APRIL 2000 ISSUE 2 3 Contributors 4 6 9 Trading Pure Price ...forex-warez.com/Trading Books/Magazine...

ACTIVE TRADER • April 2000 • www.activetradermag.com 1

APRIL 2000 ISSUE

2 Editor’s Comments On This Issue

3 Contributors

4 Web Watch

6 Getting ConnectedWhat’s the best way to “plug in” — modem, dial-up, DSL, cable? Here’s how to set up your communications for maximum efficiency.

9 Trading Pure Price ActionCharts, technical indicators, number-crunching software...forget about it. A veteran trader shares a half dozen back-to-basics trading strategies.

14 Playing The Break(out)Momentum trading is about reacting to the right opportunity at the right time. Here’s a systematic method that triggers off the unique dynamics of price breakouts.

19 A Matter of TimingCombining analysis on different time frames — intraday, daily, weekly — gives you anedge. Here’s a unique approach that incorporates multiple time frame indicators on a single chart.

23 Navigating the ECNsFind out how different Electronic Communication Networks handle trades and how you can make the most of their order-executing capabilities.

28 Acing the Market

31 Contractor Gets The Point

34 Richard Saidenberg’s Sound View on TradingHe’s a trader and trading system designer who has worked with some of the top names in the business. Find out how he trades and controls risk.

39 Playing The PercentagesMost people place stops based on the amount of money they’re willing to risk.Such an approach will almost guarantee you’ll lose money over time.

43 A Fool And His MoneyIt’s the question that’s almost never asked: Should I trade?

47 Short-Term Strategy, Long-Term PerspectiveYou still need a big-picture perspective to trade effectively.

51 Give Me Trader Status Or Give Me...Tax issues impact trading as much, if not more, than they do any other business.

54 The Trading System LabA look at a simple short-term trading system using percentage-based stop orders.

You’ve seen the headlines, you’ve read the stories: BraveNew Trading World. Day Trade Nation. The New Cyber-Traders.

The protagonist is often a borderline obsessive who racks upfive-figure stock market profits with a few keystrokes. Tradingis portrayed as a high-stakes video game, full of super-sophisti-cated technology and arcane financial jargon. After three hoursof mastering the universe, the wunderkind knocks off for theday, driving off into the sunset in his shiny (insert your favoriteluxury car here). C’mon.

That may be fine for someone to read on a Sunday morningbetween the sports and the comics, but for someone actuallytrading, or thinking about it, such stories are about as valuableas a season’s worth of Ally McBeal episodes to a law student.

The Internet has indeed revolutionized the trading process,but taking profits out of the market is still the same game it waswhen price quotes were disseminated via giant chalkboards onfinancial exchange floors. Trading is, and always will be, aboutunderstanding the market, having an edge and executing aplan. When information overload is an increasingly real hazardfor traders, it’s more important than ever to focus on the besttrading resources available.

So, read any good trading magazines lately?Active Tr a d e r is based on a very simple concept: Trading is a

business. It’s not a pastime, it’s not a hobby. It’s a pro f e s s i o n ,one that should be approached like any other — with cleargoals and a realistic attitude.

Our goal is to provide you with the best trading informationpossible — the tools you need to become a successful trader.We’ll do the re s e a rch you wish you had the time to do and giveyou the bottom line on the trading strategies, key industry news,latest Web sites, books and software, and tax and legal issues thatimpact you the most as a short-term trader. Our coverage willencompass stocks, options, currencies and futures, with materialfor the market novice as well as the seasoned pro f e s s i o n a l .

What we won’t give you is hype about “can’t-lose” tradingsystems, tales of overnight riches or incomprehensible jargon.We won’t sugarcoat the risks or downplay the hard work.

Flip through these pages and you’ll get an idea of where we’llbe taking you in the months and years to come. The followinglist is only the tip of the iceberg.

News: We don’t have the most recent three-year forecast fromthe economic think tank, but we do explore the proposedchanges to minimum account equity and margins, as well asdevelopments in the electronic trading arena that could directlyaffect the way you trade each day.

Trading strategies: If you’ve only thumbed through a few

trading books, magazines or Web sites, you’ve undoubtedlycome across articles that A) sounded too good to be true (theyare), or B) were so incomprehensible you didn’t know if theywere too good to be true or if they were instructions for build-ing your own thermonuclear device.

Contrast this to Gary Smith’s article on the common-sensestock market strategies he has developed over decades of real-life trading. There’s no smoke, no mirrors, no instant retirementpromises, just explanations of several strategies used by anindependent trader who has averaged $14,000 profit per monthfor the last three years.

In this and all our strategy articles, you’ll get a clear pictureof how a particular strategy works, the logic on which it’s basedand examples of it in action. It doesn’t matter if the strategy isabout trading intraday breakouts or combining multiple timeframes, we’ll give you concrete ideas you can apply to your owntrading.

Profiles and interviews: Each issue, you’ll read about traders— successful and unsuccessful, professional and part-time —who will give you both fresh insights on different tradingapproaches and a feel for how your industry is developing.

Trading hardware and software: Your computer setup, com-munications and software are an integral part of your trading.We’ll keep you abreast of the latest trading technology and howto make the most of it. In this issue, Gibbons Burke comparesthe different Internet connection methods and uncovers a newoption that can decrease your risk of getting blown off the ‘Netin the middle of a trade.

Risk control: Rather than simply pay lip service to the sub-ject, every month we’ll devote an article to risk control andmoney management — specific ideas to help you control lossesand maximize your profitability. This month, for example,Thomas Stridsman explains why a popular stop approach does-n’t work and then illustrates a technique to keep your risk at thesame level on all your trades.

Trading as a business: Finally, our monthly “The Business ofTrading” column will give you the bottom line on taxes, legalissues and other little-discussed aspects of trading that canmean the difference between actually keeping the majority ofyour hard-earned profits and watching them disappear everyApril 15. Do you have trader status? Do you even know whattrader status is? Reading CPA/trader Ted Tesser’s article on p.88 could be one the best moves you make this year.

Good traders know the value of good research — it’s thefoundation of every solid trading plan. That’s what Active Traderis all about. Think of us as a low-risk opportunity with unlimit-ed upside potential.

In other words, a good trade.

Minding your business

Active Trader is based on a very simple concept:

Trading is a business.

EDITOR’SNote

Mark Etzkorn, Editor-in-chief

2 www.activetradermag.com • April 2000 • ACTIVE TRADER


THIS MONTH’S Contributors

Gary Smith is a full-time home-based

trader and the author of How I Trade for a

Living (2000, John Wiley & Sons). Smith,

who has not had a losing year (and only

a few losing months) since 1985, has

turned a $2,200 trading account into

nearly $1 million and a full-time career.

He has been profiled extensively in the

financial press and is a frequent speaker

at trading seminars.

Mark A. Seleznov is a general securities

principal and managing partner of Tre n d

Tr a d e r, a NASD, SIPC bro k e r-dealer firm

in Scottsdale, Ariz. Ap rofessional trader

for more than 25 years, he was a market

maker on the Philadelphia Stock

Exchange, a retail re g i s t e red re p re s e n t a-

tive and a futures trader.

Seleznov is a recognized expert in

equity day-trading and conducts stock

day trading seminars. In addition to his

TV appearances and regular newspaper

and magazine contributions, Seleznov is

a featured analyst three times a day on

KFNN 1510 AM radio in Phoenix.

Robert Krausz is president of the

Fibonacci Trader Corporation

(www.fibonaccitrader.com) and presi-

dent of Wizard On Wall Street, Inc.

(www.the-wow.com), publisher of a

home study course for traders.

He has been a private trader and trad-

ing coach for more than 20 years. His

work in this area was featured in Jack

Schwager’s New Market Wizards (1994,

HarperBusiness) He is also author of the

book AW. D. Gann Treasure Discovered.

Krausz also is a master hypnotist,

British Council of Hypnotist Examiners

(MH, BCHE).

M. Rogan LaBier, author of the e-book

The Tools of the Trade (www.tools-of-the-

trade.com), was formerly a registered

principal of Terra Nova Trading LLC

and head trader at MB Trading. Prior to

that he was an institutional sales trader

and Nasdaq market maker.

LaBier’s trading experience encom-

passes the stock, derivative and world

currency markets, both for his own

account and managed accounts. He also

is a nationally known speaker on the

subject of order execution.

Gibbons Burke is a Silicon Valley, Calif.-

based independent trader, writer and

software developer. He operates

TraderCraft.com, a Web site that pro-

vides tools and information for master-

ing the craft of trading.

Burke has 23 years of experience in

the financial markets at firms such as

CompuTrac/Telerate, Logical

Information Machines, Dow Jones

Markets and Quote.com. He has pub-

lished hundreds of columns and articles

in Futures magazine and spoken at

industry conferences on topics such as

the Internet, technical analysis and sys-

tem development, and money manage-

ment. He can be reached at

[email protected].

Ted Tesser (contributing editor), is a certi-

fied public accountant and president of

Waterside Financial Services, Inc., Boca

Raton, Fla. He specializes in assisting

traders create and manage more pro f-

itable trading businesses by implement-

ing sound trading, business and tax man-

agement strategies. He also actively

trades small-cap stocks, bonds, mutual

funds, futures, options and curre n c i e s .

Tesser’s clients have included many

prominent traders and members of the

U.S. government, including a former

Secretary of State, a former Secretary of

the Treasury and several members of

Congress. He is a featured speaker at

many trading conferences, and has

appeared frequently as a guest on CNBC

and KWHY TV-Los Angeles.

Tesser has authored more than a

dozen books and manuals, including The

Serious Investor’s Tax Survival Guide, The

Trader’s Tax Survival Guide, The Ultimate

Tax Shelter and Tax Strategies for Traders,

among others. His latest book, The

Trader’s Tax Solution (John Wiley & Sons),

was released in January. You can reach

him at (800) 556-9829 or at

[email protected].

Allen Sykora has been a journalist for 21

years, including several years covering

foreign exchange trading and the futures

markets. He has interviewed dozens of

traders, profiling many of the top names

in the stock and futures industries.

In addition, Sykora has held positions

as editor and reporter for newspapers in

Minnesota, Iowa and Alaska and has

worked as a freelance writer for Reader's

Digest, among other publications.

Corey Goldman has worked as a financial

journalist with Bloomberg News and the

Globe and Mail in Canada, covering eco-

nomics, markets, currencies, technology,

politics and U.S. and Canadian mone-

tary policy. He currently writes about

economic and financial issues for

CNNfn.com in New York.

I f you’re looking for a thorough, comprehensive and

downright helpful Web site, Hard Right Edge (HRE)

— www.hardrightedge.com — should be your next stop on

the Web. It has a plethora of information for the active trad-

er, from the basics (price charts, suggested reading) to the

advanced (Bollinger bands, Fibonacci charts). And it’s free.

The site is broken down into six sub-sites: Daily, Courses,

Tactics, Wizards, Resources and Systems. Courses is merely an

advertisement for HRE’s trading system, but the other five

deserve a closer look.

D a i l y lists stocks whose price

charts suggest a sharp move

could be imminent, or ones that

fall into categories like Dip Trip,

Power Spike and Finger Finder

(yes, these concepts are explain-

ed). Links are plentiful on this

page and pretty basic, connecting

to news sites (Bloomberg, CNNfn),

market sites (currencies, U.S. indices)

and tools sites (earning calendars, buy-

backs, splits), among others.

Ta c t i c s is just that — strategies bro k e n

down into eight sections (bottoms, bre a k-

outs, corrections, day trading, indicators,

market quirks, new highs and tops). Wi t h

38 diff e rent terms explained (our favorites

a re fun with Fibonacci and hell’s triangle),

the newbie could spend days here and

even the experienced trader might find a

new nugget of knowledge.

Wi z a r d s picks the brains of various

trading gurus (including Mark Seleznov,

who contributed “Playing the bre a k ( o u t ) ”

for this month’s issue).

Resources lists numerous books that

might be of service to the short-term

trader and has links to magazine articles

and other helpful items on the Web. In

addition it features a complete glossary

of technical terms and topics, and gives

in-depth information on dozens of indi-

cators, patterns, systems and market con-

cepts. When HRE says re s o u rces, it

means resources.

Systems focuses on the hardware nec-

essary for online trading. Hard drives,

monitors, memory and storage are dis-

cussed in detail, with (of course) plenty

of links to choose from.Ý

T h e t r a d i n g E D G E

W H AT ’ S t h e b u z z ?

T he Fly on the Wall (www.theflyonthewall.com) doesn’t attempt toinundate visitors with detailed analysis or in-depth discussion.

Instead, this subscription-based delivers quick-hit information on stocks mak-ing news. Cost: $49.99/month or $39.99/month paid a year in advance (two-week free trial for visitors).

Fly’s goal seems to be to give you an idea of which stocks might be hoppin’based on the latest word from Street insiders. Upgrades and downgrades,earnings reports, conference calls, splits — they’re all chronicled on the news“ticker” (it’s not streaming text, but it does update automatically) that staysat the top of the page, no matter what part of Fly you visit (you can set it upso that the ticker stays with you no matter where you go on the Web).

The ticker is broken down into seven categories: hot stocks, general news,rumors, recommendations, pre-opening news, conferences/meetings and syn-dicate.

Clicking on an item in the ticker accomplishes two things: First, it brings upa pop-up box showing all stocks that have similar news (i.e., if you click on anitem about a company being upgraded, you’ll get a list of all companies thatfall under the “recommendation” category). Also, it will take you to thatcompany’s main page on Fly, where every tidbit of information that has comeacross the ticker is listed for easy viewing. On the main page, there’s alsoaccess to a stock chart that can be configured many different ways (perhapsFly’s best feature).

First-time visitors to Fly may find things a bit confusing. There’s a help linkon the top of every page, but we pretty much just clicked our way arounduntil we got a better feel for the site. And, we noticed one strange thing: The“rumors” section of the ticker was usually blank or filled with a minimumnumber of items. Perhaps that fly has a hearing problem.

Fly will e-mail you alerts when news comes in on a company you’re follow-ing, and its cross-referencing options are plentiful.Ý

WEBWatch


A nother technically oriented site is

Intelligent Speculator (www. i n t e l l i-

gentspeculator.com). It’s broken into three main sec-

tions: Chat rooms, Market Commentary and

Analysis, and Trading, Risk and Money Management.

The site is free except for the Chart Room

($75/month), where the site’s founder, Teresa Lo,

partners with Alan Farley (of the Hard Right Edge) to

provide real-time commentary and analysis on their proprietary

trading strategies

One of the site’s more interesting features is the ability to post

charts to the chat rooms for analysis. It’s a nice effect: When

someone comments about the latest move in a particular stock,

they can upload the accompanying chart to make traditionally

murky cyber-chat crystal clear. In the “Technical Traders” room,

for example, several users included heav-

ily annotated charts of their latest trades

and market calls.

The commentary section includes

seven regular features ranging from fun-

damental economic developments to day

trading, including the “Day Tr a d e r’ s

Diary,” a feature that chronicles, as you

would expect, the travails of a new day

trader.

Another nice tool is the “Matrix

Spreadsheet” in the Trading, Risk and

Money Management section. It’s a down-

loadable Excel file that allows you to per-

form some quick-and-dirty (but very

helpful) risk-reward analysis of your trad-

ing approaches, including the Probability

of Ruin (POR) — the odds that you’ll lose

everything before you reach your trading

goal.

Along with the spreadsheet is a helpful essay on risk and

money management, which uses actual examples from the

Matrix screen to graphically enhance the information. It’s a

good tutorial for those unfamiliar with these concepts.

Intelligent Speculator won’t win any awards for Web design,

and it doesn’t have the extensive links of some other sites. Still,

it does provide a wide range of thorough and balanced trading

information, and increased knowledge is never a bad thing.Ý

J U S T the phacts

Phactor (www.phactor.com) is a loosely organized education and links sitethat should interest beginning and intermediate-level traders looking for

some practical information on various aspects of day trading.One of the best features on the site is a Nasdaq Level II tutorial, which takes

you through a trade step-by-step, providing full-color graphics of the Level IIscreen at each step along the way.

There’s also a pair of helpful downloads: a utility for measuring ping/tracert(two concepts crucial to a fast Internet connection — see “Getting connected,”p. 20) and a spreadsheet that can be used to track trades and commission dol-lars. A printable table, which gives the decimal equivalent of every fractionfrom 1⁄3 2 to 3 1⁄3 2, and their value in factors of 200, 500, 600, 800, 1,000, 1,500and 2,000, is downloadable, and can be modified in a spreadsheet. Links toWeb pages discussing whisper numbers, short selling and halted stocks willinterest many traders.

Phactor won’t blow anybody away with revolutionary new trading ideas. Butit’s likely many day traders will find something of value on the site. You maywant to check it out while you still can, though: It doesn’t look like it has beenupdated in quite a while, so who knows how long it will be around. Fortunately,this doesn’t affect its most useful educational content.Ý

GET s m a r t

WEBWatch

Source: www.intelligentspeculator.com

WINNING TRADES

Intelligent Speculator’s Risk Matrix enables you to calculate the probability of ruin (POR) of your trading strategy.



Getting connected Your trading setup starts with your Internet connection — it’s your lifeline to the market. Get the bottom line on the different communication technologies and how you can

not only get connected but stay connected — when it counts most.

Hardware • Software • Communications

BY GIBBONS BURKE

W hen trading first sweptthe country in the earlypart of the 20th century,the only way to get a

stock quote was through your broker’soffice.

The broker had a direct connection tothe exchange and a “ticker” devicewould spit out quotes onto a thin sheetof paper — the ticker tape. One personwould stand at the ticker and shout outquotes, while another person wouldwrite down the quotes on a chalkboardfor everyone in the office to see.

For decades this system re m a i n e dessentially unchanged.

Eventually, the ticker box and chalk-boards were replaced by electric dis-plays, but the broker’s office was still theonly place to get quotes.

To d a y, the Internet allows onlinetraders to get instant quotes, researchreports, company news and financial fil-ings — not to mention place trades —anytime. Because “trading” is quicklybecoming synonymous with “onlinetrading,” your Internet connection is afundamental component of your tradingsetup. Lost seconds or, God forbid, min-utes because of a communication failuremay not mean much if you’re browsingthe Web for tuna casserole recipes, but it

can be disaster when you’re in the mid-dle of a trade.

The active trader has many availableoptions to connect to the World WideWeb and all the information it provides.However, there are some key considera-tions in making a selection:

Speed: How much bandwidth do youneed?

Reliability: Your Internet connectionis your trading lifeline — can you trustit?

Cost: You can’t be penny-wise andd o l l a r-foolish. While cost is a factor,active traders must weigh it against theamount of money they regularly put atrisk. Saving money and choosing aninferior Internet connection can result inlarge trading losses.

The most important thing to re m e m-ber is that getting connected is one thing,staying connected is another.

The Internet is a relatively new methodof communicating. If you choose to relyon it for trade entry and market informa-tion, you must be prepared to deal withthe problems that can occur. With someplanning and precaution, you can takesteps that minimize the risk of your trad-ing being interrupted.

The first step in the process is getting aconnection. You have five basic choices:analog telephone dial-up (modem), digi-tal telephone (ISDN, xDSL), digital cable,w i reless, and hybrid solutions (We br a m p ) .

Telephone modems have been aroundfor a long time. The very first ones couldsend and receive information at 110 bits

per second (bps) using Plain OldTelephone Service (POTS).

Over the years, technologicaladvances allowed the bps rate to steadi-ly increase, up to the 56,000 bps modemsin use today. Considering telephonesp rovide analog transmission, 56K isprobably the upper limit for modems. Infact, with the limitations of analog, themaximum speed of a telephone connec-tion can’t even reach 56K, no matterwhat modem manufacturers would likeyou to think.

When your computer dials up anothermodem — say, for example, yourInternet Service Provider (ISP) — thetwo engage in a “hand-shaking” ritualwhere they test the quality of the con-nection. When your computer makesthose crazy, screeching noises while con-necting, that’s what is happening.

The two modems often speak differentdialects, so a peak data transfer rate isnot always achieved. Furthermore, ISPconnections are often digital, so the ana-log-to-digital connection makes it diffi-cult for maximum speed to be achieved.

Certain companies (AltaVi s t a ,N e t Z e ro) offer free Internet service,although these systems will log you off ifyou don’t do anything on your computerfor 20 minutes, so they’re probably notsuited for trading.

The standard rate is between $19.95-$21.95 per month for unlimited access —sometimes lower if you sign up for ay e a r’s service ahead of time.

Bottom line: Dial-up service is mostuseful for two reasons. First, it is the eas-iest to use. Modems are commonplaceare relatively inexpensive.

Second, it is transportable. You can dialinto your ISP f rom just about anywhere


t h e re is a computer and a phone connec-tion. And many of the major servicep roviders such as Compuserve, A O L ,Earthlink and ATT provide internationalaccess numbers when you travel over-s e a s .

Realizing that analog data transmissionis not the best way to transfer informa-tion, the phone companies began todevelop Integrated Digital ServicesNetwork (ISDN), which used the exist-ing copper wiring already in people’shomes. This new service was introducedin 1988 with the expectation that itwould replace POTS within 10 years.

The premise was great: ISDN is madeup of two 64 Kbps channels with anadditional 8 Kbps controlling channel,with POTS provided over the same con-nection, allowing people to be on thecomputer and talk on the telephone atthe same time. And because ISDN is dig-ital, it can achieve speeds five timesfaster than the fastest analog modem.

H o w e v e r, ISDN was slow to bedeployed, was often unreliable andrequired a special “router,” which costbetween $400 and $800.

Bottom line: While many people areusing ISDN, it has effectively beenleapfrogged by DSL and cable, althoughISDN, for now, is more widely available.

ISDN service often requires you topay an extra charge for connecting to anISP because the ISP must itself buy anISDN modem and connection. Also, thebandwidth required for connection is

sometimes not available from certainISPs.

Like ISDN, Digital Subscriber Line (DSLor xDSL) uses the existing copper wiringof the POTS telephone network, but itcan achieve much higher data transmis-sion speeds — potentially 7 million bitsper second (megabits or Mbps).

However, this connection option hasits limits. Computers hooked up to DSLsmust be within 18,000 feet of the“DSLAM” router at the telephone com-pany’s central office. Beyond that dis-tance, the data-carrying capacity of DSLdecreases significantly.

Check with your local phone carrier,or ISPs such as Earthlink.net, to see ifDSL is available to you.

DSL service is relatively inexpensive,ranging from $39 to $89 per monthdepending upon your provider and thetype and term of service you desire. Aspecial router is re q u i red, which canrange from $200-$800.

Bottom line: People using DSL at theirresidences usually opt for AsymmetricalDSL(ADSL), which transfers data out ofthe user’s PC at 128 Kbps and brings it inat 5 Mbps. While this would not workfor hosting a Web site, it is fine for trad-ing purposes because most of the datatraffic is incoming market information.

Besides ADSL, there are a few otherflavors of DSL, such as R-ADSL, ADSLLite, VDSL, HDSL and IDSL. Othersmay be available in your particular area.

The Web site www. x d s l . c o m / c o n-

t e n t / b a c k g ro u n d i n f o / o v e r v i e w / d e f a u l t.asp is a good source of informationabout different types of DSL:

The connection options discussed so faruse twisted-pair copper wires thata l ready exist on your telephone net-work. Another method growing in pop-ularity employs coaxial cable.

Companies such as @Home claim thebandwidth of a cable connection is 100times faster than a 56K hookup. Unlikethe telephone system, which is designedfor two-way connections, cable is intend-ed for broadcast, which means it isdesigned for a one-way informationf l o w. As a result, to adapt cable technolo-gy to the Internet, cable companies havebuilt an additional network of “head-end” connection points in various neigh-b o rhoods. Everyone in the neighborh o o dconnects through that central point.

Bottom line: Cable Internet access canbe very fast, but speed is dependentupon the amount of traffic in your area.Usually, the first people in the area to gethooked up via cable experience blazingspeed on the Internet, but as others inthe neighborhood log on, the perform-ance of the connection decreases. This issomething you cannot control.

T1 and T3 connections are high-speed,commercial quality digital connections,and are priced accordingly. If you arepowering a half-dozen PCs crunchingreal-time data, running a small office or

THE NEED FOR SPEED (all prices approximate)Connection Monthly Cost Equipment Speed Advantages Disadvantages

(upstream/downstream)Dial-up $0-$35 Modem 56 Kbps Easy, inexpensive, Slow, unreliable

plus phone line $50 (30 Kbps practical real limit) “transportable”ISDN $30 plus Router 64 Kbps or 128 Kbps Combines voice and Unreliable — frequent

metered time $300-$1,500 data over same lines disconnections; charges — $100 metered access rates

DSL $40-$100 Router 384 Kbps-1.5 Mbps/ No speed degradation Speed degrades with $200-$800 128 Kbps with users in distance from central office;

neighborhood Regional Bells slow to installCable $40-$50 Cable Modem 30 mbps/ No interference Speed degrades as

$100 128 kbps-10 Mbps with phone other people in or TV viewing area get the service.

Wireless — $29 Ricochet modem 28.8 Kbps Total mobility Slow Ricochet $160 within a few areas Wireless — $40-$65 Wireless modem 9,600 Kbps Available in more Slower Bell Atlantic $150-$520 areas than Ricochet T1 $900 Router 1.544 Mbps Extremely fast Very expensiveT3 $1,000 Router 45 Mbps Extremely fast Very expensive


you need to provide outgoing informa-tion on a Web site, a T1 or T3 would bewhat you would need.

Most Web sites are powered, however,on servers hosted at facilities owned byISPs that can provide adequate "enviro n-mentals" 24-7 monitoring, an air- c o n d i-tioned secure facility with uninterru p t e dpower supplies and dedicated high-speedconnections to multiple "peering" pointson the Net.

Bottom line: Although these are thefastest connections around, most indi-vidual traders have no need for them ortheir high price tags.

For active traders who findthemselves away from a tele-phone jack, wireless connectionscan allow them to stay in touchwith the markets from any-where.

Right now, wireless modemservice availability is very limit-ed and connection speed is slow,but the convenience of beingable to stay in contact with themarkets makes this a com-pelling choice for active traders.

Ricochet (www. r i c o c h e t . n e t )o ffers a solution in the SanFrancisco, Washington D.C. andSeattle areas. Its network ofM i c rocell Radios — shoebox-sized devices mounted on utility

poles and street lamps every quarter- tohalf-mile in the company’s coverageareas — allow access speeds up to 28.8Kbps. Service is $29 per month forunlimited access, while the Ricochetexternal modem costs $159.

Another solution, off e red by BellAtlantic (www. b a m . c o m / w i re l e s s / I n t e r-net1.html) piggybacks on the cellularnetwork to provide 9600 bps connectionsa n y w h e re on the Eastern seaboard for aflat rate of $40 to $65 per month.

Apple Computer now offers A i r p o r t( w w w.apple.com/airport), a mobile

Internet connection station for the homeor small office that allows up to 10 iBookor iMac units to be networked together. Itis fast (11 Mbps) for a wireless network,and allows you to stay connected no mat-ter where you are in your home office.

Dell Computers (www.dell.com) alsoo ffers a wireless network with its PC line.

Bottom line: These are obviously theslowest and least reliable connections,but if you’re frequently mobile and needsome way to connect, you have somechoices.

While most people think in terms offinding a single communicationsmethod with the best performance fea-tures, the ultimate in speed, flexibilityand reliability may be achieved by com-bining two or more simultaneous con-nections. This can increase your band-width and reduce the dangers of beingdisconnected or slowed down to asnail’s pace if your ISP develops troubleor Internet traffic becomes congested.

For example, in areas where high-speed digital access is not available, a$250 router will allow you to connect tothe Internet via three separate dial-upmodem connections to three differentISPs. The combined bandwidth of thethree connections is a vast improvementover one connection, sometimes ap-p roaching the speeds of ISDN. A l s o ,connecting to three different ISPs givesyou an additional measure of reliabilityif one of the ISPs fails. Figure 1 showshow this connectivity functions.

Ramp Networks, Inc. (www. w e b -ramp.com) manufactures the ro u t e r sthat allow you to pool bandwidth. Thecompany’s Web ramp black boxes alsoinclude an Ethernet hub with four jacks.

Obviously, the more phone lines andISPs you use, the higher the costs aregoing to be. However, at $20 per monthper ISP, it’s not prohibitive. And, addi-tional phone lines are not that muchmore if you avoid all the extras (i.e., callwaiting, call forwarding, three-way call-ing) the phone company wants to sellyou. Considering what could happen ifyou are frozen out from making a tradeat a critical time, it’s money well spent.

Bottom line: Web ramps are truly themost robust way to connect to theInternet for trading, at least until theInternet itself is more robust.Ý

Reducing information and execution risk

Someone once said, “Diversification is the only free lunch on Wall Street.” What he meant was that the best way to reduce your risk exposure was to

diversify your investment portfolio among a number of stocks. The same logic canbe applied to the information and execution risk in your trading.

If you have only one way to get connected to the Internet — say through an ISP— and that ISP is having a bad day, your portfolio could have a bad day, too.

A trader should, at a bare minimum, have at least two ISP accounts. A backupis necessary if the first one shows any sign of trouble. And even if your main ISPseems OK, it may develop traffic snags. Having a second ISP ready to go shouldallow you to find another route and bypass the traffic.

There are some useful tools for diagnosing Web traffic. Windows comes withtwo of them: “ping” and “tracert.”

Ping measures the time it takes for a message to travel from your PC to thedestination s e r v e r. Tracert traces the route between your PC and the destinationserver and lets you know how much there was at each “hop” along the route.

Ping Plotter, a $15 shareware tool available at www.nessoft.com, combines thefunction of ping and tracert into a visual display. It provides a dynamic trace routedisplay that continually monitors connection quality. It allows you to instantly spota traffic jam and even gives you the phone numbers of the network operators soyou can let them know when there is a problem. Highly recommended.

Source: Ramp Networks

FIGURE 1 RAMPING UP

WebRamp allows you to pool the resources ofmultiple Internet connections, increasing yourspeed and protecting yourself from a completecommunication disruption.

Modems

Computers

WebRamp

ISP

ISP

ISP

Internetservice

providerPhonejacks


BY GARY SMITH

M any traders look at mewith a skeptical eyewhen I tell them how Itrade the stock market

for a living. That’s because I’m totallyopposed to perceptual filters like charts,oscillators, waves, cycles, moving aver-ages, and all the other approaches andsystems traders typically use to under-stand price behavior. To add insult toi n j u r y, I also believe all the glitzy com-puter equipment and software so fre-quently advertised for traders is unnec-e s s a r y.

For me, less is more. I believe in trad-ing pure price action — market behavioryou can see and do not have to measureby traditional (and often lagging) analyt-ical tools. My trading has evolved to thepoint that if I had to, I could make mytrading decisions based solely on half-hourly quotes of the Dow, S&P 5 0 0 ,

Nasdaq 100 and Russell 2000 cashi n d i c e s.

A year ago, in fact, I had to do just thatas I helped a friend move across country.For an entire week, I did not have accessto CNBC, the World Wide Web or any ofthe financial publications I usually relyon for information. I survived solely bymaking frequent phone calls to getupdates on my cash indices. But mytrading did not suffer: I actively tradedand made $10,000.

So, you may ask, how profitable hasthis simplistic trading style been overthe years? Starting with a $2,200 accountin the spring of 1985, I have methodical-ly parlayed my trading skills and capitalin such a way that over the past threeyears (ending December 1999), I’ve aver-aged over $14,000 in monthly trading

profits. Successful trading is about quickness,

flexibility and reacting to market actionas it is occurring, not after the fact whenit can easily be quantified and identifiedby the analytical horde. That is why overthe years I have gravitated toward trad-ing pure price action. This simply trans-

lates into being in sync with the rhythmof the market — and that rhythm is itsmomentum.

My trading methodology is based onseveral short-term momentum patternsthat keep me attuned to the market’srhythm. These are outlined below andfollowed by real-life trading examplesthat show how they capture significantprice moves.

While these patterns are all short-termtechniques, they can sometimes developinto bigger trades. I trade all my momen-tum and divergence patterns with theexpectation they will result in immediatefurther strength (or weakness) over thenext few trading days. If this pricestrength continues, so much the better.

V-bottoms: V-bottom reversals occurintraday when the Dow has been downthe entire trading session (as much as .75percent from its previous close) and thenmakes a furious comeback, closingeither near the unchanged level or,preferably, up for the day. The later inthe day the reversal occurs, the more sig-

POP QUIZ — THE MOST VALUABLE TOOL FOR THE SHORT-TERM TRADER IS:

Maverick short-term trader Gary Smith, who has averaged $14,000 per month

in profits over the last three years, will choose D every time.

Find out how he takes consistent profits out of the stock market.

My trading methodology is based on several short-term momentumpatterns that keep me attuned to the market’s rhythm.

Trading pure price action

A) A PRICE CHART

B) A COMPLEX TECHNICAL INDICATOR

C) HIGH-SPEED COMMUNICATIONS

D) NONE OF THE ABOVE

TRADING Strategies


nificant it is. I instinctively trade V-bottom rever-

sals if the Dow closed down the previousday or if it has been in a recent down-t rend. V-bottom reversals that occurafter a strong up day or during a periodof rising prices are much less important.

Late-day surges: This pattern is close-ly related to the V-bottom. Late-dayprice surges normally occur during thelast two- to two-and-a-half hours ofchoppy and non-trending trading days.A late-day price surge should take theDow to a close of at least .5 percentabove the prior day’s close. Like V-bot-tom reversals, this pattern is most signif-icant when it comes after a down day ora period of declining prices.

Extreme momentum days: Extrememomentum days are just that — tradingdays of out-of-the-ordinary price actionthat has not occurred for the past sever-al months. This type of momentum dayis normally followed by a continuationin the direction of the thrust.

Weekend patterns: Some of my morereliable momentum patterns over they e a r s have been Friday-to-Monday pat-terns.

G re a t e r-than-average strength on aFriday is often followed by more

s t rength on Monday (or Tu e s d a y, ifMonday is a trading holiday).Conversely, extremely weak price actionon a Friday typically leads to moreweakness on Monday. I buy on the closeof any Friday when the Dow andNasdaq 100 both close up .5 percent ormore.

A Friday-to-Monday momentumb reak pattern occurs when extre m estrength or weakness Friday does notcarry over to Monday. These weekendmomentum break patterns are highlysignificant and indicate short-term trendchanges.

One-percent selling days: A 1-per-cent true-selling day occurs when, after aperiod of rising prices (at least seven to10 trading days), the cash Dow, S&P,Nasdaq 100 and Russell 2000 indices allclose down 1 percent or more on thesame trading day. Such days often are“trend busters” — harbingers of seriousprice declines.

I use a little leeway in defining suchselling days. For example, if three of thefour indices are sharply lower — say,down 1.5 percent to 2 percent or more —but one index is down only .75 percentto 1 percent, I would still interpret thatas a true-selling day. Any index down

less than .75 percent invalidates the true-selling day because it indicates buyinginterest in at least one segment of themarket (in an otherwise extremely weakoverall market).

Divergence patterns: Divergence pat-terns are my favorite technique becausethey have made me the most moneyover the years. Divergences (when onemarket or indicator goes in one directionand another market or indicator goes theopposite direction) between the Dow,S & P, Nasdaq 100 and Russell 2000indices tell me where money is flowingand which sector I should be trading.

Before looking at specific trade exam-ples, let’s first discuss a couple of thenuts-and-bolts issues: what to trade andhow to time entries and exits.

There are a number of vehicles youcan use to trade these patterns — indi-vidual stocks, equity shares like theSPDRs, DIAs or QQQs, stock indexfutures, stock index options or mutualfunds. In the following trading exam-ples, it really does not matter whichtrading weapon would have been used— they all can be effective in exploitingthe types of price action I havedescribed.

Regardless of your preferred tradingvehicle, the challenge remains the same— understanding price behavior andbeing in sync with the momentum of themarket. In the end, what you trade boilsdown to your individual risk tolerancesand preferences. In the past I have trad-ed stocks, equity and index options, andstock index futures. But at this point inmy trading career, I make most of mymoney trading mutual funds, partlybecause of their trend persistency com-pared to other trading vehicles.

I am a close-of-the-day trader, whichmeans my trading decisions are basedon the entire day’s trading action. I makemy trades right before the close of trad-ing.

Strategies: Gary Smith short-term stock market strategies

Approach: Discretionary; the following strategy elements are general guide-lines, not systematic rules.

Market: Stocks or stock-related instruments — equity shares (QQQs, SPDRs,DIAs), stock index futures, mutual funds.

Setup: See descriptions of individual strategies.

Entry: On today’s close.

Exit: Exit winning trades on a 3 percent to 4 percent reaction from a relativehigh (for long-side strategies). Trades can also be exited with other patterns,such as a 1-percent true-selling day.

Risk control/money management: Risk no more than 1 percent to 2 percentinitially. Exit on next-day’s close if expected follow-through does not materi -alize. Add to position with each 1 percent to 2 percent price advance. Trailstop and exit on reaction as described above.

STRATEGY SNAPSHOT

I trade all my momentum and divergence patternsin the expectation they will result in immediate further strength

(or weakness) over the next few trading days.


In the past, I used to trade intraday.However, my trading account is hun-dreds of thousands of dollars to the bet-ter since I’ve moved beyond intradaytrading in favor of close-of-the-day trad-ing. This approach has allowed me tocapture much more of the gains from thegreat bull market of the past decade thandarting in and out on a daily basis.

As mentioned earlier, my price pat-terns are short-term and are intended toexploit immediate further strength (orweakness) over the next few tradingdays. As a trader, I never cut my profitsshort or set price objectives. My sell cri-terion is very simple: If the expecteds t rength fails to materialize the nexttrading session, I exit my position on theclose — no hoping, praying or wishing.

Once I am in a profitable trade, I willadd to that position as the market movesin my favor. This is a scale-up tradingstrategy I learned from master traderssuch as Jesse Livermore and NicholasDarvas.

On initial purchases, I do not riskmore than 1 percent to 2 percent ofaccount equity. Then, if the trade movesin my favor, I will add to my position oneach 1 percent to 2 percent incrementalprice advance.

Livermore and Darvas also believedin trailing their stops as prices rose, soonce the market retraced a certain per-centage from their highs, they weretaken out with a profit. I usually get outif the market moves 3 percent to 4 per-cent off any recent high since I have beenin. If these percentages seem like I don’tgive the market much room for error, itis because I focus on trading mutualfunds moving upward in tight, risingchannels with few or no reactions alongthe way. (This part of my strategy is oneof the key elements of my success.)

Enough of the explanations. Here aresome real-life examples that illustratehow to trade these momentum anddivergence patterns.

Weekend break: The Dow had beenin correction mode from August throughmid-October 1999, declining more than11 percent. This correction reached itsnadir with a 266-point (2 perc e n t )decline Friday, Oct. 15. Doom and gloompervaded the Street after the close thatFriday, with forecasts of another sharpdecline and a break of the critical 10,000

level on Monday, Oct. 18. But a funny thing happened when the

market re-opened that Monday: Insteadof suffering follow-through selling, theDow chopped around most of the day,flipping between positive and negativeterritory (see Figure 1 ). Then, in the last90 minutes of trading, the Dow shot up116 points, closing ahead 96 points forthe session.

It was a classic example of the Friday-to-Monday momentum break pattern.Coming after a period of decliningprices, Oct. 18 marked a major bottom inthe market and launched a rally thatresulted in the Nasdaq 100 gaining 57percent by the end of the year.

Over the years, Friday-to-Mondaymomentum break patterns have markedseveral significant lows. Both the Friday-to-Monday momentum break patternsof April 14, 1997, and Jan. 12, 1998, led to30 percent advances in the major indicesover a period of a few months. OtherFriday-to-Monday momentum bre a kpatterns have led to smaller, but still sig-nificant, price moves.

As with any of my trading patterns, Itrade Friday-to-Monday momentumbreak patterns instinctively. Trading isnot about analyzing or rationalizing, it isabout being quick, flexible and capable

of reacting to changes in the market. On Oct. 18, 1999, however, I was not

quick or flexible. I was psychologicallyunable to make the trade because I gotbogged down in bearish analysis. Thatwas my loss: The Dow rallied nearly 300points the following two trading days.(The lesson: Even experienced tradersneed to be vigilant about adhering tosound trading practices. You have to beable to execute your game plan to profitf rom it.) Fortunately, another tradingpattern — extreme price momentum —got me in the market on Thursday, Oct.21.

Momentum extreme : On thatThursday, the Nasdaq 100 dropped morethan 60 points in the first hour of trad-ing. (This was a reaction to some adversenews that technology giant IBMannounced after the previous day’sclose.) Beginning with the second hourof trading, the Nasdaq 100 graduallytraded higher throughout the day (tradenot pictured).

Then, in the last hour of trading, itsurged upward to close 10 points higheron the day. I found this type of extremedaily momentum in the tech-heavyindex especially significant because IBMwas getting pummeled in trading on theNYSE. As a result of its extreme price

Source: Defender Capital Management

FIGURE 1 FRIDAY-TO-MONDAY BREAK PATTERN

Dow Jones Industrial Average, 30-min., Oct. 18, 1999: Weakness from the preceding Friday did not carry over to this Monday; prices rocketed in the last 90minutes of trading. The day turned out to be a significant bottom.

Open 10,041.87

Close10,116.28

Previous day’s close, 10,019.71

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996010/18/99 Open 10:00 10:30 11:00 11:30 12:00 12:30 1:00 1:30 2:00 2:30 3:00 3:30 Close


momentum off the morning lows andalso its divergence with IBM and theDow (which closed lower by 94 points),I took a position before the close in theINVESCO Technology fund.

As I expected, prices rallied the nextday (Oct. 22) and then traded sidewaysfor a few days. But on Wednesday, Oct.27, this time in the Dow, anothermomentum pattern triggered — the late-day price surge.

Surging market: On this day, the Dowhad been trading around the break-evenlevel for most of that session when itsuddenly broke out and staged a 100-point rally in the last hour (see Figure 2).This also was a day when the Dow JonesUtilities index was making one of it bestadvances in several years.

Buoyed by the late-day price surge inthe Dow and the out-of-the-ord i n a r yprice action in the Utilities, I increasedmy technology fund position before theclose on Oct. 27. The Dow rallied morethan 300 points the following two days,with technology leading the way.

While this would have been a com-pletely acceptable two-day trade, I con-tinued (as I do whenever I am in a win-ning position) to increase my technologymutual fund position as the Nasdaq 100and other tech-related indices movedsteadily higher over the next two

months. Mixed signals: My favorite patterns

are divergences between the Dow, S&P,Nasdaq 100 and Russell 2000 indices. Bytelling you which sectors — large cap,technology or small cap — are thestrongest, divergences provide a goodindication of where you should put yourmoney.

Table 1 shows the performance of theDow and the Nasdaq 100 for the seventrading days from Oct. 28 through Nov.5, 1999. At the time, a one-point move inthe Nasdaq 100 equaled a 4.23-point

move in the Dow (computed by dividingthe Dow by the Nasdaq 100).

It was pretty obvious beginning Oct.28 where the strength was in the marketand, hence, where to be invested — theNasdaq 100 and technology sector. Thisdivergence between the Nasdaq 100 andthe large-cap stocks was particularlynotable Oct. 29, when the Nasdaq 100rose the equivalent of 412 Dow points. Italso was very glaring Nov. 2 when theDow closed down for the day in the faceof a strong Nasdaq 100.

Many traders began backing awayfrom the Nasdaq 100 around the timeshown in Table 1 because most tradition-al technical indicators were flashing“overbought” signals. However, theextreme divergence between the Nasdaq100 and the rest of the market suggestedsomething very big was brewing. Andfar from being overbought, the Nasdaq100 rocketed ahead another 900-pluspoints from the close of trading Nov. 5through the end of December.

The rule regarding diverging marketsis to always buy the strong market. Ifyou find yourself in a sector that sud-denly begins to diverge negatively fromthe other indices, get out as quickly aspossible and re-deploy your capital inthe sector diverging positively.

A classic example of negative diver-gence occurred in early April 1999. Asshown in Table 2, there was a viciousrotation out of tech stocks and into large-

cap Dow and value stocks beginningApril 12. I was in technology during thisrotation and exited part of my positionon April 12 and the remainder on April13.

I repositioned myself in the value sec-tor of the market. As it turned out, theDow and other value stocks continuedsoaring through the month, while tech-nology went nowhere.

Catching the bottom: The V-bottomupside reversal pattern does not occur

Dow Nasdaq100

Oct. 28 +227.64 +82.47

Oct. 29 +107.33 +97.51

Nov. 1 (-81.35) (-21.08)

Nov. 2 (-66.67) +10.63

Nov. 3 +27.22 +45.73

Nov. 4 +30.58 +30.39

Nov. 5 +64.84 +52.59

Totals +309.59 +298.24(1,261.55 Dow pts.)

TABLE 1 OCT. 28 - NOV. 5, 1999

Dow Nasdaq100

April 12 +165.67 (-13.26)

April 13 +55.50 (-44.03)

April 14 +16.65 (-76.22)

TABLE 2 APRIL 12 - APRIL 14, 1999


FIGURE 2 LATE-DAY SURGE

Dow Jones Industrial Average, 30-min., Oct. 27, 1999: A 300-point Dow rally followed the late-day momentum move on this day.

Open 10,307.19

Close10,394.89

Previous day’s close,10,302.13

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10/27/99 Open 10:00 10:30 11:00 11:30 12:00 12:30 1:00 1:30 2:00 2:30 3:00 3:30 Close


very often, but when it occurs, get readyfor some fireworks. The last notable V-bottom reversal I traded was the majormarket bottom of Oct. 8, 1998. That daymarked the culmination of the summermeltdown, which took most indices 20percent or more off their summer highs.

It looked like the market was about tofall deeper into the abyss that day, open-ing lower and continuing to plummet(see Figure 3). By 2 p.m. EST the Dowwas down 274 points, or almost 4 per-cent. Around that time, I had to leavehome to conduct some personal busi-ness, never imagining I would soon bemoving money into the market. Butwhen I returned home near the end ofthe trading session, the Dow had made amiraculous turnaround. Right before theclose it briefly pushed into positive terri-tory, then drifted back to close marginal-ly lower, down only 9 points.

Even though I was bearish, I had nochoice but to trade this pattern. A l t h o u g hI doubted it was a bottom, I thoughtt h e re would have to be some carryoverbuying. That is, in fact, how the situationunfolded: The Dow rallied 235 pointsover the next four trading days.

Again, this would have been anothergreat short-term trade, but this 235-pointrally was luckily only a prelude to theexplosion that was about to occur. OnThursday, Oct.15, shortly before 3 p.m.,the Fed unexpectedly lowered the dis-count rate. After the surprise Fedannouncement, the Dow surged a stun-ning 220 points during the last 60 min-utes of trading and closed up 330 pointsfor the day.

This was another example of extre m eprice momentum — the kind of out-of-t h e - o rdinary price action that invariablyleads to much larger gains in the daysand, sometimes, weeks ahead. Sometraders, intimidated by extreme momen-tum, re t reat to the sidelines awaiting pricepullbacks that never occur. As with all mytrading patterns, whenever I see ane x t reme momentum day, I don’t think,analyze, or reason — I simply buy. Fro mthe close of Oct. 15, the Dow ran up anoth-er 900 points through the end of the year.

The short side: I have only one sell-side momentum pattern — the 1-percenttrue-selling day. True selling for me is

when all the indices — the Dow, S&P,Nasdaq 100 and Russell 2000 — concur-rently decline 1 percent or more on thesame trading day. Although this is myleast reliable trading pattern — mostlikely because of the historical upwardbias in stock prices — it nevertheless hasgiven me some excellent sell signals.

For example, the summer 1998 top onJuly 21 came in the form of a 1-percenttrue-selling day. Another 1-percent true-selling day occurred two days later onJuly 23. Usually, I will sell up to 50 per-cent of my position on an initial true sell-ing day, and the remainder of my posi-tion on a second true selling day (or ifprices continue trending down). Afterclosing out my remaining positions onJuly 23, the Dow sank nearly 1,600points through the end of August.

Incidentally, my 1-percent true-sellingday pattern also got me out of the mar-ket in mid-October 1997, when two suchdays occurred back-to-back on October16 and 17. That effectively ended the

spring and summer rally in technologyand small caps, and enabled me to avoidthe mini-crash of October 27 (as well asthe weakness leading up to that deba-cle). However, because the 1-perc e n ttrue-selling day is my least accurate pat-tern, there have been occasions when Ihave exited only to reenter a day or twolater when one of my other momentumpatterns kicked in on the upside.

The patterns we have analyzed shareseveral common traits: They are simple,based purely on easily observable priceaction and easy to trade. By focusing onprice action and momentum, and avoid-ing perceptual filters like charts andindicators that can adversely influencetrade decisions, I have been able todevelop short-term strategies that iden-tify highly profitable trade opportunitiesin the stock market.

“Keep it simple” may be a shop-worntrading concept, but it has been a philos-ophy I have actively, and pro f i t a b l y,practiced for years.Ý


FIGURE 3 V-BOTTOM UPSIDE REVERSAL

Dow Jones Industrial Average, 30-min., Oct. 8, 1998: The V-bottom reversal is afurious rally that occurs on a day when the market has been trading dramaticallylower. The turnaround this day was followed by a strong rally over the next several days

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Open 7,621.97

10/8/98 Open 10:00 10:30 11:00 11:30 12:00 12:30 1:00 1:30 2:00 2:30 3:00 3:30 Close

Close7,731.91

Previous day’s close, 7,741.69

If strength fails to materialize the next trading session, I exitmy position on the close — no hoping, praying or wishing.


PLAYING the break(out)Short-term traders

always debate the wisdom

of trading gap openings:

t rade ’em,

fade ’em

or leave ’em alone?

Read on to learn about

a low-risk intraday

breakout system

that plays off

the market psychology

and price dynamics

of gap openings.

TRADING Strategies

BY MARK SELEZNOV

A hitter in baseball can fail 70percent of the time but stillmake it to the all-star game ifhe gets enough doubles,

triples and home runs with the other 30percent of his at-bats.

It’s the same with trading. In fact, theaverage successful floor trader is correctonly around 30 percent of the time. Hestays in business by practicing the oldcliché of “cutting losses short and lettingprofits run.” And he does that by devel-oping a sound, systematic trading plan.

Regardless of whether they are pat-

tern- or indicator-based, most successfultraders use a systematic plan to selecttheir trades. Even floor traders, whobasically trade tick by tick, follow a sys-tematic approach.

Short-term and day traders who makehundreds of trades a month have noroom for faulty judgment or excessiverisk-taking. A trading plan helps guardagainst these problems by taking theemotion out of trading.

A successful trading plan does nothave to be right all of the time, or evenmost of the time, to be profitable. It is theslugging percentage that counts. If yourloss when “striking out” is small, butyour hits are big, you can be an overallwinner.

Think of it this way: Suppose you hada method that triggered 30 trades a day

with 50 percent winners and 50 percentlosers, but the average win was $600 andthe average loss was $300. You would bep retty happy, right? Unfortunately,many inexperienced traders are uncom-fortable with being wrong a large per-centage of the time.

There is no “holy grail” in trading.The typical trader usually gravitatestoward strategies with very high win-ning percentages, but often falls prey to“black box” systems that are limited toone stock or commodity. Many othermethods show results for limited timespans, such as periods of great priceincreases or bull markets. Good tradingstrategies keep losses small, let profitsexpand and work over long periods oftime in different market conditions.

Before detailing a specific systematic


intraday trading approach, let’s take alook at some of the common elements ofall well-planned trading strategies.

Acomplete systematic trading plan needsseven components: time frame, studies, asetup, trigger, stop, exit and filters.

All trading plans must start with thetime frame, which establishes a timespan (2-minute, 10-minute, daily, etc.)for the price bar used to determine thepatterns and indicators in the approach.

For example, if you are going to buythe highest high of the last 20 bars, youmust decide whether you are going tolook at a 5-minute, 15-minute, daily oreven a weekly bar. You cannot deter-mine appropriate stop levels until youhave determined your time frame.

For example, a strategy for which theinitial stop-loss is placed below the low-est low of the past three barswould have much more riskon a daily chart than on a 5-minute chart because of thelarger range of the daily bars.You must choose a time framethat allows you to placetrades that fit your risk toler-ance level.

Studies include any calcu-lations or indicators neededto analyze market action,such as moving averages,moving average converg e n c e -d i v e rgence (MACD), the com-modity channel index (CCI),relative strength index, sto-chastics and so on. Studiesalso include chart analysistools like trend lines or hori-zontal support and resistancelines for certain times of theday.

The setup is a clearly defined condi-tion (or conditions) that makes it possi-ble to take a trade. If you are using a pat-tern-based approach, the setup clearlydefines the characteristics of the patternthat must be in place before you can takethe trade . If you use an indicator like amoving average, an example of a setupmight be that price is above or below themoving average (or above or below it bya certain amount).

The trigger is the actual entry into thetrade. After the setup conditions are met,this trigger signals a buy or sell. Thereshould be no second thoughts about

entry. For example, after the setup wejust described lays the groundwork forthe trade, an entry might be signaledwhen price exceeds the highest high ofthe last three bars.

Stops are used to exit a trade that isnot performing as expected, and can bebased on one or multiple conditions. Forexample, a trader might opt to exit witha $500 loss if the trade has not becomep rofitable after a specific amount oftime.

The e x i t is used to liquidate a pro f-itable trade after a certain amount of timehas passed. Too many traders exit tradesearly precisely because they do not havea plan for when and how to get out ofpositions. Letting winning trades run asmuch as possible is critical to successfultrading.

Filters a re additional conditionsapplied to a trading strategy. Afilter can

be something as simple as exiting longtrades only when the overall market isup. (However, in this case, you wouldneed to decide whether “market” re f e r sto the Dow Jones, Nasdaq or S&P 5 0 0 . )Filters can turn a method with averagereturns into one with above-averagere s u l t s .

Any systematic trading approach alsoshould have a “psychological” basis —that is, something that tries to exploit thecrowd behavior of the market.

Repetitive crowd behavior is whatmakes trading work, and recurring price

or indicator patterns are visual represen-tations of crowd psychology in action(this will become clearer when wedescribe our intraday breakout strategylater in the article). A clear trading planallows you to remove emotion fro mtrading and take advantage of such pat-terns.

One of the primary reasons to use aplan is that it allows you to reviewtrades and evaluate performance. Keepin mind, though, that a trading plan willnot do any good if it is not followed. Ifyou entered a trade that did not fit yoursetup criteria, you did not follow yourplan. If you closed out a trade withoutthe stock meeting your exit strategy, youdid not follow your plan. Such detoursfrom your game plan may seem likeminor lapses at the time, but they canseriously impact your performance.

Atrading plan gives you a roadmap tonavigate the markets; if yout h row the map out the window,you should not be surprisedwhen you find yourself in themiddle of nowhere with anempty gas tank.

Now we will take a look at a spe-cific system that incorporates theideas we have discussed. Thissystem (for Nasdaq stocks only)is the Seleznov Breakout MethodNo. 8 (SBM8).

This pattern is based on verysimple market psychology:When a stock gaps above theprevious day’s high on the open,new buyers are entering the mar-ket, pushing the stock higher. Insuch situations there is oftensome fundamental reason for the

higher price — an earnings announce-ment, a merger, etc.

When market orders have built upovernight, the market-making firms andspecialists gap the stock higher so theycan turn around and sell it short, capital-izing on the overzealous buyers pilinginto the stock. (Remember, in mostinstances, a market maker or specialist istaking the other side of your trade.) Themarket maker hopes the stock’s rise willbring in other sellers, pushing the stockback down and allowing him to buyback his short position at a profit.

However, sometimes the market mak-ers misjudge the true strength of a price


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A

B

C D

E

2/01

A trade is triggered when price moves 1⁄8 above the high of the previous bar(after the sequence of at least three bars with lower or equal highs).

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451⁄2

45

441⁄2

44

431⁄2

43

421⁄2

42

411⁄2

A

B

C

D1/31

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Source: Trend Trader and Townsend Analytics


An SBM8 trade occurs when price makes at least three lower or equalhighs after a gap opening.

FIGURE 1 MCI WORLDCOM (WCOM), 10-MIN.

FIGURE 2 SUN MICROSYSTEMS (SUNW), 10-MIN.

Here are examples of the SBM8 systemat work:

Figure 1 shows MCI Wo r l d c o m(WCOM), which closed at 415⁄8 onFriday, Jan. 28 and opened up the nexttrading day (Monday, Jan. 31), at 42(A). The setup began with the 10:10a.m. bar, which hit a high of 427⁄8,and continued over the next four bars,each of which made consecutivelylower or equal highs (B). The 11 a.m.bar exceeded the prior bar by 1⁄8. The10:50 bar has a range of less than 3⁄4

giving the trade a maximum risk of onepoint.

The trade is entered at 421⁄2 (C).From this entry at 11 a.m. through theentire day, the stock never traded 1⁄8

below the low of the last two bars. Exitoccurs at the end of the day “marketon close” (MOC) at 453⁄4 (D) for a 31⁄4-point profit per share.

Figure 2 shows Sun Microsystems(SUNW), which closed on Jan. 31 at785⁄8 and opened on Feb. 1 at 787⁄8

(A). The stock then moved lower, cre-ating a setup with the three 10-minutebars from 10 a.m. through 10:20 a.m.,each of which had a lower or equalhigh than the previous bar.

The trigger occurred at the 10:30a.m. bar, 1⁄8 above the high of the10:20 a.m. bar at 779⁄1 6 (B). SUNW ral-lied with each bar, never falling 1⁄8

below the low of the previous two barsuntil the 1:30 p.m. bar, when it fell to801⁄4, 1⁄8 below both the 1:10 p.m.and 1:20 p.m. bars. This exit resultedin 21 1⁄1 6-point profit on the trade.

Figure 3 shows a stock with severalentries during the day.

Biogen (BGEN) closed at 861⁄4 on Jan.31. It opened the next day at 881 5⁄1 6 ( A )and immediately completed four barswith equal or lower highs. At 10:20 a.m.(B), BGEN exceeded the previous bar(which had a range of less than 3⁄4) by

TRADING EXAMPLES

move. If the stock starts to move upagain (after the thrust of the initial gapopen move), not only will the new buy-ers be pushing the stock higher, but themarket makers and traders who fadedthe gap opening will need to cover theirshort positions.

The SBM8 trades in the direction of

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FIGURE 3 BIOGEN (BGEN), 10-MIN.

FIGURE 4 USA NETWORK (USAI), 10-MIN.

The SMB8 strategy triggered twice in the same day in Biogen (BGEN).

The bar before the entry bar must have a range of no more than 3⁄4, becauserisk on an SMB8 trade is limited to one point and the stop is placed 1⁄8 belowthe low of the bar preceding the entry bar.



1⁄8, triggering the trade at 871 1⁄1 6. At11:10 a.m., the stock slipped 1⁄8 b e l o wthe low of the previous two bars, and anexit at 877⁄8 closed the trade with again of only 3⁄1 6 ( C ) .

But immediately after this exit,BGEN made four consecutive bars withlower or equal highs. At noon (D), thestock exceeded the previous bar (a barwith a very tight range, less than 3⁄4)by 1⁄8, at 877⁄8, triggering anothertrade. BGEN rallied immediately, mov-ing higher until 1:50 p.m., when thestock traded 1⁄8 below the low of thelast two bars, signaling an exit at911⁄1 6 (E), for a nice 33⁄1 6 gain on a riskof 1⁄2 point.

F i n a l l y, late in the day BGEN wentinto another setup pattern at 3 p.m. (Fto G). However, the filter rule to nottrade after 3 p.m. keeps us out of themarket. Still, not a bad trading day,with two winners producing a 33⁄8-point profit.

In Figure 4 USA Networks ( U S A I )gapped up from its Feb. 2 close of491 5⁄1 6 to open at 519⁄1 6 (A) and thensold off. After three bars of lower orequal highs, the stock broke above theprevious bar by 1⁄8 at 10:20 a.m., trig-gering entry at 507⁄8. The previous barhad a 1⁄4-point range, giving the tradea 1⁄2-point risk (B).

USAI ran for the next 90 minutesbefore an exit signaled (at 11:50 a.m.)at 515⁄8, for a gain of 11⁄1 6. (Althoughthis was a “wiggle stop,” one that justtouches the exit point, you have to getout — rules are rules.)

From 12:20 p.m. through 12:50p.m., the stock made three lower orequal highs, a congestion pattern thatqualifies under all of our rules (C). Atrade is triggered at 523⁄1 6, and withthe previous bar having a range of only1⁄8, the risk on this trade is only 3⁄8.USAI rallied strongly until the exit ruleclosed the position at 533⁄4 at 2:10p.m. with a 19⁄1 6-point gain (D).


this trend, as buyers push the stockhigher. Here are its components:

Time frame: 10-minute bars, normaltrading hours.

Studies: None.Setup: 1. The stock opens higher than the

previous day’s close.


2. The stock makes at least three con-secutive, completed bars (i.e., not partialbars) with equal or lower highs than theprevious bars.

Trigger: Buy 1⁄8 above the high of theprevious bar.

Stop: 1⁄8 below the low of the previousbar.

Exit: 1⁄8 below low of two bars ago.Filters: Only take trades with a maxi-

mum risk of one point and do not maketrades after 3 p.m. EST.

Let’s go over each of these compo-nents in detail to make sure they’reabsolutely clear.

Time frame: A bar starts at 9:30 a.m.EST and runs to 9:40 a.m. to complete.Then the next bar begins.

S t u d i e s : Because this is a pattern-based method, there are no studies.

S e t u p : First, the stock must haveopened at least 1⁄8 higher than the previ-ous day’s close. Second, it must make atleast three complete down bars, or it canbe in a congestion pattern. (The mainpart of the setup is that each of the threeprevious bars must have equal or lowerhighs than the preceding bars.) What is

happening here is that the stock is paus-ing or pulling back after the initial open-ing burst.

Tr i g g e r : Entry can occur only after astock has completed at least three 10-minute bars with equal or lower highs(entry must occur on the fourth bar). Thefilter conditions also must be met (seebelow). What is happening here is thestock is turning back to the upside after

its pause or pullback. Stop: Because most trades will not

work out, stops are necessary to keeplosses small. If the stock drops 1⁄8 belowthe low of the bar previous to the entrybar, exit the trade at the market.

Exit: If the trade works out, stay in ituntil the price drops 1⁄8 below the low ofthe last two bars. Otherwise, all tradesa re exited “market on close” — noovernight positions.

Filter: To limit risk to a point, thelength of the bar prior to entry musthave a range of 3⁄4 point or less, becausethe stop is placed 1⁄8 below the low of theprevious bar.

This is a solid trading plan with goodr i s k - re w a rd characteristics. The filterrule keeps you from trading the patternin high-priced, riskier stocks.F o r t u n a t e l y, many stocks priced lessthan $100 provide intraday trade oppor-tunities with manageable risk.

The bottom line in trading is to designa plan and stick to it. This gives you thebest chance of racking up enough dou-bles, triples and home runs to more thanoffset your strikeouts.Ý

A trading plan gives you a roadmap

to navigate the markets; if you throw the map outthe window, you should not be surprised when you

find yourself in themiddle of nowhere with an

empty gas tank.


Trading is not necessarily easy,but it is a much simpler processthan most people imagine. Theproblem, ironically, is that gain-

ing this understanding often requires along, complicated journey — kind of likewalking out your front door and travel-

ing a few thousand miles to get to yourback yard.

New traders especially tend to runinto difficulties because they believe thatmore — indicators, charts, statistics, etc.— is better.

The truth is, simple approaches can

yield good results if your analysis isbased on a solid frame of reference. Herewe will explain a simple, but powerful,concept — multiple time-frame analysis— and show how it will enhance yourtrading by providing a well-definedframework in which to operate.

The basis of multiple time-frame analy-sis is that every time period has its owntrend and its own support and resistancelevels.

By simple inspection, you can see thetrend and support and resistance levelson a 10-minute bar chart are differentthan levels on a daily bar chart.

TRADING Strategies

A matter of timingA matter of timingBY ROBERT KRAUSZ, MH, BCHE

Analyzing multiple time frames is a simple but powerful

way to improve your trading. Here’s a technique that allows

you to look at three different levels of price action on the

same chart and time your trades accordingly.


However, the trend and support andresistance levels of the 10-minute timeframe are still part of the daily trend —the trend of the 10-minute bars obvious-ly shapes the trend of the daily bars. Inother words, while any time period is aself-contained universe, it still functionsas part of a larger structure. Longer-termprice action provides a context for short-er-term price action — the frame of ref-erence every trader needs to make gooddecisions.

The context provided by these differ-ent time frames determines how, whenand in what direction to trade.

The first step in our trading approach isto define three time frames that will pro-vide the trading structure we operate in.

The time frame we will trade is the“own” time frame. The longer timeframe is the “next” time frame. Finally,the longest time frame is simply the“high” time frame.

For example, the setup for trading 30-minute bars might be:

30-minute bars = own periodDaily bars = next periodWeekly bars = high period

For trading daily bars, the definitionsmight break down as follows:

Daily bars = own periodWeekly bars = next periodMonthly bars = high period

For most practical purposes you onlyneed to focus on two time frames, ownand next. The next time frame indicatesthe direction of the tradable trend andthe support and resistance levels fortrading. When the next time frame indi-cates an uptrend, we will trade from thelong side; when the next time frameindicates a downtrend, we will tradefrom the short side.

Let’s walk through some examplesusing America Online (AOL). Figure 1 isa daily bar chart of AOL. The line plottedin a step formation is the weekly “balancestep,” a five-week moving average of theweekly closes (Friday-to-Friday only). Inessence, we are overlaying a movingaverage of weekly price action on a dailychart, making it possible to monitor both

time frames simultaneously. The dailybars re p resent the own time frame (thetime frame we will trade) while the week-ly balance step functions as the next timeframe (the time frame that indicates thetradable trend). What does this multipletime frame analysis re v e a l ?

First, in late September there weretwo consecutive closes above the weeklybalance step (point A). Second, in earlyOctober the weekly balance step turnedup (point B) and continued to rise eachweek until the end of the year when itturned down for the first time (point F).This highlights that the next time framewas in an uptrend throughout this peri-

od from points A to F, and the safesttrades to make using daily bars (the owntime frame) would have been on thelong side — that is, in conjunction withthe longer-term trend.

This is a very straightforward con-cept. Trading with the trend of the nexttime frame is like having the wind atyour back. Keep in mind that the trendcan only change when the direction ofthe next time frame changes.

Also notice that at points C, D and Ein Figure 1 the balance step functions assupport and resistance; closing abovethe balance step is a positive sign. Atpoint C, AOLtests the near-term supportdefined by the balance step and ralliessharply from this level. Point D marks asimilar instance. Point E is a major warn-ing the trend may be changing: Thestock breaks support by closing belowthe balance step for two consecutivebars.

The same principles outlined in our firstexample are equally applicable to shortertime frames. Let’s drop down in time andtake a look at an intraday view of A O Lusing 78-minute bars (one-fifth of the 390-minute normal trading day) and addi-tional technical indicators to help filtertrades.

Figure 2 uses the 78-minute bars asthe own time period, daily bars as thenext time period and weekly bars as thehigh time period. Both weekly and dailybalance step lines are plotted, and both

indicators are calculated over five-barperiods. The daily balance step uses thedaily closing prices.

Why did we add the daily balancestep? Because we always use the nexttime frame to determine the tradabletrend. Let’s look for signs of the markettopping using our multiple frameapproach on an intraday basis.

Our first warning came when thedaily balance step (the next time frame)turned down for the first time (point H).In addition, at point E, the stock closedbelow the weekly balance step, anothernegative indication. Adding to the bear-ishness, the daily balance step crossedbelow the weekly balance step at pointX. Finally, at point F (the same point Ffrom Figure 1), the weekly balance step— the high time frame — turned downfor the first time, pointing to lowerprices as well.

To take things a step further and look fortrading opportunities, we will introduceadditional technical indicators.

The first is the Ergodic CandlestickOscillator (ECO), designed by WilliamBlau and detailed in his bookMomentum, Direction, and Diverg e n c e.This momentum indicator is a “double-smoothed” (the application of two mov-ing averages — one very long term andthe other shorter term) ratio of the dif-f e rence between the closing (C) andopening (O) prices of each bar and thedifference between the high (H) and low(L) prices for each bar:

Simple approaches can yield good resultsif your analysis is based on a solid frame of reference.

whereE M A1 is a longer-term exponentialmoving average (e.g., 26 days), andEMA2 is a shorter-term exponentialmoving average (e.g., 5 days).

F i g u re 3 is the same as Figure 2except that the ECO (calculated on the78-minute bars , the own time frame) isplotted below the price series as a his-togram. The ECO functions as a filter:Readings below zero confirm the trendis down for the own time frame andreadings above zero confirm the trend isup.

Look at point G: The ECO actuallyturned negative prior to the daily bal-ance step turning down. When the dailybalance step turned down at point H(same as Figure 2), the ECO had beennegative for some time and thereforeconfirmed this change in the trend ofthe next time period.

When price rallied above the dailybalance step at point J, the ECO only ral-lied above the zero line for one day, orfive 78-minute bars, before returning toa negative trend. After point J, the ECOalso reconfirmed the downtrend.

Having outlined the concept of using amultiple time frame approach to deter-mine the trend and support and resist-ance levels, let’s see what happens if wetake a trade when the trend changesdirection, as determined by a change inthe next time period (the daily balancestep). We’ll use the intraday (78-minutebar) time frame.

Now that we are trading, though, wealso must give thought to risk control:We will want to have some kind of trail-ing stop to lock in our profits. For thatpurpose we will introduce another indi-cator, the HiLo Activator, based on theown time period.

The HiLo Activator is a 21-periodmoving average of the lows or highs. I fprice closes above the HiLo A c t i v a t o r, theindicator is a moving average of the lows;when the market closes below the HiLoA c t i v a t o r, the indicator flips to being amoving average of the highs. The HiLo

Source: Fibonacci Trader

Weekly balance step

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B

A

C

D

E

F

FIGURE 1 WEEKLY BALANCE STEP

America Online (AOL), daily. The weekly balance step is a five-week movingaverage of Friday closing prices plotted in step formation on the daily chart. Itshows the weekly trend overlaid on the daily price action.


FIGURE 2 WEEKLY AND DAILY BALANCE STEPS

America Online (AOL), 78-minute. Here, the daily balance step is a five-daymoving average of daily closing prices plotted in step formation. In addition, theweekly balance step is shown. This makes it possible to simultaneously compareprice action on three different time frames.

Daily balance step

Weekly balance step

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H

X

D

E

F

EMA1{EMA2(C-O)}

EMA1{EMA2(H-L)} ECO= * 100( )


Activator is above prices in a down-t rending market and below prices in anu p t rending market, providing a trailingstop point as the position pro g re s s e s .

Figure 4 shows that a short sell signalin AOLoccurred on the close of Dec. 17,1999, at a price of 85 when the dailybalance step clearly turned down. TheHiLo Activator is trailing above theprices and the ECO also has confirmedthe downtrend by dropping below zero.

Prices continued to fall until Jan. 3,2000, when the market rallied above theHiLo Activator and penetrated thedaily balance step. (You can take profitswhen price penetrates the balance stepand the HiLo Activator by more than apoint.) However, notice that the stockstopped right at the resistance level ofthe weekly balance step. The daily bal-ance step went into a flat period.

The next day the downtre n dresumed with the daily balance stepturning down. Had you gone flat, youcould have gone short again becausethe HiLo Activator flipped again on theclose of the first 78-minute bar. Pricesw e re below the daily balance step,which turned down at the close, trig-gering a short trade at 73 1⁄2.

A multiple time frame approach is away of filtering price informationthrough different windows of time. Byusing weekly bar-based indicators fortrading daily bars, you avoid the noiseof the daily bars.

Likewise, if you are trading intradaybars you should filter your trades withdaily bar-based indicators, tradingwhen indicators on both time framesare in concert. This a simple, yet power-ful frame of reference for enhancingyour trading opportunities.Ý

For further research…Krausz, RobertA W. D. Gann Treasure Discovered(1997, Geometric Traders Institute).

Blau, WilliamMomentum, Direction, andDivergence(1995, John Wiley and Sons)

Kaufman, PerryTrading Systems and Methods 3rd Edition (1998, John Wiley and Sons)


FIGURE 3 ERGODIC CANDLESTICK OSCILLATOR FILTER


FIGURE 4 ADDING THE HI-LO ACTIVATOR

America Online (AOL), 78-minute. This example establishes a trade in conjunc -tion with the trend of the daily balance step. A trailing stop level is defined by a21-period HiLo Activator, a moving average of the high prices (when price crossesbelow the indicator) or low prices (when price crosses above the indicator).

Daily balance step

Weekly balance step

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J

America Online (AOL), 78-minute. A momentum oscillator, the ErgodicCandlestick Oscillator (ECO), provides an additional filter. The daily balance stepturned down at point H, confirmed by the negative ECO reading. (Notice at pointJ the prices stopped right at the weekly balance step.)

Daily balance step

Short

Short

Cover

HiLo Activator

Ergodic Candlestick Oscillator

Weekly balance step

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BY M. ROGAN LABIER

Consider the following situation:You’re sitting on a hard-earnedprofit toward the end of a chop-py trading day. Things haven’t

been going well, so you’re especiallyhappy to find yourself ahead at thispoint in the game. You decide to closeout your position and call it a day. Youenter your sell order and wait for confir-mation.

And wait … and wait.Meanwhile, the market has started to

tank and you are facing the prospect ofyour profits disappearing before youreyes. After an eternity (or so it seems),you get your fill — five points away

from where the market was when youentered.

Live and learn, you think. Occasionalcommunication glitches are part of theonline trading environment, althoughthis is the first time you have sufferedfrom such a severe problem. So youswear off your dial-up modem connec-tion and standard online broker andswitch to a DSLconnection and a “directaccess” broker. However, a few days intotrading with your new setup, virtuallythe same thing happens again.

What is going on?What you didn’t realize is that there

are many trade execution “routes” avail-able to the Level II trader (see “Level IItrading,” p. 48) and all these routes workdifferently from one another. It is notenough to simply know these routesexist — you must know exactly howthey work to be able to trade effectively.

We’ll explore the ins and outs of

E l e c t ronic Communication Networks(ECNs), the computer networks thatoffer trading of Nasdaq (and now, NewYork Stock Exchange) stocks — howthey work (and don’t work) dependingon circumstances.

First, we will briefly explain theNasdaq’s two order execution systems,SelecNet and SOES (Small Ord e rExecution System). Depending on trad-ing conditions, SelectNet and SOES havetheir own advantages and disadvan-tages as trade execution systems. Whilethe following explanations will be brief,a rudimentary understanding of thesesystems will help to understand the wayECNs work.

Unlike the NYSE, the Nasdaq does nothave a trading floor where traders buyand sell stocks face to face. On theNasdaq, trades are executed over a net-

Think all Electronic Communications Networks are created equal? Here’s the scoop on some of the little-known idiosyncrasies of the different online trading networks and how they can make or break your trading plan.

N a vigating the ECNsN a vigating the ECNs

TRADING Strategies

C


work of roughly a half-million comput-ers, through which market participantscan post bids and offers. SelectNet andSOES are trade execution systems run byNasdaq.

SelectNet can “broadcast” orders to awide field of market participants or“preference” (route) orders to particularmarket participants. SelectNet even canbe used to negotiate a better price than amarket maker has advertised.

But SelectNet’s biggest use is to pref-e rence orders at the market makers’shown price and size. Market partici-pants are required to keep firm quotes inNasdaq small-cap and large-cap stocks— they must honor the bids and offersthey show, both the number of sharesand the price.

Because SelectNet operates like aninstant messaging system, bids or offersplaced via SelectNet will not show up onthe Level II quote display. A SelectNetpreference order to an ECN results in anauto-execution at electronic speed, aslong as another trade has not alreadyoccurred at this price with this marketparticipant.

But a SelectNet preference to a marketmaker works differently from a prefer-ence order to an ECN, because, amongother reasons, market makers areallowed 30 seconds to respond to aSelectNet pre f e rence order at theirshown price/size. A market maker isliable only for the number of sharesshown at the advertised price shown. Hemay trade more if he chooses, but if hedeclines to trade more at that price thenhe must change his bid or offer accord-i n g l y. But he still has 30 seconds todecide. These aspects of SelectNet areespecially important because the“active” ECNs, like A rchipelago, useSelectNet.

SOES works differently. It gives small-er investors and traders immediate fillson up to 1,000 shares of Nasdaq stockssubject to regulations and rules specificto the use of SOES. SOES will automati-cally execute against a market maker,without his choice. However, it is impor-tant to know that SOES will not transactagainst ECNs.

Superior trade execution is all aboutidentifying the current trading situationand knowing which tool is appropriatefor a given job.

Which trade-routing method worksbest? The answer comes in two parts:understanding the trading situation youare dealing with (Level II interpretation);and knowing exactly how all the execu-tion routes work. Level II is like a map —if you know the routes well, you willknow which one will get you to yourdestination fastest. Nowhere is this moreimportant than if you are trading“direct” (see “Direct access vs. onlinetrading,” ).

We will examine the ins and outs of

ECNs — what they are, how they workand how they differ from the other avail-able trade execution routes

ECNs have been around since the 1980s,when InstiNet, the granddaddy of themodern ECN, began offering institutionsa venue to trade stocks in what hasbecome known as the “third market.”Until recently, though, this market wasl a rgely unavailable to individualtraders. Since 1997, however, there has

Level II trading

T here are three “levels” of quotes available to Nasdaq market partici-pants. Level I, what most brokers typically provide their customers, isalso known as the “inside market.” It shows only the best bid and best

offer currently available in a stock.Level II quotes (the Nasdaq Quotes Montage) contain all market partici-

pants’ bids and offers — not just the inside market. So your broker, looking athis Level I quotes, may tell you that ABCD stock is currently bid at 10 andoffered at 101⁄1 6.

Fine. But what if you could see that there were only 100 shares bid at 10,below that another 100 at 97⁄8, and below that another 100 at 9 1 3⁄1 6, whileon the offer there were 20,000 shares at 10 1⁄8, another 15,000 at 103⁄1 6 andso on? This information would change your opinion of the current supply-demand balance considerably. In this example, you might not want to buy justyet if hoping for a quick run-up, since there are very few shares on the bidand many on the offer; prices may move down as supply overcomes demand.

Level III quotes are what the Nasdaq market makers themselves have. LevelIII is fundamentally the same as Level II — the only major difference is thatmarket makers can raise and lower their bids directly through the Level IIIquote window. By comparison, when you or I trade “direct,” we must gothrough an ECN and a broker to do this.

Source: www.windowonwallstreet.com

THE LEVEL II SCREEN

Nasdaq Level II quotes go beyond displaying the inside bid — theyinclude all the bids and offers of the different market makers and ECNs.


been a proliferation of ECNs that pro-vide access to individual traders.

ECNs essentially function as separateexchanges. However, ECNs also allowindividuals and institutions to enter bidsand offers directly in the Nasdaq, along-side (and in direct competition with) themajor institutions. This ability has radi-cally changed the Nasdaq market: Whilet h e re were practically no ECNs fouryears ago, today it is not unusual to see30 percent of Nasdaq’s total daily vol-ume traded through ECNs. This technol-ogy also has affected the NYSE, whichrecently voted to repeal Rule 390 andallow Big Board stocks to trade on ECNs.

ECNs are powerful tools for short-term traders, and their usefulnessextends far beyond simply displayingquotes on the Nasdaq Level II screen.“Active” ECNs, such as A rc h i p e l a g o ,NexTrade and Attain, use sophisticateddecision-making algorithms andSelectNet to “work” orders — finding, inreal time, the best place to execute atrade, as well as get the best price possi-ble. Plus, individual traders are gainingaccess to new types of orders that previ-ously were reserved for major institu-tions with high-priced, sophisticatedsoftware.

The best software packages todayoffer direct access to the various ECNs,but they still let the user decide whichroute to use for the same reason FormulaOne race cars come with a stick shift, notautomatic transmission: There is no sub-stitute for the speed of the human mindand its ability to synthesize information.

Until there is, it is impera-tive to learn the basics ofECN routes to maximizeyour profits and minimizeyour losses.

We will focus our dis-cussion on the two mostpopular (by volume)ECNs for individualtraders, Island andArchipelago.

The Island ECN (ISLD),owned by DatekHoldings, has revolution-ized the financial markets.A sizable chunk of thetotal Nasdaq share vol-ume each day is traded onISLD.

Island allows individu-als and institutions toplace limit orders — itdoes not accept marketorders. If there is a matching order, itwill execute the trade. If not, the orderwill post to the ISLD order book, and ifthe order is the “best” bid or offer cur-rently available, it will also post to theLevel II quote display screen.

There, anyone may execute againstthat order, either via SelectNet and the“active” ECNs that use SelectNet (see“ A rchipelago”), or directly thro u g hISLD if they have access. The limit orderbook for ISLD is available for viewing inreal-time at www.island.com.

When you post an order to the Level II

screen through ISLD, you wait for some-one to come along and trade with you.It’s just like posting a classified ad in thenewspaper. Keep in mind, though, younever know how long this will take; thestock may never trade at your price.

However, there is so much liquidity inthe ISLD book, it has become a favoriteamong active traders. Your order, whileit may not be seen in the Nasdaq Level IIquote display, will often be freely visiblein the ISLD book. This can be very usefulin fast market conditions, and a greatmany traders have come to rely on theISLD as a major source of liquidity.

However, because of Nasdaq’s “mini-mum size” requirement, you may notsee small orders reflected in the Level IIquotes. A trade must be at least 100shares to appear on the Level II quotedisplay. For example, if you have an oddlot, say 23 shares, your order will post tothe ISLD limit order book, but not toLevel II. As a result, your order may takeeven longer to execute, since only thosewho have access to the ISLD book willsee it.

If ISLD does happen to be on the bidor offer and you wish to hit the bid ortake the offer, ISLD can be fast as whitelightning — your order may fill beforeyour finger even leaves the keypad.R e m e m b e r, going through the ISLDcomputer directly can be much fasterthan using SelectNet to link to Island.

Distinguishing characteristicsISLD ARCA

u Limit orders only u Limit or market orders

u Bids/offers in the L2 Quotes u Bids/offers in the L2 Quotes

u Massive liquidity u Great liquidity, especially in active stocks

u Allows “hidden orders” u Will actively “work” orders for you

u After-hours trading u After-hours trading

u Odd lot trading u Round-lot orders only

u Very fast u Will execute against other market participants

u ISLD order book available u ARCA order book available free on Web free on Web

THE ISLAND BOOK

Source: The Island ECN

The Island order book is available for public viewing at www.island.com/BookViewer.

ISLD also offers interesting ord e rcapabilities such as subscriber ord e r sand hidden orders (although many bro-kerages do not accept them). Subscriberorders show up in the ISLD book, butnot on the Nasdaq Level II quote display.Hidden orders take this one step further— they do not show up at all. Whensomebody tries to execute against theISLD bid or offer they see they mayreceive price improvement from the hid-den order. For example, you might seean ISLD bid of 431⁄1 6, and enter an orderon ISLD to sell at 431⁄1 6. But you mayactually sell the stock at 433⁄1 6, most like-ly because of a “hidden” bid at 433⁄1 6.This doesn’t happen too frequently, butit can occur.

The users of these features like the factthat the hidden or subscriber-only ord e r swill not affect the appearance of supply

and demand in the Level II quote display.H o w e v e r, keep in mind that these ord e r sa re only in the ISLD order book, andt h e re f o re cannot be seen or tradedagainst by any participants who do nothave access to ISLD. The net effect is thatthese orders rely on the liquidity in ISLDalone.

Because the small size of most orderswould not have a massive effect on thesupply-demand balance in the Level IIquote display anyway, the hidden fea-ture is not for everyone. However, somepeople swear by subscriber and hiddenorders.

One advantage, though, of subscriberand hidden orders is that they will not“lock” or “cross” the market like regularISLD orders can, because they stay inISLD and are not entered into theNasdaq market.

Locking the market occurs when youtry to enter a bid that would equal theoffer price in the Nasdaq Level II screen.A crossed market occurs when you try toenter an offer lower than the current bidor a bid higher than the current offer.Both locked and crossed markets violateNASD fair practice rules. Usually, anorder cancelled because it would lock orcross markets is the result of someonetrying to use ISLD to hit a non-ISLD bidor take a non-ISLD offer. (Remember,you cannot do that with ISLD — it ispassive.) In both cases, Nasdaq wouldautomatically refuse the order.

Of course, if you wish to deal onlywith ISLD, you can match with otherorders in the ISLD book. For example, ifthere is an offer in the ISLD book for 100shares of a stock at 10 and another offerfor 1,000 shares at 101⁄8, you could, byplacing an ISLD order to buy 1,000shares at 101⁄8, take both the 100 shares at10 and 900 of the shares at 101⁄8.

It is important to contact your brokerto see what level of connectivity andfunctionality it offers. Some offer sub-scriber and hidden orders, while manydo not. Some offer direct links to ISLD,while others do not. Also, some mayoffer real-time display of the ISLD orderbook as an integrated part of the soft-ware, and some may offer full access toISLD in the after-hours market.

ISLD is open until 8 p.m. EST and hast remendous after-hours liquidity re l a-tive to the other ECNs.

One of the current problems in after-hours trading is that ECNs are not con-nected to one another and therefore can-not execute against one another. Thiscreates arbitrage opportunities, a sure-to-be-short-lived situation some peopleare attempting to exploit.

Several proposals are on the table thatwill fundamentally improve price dis-covery and execution in the after-hoursmarket (see “ECNs strive for level play-ing field,” p. 14). Keep in mind, though,that because the ECNs operate like sepa-rate exchanges (even though they don’thave exchange status), you may not beable to access them unless your brokeroffers a direct connection to them in thehours after SelectNet has closed.

The “active” ECNs all have something in

Direct access vs. online trading

M any traders believe that because they are using an online broker, theyare “trading direct” — that is, participating directly in the Nasdaq orNYSE markets. They are not.

Standard online brokerage houses offer you the same execution capabilitiesavailable over the phone — a keyboard has merely replaced the telephoneinterface. While this is extremely convenient, your executions are no moreunder your control than when you say “buy” or “sell” over the phone.

At some point, a market maker or trader will execute your trade for you,and as you might expect, he must get paid. So your broker may take theother side of your order (and profit from the spread), or even route yourorder to a market maker for execution and receive payment for order flow.

An often overlooked aspect of the brokerage business is that broker-dealerscan profit from their customers orders. For example, say a stock is bid 10 andoffered at 101⁄8. You want to buy the stock and enter a bid through a tradi-tional discount online broker, receiving your fill seconds later at 101⁄8. It’squite possible the broker “took the other side” of the trade, buying it at 10and selling it to you for 101⁄8. His profit (1⁄8 — $125 on a thousand shares) ishis fee for doing the trade. Was the low commission price of $10 worth it?Many traders say no and instead trade direct access, which allows them to tryto get a better price for themselves.

When you trade “direct,” you are able to show your bids and offers directlyin the Level II quotes and effectively cut out the middleman (the marketmaker or trader who would have handled your order had you placed itthrough a standard online broker). But with this opportunity comes theresponsibility of getting a better price for yourself.

“Direct access” is really a misnomer. The Nasdaq and the ECNs do not dealdirectly with private, individual traders. Brokers who offer direct access trad-ing allow you to use their sophisticated software and good name to bid, offerand execute at your discretion in real-time. Nevertheless, you are never real-ly trading direct, even though you do have the ability to bid, offer and exe-cute in the Nasdaq market at your discretion. You are still, technically, usinga licensed broker and a clearing firm to execute and clear your trade.



common: They will dynamically workan order, attempting to get better prices.

To do this, they use sophisticated algo-rithms to “read” the inside market andthen choose the best way to route a trade.They will take market and limit ord e r s ,and several of them offer intere s t i n go rd e r-entry capabilities previously un-available to individuals. The best-known“active” ECNs are A rc h i p e l a g o ,N e x Trade and Attain. A rchipelago is eas-ily the largest active ECN in terms of vol-ume.

Archipelago (ARCA) offers the next gen-eration of functionality for ECNs. Forlimit orders, it functions like ISLD: Itchecks its order book for a match. Ifthere is no match and the order is thebest in the book, it will post the order tothe Level II screen.

However, that is where the similarityends. If the order is priced more favor-ably than the current inside market,ARCA starts its active operations. Usingan algorithm, it checks for who is on theinside bid or offer, dynamically decidingthe quickest way to route the order. IfECNs are present, it executes against theECNs using either direct connections tothe other ECNs or SelectNet.

A SelectNet link to an ECN is an auto-execution at electronic speed. Whenthere are several ECNs at the insidequote and ARCAgoes out to all of them,large orders can get filled — fast. (I’vepersonally sold 10,000 shares of MSFT inabout six seconds when there were sev-eral ECNs lined up at the bid. This is oneof ARCA’s best features.)

Use of SelectNet allows ARCA not tocross the market and, additionally, toaccept market orders, in which case itsimply keeps trying to get the best priceuntil it executes.

Also, if you have the appropriate soft-w a re package (one such program ismade by Townsend Analytics) you canplace several other kinds of orders onARCA, including stop orders on Nasdaqstocks and “reserve” orders that allowyou to show one size in the Level IIscreen and actually transact a differentreserve size. (For example, you can show100 shares and actually trade 10,000.)

You also will soon be able to enter anew type of order: a “conditional” orderthat allows you to set up if-then condi-tions for purchase or sales. For example,

you can place an order to buy 1,000shares of a stock if it breaks out above its200-day moving average or buy anotherstock if the Dow hits 12,000.

But let’s get back to what ARCA doesnow: It accepts limit and market orders,and uses SelectNet to execute. Say, forexample, 200 shares of a stock areoffered at 25 and 100 more are offered at251⁄8. If you placed an order to buy 300shares at 251⁄8, ARCA will “work” the

order for you, going out to each partici-pant and taking stock. It will do this allthe way up to your price target, or untilyour total order is filled.

It tries to get the cheaper stock firstand, failing that, will try the next bestprice, all the way up to your limit, exe-cuting against multiple market makersand ECNs until you are filled. And if youhave access to the ARCAorder book youcan see all the individual ARCA orders(“chippies”) bidding or offering a stock.

ARCA’s use of SelectNet opens upinteresting order entry possibilities, butSelectNet is a double-edged sword .Although a SelectNet link to an ECNgives auto-execution at electronic speed,a SelectNet preference to a market makerdoes not. In fact, market makers are

given, by regulation, 30 seconds torespond to a SelectNet pre f e re n c e .Imagine: A stock you are long is tankinghard; sellers are pouring into the marketand there are no ECNs anywhere to beseen. You place an ARCA market sellorder and wait…and wait.

Because of their 30-second time win-dow, market makers can wait (and wait)while the stock market plummets. Whatjust happened is that ARCA routed the

order to a market maker, the marketmaker took his full 30 seconds torespond and the response was a“decline” — the market maker decidednot to take the trade. When A R C Areceives notice of the decline it runsthrough its progressions and starts thewhole process over again. It preferencesanother market maker, who again takesthe 30 full seconds he is allowed to anddeclines, and so on.

Every tool has a particular job it doesbest. There are situations for whichARCA is an ideal tool, and others forwhich it is not. The same goes for ISLD.Understanding the different executionroutes and which ECN is best for a par-ticular trading “job” will enable you toexecute with confidence. Ý

THE ARCHIPELAGO BOOK

Source: The Archipelago ECN

The Archipelago book (www.tradearca.com/automm/arca_book.asp) includesArchipelago bids and offers as well as those of other ECNs.


BY ALLEN SYKORA

S helli Simon thought life wasg reat when her first tradeturned into a winner.

She bought a stock that appeared tobe at the bottom of a trading range. Shewatched it rise to the top and sold for aprofit.

“I said, ‘Oh boy! This is terrific!’”But it was not until her second trade

turned into a big loser that Simon reallybecame hooked on trading.

Once again, she bought a stock nearthe bottom of a trading range. This time,though, it fell through support, and tomake matters worse, Simon had not yetlearned about stop orders. But her reac-tion to the trade at least partiallyexplains why she has continued totrade.

“I thought it was a small price to payfor a good education,” says the Sarasota,Fla., woman. “I wasn’t discouraged. Ithought to myself, ‘This is something Iwant to do for a career.’

“It strengthened my resolve to under-stand that the market is always right andI’m not,” Simon explains. “I needed to

understand that when things are n ’ tgoing well, back away with a smile onmy face and move onto the next(trade).”

That was more than a decade ago.Simon is still trading and went full-timetwo years ago. She spends up to 11⁄2h o u r s each day studying charts. Shemakes as many as 25 trades a month,mostly holding her positions betweentwo and five days, although she willtake a profit the same day if the pricehits her objective. At the time of this

interview, she was on something of a hotstreak: Of her last 35 trades, 29 werewinners — a rate of 83 percent.

When she’s not trading, one ofSimon’s passions is tennis. She playsseveral days a week and uses the samemental approach on the court as shedoes in trading.

“On the tennis court, my focus is onthe ball, my stroke and execution,” she

says. “In trading, I focus on the charts,recognition of the pattern, execution andprotection of my capital.”

Over the years, she has read numer-ous trading books, taken courses andworked with a couple of trading tutors.

“I am an extremely tenacious person,”says Simon — so much so she uses thew o rd “tenacity” as part of her e-maila d d ress . “When I find something I havea love for or curiosity about, I will dowhatever is within my ability to learn asmuch as I can and make that come to

Acing the m a r k e t

The Face of TRADING

f ru i t i o n . ”After studying various forms of tech-

nical analysis, she has settled upon pat-tern recognition as her trading methodof choice. There are about 10 she looksfor, many based on Fibonacci ratios (seesidebar).

“I approach my trading on nothingbut the harmonic relationship of priceand time,” Simon explains. “I’m lookingat the random movement of price andI’m looking for certain harmonic levelsthat stocks seem to gravitate to. Stocks,for some reason, seem to gravitate toFibonacci ratios before they make achange either up or down.”

She looks for trends, then a retrace-ment, often based on Fibonacci levels.The retracement levels she uses could beas small as 38 percent or 50 percent, orthey could be 61.8 percent or higher. Shewill then buy or sell at the support orresistance level implied by the retrace-ment percentage.

When Simon spots such a pullback,she will wait one time period — one dayif she’s trading on the basis of a dailychart (she uses both daily and intradaytime frames) — to make sure the patternis not violated. Then she will establish

“On the tennis court, my focus is on the ball,

my stroke and execution. In trading, I focus

on the charts, recognition of the pattern,

execution and protection of my capital.”

The Fibonacci series

T he Fibonacci series is a number progression in which each successivenumber is the sum of the two immediately preceding it: 1, 2, 3, 5, 8,13, 21, and so on.

As the series progresses, the ratio of a number divided by the immediatelypreceding number approaches 1.618, the “golden mean” found in the dimen-sions of the Parthenon, the Great Pyramid and many natural phenomena.Some traders use 1.618, its inverse — .618 (.62) — and other ratios (such as.38 and .50) to calculate price targets and retracement points.

For example, if a stock rallied from 25 to 55, potential retracement levelscould be calculated by multiplying the distance of the move (30 points) byFibonacci ratios — say, .38, .50 and .62 — and then subtracting these results

from the high of the price move. In this case, levels of 43.6 [(55 - (30 *.38)], 40[(55 - (30 * .50)] and 36.4 [55 - (30 * .62)] would result.

Figure 1 illustrates a trade Shelli Simon made in General Electric (GE).The stock made a low of 1145⁄8 on Oct. 18, 1999, and rallied to 1415⁄1 6 onNovember 17, a 261 1⁄1 6-point move. The stock then pulled back to 1297⁄8 onNovember 30, a little more than a Fibonacci 38.2 percent retracement ofthe preceding rally. Simon waited for a day (Dec. 1) to make sure theretracement was not violated, then entered long on Dec. 2.

Low of 1145⁄8 on 10/18/99

High of 1415⁄1 6

on 11/17/99

Enter long on 12/2/99

Low of 1297⁄8

on 11/30/99

Approx. 38.2%

retracement(1311⁄8)

Source: www.windowonwallstreet.com

FIGURE 1 GENERAL ELECTRIC (GE, DAILY)



her position.Simon puts a protective stop two to

six ticks away from the bottom of thepullback, with the exact distancedepending upon the strength of themove. Once the stock moves in herdirection, she will raise the stop to thebreak-even point.

She showed a chart of General Electric(GE) from late fall 1999 (see Figure 1).The stock was steadily climbing, thensuddenly pulled back, at which point

she bought.“I’m looking for a nice-sized move

that retraces itself,” she says. “I’m look-ing for a move either to the upside ordownside, followed by a reaction.

“I like working with physical highsand lows of stocks,” Simon adds. “Thereality of what the market is saying isbased upon the actual price movementof the stock. I don’t care what an analystor guru has to say. I’m not interested inthe TV shows, papers or any events. Ahigh is a high and a low is a low. There isno gray area or debate.”

There was a time Simon was studyingtechnical indicators so heavily she beganto suffer from “analysis paralysis.” Shefound herself trying to use too manyindicators at a time, trying to have oneconfirm another. She was studying sto-chastics, the relative strength index andBollinger Bands, just to name a few.

“I was looking for too many things tomake a decision,” she says. “I realizedthat analysis paralysis and worryingabout what everyone else was doing washindering me from becoming what Iwanted to be.

“What I found is that with indicatorslike MACD [moving average conver-g e n c e - d i v e rgence] and the re l a t i v estrength index, there is a lot of gray area.Everybody had a different way of inter-preting what is oversold.

“The Fibonacci ratios, and working

with physical highs and lows, gave mewhat I needed,” she says.

Having eliminated the “gray areas”from her trading, Simon considers themany hours she spends studying chartsto be “very relaxing.”

“There is no ego involvedand I have a lot of confi-dence,” she says. “I knowthat there will always besome losers. But I’m pre-pared [for that] and know

my losses will most likely bevery small.

“Whatever system youuse, it’s a probability situa-tion. The thing is to under-stand nothing is ever 100percent. You must be prepared to reverseyour decision if the market is not goingin the direction you were hoping itwould go.”

Simon also looks for ratios to help herdecide when to capture a pro f i t .Generally, she is looking for a move to aFibonacci ratio of 61.8 percent or 78.6percent. At that point, she usually takesa profit on about half of her position. Shewill continue to use a trailing stop for therest of the position, so she can profit ifthe stock continues to move in her direc-tion.

“If the stock is moving, stalls out andmoves sideways for a couple of days, I’lljust take my money off the table andlook for something else,” she says.

Simon trades only high-volatilitystocks, which means a high percentageare Nasdaq issues. Greater price move-ment means more potential for a profit,since it’s hard to post a gain on a stockthat stays flat.

Simon is a former English and historyteacher who later helped her husband,Cary, run a small chain of pharmacies.Upon their move to Florida, she went towork part-time at a natural-food store

chain.Her husband’s family always had

been involved with the stock market, butSimon initially paid little attention.H o w e v e r, her interest was tweakedwhen a friend began studying stocks

and told her about the famous chart pat-tern analysis book, Technical Analysis ofStock Trends, by Robert D. Edwards andJohn Magee. Simon began reading otherbooks about trading during the next sixto nine months, including those by StanWeinstein and John Murphy.

“I was fascinated not only at howmarkets went up, but why they wouldstop, go down, go up and back downagain,” she recalls. “I became very curi-ous about why these things do whatthey do.”

Simon considers it important fortraders to manage stress in their lives,and has read books on mental coaching.

“Stress in general, whether it be inyour home life or outside forces, puts atremendous amount of pressure on yourtrading,” she says. “I have found thatwhen I was in a stressful situation, mydecisions were not as good as they couldhave been or should have been.

“Consistent results occur as a functionof trading from an objective state ofmind. We make ourselves available top e rceive and act upon whatever themarket is offering us in any givenmoment from its perspective.”Ý

“The reality of what the market is saying

is based upon the actual price movement

of the stock. I don’t care what an analyst

or guru has to say. ”


BY ALLEN SYKORA

When Jerry Olson took upshort-term trading in themid-1990s, he studiednearly every possible

form of technical analysis: Gann angles,Fibonacci retracements, cycles, oscilla-

tors and more.“It was way over my head,” Olson

says. “It was way too technical for meand left too much to interpretation. I wasreally pulling at straws trying to findtechnical analysis that would be simpleand work.”

Then a little more than two years ago,while visiting the stock market chat site,Silicon Investor, the retired general con-tractor became aware of point-and-fig-ure charting. He began studying it, and

that has been the basis of his tradingsince.

“It was the perfect technical analysistool for me,” he says. “I realized that inthe simplest terms, this is what makesthe markets move.

“It’s an actual picture of supply anddemand, and that’s what moves a stock.Either you have more buyers or moresellers. If you have more buyers, thestock is going to go up. And if you havemore sellers, the stock is going down.”

The Face of TRADING

C o n t r a c t o r GETS THE POINTGETS THE POINT


Point-and-figure charting plotsprice action using a series ofcolumns of Xs (for rising prices)and Os (for declining prices). So,when a stock is rising, theincreased demand is reflected by acolumn of Xs. And when a stock isfalling, the increased supply isreflected by a new column of Os.

The method Olson relies upon isknown as the “three-box re v e r s a l . ”The box size refers to the pointmove that must occur to add an Xto a column in an up move. For aone-point box, an X would beadded for every one-point gain in astock’s price. A column of Oswould not be started until pricemoves down three points (thre eboxes, re f e r red to as the re v e r s a ls i z e). A new column of Xs wouldnot begin until it has moved upt h ree points.

Many point-and-figure chartformations are similar to their barchart counterparts, such as dou-ble, triple and quadruple tops andbottoms. These patterns’ basicprinciples of support and resist-

ance are constant on both bar andpoint-and-figure charts.

As an example, Olson refers to achart of Lam Research Corp (LRCX),shown in Figure 1. There is a columnof Xs (each one re p resenting twopoints) rising to 144. Then three Ospull back to 138 (the three-box re v e r-

sal amount). Then a column of three ris-ing Xs climbs back to 144. At this level,the market is finding more sellers thanbuyers, resulting in resistance. If demandcaused the stock to break through thatlevel, a buy signal would re s u l t .

Instead, supply returns, resulting inthree Os as the price drops back to 138.

Then demand sets back inagain, and the Xs return to144. This time the stock does-n’t stop, however, but contin-ues to climb, pushing above144 and resulting in a triple-top breakout. Olson boughtaround 144, right as the mar-ket was moving through thislevel.

He later sold this stock at147, taking his profit quickerthan he normally might, sincethe trade was occurring in theweek of an options expira-tion, when volatility is oftenhigh.

While Olson relies onp o i n t - a n d - f i g u re charts, healso makes sure he only buysstocks from uptrending sec-tors. Likewise, he only buyswhen the broad market ismoving ahead.

Olson will study a series ofcharts and determine wherethe breakout points for vari-ous stocks might be. Thenhe’ll set the “alert” feature onhis computer so it will let himknow when these levels arereached.

“If I get an alert that we’rebreaking out of a triple top,before I buy I check the mar-ket to see where the S&P(500)futures are,” Olson explains.“I want to make sure I’m notgoing to buy this stock whenthe market is being slammedto the ground. If the [DowJones] is down a couple hun-

156154152150148146144142140138136134132130

120

110

100

95

90

85

Resistance Breakout

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Source: Dorsey, Wright & Associates

FIGURE 1 BREAKING ABOVE RESISTANCE

LAM Research (LCRX), 1-point box, three-box reversal:A resistance level is defined by the highs of two columnsof Xs. A breakout above this level provides a buyingopportunity.


dred points, I don’t think that would bea smart move, because you’re movingagainst the tide.”

He also keeps an eye on volume dur-ing breakouts, wanting to see it increaseabove the level of the previous few days.

“Then you know there are a lot ofbuyers involved and demand is in con-trol,” he says.

Olson spends two hours each eveningand morning studying point-and-figurecharts he accesses through the Web siteof technical analysis firm Dorsey, Wright& Associates. Looking at charts is “calm-ing” and “relaxing,” according to Olson,because of his confidence in the method-ology. He normally pulls the trigger ontwo to three trades a week, with mostlasting around three to five days.

About half of Olson’s trading is instocks, with the other half in options. Infact, he says, he likes options so much hegoes by the handle “Options Jerry” inchat rooms. But while he puts on optionstrades, he prefers to short stocks ratherthan buying put options when heexpects a pullback.

With point-and-figure charting, Olsonexplains, resistance becomes obvious.Often a stock will roll over and sell offwhen it hits such resistance. So, he likesto short stocks near these highs, but witha buy stop just above this resistancelevel, in case he is wrong and the marketcontinues to rise instead.

Olson tends not to put in a pro t e c t i v estop immediately after buying a stock,h o w e v e r, so he won’t get stopped out of apotentially good trade just because the

first few ticks might not go his way. Still,he keeps a close eye on the price move-ment and will quickly bail out if itappears the market is moving againsth i m .

Once the stock has gone his way for awhile, however, he may put in a protec-tive stop at the point where he enteredthe trade, so he is assured of at leastbreaking even. Then, after the stock hasgone his way several points, he mightraise the stop to lock in profits.

“When a stock breaks through resist-ance — either a double top or triple top— there is usually a huge surge accom-panied with this move,” Olson says. “Iwould say nine out of 10 trades, thestock will move up very rapidly three orfour points right away. That’s when Iwould put in my break-even stop.”

While Olson may calculate what heconsiders to be a potential upside targetfor a stock he buys, he won’t necessarilywait until the stock climbs that high tocapture his profit. He’ll simply take theprofit whenever he feels comfortable,even if it’s only halfway to where hethinks it could go.

Then, no matter what happens, hetries not to look back or second-guesshimself.

“If you miss it, you miss it,” Olsonadvises. “Forget about your missedtrade or your last trade. Forget abouthow much money you made or didn’tmake. If you buy a stock and it goes up10 points, you sell, then it’s up 20 thenext day, so what? There are thousandsof stocks to trade each day.”

Olson has learned to tune out what heconsiders “noise” — news about compa-nies, reports about stocks put out bybrokerages, analysts’ comments on tele-vision and government economicreports. While these might be helpful toa long-term investor, they can “kill” atrader, according to Olson.

“I want to trade a stock by looking ata chart and seeing whether it’s time tobuy or time to sell,” he says. “When youread about stock in the Wall Street Journalor Barron’s, it’s too late. The news isalready out. At that point, everybodywho has made money is selling you thatstock at the top.”

In fact, Olson won’t put on a tradeduring the first 30 minutes each day toavoid some of the gyrations that canoccur at the open after potentially mar-ket-moving news.

He considers it important for tradersto learn to control their emotions. Oneway to accomplish this, he thinks, isthrough regular exercise. Olson hops ona treadmill daily and often “powerwalks” with his wife of 33 years, Arlene.

“Mentally, you have to be calm, cooland collected,” he says. “I haven’t beenthat way in my life. I am more of an out-going, gregarious, emotional kind ofguy. It has taken me years to calm myselfdown.”

That’s an accomplishment Olsonattributes in part to his discovery ofpoint-and-figure.

“[It] helps a great deal, because ittakes a lot of the anxiety out of atrade.”Ý


BY MARK ETZKORN

W hether you’ve justopened up your firstm a rgin account ora re managing mil-

lions of dollars, the basic rules of tradingare amazingly constant: Have a gameplan, control risk and strive for consis-tency rather than an overnight killing.

Witness trader Richard Saidenberg ,president and chief trader of SoundViewCapital Management in Pleasantville,N.Y. With 20 years of experience in themarkets under his belt and $10 millionunder management, he still attributes

much of his success to a very simple fact.“I haven’t been anything close to a

perfect trader,” he says, “but I think oneof the reasons I’m still here is that I’venever allowed myself to get wiped out.”

It doesn’t get much simpler than that.Saidenberg’s method of eluding wipe-

outs has been to stick to mechanical trad-ing approaches. While he may not thinkof himself as a perfect trader, he hasdone well enough to avoid having “aregular job” (as he puts it) for all but 10months of the past 14 years, evolvingfrom a somewhat fundamentally orient-ed stock-picker into a systematic S&P500 stock index future, currency andinterest-rate trader.

Through SoundView, Saidenberg hasposted compounded annual returns of252 percent, 95.5 percent, 8.5 percent and

6.6 percent for 1996 through 1999,respectively, and was up 15 per-cent through mid-February thisyear. The two trading systems hehas sold to the public, R-Breakerand R-Levels, have been stand-outs on Futures Truth’s list of topS & P 500 trading systems foryears. (Futures Truth is an inde-pendent trading-system testingcompany.)

S a i d e n b e rg, 37, got startedyoung in the markets, tradingstocks while in high school andcollege, although his appro a c hwas a little more casual than themultiple-system one he uses todayin the S&P500, currency and inter-est-rate markets.

“I just bought stocks that Iknew,” he explains. “I’d be longanywhere from five to 15 stocks. Iliked the Value Line InvestmentSurvey — its summary pageshowing all the stocks that wererated No. 1 or 2 for timeliness andsafety. It was a strong bull marketfrom the time I started college atthe end of 1981 to when I gradu-ated in 1986. The market was uppretty big over that period, and ifyou were long stocks you weremaking money.”

After graduating with a degreein economics from the University

of Michigan, Saidenberg took a job as aspecialist arbitrage clerk on the floor ofthe American Stock Exchange. The joblasted 10 months, but Saidenberg man-aged to squeeze some value out of it.

“One of my jobs was to make copiesof different market letters and give themto the big guys in the company wholiked to see them,” he recalls. “One of themarket letters I really liked and alwaysmade an extra copy of for myself wasSystems and Forecasts, by Gerald Appel.”

S a i d e n b e rg got a feel for both the equi-ty options and futures markets duringhis tenure and decided to leave the floorand trade on his own. On the basis ofSystems and Fore c a s t s, Saidenberg furthere x p l o red Appel’s re s e a rch and writings.

“I purchased a group of reports Appelw rote called the Scientific Investment

Richard Saidenberg’s

sound view on trading

ACTIVE TRADER Interview


R e s e a rch Gro u p reports, which wereabout technical analysis and systematictrading and showed historical back-test-ing results,” he says. “That was my firstexposure to trading systems.

“I also bought Time Trend II, Appel’sstock index timing system. It was atrend-following system that used inputslike advances and declines, new highsand new lows, the closes of the NYSEand Value Line indexes and other calcu-lations using the McClellan oscillator.

“The system was either long mutualfunds or stocks, or out of the market andearning interest. But I traded NYSE stockindex futures with it, either long or shortthe futures, so I was always in the mar-ket,“ Saidenberg explains. “That was ap retty heavy risk for one contract — themaximum drawdown might be some-w h e re around $25,000 per contract. But Ididn’t know that at the time.”

Saidenberg was a full-time trader atthis point, but he noticed a differencebetween his discretionary trading andthe trading system he was following.

“I found the only thing that was mak-ing me money was the Time Trend sys-tem,” he says. “I kept a position in thatsystem consistently from late 1988 until1995 — that’s a long time to follow a sys-tem. That systematic style was some-thing that really stuck with me as theproper way to trade and make money. Itwas the actual experience of seeingsomething work that attracted me to sys-tematic trading.

“Here I was, believing I could read themarket by watching indicators and priceaction, but I was making many, manytrades and not generating much in theway of profits from that pro c e s s , ”Saidenberg says.

“ With all the commissions I paid, Ithink I was, on balance, profitable — I hadan account that went from $20,000 to$28,000 in approximately 2,000 trades. Butat the same time I had this parallelaccount that I started with $15,000 andwas trading one NYSE stock index future scontract that was at $45,000 in around fivetrades using a trading system.”

In the early ’90s Saidenberg hadadded another item to his tradingrésumé, one that helped further expandhis understanding and appreciation forsystematic trading approaches.

At a trading seminar, Saidenberg’s com-puter proficiency (he helped out a speakerwho was using a software program

S a i d e n b e rg was familiar with) bro u g h thim to the attention of Alexander Elder,author of Trading for a Living. Elder invitedS a i d e n b e rg to help out with computerduties at several other trading seminars.Besides exposing him to new tradingideas, it led to Saidenberg becoming some-thing of a technical-analysis pro g r a m m i n gg u ru in the trading community.

“When somebody in the class wouldgo up to Alex and say, ‘Wow, this stuff isgreat. How do I set up my computer todo this on my own?’ he would sendthem to me,” Saidenberg says. “Mostpeople didn’t know much about com-puters at the time. So I started doingtechnical-analysis computer consultingfor traders.

“I started doing this in late 1992, rightwhen I started using Tr a d e S t a t i o n(Omega Research’s system testing pro-gram), and turned it into a business,” hesays. “I probably worked with over

1,000 traders. I was not necessarily asgood at creating concepts as much aslearning concepts and then being able to‘ realize’ them on the computer.Programming sort of matches my styleof thinking. People would say, ‘I’ll sharemy wonderful system ideas with you ifyou’ll do the programming.’”

Saidenberg continued to trade, con-sult for other traders, and design andtest his own trading systems. In 1995, hebegan trading client capital, implement-ing his trading ideas on a large scale andmanaging accounts with a multi-system,multi-market approach.

One afternoon, promptly after theclosing bell, he discussed his evolutionas a trader and shared some insights onseveral trading ideas and about whatworks and what fails when put to thetest of the markets.

AT: When did you start designing yourown trading systems?RS: I started experimenting with manydifferent ideas while I was consultingwith other traders. I was programmingfairly complex systems three or fourweeks after I started using TradeStation.I was still trading the Time Trend systemat this point, but I put together my ownhalf-hour-based S&Ptrading system thatI followed religiously as well. It was oneof the first complex things I pro-grammed.

It was an always-in-the-market sys-tem based on 30-minute price bars and anine-bar relative strength index (RSI)with overbought and oversold lines of

The trade-off:

“The most profitable

day trading systems

are the ones that let

the trade run all

the way until the close,

or until the [initial] stop

gets hit. Systems that

use some kind

of exit rule that creates

a higher winning

percentage and prevents

large winners from

turning into losers makes

your equity growth more

consistent, even if it’s

not as large.”


70 and 30. The rules for buys and sellswere identical.

When the RSI moved below 30, I’dwatch for the lowest value it reached aftermoving below that threshold. Then Iwaited for it to move back above 30. If itmade a bottom by coming down and thenturning up, and the new bottom waswithin 10 RSI points of the initial bottombelow 30, that was a basic buy signal.

So, if the RSI made a bottom at 15, ral-lied above 30, then came down and madeanother bottom between 15 and 25, thatwas a buy. If the spread was more than 10points, I wouldn’t allow the buy — I’dwait for a subsequent bottom.

Sometimes I had two different bot-toms working at the same time — theRSI would make a bottom at 5, move upabove 30, then make another bottom at25 and again move up above 30. So, nowI could have a following bottom to get abuy that was either between 5 and 15, orbetween 25 and 35. If it went up from

t h e re and made a top above 70, Ireversed the rules to generate sells.

Those are the basic buy and sell sig-nals. There was also a breakout compo-nent that allowed you to get out of atrade if a basic signal in the oppositedirection didn’t trigger.

I tracked that system by hand evenb e f o re I was using TradeStation. (H es e a rches through old re c o r d s .) I have chartsfor this system dating back from October1990 to January 1992 — 319 signals.

AT: Did doing thingsby hand like thatgive you a betterunderstanding ofthe strategy?R S : Of course. Itforces you to look atevery trade veryclosely and makesyou realize what alltypes of trades looklike, good and bad.So when you experi-ence all the differentkinds of trades in reallife you are ready totake them and con-tinue with your trad-ing system, asopposed to someonewho just looks at aperformance table orequity curve and

thinks, “Yeah, I can make that money,”and then tries to trade it, not realizingthere is a whole, long process to tradingthat can be difficult to endure.

AT: Did you have a preference towarda particular time frame?R S : Trading very short-term — one-minute or five-minute time frames, forexample — seemed like overkill. I mighthave eight trades in a month with a sys-tem triggering off 30-minute price data.But I could stand position trading, eventhough I preferred day trading.

But at the beginning I thought therewas a big advantage to position-tradingsystems that were also sensitive to intra-day movements and would adjust posi-tions during the day. For example, my30-minute RSI system was always in,long or short, with some positions last-ing a few weeks even though I wastracking the market intraday with trad-ing signals which were sensitive to intra-

day price movement.One of the things I discovered was

that I could use systems that didn’t haveovernight exposure, but were similar instyle to the original 30-minute systems Iwas using. I turned my intraday positionsystems into day-trading systems. Oneof the biggest risks of trading in theS&Ps is overnight exposure — what canhappen between the close and the nextday’s open.

I found that using intraday triggersfor entry was a good concept. But toeliminate the risk of overnight positions,I turned my 30-minute position systemsinto day-trading systems. I’d have alower overall return, but much lowerdrawdown.

AT: Was this a matter of adjusting thetime frame of the bars you used, ordid you put in an automatic exit ruleon the systems?RS: An exit-on-close rule. Also, I foundthat I moved away from indicators andtoward complete price calculations justusing highs, lows and closes. I movedt o w a rd trading threshold levels andprice breakouts: one level to first set up atrade and another level to enter thetrade.

The levels are generally based oneither the range of a certain period of aday, the entire day’s range or the previ-ous day’s range. It really didn’t matterwhich time frame chart I was using forthose types of systems, because I was notusing any indicator calculations thatwould require a specific number of min-utes for the bars. Instead, I was usingprice action within a certain time inter-val. I found that by working with one-minute or five-minute charts I could bemost accurate for system testing, evenfor a day-trading system which wouldtrade only a few times per month.

AT: Do you still use any indicators?RS: Yes. I still like to look at the stochas-tics and RSI on my charts. Also, I createcustom indicators that are helpful in sys-tem development for making sure thatwhen I’m writing a system it’s doingwhat I expect. An indicator can help youtrack trades to make sure they’re behav-ing correctly. I write all kinds of indica-tors that apply to certain systems.

AT: You’re trading multiple markets,multiple systems and multiple ac -

“There’s a tremendous

desire for people to be

able to buy low and sell

high. I don’t know how

to make it profitable on

a purely mechanical

basis.”


counts. What kind of positionsizing and money managementtechniques do you use?R S: That’s taken a long time todevelop. I put together a group oftrading systems I want to use, andcall that my “trading plan.” Since Itrade diff e rent-sized accounts, Iwant to make sure the perc e n t a g edrawdown is approximately thesame in all of them. If an account isbig enough to trade my completetrading plan, I will use six diff e re n tS & P day-trading systems, six sys-tems in each of the four major c u r-rencies and systems in the T-note future s .

I take the single-contract equity curvesof the individual trading systems and Icombine them to get a net combinedequity curve. That gives me the perform-ance of the group of systems as a unit.

Now, if I have an account of a certainsize, say $100,000, and I want to makes u re the maximum drawdown in anaccount is 30 percent — $30,000, peak tovalley — I pick a specific combination ofsystems where the combined maximumdrawdown is $30,000. That gives me thetrading position size for that particularaccount. I trade one contract for eachsystem that account uses, so the totalnumber of contracts is based on thenumber of systems followed.

AT: Are your S&P systems literallyday-trading systems — they’re flat atthe end of the day?R S : Yes. I like S&Ps for day tradingbecause of the large intraday price moves,but I like the currencies and the intere s trates for trend-following or longer- t e r mposition trading because of the consisten-cy of trends in those markets.

AT: What kind of time frame do youuse for these longer-term systems?RS: One of the things I do, since I’m fol-lowing, say, six different systems in theyen, is have them vary in time frame.The shortest-term system will changepositions on average about 20 times peryear, and the longest-term system willchange positions around four times peryear. If I’m going to use two systems, forexample, they’ll overlap so my positioneither is long, short or flat.

AT: How do your systems typically getin and out of the market?RS: A system is just something that tries

to determine when and at what price toplace your order. For triggers, regardlessof time frame, I like to use stop ordersfor entry. I sell as the market goes downthrough my price level or I buy as themarket goes up through my price level.

One style of day-trading system that Iuse is to take an average of the ranges ofthe previous days, maybe two to fourdays, then multiply that average by afactor, maybe a third, and now I have avolatility amount.

Then I’ll use today’s open, and addand subtract that volatility amount to theopen to get buy and sell levels for thed a y. There are a couple of other thingsthat go into this though, which I cansummarize briefly: First, it pays to havethose levels operate only at certain timesduring the day, as opposed to all day.Second, it also pays to have some dayswhen the system is filtered out, so therewould be no trades, either because theopen doesn’t satisfy certain conditions ora trend filter, or some other factor.

A really simple example of one ofthese conditions is to look at the gapbetween today’s open and yesterday’sclose. Some people define gaps as thed i ff e rence between today’s open andyesterday’s close; I also like the differ-ence between today’s open and yester-

day’s high or low. If that gap is,say, more than one-third the previ-ous day’s range or more than someother absolute amount, then thatday that is acceptable to trade.

AT: Does this kind of system usea stop to control losses?RS: All my systems control losses.Once I get a trade on, the simplestthing to do is have a money-man-agement stop to know what mymaximum loss is. I use stops any-w h e re from 400 to1,200 S&Ppoints.

AT: How do you determine exactlyhow big that stop is?RS: There are all sorts of things you cando. You can use an arbitrary fixedamount, you can have it be a percentageof the price level — half of 1 percent is areasonable percentage.

Looking at an absolute dollar riskamount on a trade is not great for exten-sive historical testing because the S&Phas gone from the 200s to over 1,400 (see“Playing the percentages,” p. 72). Theactual stop amount is not crucial to long-term performance. You really want tolook at the risk of the system as a whole,following the system through multipletrades.

There are some other commonly usedstop techniques, like using a volatilityfactor to determine the stop, that I don’treally like — there is something funda-mentally wrong with having a volatility-based stop. If the recent volatility is verylow, your stop will be smaller. But break-outs out of small volatility situations areoften very good trades, and I don’t wantto have that trade get knocked out witha tight stop.

Also, when there’s extremely highvolatility, your stop will be very large.On those trades, the market often reactsviolently against the position right awayand if it does, I don’t necessarily want towait for a very large stop to get me out— I’d rather get out sooner. I prefer tohave consistent, similarly sized stops, ina particular system.

AT: Do you use any kind of profit-taking or trailing stop techniques?RS: Well, I’ve been working things likethat for many, many years, trying tocome up with better stuff. The mostpainful aspect of profit-target develop-

“ I found that by turning

30-minute position

systems into day-trading

systems, I’d have a lower

overall return, but much

lower drawdown.”


ment is that the systems that give youthe most total profit are the ones that letthe trade [in a day-trading system] runall the way until the close or until the ini-tial stop-loss gets hit. So even if you’reup a huge amount, you have to be will-ing to give back that profit and let it turninto a loss.

A system like that does give you themost total net profit in the long run, butit’s not as easy to trade as a system thattrails a stop, which sometimes willknock you out of a trade that could growinto a much larger profit. The way to getlong-term, large, total net profits is tomake sure you capture all of your reallylarge trades. So, eliminating the trailingstop makes sure you don’t ever getknocked out of a really large profit.

However, there is a degree of consis-tency you can get by using some kind ofexit routine that gives you a higher per-centage of winning trades and preventslarge winners from turning into losers,so your equity growth is more consis-tent, even though the long-term totalprofit is less.

What I specifically don’t like abouttrailing stops is that you generally endup getting stopped out of a long trade ina low price area. I would prefer to exitwith a limit order as the position is mov-ing in my favor. I have some complexroutines where I place limit orders forexit, but I don’t want to place a targetexit when I first enter a trade because Iwant to allow that trade to grow verybig if it happens to do so very fast.

I’ll give you an example. Say I’m run-ning a one-minute chart, and on it I havea 15-bar stochastic. If I go long on abreakout the stochastic reading is goingto be up pretty high. If this trade getsprofitable — the market is rising — thestochastic is still going to be in its upperzone. But at some point in the tradethere’s going to be a consolidation andthat stochastic is going to go down.

One of the things I might do is waitfor the stochastic to drop below somevalue, say 30, and at that time I’ll makesome calculation of the price bars fromwhen the stochastic was at its peak, towhere it is now — the range of thosebars — and add it to a certain value, per-haps the middle of the range of the bars.Now I have a target price.

I call this a “late in the game” targ e tbecause the absolute profit is not knownat the beginning of the trade, as it is with

a typical profit target. This allows thetrade to grow as big as it can initially, butthen when the market settles down,t h e re’s a mechanism for placing a pro f i tt a rget at some high level so you’re exit-ing a long trade as the market is going upand price is moving in your dire c t i o n .

That routine also works pretty wellfor trades that don’t work out well atfirst. When the stochastic ends up goingbelow 30 relatively quickly, you may beat a loss during that period, but not quiteat your stop-loss level, and you end upplacing a profit target in this manner —a very small profit target.

I’ve found that kind of exit routine iscertainly satisfying to watch when itworks in real time, but again, it does cutinto your total net profits because thereare some trades that exit at the profit tar-get when they might have turned into

much bigger winners.

AT: Do you trade on the open?R S: For day trading, I never trade on theopen because the opening price is oftengoing into the calculation of the rules ofthe system. If it’s not, I still have somekind of time factor — 10 or 10:30 a.m. EST— and I don’t do anything until then.

For position trading, if the marketopens through my stop level, either toexit a position or to enter a new position,then I execute the trade at the open.

AT: Would you characterize most ofyour trading ideas as breakout-based?R S : (Laughing) I wouldn’t characterizemost of them that way, but I would charac-terize the ones that actually work that way.

By contrast, most of the things I’vep rogrammed for people are things Iwould say d o n ’t work. There’s a tre m e n-dous desire for people to be able to buylow and sell high. I don’t know how tomake it profitable on a purely mechani-cal basis.

I have worked out systems when themarket goes into an extended flat peri-od. Say, the market has been going downfor two weeks in a flat area — I wouldallow a buy stop to come in the lowersection of that range, so if the marketturns around in that low area and thengoes up through the buy stop, the sys-tem goes long. If you look at a chart,you’d say, “Look, you bought a lowarea,” but you’re still using a buy stopfor the entry. Movement in your direc-tion at the time of entry is crucial to prof-itable systems.

AT: How rigid are you with your sys -tems? Do you stick with them regard -less of circumstances — are you onauto-pilot? RS: Well, the process of becoming a sys-tematic trader was not something thatjust happened overnight. But the biggestproblems I have, and the most uncom-fortable feelings I get, are when I’m notfollowing the rules of my systems.

AT: So you do use discretion?RS: Technically no, I’m not supposed to,but you can’t be perfect. Right now, I’dsay the reason I’ve been successful as atrader is because I’ve followed systemat-ic rules; the problems have come whenI’ve tried to override those rules.Ý

“ It was the actual

experience of seeing

[a trading system] work

that attracted me

to systematic trading.

That style was something

really stuck with me as

the proper way to trade

and make money.”

BY THOMAS STRIDSMAN

A hhh, stops. Can’t live with‘em, can’t live without ‘em.

No trading advisor worth his saltwould recommend you follow hisadvice without also suggesting a stoploss. The same goes for most trading-system vendors. That’s fine, but thereare stops and then there are stops, as theold saying goes. It’s how stops aredetermined that will really define howgood your trading plan is. If the stopshave been poorly calculated, sooner orlater they will do you more harm thangood.

RISK Control and MONEY Management

THE P E R C E N TA G E STHE P E R C E N TA G E S

P l a y i n gP l a y i n g

A

You know the risks oftrading, so you alwaysuse a conservative stoporder. Risk-control mission accomplished,right? Well, there’smore than one way tocalculate a stop level,and some of the morepopular ones can blowyou right out of thewater. Find out about a rational way toapproach the problem.



Many traders think limiting risk is amatter of making a personal decisionabout how much money they want to (orcan afford to) lose and then sticking tothat figure like glue: “I’ll only risk $750per trade on any stock I trade — not apenny more.”

The problem is that the market may betelling you it is necessary to risk $1,250per trade to succeed — and that’s just fora particular stock; the figure may be dif-f e rent for other stocks and it may be dif-f e rent for the same stock tomorro w. Themarket does not care how much youwant to risk or how much you can aff o rdto risk. It dictates the terms of risk. It is upto you to listen to what it has to say ands t ru c t u re your trading plan — includingstops and other risk control measures —a c c o rd i n g l y.

To fully understand this, you first needto understand the difference between agood trading strategy and a profitable

one. For example, suppose you havedeveloped a strategy that will let youcatch all 1-percent moves in any stock. Ifyou apply this strategy to an S&P 500index futures contract, with the markettrading around 1,350 points, a 1-percentmove would equal 13.5 points and beworth approximately $3,375 (1,350 * .01 *250).

However, if you instead were tradingthe E-mini, the same move would beworth only $675 (one-fifth the standardcontract). For the Dow Jones andNasdaq indices, with the markets trad-ing at 10,500 and 2,500, respectively, thesame trade would be worth $1,050 and$250. For several individual stocks, thedollar value would be too low to make atrade worthwhile. So, for a good work-ing strategy to also be profitable, it needsto be applied to a stock that has a highenough dollar value (or to a market thatis trading at a high enough level).

On the other hand, a profitable, butmarket-specific strategy is not necessari-ly a good strategy when applied to othermarkets. Eventually — and soonerrather than later — it will turn into a los-ing strategy. Sometimes, this holds trueeven if applied to the same market attwo different points in time.

For instance, say you are about to puttogether your own trading strategy thatshows a historical back-tested profit of$150,000 by consistently buying and sell-ing 100 shares of a stock that trades at$90. Suppose that at the end of the trad-ing day, the stock splits 3-for-1 andopens the next morning at $30. At thatpoint, the profit derived from your strat-egy has decreased to $50,000.

Does this mean that the system sud-denly does not work? Of course not. It’sexactly the same system, but because ofthe split you need to trade in 300 sharelots. Further, if you had a $9 stop-lossbuilt into the system, you would need tochange it to $3. And as luck would haveit, things aren’t always this easy in the

real world.Consider another hypothetical situa-

tion. Say your 1-percent system is rightonly 50 percent of the time. Because ofthis, you place a $2,000 stop on everytrade in case things don’t work out.Again, using the S&P 500 futures con-tract as an example, you will still aver-age a $687.50 profit per trade (you’llmake $3,375 half the time and lose $2,000the other half, when you get stoppedout).

Not bad, but what about the othermarkets we mentioned? For the E-mini,the average trade would result in a $663loss. For the Dow Jones and Nasdaqindices, the same number results in loss-es of $475 and a $250 profit, respectively.

Of course, you could adjust the stopaccordingly for each market, as you didin the stock trading example. A stop forthe E-mini would be set to $400, whichwould result in an average trade making

a $138 profit. In doing so, though, youtransform your original strategy fromone that worked well in several differentmarkets and time frames into one that isprofitable only in one market.

What will happen the day the marketis trading twice as high as today when,for instance, a 1-percent move for theS&P 500 will be worth $6,750? Will thatmean your average trade will be worth$2,375? Actually, it will probably meanyou are no longer trading, because thisoriginal strategy would have made yougo bust. Why? The higher the market istrading, the greater the volatility, in dol-lar terms, is likely to be. As a result, youare more likely to hit your stop loss thanyour profit target, because the pricemovement that would result in a $2,000loss would only be a ripple on the sur-face compared to the 1-percent gain youare looking for in a winning trade.

Figure 1 shows the absolute monthlychange for the S&P 500 from January

1983 to April 1999, while Figure 2 showsthe absolute percentage change. Thestraight lines that run through the chartsare best-fit regression lines — they revealthe underlying trend. As you can seefrom Figure 1, the line has increasedfrom near zero to more than 30 pointsper month. Contrast this to the regres-sion line for Figure 2, which has stayedclose to level (the slope is slightly down,around 3.5 percent per month).

What these charts reveal is peoplewho say the volatility of the stock mar-ket has increased over the years, makingit more difficult to trade, are wrong. Yes,the dollar, or point-based volatility hasincreased considerably (Figure 1), butthis is only a natural consequence of themarket trading at higher price levels. Inpercentage terms, the volatility, if any-thing, has actually decreased somewhat.

This means if you use a fixed-size,dollar-based stop in a market consistent-

If you use a fixed-size, dollar-based stop in a market consistently

trading higher, you will suffer more and more l o s e r s .


ly trading higher, you will suffer moreand more losers. If that is not scaryenough, the following example willmake plain just how quickly the losingtrades can pile up if you use thisapproach.

Back-testing a standard breakout sys-tem (buy the highest high of the last ndays, sell the lowest low of the last ndays) on the S&P 500 beginning inJanuary 1983 — using a $5,000 moneymanagement stop, equal to appro x i-mately 1.5 percent of current marketvalue with the market trading around

1,350, and a $10,000 trailing stop,approximately 3 percent of current mar-ket value — it took 55 trades (out of 197)before either of the stops got hit (inOctober 1987). After that, it took another35 trades before they were hit (October1990) and they did not get hit again untilMarch 1996.

From then on, however, the hits justkept on coming. From December 1996 toJune 1999, 25 out of 33 trades werestopped out, and for the last year in thetest, all 13 trades were stopped out. Asprices get higher, the fixed-dollar stop

actually decreases in size (on a percent-age basis) because the market is tradingat increasingly higher prices.

Those are the results from an uptrend-ing market. What would happen in adeclining market? Reversing the logicused in our example, any fixed-dollarstop would be hit less frequently. Thatmeans the number of winning tradeswould increase, but the dollar value ofthe 1-percent move would decre a s ebecause the market is trading at lowerand lower levels. In other words, whenthe market declines, you will experiencea higher percentage of smaller profits.That might be fun in the beginning, butthat $2,000 stop will wipe you out,because by then each loss will be huge incomparison to each small winner.

Consequently, applying the same dol-lar-based stops to any type of tradingstrategy or system will only work in theshort run on one specific market or stockat a time. However, even if you decide todo only that, you probably still are in bigtrouble, because the market value is con-stantly changing and there is no way touse historical back-testing to come upwith a dollar value that would work besthere and now.

Figure 3 shows the dollar profit for everytrade made with a simple strategy testedon the S&P 500 index contract over thesame time as in the previous example.Notice how the profits (or losses) pertrade have increased dramatically forthe last 100 trades or so. By measuringthe trades in dollars, the size of the prof-its will increase at the same rate at whichthe market trades higher (and vice-versafor declining markets). This will givemore weight to the more distant resultsand, consequently, lower the value of theaverage trade because the dollar value ofthe past winning trades was not as highit is today. In this case, the average prof-it per trade comes out to $402.

Now, contrast this to Figure 4, whichshows the same sequence of trades,except that they all are measured interms of percentages. By measuring theprofit per trade in percentages, all tradesare given an equal weighting. Noticehow the profits and losses per trade aremuch more evenly distributed. Thismeans for a robust trading strategy, thepercentage returns for both the profits

Source: Omega Research

On a percentage basis, the S&P 500’s fluctuations have actuallydecreased slightly.

FIGURE 2 S&P 500: PERCENTAGE VOLATILITY

20.00

18.00

16.00

14.00

12.00

10.00

8.00

6.00

4.00

2.00

0.00

84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99

Source: Omega Research

On a dollar-for-dollar basis, the fluctuations in the S&P 500have increased because of the steady rise in the index.

FIGURE 1 S&P 500: DOLLAR VOLATILITY

150.00

140.00

120.00

100.00

80.00

60.00

40.00

20.00

0.00

84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99


and the losses will stay thesame no matter what themarket is doing.

Once the system-buildingprocess is over, it is easy totransform the average per-cent return into a dollar valueapplicable to today’s market.In this case, the average prof-it per trade is 0.23 percent,which comes out to $781 interms of today’s marketvalue. If you were to startusing this system today (andp rovided it is robust andyour reasoning is sound), thisis the average profit per tradeyou could expect to make inthe immediate future — not$402 as is implied by the dol-lar-based calculations. That’sa big difference and it obvi-ously would impact how youplace stop orders.

Let’s follow up with anotherexample that also ties intoboth “Short-term strategy,long-term perspective,” andthe Trading System Lab.

The Trading System Labshows the results of trading ashort-term system on theS&P 500 futures index thatrisks 3 percent of accountequity per trade. It goes longif the market has been downtwo days in a row within aweek, following a down week,except if this coincides with themarket also setting a new 60-day low, which suggests a possi-ble downside breakout. Reversethe rules for the short side.

The exits are exactly the sameas in “Short-term strategy, long-term perspective”: stop outimmediately if the marketmoves against you 1.1 percent;always lock in a profit after amove of 0.6 percent or more inyour favor; exit immediately ifthe market moves 2.8 percent inyour favor. If still in the trade,always exit after eight days.

As should be clear by now, allstops are calculated as a percent-age of the market value at thetime of the trade. This means that a 1.1

percent stop loss would have been worthapproximately $975 in early 1990 with

the market trading aroundthe 350 level. Today, withthe market trading around1,350, the value would becloser to $3,700. Thismeans, with everythingelse equal, a $3,700 stoploss should work the sametoday as a $975 stop lossdid 10 years ago. Theresults of using the per-centage-based stop isshown in Active Trader’sTrading System Lab.

For comparison, sup-pose in early 1990 youstarted to trade the samesystem outlined above, butinstead of using perc e n t-age-based stops you decid-ed to use a stop based onthe dollar value thatseemed to be the mosta p p ropriate when youstarted trading the system.What would have hap-pened? Table 1 shows youwould have lost more than50 percent of your initialequity.

N o w, when you knowyou should work with per-centage stops, where andwhen should they beplaced for best results? Thiswill be discussed in gre a t e rdetail in upcoming issues.For now, here’s some foodfor thought: You should

always strive to trade your aver-age trade (as determined by his-torical testing or actual perform-ance). Yes, your average trade,not your best trade.

The reason is quite simple:The further away a trade is fromaverage, the further you aref rom familiar trading gro u n d .And the further you are fromfamiliar ground, the more inse-cure you will be and the worseyou will function as a trader -both in managing this particulartrade and managing all trades tocome.

Besides, if all your tradeslooked exactly the same, youraverage trade would also beyour best trade. But that’s anoth-

er discussion for the future.Ý

Source: CSI, Unfair Advantage

Using a dollar-based stop resulted in a -52 percentreturn over the test period. (For an explanation of anyof these statistics, see our Trading System Lab page onp. 96.)

TABLE 1 DOLLAR-BASED STOP RESULTS

Profitability Trade statisticsEnd Eq ($) 47,796 No trades: 445Total (%): -52 Avg. Trade ($): -126Year (%): -7.26 Tr/Mark/Year: 9.1P factor: 0.95 Trades/Month: 3.8

Risk measurers Time statisticsMax DD (%): -83.93 Long. Flat (m): 45.57Lrg. Loss ($): -58,463 TIM (%): 35.71Winners (%): 50.79 Avg. days: 4.00

The same trades from Figure 3 shown in percentage terms. The trades are much more consistent.

FIGURE 4 AVERAGE TRADE: PERCENT VALUE

6

5

4

3

2

1

0

-1

-2

-3Time

The trades of a simple system, shown increasing in sizeas time passes and the market rises in value.

FIGURE 3 AVERAGE TRADE: DOLLAR VALUE

15000

10000

5000

0

-5000

-10000Time


BY MARK ETZKORN

T he market has a knack for reg-ularly making fools of even theb e s t - p re p a red and conscien-tious traders and investors; it

will utterly humiliate (or worse) theunwary, lazy or foolhardy.

That leads to a question almost neverasked — one that gets lost amid all theexcitement over a stampeding bull mar-ket and point-and-click order-entry tech-nology — but is nevertheless the mostimportant thing would-be tradersshould ask themselves:

Should I trade?That very few people bother asking

themselves this question before puttingmoney at risk at least partially explainsthe low success rate of new traders.

If you were an engineer and wantedto start your own business in a com-pletely new field — say, open a restau-rant — you probably wouldn’t do it on awhim. You certainly wouldn’t quit yourjob one day, dump your life savings intoyour new business, and, without know-ing the first thing about what you weredoing, expect to make an easy killing.

If you were smart, you’d probably:• Spend a great deal of time research-

ing your new field, consult with profes-sionals in the business and even try togain some hands-on experience.

• Put together a plan outlining the

goals of your business and establishingsteps to accomplish them.

• Make sure the business is adequate-ly capitalized, using the most conserva-tive possible estimates.

• Start slowly, and put in the time ande ffort re q u i red of any entre p re n e u rattempting to launch a new business,expect your business to go thro u g hrough times initially, and prepare your-self psychologically and financially tosurvive this incubation period.

• Make sure the business is adequate-ly capitalized. (Yes, that’s twice.)

Sounds fairly reasonable, right? Butthis is precisely what many — maybeeven a majority of — new traders don’tdo.

Why? Maybe people tend to thinkthey know more about trading than theyreally do. Everyone sees the recaps of theday’s market action on the nightly news(or watches round-the-clock financialcoverage), gets their quarterly 401(k)reports, or logs on to the Internet tocheck quotes and graphs and enterorders for their favorite stocks.

It makes it easy to feel like they re a l l yhave a handle on things, especially whenthe Greatest Bull Market In History hashad a nice habit of bailing people out ofbad (i.e., seat-of-the-pants) trades by con-sistently rebounding — usually soonerrather than later. Anyone can do it, right?

And if you think being a part-timetrader means you don’t have to put inthe time and effort a full-time traderdoes, think again. You’ll still be compet-ing against full-time traders, and full-time traders tend to be people you’ddescribe as Ty p e - A personalities onlybecause there isn’t a letter that comes

beforeA in the alphabet. Trading is never a hobby. It probably

re q u i res more work than most otherbusinesses and often carries the uniquerisk (if you trade on margin) of losingmore than you initially invested. But, forthose who approach the pro f e s s i o nsoberly and with reasonable expecta-tions, the rewards are there.

T h e re are certain realities to trading.They don’t have anything to do withwanting to trade or having the right orprivilege to trade, but rather with beingable to determine whether you’re likelyto benefit from trading. After all, thegoal is to make money. If circumstancesexist that make this a less-than-likelyprospect, perhaps the best trading deci-sion you can make is not to trade.

The simple truth is that trading is notfor everyone. Just as some people are notcut out to be engineers, lawyers, gram-mar school teachers or NBA p o i n tg u a rds, some people would do them-selves huge favors in the financial andmental-health departments by not trad-ing. One study estimated there are fewerfull-time professional traders in theUnited States than professional athletes— a sobering thought. (Maybe that pointg u a rd dream isn’t so unrealistic after all.)

Obviously, trading for a living is noteasy and it’s not something that can bemastered overnight. It’s a business, andto succeed in it you should expect toinvest the same kind of time and equity(both real and sweat) you would tolaunch any other business. You should-n’t trade because you think it’s an easieror faster way to make money than open-

TRADING Basics

A fool and his moneyHow do I pick a broker? When can I sell short? Should I position trade or day trade?

If you’ve never traded and these are the questions you’re asking yourself, you’dbetter take a step back. There’s a far more important question to answer first.


ing a restaurant. You should tradebecause you think it’s a better way tomake money than opening a restaurant.And there should be a reason you thinkthat way, a reason that has nothing to dowith luck or wishful thinking.

Sufficient time (both for learning thep rofession and practicing it), persist-ence, a love for the business and, yes,some aptitude are a few oft-quoted char-acteristics of successful traders. Thesecertainly are key components to tacklingthe markets (or any other business, forthat matter), but they are rendered mootby something far more academic.

Money.

The No. 1 reason, by far, most newtraders fail is the same reason most newbusinesses of any kind fail: lack of capi-tal. You can talk about discipline andstrategies all you want, but the greatesttrading approach in the world won’t doyou any good if you don’t have themoney to trade it.

Determining how much you need to

trade is more complicated than simplymeeting your brokerage’s minimumaccount balance re q u i rement. It’s theend result of the interaction of your age,net worth, outside financial responsibili-ties, risk tolerance and specific tradingplan you intend to follow.

P re s s u red traders are never goodtraders, and if you have too little money— or your trading equity represents toobig a portion of your total worth — youwill be apt to make poor (read: emotion-al) trading decisions, or you simply willnot be able to weather the naturalvolatility that accompanies many tradesbefore they are profitable.

A little common sense goes a longway here. Putting half your net worth ina trading account is one kind of proposi-tion for a single 29-year-old with nodebt, and another entirely for a 49-year-old with a mortgage who also is facingputting two kids through college in thenext couple of years. Similarly, someonein or approaching retirement would bewise not to risk a substantial portion ofhis or her wealth in short-term specula-

tion. “Risk slope,” shows the inverserelationship between how much money(in terms of percentage of income or networth), relative to age, a person couldprobably devote to short-term trading.

The downward slope of the moneyline is based on a few assumptions. First,when people are younger, they generallyhave few financial obligations and arethus freer to speculate with more of theirmoney — they have more time, andyears of future income, to bounce backf rom any setback. As people get older,they tend to assume greater financialb u rdens (mortgages, children), so thep e rcentage they can risk probably will belimited — you don’t want the kids’ edu-cation cut short because you risked thecollege fund on a “hot” IPO that wentcold. Finally, as people approach re t i re-ment, preservation of capital hopefullybecomes the key goal. Speculating with al a rge percentage of the funds you need totake you through the rest of your life —when you will have less time and abilityto replace them — is hardly prudent.

Keep in mind, though, that because

Trading is never a hobby. It probably requires more work

than most other business ventures.


people tend to earn more asthey get older, the absolutedollar amount they candevote to trading cani n c rease, even if it is a smallerp e rcentage of their total capi-tal. The 49-year-old with thetwo college-bound childre nmay have more money withwhich to trade, even if he’sonly risking 10 percent of hisinvestment capital compare dto 40 percent for the 29-year-old. “Equity arc , ” ( F i g u re 2)shows how the line fro m“Risk slope” might lookwhen adjusted for income and a 5-per-cent annual increase in earning powerover someone’s working lifetime.

Obviously, every trader’s situation isunique. The object is to trade with asmuch money as possible while minimiz-ing the impact — psychologically andfinancially — on the rest of your life.Nervous money tends to become some-one else’s money.

When you start talking about puttingspecific dollar amounts on what it takes

to trade, another layer of considerationsunfolds. First, there is no fixed amountthat gains your entry into the tradingclub. For example, all brokerages havecertain financial requirements customersmust meet — minimum account equity,net worth, annual income. Some aremore stringent than others and they maylimit the kind of trading you can dodepending on how much you have inyour account. But for the most part,these requirements are designed to pro-tect the solvency of the company, not theindividual trader (although they mayalso function in this respect).

A typical online discount broker maylet you open an account with as little as$2,000, but such brokers are generallyused by more traditional investors andless by active traders. If you’re a moreactive, shorter-term trader (and especial-ly if you’re day trading), a quick surveyof several direct access brokerages tells adifferent story: $35,000-$50,000 is a typi-cal account minimum, and they would“ p refer” you to have $100,000.(Sometimes you can open an accountwith less, but again, you may have

restrictions put on the kind of tradingyou can engage in.) A decade-old studyof future trading accounts found theodds of success jumped dramaticallywith accounts $50,000 and larger. Thingshaven’t gotten any cheaper since.

Still, you should not measure yoursuitability for trading by whether or notyou meet a brokerage’s requirement, butby whether you can stand up to a muchmore stringent measuring stick: Howmuch money it will take to successfully

trade a particular strategy.How can you determine this?

Research. Testing. Real trading resultsfrom someone who has used a strategyor approach you’re interested in. Forexample, there are several softwarepackages that will allow you to programtrading ideas and test them over years ofhistorical price data. Say you test a strat-egy you’re interested in and discoverthat over the last 10 years, this approachhas been down as much as $15,000 onseveral different occasions, even thoughit was profitable over the long haul.Common sense would tell you that youneed at least $15,000 to trade this systemsuccessfully. If you had less, the expect-ed loss would knock you out of thegame, sooner or later.

But wait, there’s more. Pro f e s s i o n a ltraders will quickly tell you the maxi-mum potential suggested by such histor-ical testing will almost certainly be larg e rin real-life trading. The biggest loss isalways in the future, the old saying goes.A c c o rd i n g l y, professional traders willtypically double (or more) the maximumloss estimate of a historical test to deter-

mine what their potentialloss in real trading is likelyto be and plan accord i n g l y.That means our strategywould probably produce atleast a $30,000 loss in thereal world.

What if you had $20,000to trade with? Should youtrade the strategy andhope you didn’t run into alosing streak until you hadhad enough winningtrades to bump youraccount equity above the$30,000 mark?

You could, and this is exactly whatmany traders — losing traders — try todo. (That dirty word, hope.) The profes-sional, however, would take one of threetacks: refrain from trading the strategy,wait until he or she has adequate capitalto trade the strategy safely or determineif trading fewer shares (or some otheradjustment) will reduce the strategy’srisk to the point that a $20,000 account issufficient.

This is a simplification, but it at least

gives an idea of the kind of due diligencenecessary to get your trading career offon the right foot. The great thing abouttoday’s technology is that it gives youmore direct and immediate access to themarket and the ability to take charge ofyour own trading and investing thanever before. But, as in all areas of life,this freedom comes with a great deal ofpersonal responsibility.

It’s no coincidence that many toptraders claim to focus more on limitingrisk than reaping profits. Take care of therisk, and the profits will take care ofthemselves. No one can be careful foryou when it comes to trading — youhave to do it yourself.

After money, the new trader’s best ally istime — both on a daily basis and interms of committing to a potentiallylengthy apprenticeship.

You can go to any number of tradingseminars and listen to someone tell youthat, no matter what, you have to “payyour tuition” in the market — i.e., you’lllose $5,000 (or $10,000, or $20,000, etc.)

FIGURE 1 RISK SLOPE

As we get older, the percentage of our income or worthwe devote to short-term trading generally declines.

Age

Percentageof income

Nervous money tends to become someone else’s money.


before you begin making money. Just asyou would have to spend money tolearn to become a lawyer or doctor, thisline of reasoning goes, so must you payto learn to trade.

Maybe so. Losses are part of the game,and one of the distinguishing character-istics of successful traders is that they areable to accept losing trades (relatively)unemotionally and move on. But, thereis no rule that states youmust kiss away a sizablechunk of money because ofimpetuousness or impa-tience.

There are other ways topay your trading tuition —n a m e l y, giving yourselftime to learn about both themarket and the process oftrading, and even moretime to re s e a rch, designand test trading strategies.You may still lose moneyout of the gate (not neces-sarily a bad thing, sinceoverconfidence has claimedmore than its fair share oftraders), but your tuitionbill might be a little smallerthan it would have beenhad you dived into themarket headfirst.

There’s no rule that says you have tostart trading in the next 90 minutes. Formany years, one bit of sage advice fromconscientious traders was to “papertrade” — instead of placing real trades,keep track of the performance of tradesyou would have made to see (withoutrisking actual dollars) how your strategymight fare. It’s a sound (if not foolproof)concept, and one made easier today withvarious kinds of software and onlinetrading aids to help with the process.

The truth is that there is simply noexcuse for blundering into the marketunprepared. The ease with which poten-tial traders can access price data, finan-cial re s e a rch, analytical software andsophisticated trading simulators leavesno excuse for foolhardiness. Give your-self time to learn — read a book (or,ahem, a magazine article) or two, studyand practice. Time is on your side. Themarket will still be there 10 weeks, 10months or 10 years down the line.

There’s always a psychological shiftwhen your paycheck is finally on theline, and no amount of paper trading or

simulated trading can totally prepareyou for it, but being as thorough as pos-sible before you risk real money canmake the adjustment much easier.

And when you start trading, starttrading small, far below what you’vedetermined to be your normal risk level.Doing so will allow you (even more sothan simulated or paper trading) to mas-ter the actual process of trading without

putting undo stress on your psyche — orwallet — when you make the switch toreal money.

Building on our original proposition —that trading is a business like any other— it’s possible to give an idea of where atrader should be when he or she is final-ly ready to place a trade.

It’s all about having a plan — be it arigid system or a set of general rules youmodify depending on circ u m s t a n c e s .Such a plan should determine:

• how, when and why to enter a trade(which implies there are times youdon’t take a trade),

• how, when and why to take a prof-it on that trade and

• how to control losses on that trade(stops orders, etc.).

The “why” part of the equation can-not be downplayed. If you don’t under-stand why you’re doing something, youwon’t be able to do it under adverse cir-cumstances. When things aren’t going

well, you’ll second guess yourself — amajor hazard considering executing aplan is half the trading battle You mustunderstand your approach — it must bebased on sound market principles — tobe able to trade it effectively.

Neither the hows nor whys can bebased on casual observations or “gutfeelings.” They must be based on logicalmarket behavior and confirmed by

extensive re s e a rch. Yo umust prove to your ownsatisfaction that your basictrading idea is sound andyour plan for executing it ispractical.

If you’re not willing to dowhat it takes to get to thislevel, you probably should-n’t be in any rush to trade.How do you get there ?Well, that will be the subjectof a steady stream of futurearticles in this section of themagazine.

Most people only under-stand the stove is hot whenthey burn their fingers on it,and unfortunately, manypeople will ignore theadvice outlined on thesepages.

But then again, they’ll be the ones giv-ing you their money.

For those with the proper capital,patience, persistence, time and a certainproclivity, trading can be a great way tomake money independently, either on afull- or part-time basis. But it’s not foreveryone, and it’s much better for cer-tain people to devote their income tol o n g e r-term, less risky investmentoptions if the odds of trading success arenot in their favor.

A very successful trader once said,“Trading is not an IQ contest.” This mayoffer comfort to some and disheartenothers who had hoped that what theythought was superior gray matter wouldbe the key to their success.

But if trading isn’t about matchingwits with others in the market place,what is it about? Maybe it’s fair to saytrading requires a specific kind of intelli-gence — the kind that recognizes therealities of the business and is dedicatedto approaching it professionally. To theprofessional go the spoils.Ý

FIGURE 2 EQUITY ARC

Because we tend to earn more as we age, the absolute dollar amount we speculate with can increase over timeeven though it generally tapers off in retirement.

AgeIncomeavailablefor trading


Short-term strategy, Short-term strategy, You’re a short-term trader —

what do you care about

investing, the long-term trend

or what’s happening in the

larger economy? Find out why

traders who understand

longer-term approaches

(and investors who understand

trading) have an edge over their

one-dimensional competition.

The Big PICTURE

BY THOMAS STRIDSMAN

Call it the Titanic rule.You cannot, in an instant, turn aro u n d

a massive ship sailing full steam ahead.Its mass and momentum will make thep rocess long and slow. The same goes forthe economy, or any smaller part of it,such as an individual stock. Strong tre n d sgenerally keep going — with some twistsand turns along the way — until some-thing big happens to reverse them.

To be sure, strange things happen inthe markets now and again, bringingshort-lived fame and fortune to a luckyfew. However, you cannot count on suchexceptions to be the rule. Generallyspeaking, you are much better off goingwith the current flow of events — swim-ming with the economic tide instead offighting it.

For short-term traders, this meansgoing with the flow of the market andonly placing trades in the same directionas the trend, either as a long-term bet tocatch the beginning of a move (but beingprepared to get out as soon as the marketmakes it clear it is not heading where

you expected it to), or as a short-term betthat allows you to jump from one “ship”to another — if that ship can take you toyour destination more efficiently. Onemajor advantage of trading short-term inthe direction of the long-term trend isthat you can dare to work with limitorders, trying to pick tops and bottoms.

Of course, doing so takes disciplineand a thoroughly researched arsenal ofentry strategies, and stop and exit tech-niques, but that is a topic for anotherarticle (or an entire book). For now, wewill focus simply on trading with thetrend and how that trend can be meas-ured with the help of different technicalanalysis tools.

Basically, there is one way to fish outh i g h - p robability trading opportunities.First, ask yourself, “Is it better to tradewith the long-term trend, and can theshort-term volatility help determine theoutcome of the trade?” Then, do the nec-essary research to find the answers.

Well, there is another way, but it doesnot work — even though it is especiallypopular among new traders (and, horri-fyingly, some brokers who make theirlivings exclusively off your commissiondollars instead of in the markets).

This method is called “indicator pil-

ing,” and it consists of combining sever-al related indicators and so-called“expert commentaries” on top of eachother in the hope that one day, when allthese signals simultaneously flash greenlights, you will have a sure winner. (Andin the meantime, it sure looks fancy.) Theproblem is that these indicators will allgive different signals; with 10 indicatorson your screen and only one being“right,” you actually have a 90 percentchance of coming to the wrong conclu-sion if you look at them one at a time.The odds get even worse if you startcombining them.

Once you are past the piling stage(which you probably are, since you haveread this far), the next step is to see ifthere really is anything to be gained fromtrading only with the longer-term trend.

You can determine the longer-termtrend several ways. The simplest (butcertainly not the easiest) approach is touse your own fundamental and discre-tionary judgment about where the econ-omy in general, and your stocks in par-ticular, are headed, and then stick to thatprognosis over a long period of time.Other ways could be to trade only in thesame direction as a lengthy moving aver-age (e.g., 50, 100 or 200 days) or someother “long-term” indicator.

Table 1 (opposite) compares the re s u l t s


of randomly entering (long or short) fro mJanuary 1990 to October 1999 all 30 stocksthat make up the Dow Jones industrialaverage vs. entering only in the samed i rection as a 200-day moving average.

Each market was traded 10 times, cre-ating a total of 3,000 unique yearly trad-ing sequences per approach. In bothstrategies, all trades were exited afterfive days, rain or shine.

Comparing a few statistics that shedlight on the risk-reward characteristicsof these approaches — profit factor, stan-dard deviation, the percentage of prof-itable trades and its standard deviation— reveals some interesting (and signifi-cant) differences. (For an explanation ofthese concepts, see “Understanding thestats”).

Table 1 shows that with-out the trend filter, 18 mar-kets had an average pro f i tfactor above one, but wecannot say with 68 perc e n tcertainty the true profit fac-tor will be above 1 for any ofthem. Why? Because of thes t a n d a rd deviation of the results. Forinstance, for Wal-Mart, with an averagep rofit factor of 1.11 and a standard devi-ation of 0.28, we cannot say with 68 per-cent certainty that the true profit factorfor Wal-Mart will be above 1 — the “mar-gin of error” determined by the standarddeviation suggests the results, with somerounding of the numbers, could rangef rom 0.83 (1.11 - .28) to 1.39 (1.11 + .28).For all stocks, the true profit factor is

(with 68 percent certainty) likely to bes o m e w h e re between 0.83 and 1.19.

Now look at the results of using thetrend filter: This time 21 stocks had anaverage profit factor above 1, and for 10of the markets there was a 68 percentprobability the true profit factor wouldbe above 1 (marked in re d ) .Furthermore, of all stocks tested, 19 hada higher profit factor and 21 had a high-er percentage of profitable trades

On Balance Volume (OBV)Here’s the cumulative OBV formula, ready to beused in a spreadsheet (just substitute the variablenames with actual values):

OBV = Sum[(Ct- Ct-1)* Vt/Abs(Ct- Ct-1)], where

Ct is the closing price for the last period.Ct-1 is the closing price preceding the last period.Vt is the volume for the last period

Without trend filter: With trend filter:Company PF St Dev Lower % Win St Dev Lower PF St Dev Lower % Win St Dev Lower

limit limit limit limit

3M 1.05 0.15 0.90 52.52 2.66 49.86 0.85 0.12 0.74 48.14 2.48 45.66 Alcoa 0.99 0.07 0.91 52.69 2.27 50.42 1.00 0.13 0.87 48.10 2.12 45.98

Amer Expr 1.05 0.14 0.91 51.28 2.76 48.53 1.14 0.16 0.97 53.59 2.66 50.93 AT&T 0.96 0.22 0.74 49.85 4.71 45.14 1.11 0.26 0.85 51.70 2.69 49.01

Boeing 1.08 0.11 0.97 51.88 1.42 50.46 0.91 0.12 0.80 52.19 2.54 49.64

Caterpillar 1.06 0.11 0.94 52.84 2.26 50.58 0.94 0.22 0.72 50.62 2.56 48.06 Citigroup 0.99 0.12 0.87 51.02 2.82 48.21 1.29 0.22 1.06 57.01 3.85 53.17

Coca Cola 1.08 0.18 0.90 51.97 3.32 48.65 1.01 0.19 0.82 52.96 2.68 50.28 Disney 0.96 0.18 0.78 50.73 2.41 48.33 0.97 0.20 0.78 52.22 3.62 48.60

Du Pont 1.05 0.21 0.84 50.56 2.67 47.89 0.93 0.15 0.78 48.39 3.07 45.32

Exxon 0.92 0.12 0.80 50.33 2.57 47.76 0.91 0.15 0.76 50.73 1.22 49.52GE 0.95 0.11 0.84 50.10 1.86 48.24 1.37 0.25 1.12 55.10 2.48 52.62

GM 1.03 0.12 0.91 51.17 2.79 48.38 0.96 0.11 0.85 49.61 2.25 47.36Home Depot 0.94 0.18 0.76 50.37 2.10 48.27 1.29 0.16 1.12 54.86 3.05 51.81

Honeywell 1.09 0.22 0.86 52.53 3.62 48.91 1.11 0.10 1.00 54.90 1.73 53.18

HP 1.00 0.18 0.82 50.53 1.53 49.00 1.07 0.14 0.92 50.96 1.43 49.53IBM 1.00 0.27 0.73 50.73 3.16 47.56 1.22 0.22 1.01 58.36 1.75 56.61

Int Paper 1.01 0.18 0.83 51.89 3.14 48.75 0.78 0.14 0.64 48.42 2.86 45.56 Intel 1.01 0.11 0.89 50.15 2.38 47.77 1.26 0.20 1.06 52.39 2.50 49.90

J & J 1.02 0.19 0.83 51.16 1.61 49.55 1.17 0.17 1.00 54.03 2.84 51.19

JP Morgan 1.07 0.23 0.85 51.69 3.67 48.02 1.06 0.14 0.92 51.68 2.57 49.11 Kodak 0.99 0.18 0.81 51.43 2.61 48.81 0.96 0.16 0.79 50.70 3.38 47.32

McDonalds 0.89 0.12 0.77 49.85 3.15 46.70 1.01 0.19 0.83 51.98 1.91 50.06Merck 1.08 0.20 0.88 51.58 2.19 49.39 1.07 0.16 0.91 57.32 3.08 54.24

Microsoft 0.92 0.13 0.79 50.96 2.85 48.11 1.49 0.41 1.08 56.52 2.61 53.92

P&G 1.02 0.23 0.79 50.83 2.39 48.43 1.06 0.18 0.88 49.58 2.35 47.23Philip M 1.12 0.20 0.92 53.42 2.09 51.33 1.26 0.17 1.09 55.33 2.05 53.28

SBC Comm 0.98 0.15 0.83 50.07 3.41 46.66 1.01 0.20 0.81 50.24 2.44 47.80United Tech 1.04 0.29 0.75 52.34 2.53 49.81 1.26 0.19 1.07 55.51 2.87 52.64

Wal-Mart 1.11 0.28 0.83 51.40 3.14 48.27 1.42 0.24 1.17 58.61 3.58 55.03

Total 1.01 0.18 0.83 51.26 2.79 48.48 1.10 0.25 0.85 52.73 3.96 48.77


(marked in bold), with the trend filter.With the filter there also were 14 stockswith a 68 percent probability the per-centage of profitable trades would bemore than 50 percent.

For all markets combined, the averageprofit factor comes out to 1.10, with astandard deviation of 0.25. This meansthat we still cannot be 68 percent surethe true profit factor for all markets willlie above 1, but somewhere in the inter-val between 0.85 to 1.35.

We still cannot be sure that the averagep rofit factor for all stocks will be aboveone because there were a few stocks thatdidn’t “like” this particular tre n d - f i l t e r-ing technique at all, which consequently

both lowered the profit factor andi n c reased the standard deviation.

H o w e v e r, considering the trend filterwas arbitrarily chosen, all trades weree n t e red randomly and the five-day exittechnique is ru d i m e n t a r y, a simple testlike this still clearly shows the benefits ofalways trading with the long-term tre n d .Imagine what you can do by optimizing at rend-monitoring strategy with a set ofmarket-specific entry and exit techniques.

For now, however, we will continue tokeep things simple and look at what abasic trend filter will do for a specificmarket, and what will happen if we sub-stitute the random entry with a simpleentry technique and a more complex set

of exits and stops. This time, we will usethe S&P 500 stock index futures to illus-trate our point.

In this example, we measure the long-term trend with the 200-day movingaverage of the on-balance volume (OBV)i n d i c a t o r, which weights each day’sprice action with its volume (see box onp. 83 for formula). The indicator increas-es and decreases in value depending onhow much volume accompanies theprice move.

OBV is interpreted the same way as amoving average of price (i.e., when theOBV indicator is above its long-termmoving average the trend is up, andwhen it is below its long-term movingaverage the trend is down. This is one ofthe “smartest” indicators you can use forsuch a task, because by incorporatingboth price and volume in a single calcu-lation, the OBV covers everything thereis to know in terms of technical analysis— namely, the psychology of the masses.Figure 1 shows you what this indicatorlooks like plotted together with price.

One important thingto remember whenlooking at this chart isthat the trend, as youdecide to define it, doesnot necessarily have tocoincide with the actu-al trend of the pricechart. For example,according to this indi-cator, the trend for thestock market had beendown since July 1998,although prices havenot fallen that much (if

at all). In this case, however, the OBVindicator tells us the downside volumehas increased while the upside volumehas decreased, making it increasinglydifficult to trade any rallies successfully.(Keep in mind there is nothing to pre-vent you from using several differentstrategies based on several diff e re n ttrend-filters. The main thing is that youstay consistent with your beliefs andtrust in your research.)

Now let’s see how this long-termtrend filter combines with a short-termtrading technique. The rules for enteringthe market, at the close, on the long sidewill be:

Understanding the stats: profit factor and standard deviation

Profit factor simply is the ratio of every dollar gained and every dollar lostby a trading strategy. For example, if you have a strategy that makes twotrades, one a profit of $2 and the other a loss of $1.50, the profit factor

for that strategy is 1.33 (2÷1.5 = 1.33). This means that for a strategy to be prof-itable, it must have a profit factor greater than 1. The higher the profit factor,the greater a strategy’s expected prof-itability.

Standard deviation, on the otherhand, measures the disparity of thetrades a strategy produces — that is,how much they vary from an averagevalue.

For instance, if we calculate theaverage of a random series of values(say, trade results from a particularstrategy) several times, the closereach individual average is to all theothers, the lower the standard devia-tion; and the lower the standard devi-ation, the more secure we can beabout how representative the average is for future samples.

Measuring risk: To use standard deviation as a risk measurement, you simplyanalyze the cumulative trades of a particular strategy. The larger the standarddeviation, the less confidence we can have in projecting the strategy’s resultsforward in time, and the larger risk we take if we go ahead and place a bet onthese results. What we are looking for is a lower standard deviation — more sta-bility, and thus predictability, in our trading approach

Also, if a distribution of trading results is said to be “normally distributed”(remember the bell curve from your old math class?), a one standard deviationcalculation will hold approximately 68 percent of all results. In other words, ifthe average of several samples is 1.21 and the one standard deviation boundarycomes out to 0.11, we can say that we are 68 percent sure the true average forthe whole population of values will be somewhere between 1.10 (1.21 - 0.11)and 1.32 (1.21 + 0.11).

If you are interested in more of the mathematics, check out HyperStat Online(http://davidmlane.com/hyperstat/index.html). It’s an excellent resource forinformation on standard deviation and other statistical concepts.

68%One standard

deviationTwo standard deviations

Mean value

Two standard deviations

THE BELL CURVE


1. The OBV indicator must be above its 200-day moving average.

2. The high of the day must cross above its six-day moving average today.

3. The close must cross above its six-day moving average today.

4. Never enter on the same day as an exit.The exit rules will be:

1 . Stop out immediately if the loss reach-es 1.1 percent.

2. Always lock in a profit of 0.6 percent.3. Exit immediately if the profit reaches

2.8 percent.4. If still in the trade, always exit after

eight days.

(For the short side, simply reverse the ru l e s . )

To test this strategy, we will trade theS&P 500 stock index futures contractwith data covering the period fro mJanuary 1985 to October 1999. No moneywill be deducted for slippage and com-missions. Table 2 shows the results oftrading the S&P 500 with the trend filterand Table 3 (also below) shows theresults without the filter.

As you can see, using the filter pro-vides a great advantage. The averagemove we managed to catch with the fil-ter strategy was 0.27 percent, with theaverage winner being 1.32 percent. Withthe S&Pfutures trading at the 1,360 leveland a point value of $250 (in late January2000), moves like these in today’s marketwould be worth approximately $935(1,360 * $250 * 0.0027) and $4,486 (1,360 *$250 * 0.0132), respectively, per contract.

If you would like to estimate the netaverage profit per trade (after slippageand commissions), simply deduct theappropriate value from the average prof-it figure. For instance, if you believe thecosts come out to approximately $75 percontract traded, the average profit per

trade in today’s market will be approxi-mately $840 (935 - 75). If the market con-tinues higher, this value is likely toincrease; if it starts to decline, so will thevalue of the average trade.

The drawdown (the total loss from anew equity high to an equity low) andcumulative profit numbers assume youwould have been able to reinvest allprofits. In that case the worst drawdownwould have been a mere 9.25 percent,which would equal $31,450 in today’smarket. For the no-filter strategy thesame numbers would have come out to25.49 percent and $86,666, respectively,which is not too good. The percentage ofprofitable trades would have been 58.19percent. However, because we did notdeduct anything for slippage and com-missions, the number in actual trading islikely to be somewhat lower.

Another important thing to re m e m b e ris with less time spent in the market andthe increased security of a filter strategy,you can opt to trade the strategy more

with more contracts (or stocks) per trade,which will add to your bottom line.

Trading should never take place in aninformational vacuum. A s h o r t - t e r mtrader who does not appreciate or under-stand longer-term trading or investinga p p roaches is operating with blinderson. Even if you do not actively tradel o n g e r-term strategies, paying attentionto what these strategies are telling youwill help you make wiser short-termdecisions. Also, short-term traders whoblend longer-term indicators and sys-tems have a distinct advantage over theirone-trick bre t h ren — kind of like a base-ball pitcher who has a wicked curve ballto complement his fastball.

If you have a clear opinion aboutwhere the market is heading in the longrun — and dare to stick to that opinion,no matter what the newspapers and the“gurus” say — you probably will notgain fame and fortune overnight, butyou will gain an advantage that, in thelong run, is hard to beat.Ý

AprJulOct 96 Apr Jul Oct 97 Apr Jul Oct 98 Apr Jul Oct 99 Apr JulCreated with TradeStation 2000i by Omega Research ® 1999

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S&P 500 stock index, continuous futures, daily: The on balance volume (OBV) indicator determining the long-term trend: When the OBV is above its moving average, the trend is up; when the OBV is below its moving average, the trend is down.

FIGURE 1 MEASURING LONG-TERM TREND: ON BALANCE VOLUME

Total trades 177 Winners 103 58.19% Losers 74 41.81% Profit factor 1.56 Lrg. winner 4.04% $13,736 Lrg. loser -3.09% -$10,506 Avg. profit 0.27% $935 Avg. winner 1.32% $4,486 Avg. loser -1.18% -$4,007

Cum profit 59.25% $201,450 Drawdown -9.25% -$31,450

TABLE 2 BASIC S&P 500 STRATEGY, WITH TREND FILTER

Total trades 332 Winners 177 53.31% Losers 155 46.69% Profit factor 1.21 Lrg. winner 4.04% $13,736 Lrg. loser -6.29% -$21,386 Avg. profit 0.12% $423 Avg. winner 1.32% $4,567 Avg. loser -1.27% -44,309

Cum profit 44.68% $151,912 Drawdown -25.49% -$86,666

TABLE 3 BASIC S&P 500 STRATEGY, WITHOUT FILTER


BY TED TESSER

I n 1783, the United States finallywon its independence in a warstarted over unreasonable taxation.The issue at that time was an annu-

al tax of approximately $1.33 per person— a tax rate of less than .03 perc e n t .

Imagine what the Founding Fatherswould say today, when federal, state andlocal income taxes; social security,Medicare and self-employment tax; andexcise, sales and real estate taxes usuallyabsorb more than 60 percent of a taxpay-

er’s income. And if that were not badenough, death is no relief from taxa-tion. When you die, the governmenttakes what they missed while youwere alive: Federal and state estatetaxes can decimate the wealth youhave built up over a lifetime, often esca-lating to another 60 percent tax on whatis left for your heirs.

O b v i o u s l y, taxes still have a gre a timpact on everyone’s life. But nowhere isthe impact greater than on active traders.

One of the biggest reasons for this isthe Tax Reform Act of 1986, whichturned traders and investors into sec-ond-class citizens. Because of this law,taxes are often traders’ and investors’single largest expense — which is saying

something, considering thehigh cost of commissionsand slippage, data feeds,hardware and software, trad-ing advisory services, trad-ing seminars, books andother expenses.

Here is an even more shocking fact:The average trader or investor will paymore in taxes over his or her trading orinvesting career than on all otherexpenses combined.

Yet few traders take the time to incor-porate tax strategies and planning intotheir overall trading plan. They are socaught up in the trading process they failto plan for the tax consequences of what

they are doing. Although traders will routinely tell

you they are shooting for 20- to 30-per-cent average return on their capital, bydisregarding tax issues they are not con-sidering their true return.

After all, it is not just how muchmoney you make trading, but how muchyou keep.

I have always thought there are two tax

systems in this country today — one forthose with businesses and one for thosewithout. Non-business owners are enti-tled to a few itemized deductions, taken“below the line” (as subtractions fromadjusted gross income). In the 1986 taxact, the non-business owner investor gotdoubly whacked: available deductionswere increasingly phased out.

Business owners, by contrast, havealways been given special tre a t m e n t .They get to deduct all kinds of ordinarybusiness expenses — dollar for dollar —“above the line” (to arrive at adjustedgross income). These deductions are fargreater, both in number and amount,

and are taken in a much more advanta-geous place (that is, one that will savemore money) on the tax return.

From a tax vantage perspective thereis now a new breed of investor — the“active trader.” Savvy active traderswho know about their benefits under thetax law can reap all of the advantages ofa business owner. This knowledge canimpact his or her bottom line immensely.

To understand the exact nature ofwhat a trader does, and his or her tax

The Business of TRADING

The average trader or investor

will pay more in taxes over

his or her trading or investing career

than all other expenses combined.

Give me trader status or give me…So, you had a good month? A good year?

If you want to hold on to those profits, you better

start thinking about taxes and why qualifying for

“trader status” may be critical to your bottom line.

advantages, you must first understandthe other types of market players.

The broker-dealer/market maker. Reg.Section 1.471-5 of the tax code defines adealer in securities as “someone whoengages in the purchase of securities forresale to customers, with the intent ofmaking a profit.” The bro k e r-dealer/market maker is a merchant withan established place of business whoregularly engages in this practice. He orshe, therefore, treats securities or com-modities as inventory that is held forsale to his or her customers and is treat-ed as ordinary, not capital, assets. Thisresults in the generation of o r d i n a r yincome or loss, not capital income or loss.

Dealers can deduct, dollar for dollar,any expense they incur in transactingbusiness. Also, the bro k e r- d e a l e r / m a r k e tmaker is not limited to the $3,000 peryear capital loss that restricts other tax-payers (including most traders). This is amajor distinction. In addition, anyincome generated from these assets isc o n s i d e red ordinary with re g a rd to self-employment tax, re t i rement plan contri-butions, self-employed health deductionand, as of 1993, market-to-market con-siderations (Section 475). Finally, bro k e r-dealer/market makers must pay self-employment tax on their trading income.

Investors. An investor, on the otherhand, is clearly defined in the tax codeunder Section 263(a) as a person whobuys or sells securities for his or her ownaccount, as opposed to a dealer whobuys and sells for resale to customers.All expenses of the investing activity areconsidered to be investment expenses,t reated as miscellaneous itemizeddeductions on Schedule A of aninvestor’s tax return and subject to sig-nificant limitations and phase-outs.

All income is considered to be capitalgain income and not subject to self-employment tax, not eligible for re t i re-ment plan contributions (unless stru c-t u red through an entity) or the self-employed health deduction, and, hence,reported on Schedule D. Furthermore, aninvestor is always limited to a $3,000 peryear net capital loss deduction, whichcan be carried forward for his or her life-

time (or even carried back for thre eyears, in the case of Section 1256 transac-tions — commodities, futures and certaintypes of index or futures options).

Traders constitute a hybrid category.There is no election on the tax return youcan make to indicate you are a trader.But the cases decided over the past 65years in the Supreme Court and variousdistrict tax courts have recognized thishybrid category and have establishedthat traders are investors who engage inthe purchase and sale of securities fortheir own accounts. However, they do soat such a high level of activity that itbecomes a business to them.

There are no objective requirements inthe tax code to qualify a person as a trad-er and, until the Taxpayer Relief Act of1997, the distinction was bare l yacknowledged in the tax code. It wasagreed that a trader was someone whotrades in stock, securities, futures con-tracts or options on a relatively short-term and active basis, but this classifica-tion was purely subjective.

Now, in paragraph 341 of the 1997 taxact, Congress has distinguished a traderfrom a broker-dealer/market maker asfollows:

“Traders are taxpayers who are in thebusiness of actively buying, selling orexchanging securities or commoditiesin the market. On the other hand,dealers deal directly with customerswhen they regularly buy or sell secu -rities in the course of their busi -ness…”Further, on December 17, 1997, the

Joint Committee on Taxation issued itsreport (a.k.a. the Blue Book), to explainthe new tax law. Page 180 of this report,Title X, Section A (financial products),sub-section 1001(b), states:

“Traders in securities generally aretaxpayers who engage in a trade orbusiness involving active sales orexchanges of securities on the marketrather than to customers . . .”This section was codified into law in

1998.

It is obvious these definitions are, at best,vague. What Congress has done is alludeto, but not strictly define, the status of

GLOSSARYCapital income or loss:Any income or loss gener-ated from the sale of acapital (investment) asset.

Ordinary income or loss:Any income or loss notgenerated from the sale ofcapital assets or passiveactivities.

Schedule A:The schedule to reportitemized deductions,Schedule A is used by anytaxpayer not taking thestandard deduction. Thisschedule is where investorsmust deduct their invest -ment expenses.

Schedule C:The schedule for reportingprofit and expenses fromrunning a business. This isthe schedule traders use todeduct their tradingexpenses.

Schedule D:The schedule for reportingthe sale of a capital assetand reporting a capitalgain or loss. This scheduleis where (non-Section 475electing) traders andinvestors must report theirincome or loss. The capitalloss is limited to a maxi-mum net of $3,000 in anyone year. Traders whoelect Section 475 canreport more than $3,000net loss in any one year,and can report income andloss on schedule C.

It is not just how much money you make trading, but how much you keep.



“ t r a d e r.” It is the court cases thro u g h o u thistory that have really defined whatdetermines trader status and what distin-guishes a trader from an investor.

From my 25 years of experience in thisfield and through filing thousands oftrader tax returns, I can boil down thedistinguishing characteristics of a traderas being someone who:

• trades on a frequent, regular and

continuous basis (i.e., an active trader).• has a substantial number of trades.• trades short-term.• spends a substantial amount of

time trading.• has a small percentage of income

derived from dividends.• takes theseexpenses on a Schedule C.• has an office — either home or oth-

erwise.Again, we are still in murky waters.

What this does not tell you is how “fre-quent, regular and continuous” tradingmust be, how many trades constitute a“substantial number,” how short is“short-term” and so on. For theseanswers we still have to look at the courtcases that have indicated, but notunequivocally stated, in their ru l i n g s

that the seven listed characteristics of atrader are necessary.

They also tell you trading expensesmust be on a Schedule C. Although theydo not discount a home office, they dorequire an office to exist. In fact, part ofthe provisions of the new tax act has lib-eralized the deduction of a home office.

While the definition of a trader is stillunavoidably ambiguous, the tax benefits of

acquiring trader status are very tangible.

Here is a brief summary of the majoradvantages a trader has over an investor.1. Expenses are not subject to the 2- to 5-

percent floor that investment expens-es are subject to on Schedule A. Theyare deducted on Schedule C, dollar fordollar.

2. Itemized deductions are not even nec-essary to deduct trading expenses. Atrader can take a standard deductionand still deduct trading expenses (inaddition) on Schedule C.

3. Investment seminars, which weredetermined as non-deductible toinvestors in the 1986 tax act, are nowconsidered trading seminars and are

fully deductible.4. Investment interest expense, which

was severely limited under the 1986 tax act, is now considered to be trad-ing interest (a normal businessexpense) and is 100 perc e n tdeductible.

5. Section 179 depreciation (the ability to write off a business asset all in oneyear instead of depreciating it overmany years), which is unavailable toinvestors, is now available to traders.

6 . The home office expense, which cannot be deducted by investors, now becomes deductible and, in fact, becomes one of the criteria for establishing trader status.

7. As of 1997, a “Section 475” electioncan be made on a trader’s tax return. This enables traders to deduct trading losses in excess of $3,000 in any oneyear. This is one benefit that must notbe overlooked, as it often results in a much more advantageous tax position for the trader knowledgeable enough to know about the election, knowledgeable enough to make it correctly and knowledgeable enough to make it on a timely basis. Constraints on this election were recently enacted by an IRS Revenue Pro c e d u re issued in March of last year (Rev. Proc. 99-17). While the rules and criteria for qualify-

ing as a trader are still relatively subjective,

it is crucial to understand the tax implica-tions of your trading. In short, with pro p-er tax planning, the distinction of active“trader” can be the diff e rence between get-ting wealthy or just getting by.

In next month’s column, we will gointo more detail on the criteria for traderstatus and the advantages the activetrader has over the investor and the bro-k e r-dealer/market maker. In futurecolumns, we will explore the advantagesof the latest twist in the tax code, the sec-tion 475 election — how to make it,when to make it, when not to make itand why it is significant.

Note: For a free “trader status” evaluationquestionnaire, and free information on mak -ing the election, e-mail [email protected].

Ý

Calling yourself a trader or an investor is more than just a matter of words. When it comes to taxes, the distinction can seriously impact your bottom line.Traders Investors Can qualify as a business Cannot qualify as business Expenses do not need to exceed Expenses must exceed 2 to 5 percent 2 to 5 percent of adjusted gross of adjusted gross income to be income to be deducted on Schedule A, deducted on Schedule A.but can be deducted dollar for dollar on Schedule C. Itemized deductions not necessary All income is considered capital gain to deduct trading expenses. A trader income, not subject to self-employ-can take a standard deduction and ment tax, not eligible for retirement still deduct trading expenses on plan contributions or self-employed Schedule C. Income is not subject to health deductions and is reported on self-employment tax, not eligible for Schedule D.retirement plan contributions (unless structured through an entity)or self-employed health deductions,except for floor traders. “Section 475” election can allow Limited to $3,000 per year net capital traders to deduct trading losses loss deductionin excess of $3,000 in any one year.

Savvy active traders who know about their benefitsunder the tax law can reap all of the benefits of a business owner.

STATUS SYMBOL: TRADERS VS. INVESTORS


Test period: Oct. 9, 1990 to Oct. 27, 1999.

Test data: daily S&P 500 stock index futures prices; $50deducted for commissions and slippage per contract traded.

Starting equity: $100,000 (nominal).

System drawbacks: Prolonged consolidation periods resultin too few maximum-profit trades. Breakouts against thetrade may drastically increase slippage in less liquid mar-kets. Too many bad signals during deep retracements, fol-lowing prolonged explosive moves.

Buy-and-hold stats: Total return — 267 percent; Max DD — 22 percent; Longest flat period — 12 months.

While there is not much of a difference on the surfacebetween buy-and-hold and the Gold Digger system, buy-and-hold is always risking 100 percent of equity, spending100 percent of the time in the market. Gold Digger only risks3 percent of your equity on each trade, and is in the marketless than 50 percent of the time. (Note also that commissionsand rollover costs have not been deducted for the buy-and-hold strategy.)

The Trading System Lab is intended for educational purposes only,to provide a perspective on different market concepts. It is notmeant to recommend or promote any trading system or approach.Traders are advised to do their own research and testing to deter -mine the validity of a trading idea. Past performance does notguarantee future results; historical testing may not reflect a sys -tem’s behavior in real-time trading.

Market: Stocks, stock indices, index share instru-ments (SPDRs, DIAs, QQQs).

Rules: Go long if the market closes down twodays in a row in the same week (following adown week), except if this coincides with themarket setting a new 60-day low (which suggestsa possible downside breakout). Reverse the rulesfor the short side.

Exits: Stop out immediately if the market movesagainst you 1.1 percent; lock in a profit after amove of 0.6 percent or more in your favor; exitimmediately if market moves 2.8 percent in yourfavor. Exit any open positions after eight days.

The TRADING System Lab

Glossary

Total (%): Total percentage return over test period

Year (%): Annualized avg. return per year

P Factor: Profit factor = gross profit/gross loss

No. trades: Number of trades

Avg. trade: Dollar amount of average trade

Tr/mark /year: Trades per market per year

Tr/month: Trades per month

Max DD (%): Maximum drawdown (equity loss)

Lrg. Loss: Biggest losing trade

Winners (%): Percentage of winning trades

Longest flat (m): Longest period spent between two equity highs, in months

TIM (%): Amount of time system is in the market

Avg Days: Average trade length


Profitability Trade statistics

End Equity ($): 374,383 No. Trades: 474

Total (%): 274 Avg. Trade ($): 610

Year (%): 14.42 Tr/Mark/Year: 48.4

P factor: 1.23 Tr/Month: 4.0

Risk measurers Time statistics

Max DD (%): -29.61 Longest Flat (m): 14.33

Lrg. Loss ($): -58,448 TIM (%): 47.63

Winners (%): 55.91 Avg. Days: 5.00

SYSTEM SUMMARY


EQUITY CURVE

1/9/90 1/8/91 1/7/92 1/5/93 1/4/93 1/3/95 1/2/96 12/31/96 12/30/97 12/29/98

450,000

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250,000

200,000

150,000

100,000

50,000

0

Time

Gold Digger system

APRIL 2000 ISSUE 2 3 Contributors 4 6 9 Trading Pure Price ...forex-warez.com/Trading Books/Magazine...

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Transcript of APRIL 2000 ISSUE 2 3 Contributors 4 6 9 Trading Pure Price ...forex-warez.com/Trading Books/Magazine...