion that trading was easy. I began jumping into other trades—with a predictable outcome.

As I recovered and rebuilt my devastated account I knew I had to educate myself. I began to read voraciously about the markets. I looked up sources and references in every book I read, and then read those books as well. In those faraway, pre-Internet days I was fortunate to find a gentleman in Los Angeles by the name of Donald Mack who ran a business called The Investment Centre Bookstore. I must have become his biggest customer. My fantasy was that if I read everything there was to read and learn about every method, I’d surely find a good money-maker.

Once again, the outcome was predictable, and it was back to my day job, working and saving to rebuild my tiny account. Even though I lost money, all that reading left me with something positive—a good overview of the field.

Over the years, as I continued to trade and study the markets, it became increasingly clear to me that in this field “less is more.”

Whenever we look at a chart, we deal with only five pieces of data— each bar has an open, high, low, and closing prices, plus volume. If you trade futures, add open interest. It makes no sense to use a long list of tools and indicators to analyze these five numbers. An abundance of tools only increases the level of noise and adds to the confusion. I established a rule of “five bullets to a clip”—allowing me to use no more than five indicators on any given chart. You may use six if you desperately need an extra one, but never more than that. For myself, I do well with four: moving averages, envelopes, MACD, and Force Index.

This does not mean that you should use the same indicators. You should feel perfectly comfortable using others—just be sure to understand how your indicators are constructed, what they measure, and what signals they give. No one can master everything in the markets, just as no physician can master all of medicine. You need to choose a small handful of tools that feel comfortable to you.

Market newcomers often become fascinated by technical trading tools. They imagine that if they get the “right” software, the “right” indicators, and the “right” settings the profits will just roll in. Nothing could be further from the truth! While technical tools are important, they are responsible for only a small share of any trader’s success. You also need to focus on trading psychology, money management, and record-keeping. Each of those factors is like a leg of a chair, and technical analysis is just one of them. A chair that has only one leg is useful only for firewood.

Beginners’ childish faith in the power of technical analysis is often coupled with a great deal of laziness. Each week I receive e-mails from people who ask for “the exact settings” of moving averages, MACD, and other indicators. Some say that they want to save time by taking my numbers and skipping on research so that they could get right on to trading. Save the time on research, my elbow! If you do not do your own research, you will not have the necessary confidence during the inevitable drawdown periods.


My Toolbox

My approach is based on the Triple Screen trading system which I developed in the 1980s and continue to improve to this day. Since every market can be analyzed in several timeframes, Triple Screen insists that you begin by defining your favorite timeframe in which you like to work, such as daily, hourly, or weekly chart. Once you know what your favorite is, do not look at it! You must first go to the timeframe one order of magnitude higher, make your strategic decision there, and return to your favorite timeframe only to make a tactical decision—where to buy or sell—and then trade only in the direction of the longer timeframe.

Since my favorite timeframe tends to be the daily, I use weekly charts
to make my strategic decisions, and return to dailies to implement them. The weekly and daily charts are my first two screens. The third screen is the entry method, for which you can either use an intraday chart or simply place an order using a daily chart.

MOVING AVERAGES

Price is a consensus of value at the moment of a trade. A moving average (MA) reflects an average consensus of value in its time window. If price is a snapshot, a moving average is a composite photograph. It provides two important messages to traders. First, its slope identifies the direction of change in the public’s mood. A rising moving average reflects growing optimism (bullish), while a falling MA reflects growing pessimism (bearish).

Another important role of the MA is differentiating between what I call “value trades” and “greater fool theory” trades. If you buy near the moving average, you’re buying value. A person who buys well above the moving average is in effect saying—”I’m a fool, I’m overpaying, but I hope to meet a greater fool down the road.” There are very few fools in thefinancial markets, and a person who keeps buying above value is not likely to win in the long run. He may get lucky once in a while, but buying near value is a much more sensible strategy. I like using two EMAs on my charts, one showing a longer-term, and another a shorter-term, consensus of value. I call the area between them “the value zone.” There are several types of moving averages, but I always use exponential ones. EMAs are more sensitive to incoming prices and less sensitive to old prices.

ENVELOPES OR CHANNELS

One of the very few scientifically proven facts about the markets is that prices oscillate above and below value. You could say that markets are manic-depressive—rising too high and falling too low, only to swing back to the normalcy of the value zone.

There are several types of channels, and my favorite is a straight envelope—the lines above and below the EMA, both parallel to it. A well-drawn channel fits like a good shirt, covering the body of prices, with only the most extreme prices—the neck and the wrists—sticking out. Amateurs love to buy breakouts, but professionals tend to look for buying opportunities near the lower channel line and shorting opportunities
near the upper channel line.

Some traders like to use standard deviation channels, often called Bollinger Bands, which expand and contract in response to market volatility. They are only useful for options traders because volatility is a key factor in option pricing. If you trade stocks, futures, or forex, you are better off with straight envelopes.

MACD LINES AND MACD-HISTOGRAM

Moving Average Convergence-Divergence (MACD) is an indicator whose fast line represents the short-term consensus of value, and the slow line the long-term consensus. When the fast line rises above the slow line, it shows that bulls are dominant, and when the fast line is below the slow
line, the bears are in charge.

MACD-Histogram measures the power of bulls and bears by tracking the difference between the two MACD lines. When their spread increases, it shows that the dominant market group is becoming stronger—it is a good time to trade in that direction. Divergences between peaks and bottoms of MACD-Histogram and price are among the strongest signals in
technical analysis.

MACD-Lines and MACD-Histogram are derived from three exponential moving averages of closing prices. Their settings—12, 26, and 9—have migrated into trading software and become default settings in many packages. In writing my books, I used those settings to illustrate this indicator.

What settings should you use? If you want to use the same ones as everyone else, use 12, 26, and 9 because the crowd is basically lazy and uses the default values. You can also choose settings that are a little faster or a little slower. Think about it and experiment with the values, or use the defaults.

FORCE INDEX

Everybody watches prices, but it is volume that moves them. Volume reflects the intensity of traders’ commitment, the heat of their exuberance, the depth of their fear. Instead of looking at a plain plot of volume, I use Force Index, which links volume with price changes. Divergences between Force Index and prices tell me when a trend is becoming weak and ready to reverse. By contrast, new highs of Force Index tell me that
the trend is strong and likely to continue.

THE IMPULSE SYSTEM

This system identifies bullish and bearish phases in any market or timeframe by combining two indicators. The slope of the fast moving average identifies the inertia of the market, while the slope of MACD-Histogram identifies the push of the bulls or bears. The Impulse system gives a buy signal when both the EMA and MACD-Histogram rise, and a sell signal when both decline. When the two indicators get in gear, they mark especially bullish or bearish periods. Just as importantly, the Impulse shows when bulls or bears start slipping, and a trend starts growing weaker.

One of my Traders’ Camps graduates, a brilliant programmer named John Bruns, programmed the Impulse system for several popular software packages, coloring each bar in accordance with the Impulse system. When the EMA and MACD-Histogram rise at the same time, the market is in gear to the upside and the bar turns green. When both fall, bears are in control and the bar is red. When the two indicators point in opposite
directions the bar is blue.



The Impulse system works best as a censorship method. When the Impulse is green, you may buy or stand aside but absolutely no shorting is permitted. When the Impulse is red, you may go short or stand aside but buying is prohibited. I wait for the Impulse system to go “off green” before shorting and “off red” before buying.

Some programs do not allow users to change the color of their bars on the basis of conditional formatting, but you can still identify green or red Impulse by noticing the slope of the EMA and MACD-Histogram.

Adapted from Entries & Exits by Dr. Alexander Elder,
John Wiley & Sons, Inc., 2006


I believe that successful trading is based on three M’s—Mind, Method, and Money. Your Method—the indicators and tools—is just one component of this equation. Equally important is the Mind—your trading psychology—and the Money, or risk control. Record-keeping ties all of these three M’s together into a firm, working structure.

In a moment we will talk about the Mind, the Money, and the Record-Keeping. But before we move on, let us stay a little longer with the trading tools and review what I think is the best leading indicator of the stock market—the New High–New Low Index.