term trading does not provide asgood a learning experience as shorter-term swing trading.Question 67—Wider StopsFind the correct statement about using wider stops:1. A major uptrend is less volatile than a minor one.2. The wider the stop, the greater the risk of a whipsaw.3. A stop belongs outside of the zone of the normal chop of prices.4. The wider the stop, the larger position you can carry.Answer: 3Prices meander, and the more time they have, the wider their swing.The tighter the stop, the greater the risk of a whipsaw. The whole pointof using wider stops is to put them outside the zone of the normal chopof prices. The downside of using a wider stop is that by acceptinggreater risk per share you reduce the size of the position you can carry.Question 68—Moving StopsWhich of the following statements about moving stops is incorrect?1. You may move stops only in the direction of the trade but neveragainst it.2. When you switch to a trailing stop after the prices reach their targetyou increase your risk.3. When prices hang just above your stop, it makes sense to lower itto reduce the risk of a whipsaw.4. When prices move in your favor, it makes sense to raise your stopto protect a part of your paper profit.Answer: 3
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No matter how strong the temptation to make your stop wider, youmust stick with your original decision. If prices move your way, you maywell adjust your stop to protect a part of your paper profit. If prices reachyour target but you want to stay in the trade, you may switch to a trailing stop; reaching for a greater profit means accepting the risk of givingback some of the existing profit if the trend reverses on you.Question 69—The SafeZone StopsFind the correct statement about the SafeZone stop:1. It acts as a filter that suppresses the signal of the trend.2. Noise is any part of today’s range that protrudes outside of the previous day’s range.3. SafeZone tracks Average Upside Penetration in uptrends and AverageDownside Penetration in downtrends.4. SafeZone works best during trends and worst during trading ranges.Answer: 4The purpose of SafeZone is to suppress noise so that the signal of thetrend can come through. The noise is that part of the day’s range whichprotrudes outside of yesterday’s range but only in the direction opposite to the trend. For example, when the trend is up, upside penetrations are normal, while downside penetrations are considered noise. Whenthe trend is down, downside penetrations are normal while upside penetrations are considered noise. SafeZone tracks Average Downside Penetrations during uptrends and Average Upside Penetrations in downtrendsand sets up stops outside of the noise level. Like many other methods,it works best during trends but leads to whipsaws during trading ranges.Question 70—Trading with the SafeZoneWhich of the following statements about SafeZone stops is incorrect?1. SafeZone is a mechanical trading system.2. You have to establish the lookback period for the SafeZone.3. You need to choose the coefficient by which to multiply the normalnoise to obtain the SafeZone stop.4. Usually, a coefficient between two and three provides a margin ofsafety.
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Answer: 1To use SafeZone one must establish its lookback period and the coefficient by which to multiply the normal noise to obtain the SafeZonestop. Setting that coefficient must be done individually for every market—hardly a mechanical approach to trading.Question 71—The Volatility-Drop MethodWhich of the following statements about the Volatility-Drop method isincorrect?1. A Volatility-Drop ensures getting greater profit from every trade.2. This methods allows a trader to start out with a modest target, butreach out for more while in the trade.3. Using a Volatility-Drop stop involves risking some of the paper profit.4. Using this method helps automate profit-taking decisions.Answer: 1Kerry Lovvorn, the author of this method, says “I do not think ofusing a trailing stop until my target is hit. At that time the trade has fulfilled its duty, but the market may be moving in a way that seems tohave potential for an additional reward.” The Volatility-Drop methodputs some of the existing profit at risk to squeeze more money out ofthe trade but it does not guarantee that every trade will become moreprofitable as a result.Question 72—“Engine Noise” in the MarketsSelling “engine noise” refers to selling when:1. Your target is reached.2. Your stop is hit.3. You want to take partial profits.4. You do not like how the market is acting.Answer: 4
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A discretionary trader does not have to hold every trade to itsplanned target. Perhaps the market wants to give you less than you initially expected. If you see signals of the trend weakening, it could bea wise decision to sell sooner than originally planned.Question 73—Selling “Engine Noise”Which statement about selling “engine noise” is incorrect?1. A system trader may not sell “engine noise.”2. A discretionary trader may exit the market sooner or later thanplanned.3. Selling “engine noise” is especially well suited for beginning traders.4. Selling “engine noise” carries a risk of cutting profits.Answer: 3While selling at profit targets or using protective stops works fortraders at all levels of expertise, selling in response to “engine noise”requires a much greater level of experience. There is a very real riskthat a trader, especially an inexperienced one, will sell too soon out ofboredom or anxiety.Question 74—Not Liking Market’s ActionYou are holding a long position but do not like the toppy signals ofindicators. Which statement about the courses of action open to you isincorrect?1. If you are a system trader, you must hold your position as planned.2. If you are a discretionary trader, you may sell your position.3. If you are a system trader, you may switch to a different system thatallows an earlier exit.4. If you are a discretionary trader, you may take partial profits butretain the core position.Answer: 3
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A system must be followed. Using your discretion to change to a different system in the middle of a trade means that you are no longer asystem trader. Exiting a trade or reducing its size in response to “enginenoise” is the privilege and the responsibility of a discretionary trader. Asystem trader may anticipate some of the “noises” and incorporate theminto his system—but not change that system while in an open trade.Question 75—Earnings ReportsWhich statement about the impact of earnings reports is incorrect?1. Prices are largely driven by the anticipation of future earnings.2. An earnings report never changes a long-term stock trend.3. Earnings reports rarely come as a surprise to professional watchers.4. Insider trading is usually linked to the way a company is managed.Answer: 2When we buy a stock we are paying for future earnings and dividends. Insiders have the best knowledge of those factors and many ofthem profit from it. Stocks seldom jump on earnings reports becausesmart bulls have already bought or clever bears have already sold. Still,the stock of an honestly run company can change its trend followinga surprising earnings report.Question 76—The Market “Rings a Bell”The market “rings a bell” when:1. It makes a multiyear high.2. It falls to a multiyear low.3. An event occurs far outside the norm for this market.4. The market flashes a signal anyone can recognize.
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Answer: 3You hear the market bell when you recognize an event so far outside the norm that it may seem as if the laws of the market have beencancelled. In fact the laws of the market cannot go away, any morethan the law of gravity can. An extraordinary event is a sign of a bubble ready to burst. This behavior is very clear only in retrospect, butduring the bubble it seems perfectly normal; only a cool and objectivetrader can hear this bell.Question 77—Trading with the New High–New Low IndexWhich statement about the New High–New Low Index (NH-NL) isincorrect?1. When NH-NL is above zero it shows that bulls are stronger than bears.2. New Highs are the leaders in weakness and New Lows are the leaders in strength.3. Bearish divergences are commonly seen near the ends of bull markets.4. A severe downspike of weekly NH-NL usually signals a marketbottom.Answer: 2New Highs are the leaders in strength—they are the stocks that havereached their highest point for the past 52 weeks on any given day.New Lows are the leaders in weakness—the stocks that have reachedtheir lowest point for the past 52 weeks on that day. Tops and bottomsin the stock market tend to be asymmetrical. Tops are formed moreslowly and often show bearish divergences of NH-NL. Bottoms areformed faster and often marked by panicky downspikes of NH-NL aslosers dump their shares on the market, creating an opportunity forsavvy bulls.
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Question 78—A Decision-Making Tree vs. a Trading SystemThe key difference between a decision-making tree and a trading system is that only one of them includes:1. The rules for entering a trade2. The rules for exiting a trade3. The permission to bend your exit rules4. The parameters for trade sizingAnswer: 3A good trading system is totally objective—if you give it to two different traders, both should come up with the same entries, exits, andtrade sizes. The decision-making tree of a discretionary trader alsoaddresses entries, exits, and trade sizing, but it permits some flexibilityin applying those rules.Question 79—A Decision-Making TreeWhich of the following questions does not belong in a decisionmaking tree:1. Is this a short-term or a long-term trade?2. Where will you place your stop?3. What kind of “engine noise” will you listen to while in a trade?4. What kind of record-keeping will you perform for a trade?Answer: 4Good record-keeping is extremely important—it is the foundation ofsuccessful trading. The records of a serious trader must address theissues of record-keeping, choice of software, and psychology. Decisionmaking trees are built on this foundation but deal with specific tradingissues, such as entries, exits, and position sizing.
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Question 80—Value Buying and Selling Targets
CA
B
D
Figure 2.80
Please identify value buying zones and selling targets among the letterpoints on this chart:1. Value buying zones2. Selling targets in overvalued zonesAnswer: 1.2.
B and DA and C
In a steady uptrend, it pays to go long near value, as defined bymoving averages, and take profits in the overvalued zone, above theupper channel line. Note that markets have quite a bit of noise, andthe best signals are clearly visible only in retrospect. For example, afterbuying at point D, prices never reached the upper channel line andeventually slid lower. People who seek perfection feel overwhelmedby such turns, while mature traders protect themselves with goodmoney management and charge ahead.
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Question 81—Support, Resistance, and Targets
ED
A
B
C
Figure 2.81
Please match the following descriptions with the letters on the chart.1. Line of support broken2. Prices close above support, giving a signal to buy3. Support established4. Second seling target at the upper channel line5. First selling target at the EMAAnswer: 1. B
2. C
3. A
4. E
5. D
A false downside breakout, accompanied by a bullish divergence isone of the strongest signals in technical analysis. Once prices breakbelow an important support line, you need to watch very closely whathappens next: Will the decline accelerate or will the break fizzle out?When a price bar closes above the previously broken line of supportit gives a powerful buy signal. Here this signal was reinforced by abullish divergence of MACD-Histogram. Notice the pullback to supportbetween points D and E, which provided an excellent opportunity tohop aboard the long trade. You cannot count on such pullbacks happening very often; they are an exception rather than the rule.
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Question 82—Multiple Targets
ABCD1
Figure 2.82
Please match the following descriptions with the letters on this monthlychart:1. The minimal price target2. Support3. The bull market targetAnswer: 1. B
2. D
3. A
Line D identifies the zone of major support, the floor of a viciousbear market. Near the right edge of the chart prices broke below support but then, instead of falling any lower, reversed and closed abovesupport. A false downside breakout, coupled with a bullish divergenceof MACD, provided a major buy signal. Since we are looking at amonthly chart, it is reasonable to expect a major move—the longer thetimeframe, the greater the forecast. If we expect a new bull market tobegin, then line C, drawn across the top of the most recent rally, is noteven a target—it is too close. Line B, drawn across the top of the previous major rally, provides a minimal measurement for the upmove.Line A, drawn across the bottom area of the all-time top, provides amore reasonable target for the bullish move, although reaching thatheight will require patience. The stock eventually exceeded its previous peak, rising to a new all-time high.
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Question 83—Holding, Adding, or Profit-Taking
A
B Zone togo long
Figure 2.83
At point A′ the stock declined to 58.78. At point B′ it fell to 58.71 butrecoiled from its new low. This false downside breakout was accompanied by bullish divergences in several indicators. If a trader wentlong with a target near the upper channel line, which of the followingactions are legitimate at the right edge of this chart?A. Sell and take profits.B. Sell half, hold half.C. Continue to hold, tighten the stop.D. Add to the winning position.1. A2. A or B3. A, B, or C4. All of the aboveAnswer: 3A false downside breakout, coupled with a series of bullish divergencesprovides a powerful buy signal. A system trader or a beginning discretionary trader must take profits at the target, in this case the upper channel line. A more experienced discretionary trader is allowed to hold outfor more, depending on his judgment. It would make no sense for avalue trader to add to his position near the upper channel line, in theovervalued zone.
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Question 84—Handling a Profitable TradeDB
EA
C
Figure 2.84
A trader recognizes an uptrend and starts buying the stock near value,selling near the upper channel line. He goes long at point A and sellsat B, long at point C and sells at D, long again at point E. When pricesgap above the upper channel line he decides to hold for a greater gain.What is the wise course of action at the right edge of this chart?1. Sell and take profits.2. Sell half the position.3. Hold the position.4. Add to the position.Answer: 1When a rally goes vertical, it is extremely difficult to forecast where itwill end. At the rightmost bar on the chart we see that, for the first timesince the stock blew through its upper channel line, it failed to reach anew high. This reduction of momentum flashes a signal to take yourmoney and go home. Additional support for this decision is provided byMACD-Histogram which has reached a level consistent with tops. Also,you can see here that the tall peaks of Force Index are usually followedby a period of flat prices rather than a continuation of an uptrend.
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Question 85—Placing a Stop
Low29.50
Low29.34
Low29.99
Figure 2.85
A trader recognizes a bullish divergence accompanied by a false downside breakout. He decides to go long, but needs to place a stop. Atwhich of the following levels would he be advised to place it?1. 29.492. 29.333. 29.344. 29.985. 28.99Answer: 3A stop needs to be placed fairly close to prices, but not so close asto get into the zone of normal market noise; 29.34 marks the lowestpoint of the latest downmove. Putting a stop at this level tells the market to “put up or shut up”—a strong buy signal should lead to a quickrally; if the signal fails, there is no reason to give that stock extra time.Putting the stop a penny lower, at 29.33 would risk slippage—once thebottom tick is taken out, prices tend to go flying, leading to gaps andslippage. Placing the stop below the low of the last trading day in sucha flat market would mean getting into the zone of normal market noise.
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Question 86—The Decision at the Right Edge of the ChartB
CA
Figure 2.86
A trader recognizes an uptrend and goes long at point A. He sells atpoint B, after prices blow out of their channel but then fail to make anew high. He buys again at point C, after prices decline below valueand stop making new lows. What would be the reasonable course ofaction at the right edge of this chart?1. Continue to hold.2. Add to long position.3. Sell.Answer: 3At the right edge of the chart the trade continues on track, showinga small profit. There are, however, disturbing technical signs. The primary sign of danger for the bulls is a severe bearish divergence ofMACD-Histogram. At point A, the indicator rallied in gear with price,confirming the upmove. At point B prices returned to the top area, butthe indicator barely rose above the zero line, pointing to a severeweakness of the bulls. This kind of “engine noise” coming from themarket provides a signal that the uptrend is weak and it is better to getout of a long trade.
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GRADING YOUR ANSWERS
If a question requires only one answer, you earn a point by answeringit correctly. If a question requires several answers (for example, “Whichtwo of the following four statements are correct?”), rate your answerproportionately. If you answer both correctly, give yourself a point, butif only one, then half a point.43–50: Excellent. You have a good grasp of selling. Now is the timeto turn your attention to selling short.35–42: Fairly good. Successful trading demands top performance.Look up the answers to the questions you’ve missed, review them, andretake the test in a few days before moving on to the next section.Below 35: Alarm! Not being able to perform in the top third may beacceptable in many professional fields, but not in trading. The competition is just too intense to accept this result. Before you go into themarkets, you must bring yourself up to speed. Please study the secondsection of Sell and Sell Short and retake the test. If your grade remainslow on the second pass, look up the books recommended in that section and study them before retaking the test.
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T H R E E
HOW TO SELL SHORT
Question 87—Shorting a StockSelling a stock short means:1. Selling an overvalued stock from your portfolio2. Selling a borrowed stock3. Selling a stock in a severe downtrend4. Selling a stock you expect to be delistedAnswer: 2There are many reasons to sell a stock—you may think that it isovervalued or about to decline. While these reasons can apply to anystock, there is only one way to sell a stock short—by borrowing itsshares. People who sell short reverse the standard process of buyingfirst and selling later. Shorts begin by selling borrowed shares in orderto buy them back later. This allows them to profit from stock declinesrather than rallies.Question 88—Risk Factors in ShortingThe major risk factors in selling short include all of the following,except:1. A stock might rally.2. A stock might issue a dividend.3. A stock might be called back by the owner.4. A stock might crash.113
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Answer: 4A crash is profitable for shorts, whereas a rally leads to a loss. If thecompany whose stock a trader sold short declares a dividend, it goesto the person who bought that stock. Now the short-seller must reimburse the owner, whose shares he borrowed, for the cost of that dividend. If the owner decides to sell his stock and the broker cannot findanother owner willing to lend his stock to a short-seller, that shortseller will be forced to cover earlier than planned in order to return theborrowed shares.Question 89—The Impact of ShortingPeople who sell stocks short help create a more orderly marketthrough all of the following, except:1. Dampening price increases2. Cushioning price declines3. Increasing price swings4. Dampening volatilityAnswer: 3Short-sellers sell into rallies, increasing supply when prices are high.They cover during price breaks, thus cushioning them. By tradingagainst the crowd, which is almost uniformly long, short-sellers helpdampen excessive price swings.Question 90—Short vs. LongThe main advantage of shorting over buying is that:1. Tops are easier to recognize than bottoms.2. Stocks fall faster than they rise.3. It is easier to sell into a rally than buy into a decline.4. Stocks rise faster than they fall.
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Answer: 2The great advantage of selling stocks short is that they tend to godown about twice as fast as they rise. This applies to all timeframes—to monthly, weekly, daily, as well as intraday charts. It takes buying toput the stocks up but they can fall under their own weight. Nothing isreally “easy” in the markets, whether selling tops or buying bottoms.Question 91—Disadvantages of ShortingThe greatest disadvantage in shorting stocks is that the stock market:1. Keeps fluctuating2. Has relatively slow rises and fast declines3. Rises over time4. Has an uptick ruleAnswer: 3The one great disadvantage of shorting stocks is that the broad stockmarket has a centuries-old tendency to rise over time. The estimatesvary, but an average 3% rise per year above the rate of inflation seemslike a reasonable estimate. This means that in shorting you are swimming against a gently rising tide. To deal with this, you want to bemore short-term oriented in shorting than in buying. The uptick rule isno longer in effect in the United States.Question 92—Learning to Sell ShortWhich statement about learning to sell short is incorrect?1. Find a stock you’d hate to own.2. Trade a large size to make the experience worthwhile.3. Avoid shorting stocks making new highs.4. Look for expensive stocks.Answer: 2
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When learning to short, think of the stocks you expect to decline andzero in on those you would hate to own. If it makes sense to buy lowand sell high, then more expensive stocks are likely to produce goodshorting candidates. When you go long, it is not a good idea to buy astock that keeps making new lows. Similarly, when you want to goshort it is not a good idea to sell a stock that keeps making new highs.Trade size serves as a huge emotional amplifier—the bigger the size, thegreater the stress. Make your first baby steps while trading a size sosmall that neither gain nor loss will matter much at all—this will allowyou to focus on quality.Question 93—Shorting vs. BuyingFind the correct statement among the following comparisons of buyingand shorting:1. Tops take longer to form than bottoms.2. Stock bottoms are built on hope and greed.3. Precise timing is more important in buying than shorting.4. Fear is the dominant emotion of stock tops.Answer: 1Stock market bottoms tend to be narrow and sharp, while the topstend to be broad and uneven. Stock market bottoms are built on fear,a sharp and powerful emotion. Tops are built on greed, a happy emotion that can last a long time. Since the declines tend to occur fasterthan rallies, precise timing is more important in shorting.Question 94—Shorting Stock Market TopsWhich statement about shorting stock market tops is incorrect?1. Stops need to be placed relatively farther away, due to high volatility.2. Wider stops require larger positions.3. There is nothing wrong with trying to re-enter a trade after gettingstopped out.4. Trading positions smaller than the maximum allowed by moneymanagement rules increase holding power.
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Answer: 2When prices are boiling near the top, you can expect high volatilityand wide price swings. As a result, stops are hard to place. The widerthe stops, the greater your risk per share. As the risk per shareincreases, the size of the position must be reduced. It is not uncommon to take several stabs at shorting a top before catching a big break.Reducing the size of your position below the maximum dictated bymoney management rules increases your holding power.Question 95—Shorting in DowntrendsFind the correct statement regarding shorting in downtrends:1. Shorting in the middle of a channel means shorting above value.2. Covering near the lower channel line means buying below value.3. There is only one good shorting opportunity within a channel.4. Grading your trades by the percentage of a channel does not workfor shorting.Answer: 2In the middle of a channel prices are near value. The time to covershorts and take profits is when prices fall to the undervalued zone nearthe lower channel line. Channels often provide multiple trading opportunities, as prices keep rising to value only to collapse below valueagain and again. Grading swing trades by the percentage of a channelcaptured in that trade works equally well for longs and shorts.Question 96—The Tactics of Shorting DowntrendsFind the incorrect statement about shorting in downtrends:1. Make a strategic decision on the weekly chart, make tactical planson the daily.2. Shorting within a channel lowers both the risk and the potentialrewards.3. Shorting within a channel increases the risk of a whipsaw.4. A single short within a channel will not catch a major move.
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Answer: 3The risk of a whipsaw is the greatest when trying to short a markettop. Shorting within a channel reduces the risk of a whipsaw. Nothingis free in the markets, and one pays for reduced risk by a corresponding reduction in potential profits—those are greater when shortingtops and relatively smaller in downtrends.Question 97—Shorting the FundamentalsFind the correct statement about shorting on the basis of fundamentalinformation:1. A fundamental analyst can cover more markets than a technician.2. One can use technical studies as an idea generator and fundamentals as a trigger.3. Fundamental information overrides technical factors.4. The most powerful situation exists when the fundamentals suggesta trade and technical factors confirm that signal.Answer: 4Fundamental analysis is narrower than technical analysis because ofthe economic differences between various markets; a technician canapply his tools across the board. Fundamental ideas must be verifiedwith technical analysis. No matter how good a fundamental story, if thetechnical factors do not confirm it, there is no trade. When both pointin the same direction, they create a very powerful combination.Question 98—Looking for Shorting CandidatesWhich of the following is not a valid method of looking for shortingcandidates?1. Looking at the weakest stock industry groups2. Listening to rumors and tips, then checking them using your analytic method3. Looking for the weakest stocks among the Nasdaq 1004. Selling short stocks that are being upgraded by major analysts
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Answer: 4There are just as many methods of looking for shorting as for buying candidates. The key principle is to verify any idea using your ownmethod or system. You may do something as labor-intensive as diggingthrough industry groups or the 100 biggest stocks on the Nasdaq; alternatively, you may do something as simple as listening to tips, rumors,or downgrade news. Anything can provide grist for the mill—as longas you test all tips and ideas using your