ets. The other half acts asa reserve during periods of adversity and drawdown. If, forexample, the size of the account is $100,000, only $50,000would be available for trading purposes.396 Chapter 16
2. Total commitment in any one market should be limited to 10-15% of total equity. Therefore, in a $100,000 account, only$10,000 to $15,000 would be available for margin depositin any one market. This should prevent the trader fromplacing too much capital in any one trade.
3. The total amount risked in any one market should be limited to5% of total equity. This 5% refers to how much the trader iswilling to lose if the trade doesn’t work. This is an impor-tant consideration in deciding how many contracts to tradeand how far away a protective stop should be placed. A$100,000 account, therefore, should not risk more than$5,000 on a single trade.
4. Total margin in any market group should be limited to 20-25%of total equity. The purpose of this criteria is to protectagainst getting too heavily involved in any one marketgroup. Markets within groups tend to move together. Goldand silver are part of the precious metals group and usual-ly trend in the same direction. Putting on full positions ineach market in the same group would frustrate the princi-ple of diversification. Market commitments in the samegroup should be controlled.
These guidelines are fairly standard in the futures industry,but can be modified to the trader’s needs. Some traders are moreaggressive than others and take bigger positions. Others are moreconservative. The important consideration is that some form ofdiversification be employed that allows for preservation of capitaland some measure of protection during losing periods. (Althoughthese guidelines relate to futures trading, the general principles ofmoney management and asset allocation can be applied to allforms of investing.)
Diversification Versus Concentration
While diversification is one way to limit risk exposure, it can beoverdone. If a trader has trading commitments in too many mar-kets at the same time, a few profitable trades may be diluted by alarger number of losing trades. A tradeoff exists and the properMoney Management and Trading Tactics 397
balance must be found. Some successful traders concentrate theirtrading in a handful of markets. That's fine as long as those mar-kets are the ones that are trending at that time. The more nega-tive correlation between the markets, the more diversification isachieved. Holding long positions in four foreign currency marketsat the same time would not be a good example of diversification,since foreign currencies usually trend in the same directionagainst the U.S. dollar.
Using Protective Stops
I strongly recommend the use of protective stops. Stop placement,however, is an art. The trader must combine technical factors onthe price chart with money management considerations. We’llshow how this is done later in the chapter in the section on tac-tics. The trader must consider the volatility of the market. Themore volatile the market is, the looser the stop that must beemployed. Here again, a tradeoff exists. The trader wants the pro-tective stop to be close enough so that losing trades are as smallas possible. Protective stops placed too close, however, may resultin unwanted liquidation on short term market swings (or“noise”). Protective stops placed too far away may avoid the noisefactor, but will result in larger losses. The trick is to find the rightmiddle ground.
REWARD TO RISK RATIOS
The best futures traders make money on only 40% of their trades.That’s right. Most trades wind up being losers. How then dotraders make money if they’re wrong most of the time? Becausefutures contracts require so little margin, even a slight move inthe wrong direction results in forced liquidation. Therefore, itmay be necessary for a trader to probe a market several timesbefore catching the move he or she is looking for.
This brings us to the question of reward-to-risk ratios.Because most trades are losers, the only way to come out ahead isto ensure that the dollar amount of the winning trades is greater398 Chapter 16
 
than that of the losing trades. To accomplish this, most traders usea reward-to-risk ratio. For each potential trade, a profit objective isdetermined. That profit objective (the reward) is then balancedagainst the potential loss if the trade goes wrong (the risk). A com-monly used yardstick is a 3 to 1 reward-to-risk ratio. The profitpotential must be at least three times the possible loss if a trade isto be considered.
“Letting profits run and cutting losses short” is one of theoldest maxims of trading. Large profits in trading are achieved bystaying with persistent trends. Because only a relative handful oftrades during the course of a year will generate large profits, it’snecessary to maximize those few big winners. Letting profits runis the way that is done. The other side of the coin is to keep los-ing trades as small as possible. You’d be surprised how manytraders do just the opposite.
TRADING MULTIPLE POSITIONS:TRENDING VERSUSTRADING UNITS
Letting profits run isn’t as easy as it sounds. Picture a situationwhere a market starts to trend, producing large profits in a rela-tively short period of time. Suddenly, the trend stalls, the oscilla-tors show an overbought situation and there’s some resistance vis-ible on the chart. What to do? You believe the market has muchhigher potential, but you’re worried about losing your paper prof-its if the market should fail. Do you take profits or ride out a pos-sible correction?
One way to resolve that problem is to always trade in mul-tiple units. Those units can be divided into trading and trendingpositions. The trending portion of the position is held for the longpull. Loose protective stops are employed and the market is givenplenty of room to consolidate or correct itself. These are the posi-tions that produce the largest profits in the long run.
The trading portion of the portfolio is earmarked for short-er term in-and-out trading. If the market reaches a first objective,Money Management and Trading Tactics 399
is near resistance and overbought, some profits could be taken ora tight protective stop utilized. The purpose is to lock up or pro-tect profits. If the trend then resumes, any liquidated positionscan be reinstated. It’s best to avoid trading only one unit at a time.The increased flexibility that is achieved from trading multipleunits makes a big difference in overall trading results.
WHAT TO DO AFTER PERIODS OFSUCCESS AND ADVERSITY
What does a trader do after a losing or a winning streak? Supposeyour trading equity is down by 50%. Do you change your style oftrading? If you’ve already lost half of your money, you now haveto double what you have remaining just to get back to where youwere in the first place. Do you get more selective choosing trades,or keep doing the same things you were doing before? If youbecome more conservative, it will be that much harder to winback your losses.
A more pleasant dilemma occurs after a winning streak.What do you do with your winnings? Suppose you’ve doubledyour money. One alternative is to put your money to maximumuse by doubling the size of your positions. If you do that, howev-er, what will happen during the inevitable losing period that’ssure to follow? Instead of giving back 50% of your winnings,you'll wind up giving it all back. So the answers to these two ques-tions aren’t as simple or obvious as they might first appear.
Every trader’s track record is a series of peaks and troughs,much like a price chart. The trend of the equity chart should bepointing upward if the trader is making money on balance. Theworst time to increase the size of one’s commitments is after awinning streak. That’s much like buying into an overbought mar-ket in an uptrend. The wiser thing to do (which goes againstbasic human nature) is to begin increasing one’s commitmentsafter a dip in equity. This increases the odds that the heaviercommitments will be made near the equity troughs instead ofthe peaks.400 Chapter 16
 
TRADING TACTICS
Upon completion of the market analysis, the trader should knowwhether he or she wants to buy or sell the market. By this time,money management considerations should have dictated thelevel of involvement. The final step is the actual purchase or sale.This can be the most difficult part of the process. The final deci-sion as to how and where to enter the market is based on a com-bination of technical factors, money management parameters,and the type of trading order to employ. Let’s consider them inthat order.
Using Technical Analysis in Timing
There’s nothing really new in applying the technical principlesdiscussed in previous chapters to the timing process. The onlyreal difference is that timing covers the very short term. The timeframe that concerns us here is measured in days, hours, and min-utes as opposed to weeks and months. But the technical toolsemployed remain the same. Rather than going through all of thetechnical methods again, we’ll limit our discussion to some gen-eral concepts.
. Tactics on breakouts
. The breaking of trendlines
. The use of support and resistance
. The use of percentage retracements. The use of gaps
A mk WN
Tactics on Breakouts: Anticipationor Reaction?
The trader is forever faced with the dilemma of taking a positionin anticipation of a breakout, taking a position on the breakoutitself, or waiting for the pullback or reaction after the breakoutoccurs. There are arguments in favor of each approach or allthree combined. If the trader is trading several units, one unitcan be taken in each instance. If the position is taken in antici-Money Management and Trading Tactics 401
 
pation of an upside breakout, the payoff is a better (lower) priceif the anticipated breakout takes place. The odds of making abad trade, however, are increased. Waiting for the actual break-out increases the odds of success, but the penalty is a later(higher) entry price. Waiting for the pullback after the breakoutis a sensible compromise, providing the pullback occurs.Unfortunately, many dynamic markets (usually the most prof-itable ones) don’t always give the patient trader a secondchance. The risk involved in waiting for the pullback is theincreased chance of missing the market.
This situation is an example of how trading multiple posi-tions simplifies the dilemma. The trader could take a small posi-tion in anticipation of the breakout, buy some more on the break-out, and add a little more on the corrective dip following thebreakout.
The Breaking of Trendlines
This is one of the most useful early entry or exit signals. If thetrader is looking to enter a new position on a technical sign of atrend change or a reason to exit an old position, the breaking ofa tight trendline is often an excellent action signal. Other techni-cal factors must, of course, always be considered. Trendlines canalso be used for entry points when they act as support or resis-tance. Buying against a major up trendline or selling against adown trendline can be an effective timing strategy.
Using Support and Resistance
Support and resistance are the most effective chart tools to use forentry and exit points. The breaking of resistance can be a signalfor a new long position. Protective stops can then be placed underthe nearest support point. A closer protective stop could be placedjust below the actual breakout point, which should now functionas support. Rallies to resistance in a downtrend or declines to sup-port in an uptrend can be used to initiate new positions or add toold profitable ones. For purposes of placing protective stops, sup-port and resistance levels are most valuable.402 Chapter 16
Using Percentage Retracements
In an uptrend, pullbacks that retrace 40-60% of the prior advancecan be utilized for new or additional long positions. Because we’retalking primarily about timing, percentage retracements can beapplied to very short term action. A 40% pullback after a bullishbreakout, for example, might provide an excellent buying point.Bounces of 40-60% usually provide excellent shorting opportuni-ties in downtrends. Percentage retracements can be used on intra-day charts also.
Using Price Gaps
Price gaps on bar charts can be used effectively in the timing ofpurchases or sales. After an upmove, for example, underlyinggaps usually function as support levels. Buy a dip to the upperend of the gap or a dip into the gap itself. A protective stop canbe placed below the gap. In a bear move, sell a rally to the lowerend of the gap or into the gap itself. A protective stop can be keptover the gap.
Combining Technical Concepts
The most effective way to use these technical concepts is to com-bine them. Remember that when we're discussing timing, thebasic decision to buy or sell has already been made. All we’redoing here is fine tuning the entry or exit point. If a buy signalhas been given, the trader wants to get the best price possible.Suppose prices dip into the 40-60% buying zone, show a promi-nent support level in that zone, and/or have a potential supportgap. Suppose further that a significant up trendline is nearby.
All of these factors used together would improve the tim-ing of the trade. The idea is to buy near support, but to exitquickly if that support is broken. Violation of a tight downtrendline drawn above the highs of a downside reaction couldalso be used as a buying signal. During a bounce in a down-trend, the breaking of a tight up trendline could be a shortingopportunity.Money Management and Trading Tactics 403
COMBINING TECHNICAL FACTORSAND MONEY MANAGEMENT
Besides using chart points, money management guidelines shouldplay a role in how protective stops are set. Assuming an accountsize of $100,000, and using the 10% criteria for maximum com-mitment, only $10,000 is available for the trade. The maximumtisk is 5%, or $5,000. Therefore, protective stops on the total posi-tion must be placed in such a way that no more than $5,000would be lost if the trade doesn’t work.
A closer protective stop would permit the taking of largerpositions. A looser stop would reduce the size of the position.Some traders use only money management factors in determin-ing where to place a protective stop. It’s critically important,however, that the protective stop be placed over a valid resis-tance point for a short position or below a valid support pointfor a long position. The use of intraday charts can be especiallyeffective in finding closer support or resistance levels that havesome validity.
TYPES OF TRADING ORDERS
Choosing the right type of trading order is a necessary ingredientin the tactical process. We’ll concern ourselves only with some ofthe more common types of orders: market, limit, stop, stop limit,and market-if-touched (M.I.T.).
1. The market order simply instructs your broker to buy or sellat the current market price. This is usually preferable in fastmarket conditions or when the trader wants to ensure thata position is taken and to protect against missing a poten-tially dynamic market move.
2. The limit order specifies a price that the trader is willing topay or accept. A buy limit order is placed below the currentmarket price and states the highest price the trader is will-ing to pay for a purchase. A sell limit order is placed over thecurrent market price and is the lowest price the seller is404
Chapter 16
willing to accept. This type of resting order is used, forexample, after a bullish breakout when the buyer wants tobuy a downside reaction closer to support.
. A stop order can be used to establish a new position, limit a
loss on an existing position, or protect a profit. A stop orderspecifies a price at which an order is to be executed. A buystop is placed over the market and a sell stop under the mar-ket (which is the opposite of the limit order). Once the stopprice is hit, the order becomes a market order and is exe-cuted at the best price possible. On a long position, a sellstop is placed below the market to limit a loss. After themarket moves higher, the stop can be raised to protect theprofit (a trailing stop). A buy stop could be placed aboveresistance to initiate a long position on a bullish breakout.Since the stop order becomes a market order, the actual“fill” price may be beyond the stop price, especially in a fastmarket.
. A stop limit order combines both a stop and a limit order.
This type of order specifies both a stop price where thetrade is activated and a limit price. Once the stop is elected,the order becomes a limit order. This type of order is usefulwhen the trader wants to buy or sell a breakout, but wantsto control the price paid or received.
. The market-if-touched (M.L.T.) order is similar to a limit
order, except that it becomes a market order when thelimit price is touched. An M.LT. order to buy would beplaced under the market like a limit order. When the limitprice is hit, the trade is made at the market. This type oftrade has one major advantage over the limit order. Thebuy limit order placed under the market does not guaran-tee a fill even if the limit price is touched. Prices maybounce sharply from the limit price, leaving the orderunfilled. An M.I.T. order is most useful when the traderwants to buy the dip, but doesn’t want to risk missing themarket after the limit price is hit.Money Management and Trading Tactics 405
Each of these orders is appropriate at certain times. Eachhas its own strong and weak points. Market orders guarantee aposition, but may result in “chasing” the market. Limit ordersprovide more control and better prices, but risk missing themarket. Stop limit orders also risk missing the market if pricesgap beyond the limit price. Stop prices are strongly recom-mended to limit losses and protect profits. However, the use ofa buy or sell stop to initiate new positions may result in badfills. The market-if-touched order is particularly useful, but isnot allowed on some exchanges. Familiarize yourself with thedifferent types of orders and learn their strengths and weak-nesses. Each of them has a place in your trading plan. Be sureto find out which types of orders are permitted on the variousfinancial exchanges.
FROM DAILY CHARTS TOINTRADAY PRICE CHARTS
Because timing deals with very short term market action, intradayprice charts are especially useful. Intraday charts are indispensablefor day trading purposes, although that’s not our focus here. We'remainly interested in how intraday activity can be used to aid thetrader in the timing of purchases and sales once the basic decisionto enter or exit a market has been made.
It bears repeating that the trading process must beginwith a long range view and then gradually work toward theshorter term. Analysis begins with monthly and weekly chartsfor long term perspective. Then the daily chart is consulted,which is the basis for the actual trading decision. The intradaychart is the last one viewed for even greater precision. The longterm chart gives a telescopic view of a market. The intradaychart allows more microscopic study. The technical principlesalready discussed are clearly visible on these very sensitivecharts. (See Figures 16.1-16.3.) 
03/10/98 3:10pm (SP H8) 03/12/98 12:30p1S&P 500 Futures
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hy! i 5 Minute Bar Chart '
 
 
 
 
 
 
 
Figure 16.1. A 5 minute bar chart of an S&P 500 futures contract showinga day and a half of trading. The last five stochastic signals (see arrows) workedpretty well. Intraday charts are used for very short term trading purposes.
 
fp2re4i98 12:50pm (US H8)Treasury Bond Futures
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10 Minute Bar Chart
 
 
 
Stochastics (14-Bar)400 228 "9:50 99:00 92:10 "4:20
 
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Figure 16.2 A 10 minute bar chart of a Treasury Bond futures contractshowing three days of trading. The last two stochastic signals show a selljust after 10:10 on the morning of 2/26 and then a buy signal the followingmorning around the same time.Money Management and Trading Tactics 407
 
fo2/13/98 41:20am (DM H8) 03/02/98 10:20an|
 
Deutsche Mark Futures | | |
|
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60 Minute Bar Chart
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Figure 16.3 A one hour bar chart of a Deutschemark futures contractshowing ten trading days. Three stochastic signals are shown (see arrows). Abuy signal on 2/17 turned to a sell on 2/24 and then another buy on 2/26.
THE USE OF INTRADAYPIVOT POINTS
In order to achieve earlier entry with even tighter protective stops,some traders try to anticipate where a market will close by the useof pivot points. This technique combines seven key price levelswith four time periods. The seven pivot points are the previousday’s high, low, and close and the current day’s open, high, low,and close. The four time periods are applied to the current tradingday. They are the open, 30 minutes after the open, midday (about12:30 New York time), and 35 minutes before the close.
These are average times and can be adjusted to the indi-vidual markets. The idea is to use pivot points only as a timingdevice when the trader believes a market is topping or bottoming.Buy or sell signals are given as the pivot points are broken duringthe day. The later in the day the signal is given, the stronger it is.408 Chapter 16
As an illustration of a buy signal, if the market opens above theprevious day’s close, but is below the previous day’s high, a buystop is placed above the previous day’s high. If the buy stop iselected, a protective sell stop is placed below the current day’s low.At 35 minutes before the close, if no position has been taken, abuy stop is placed above the current day’s high, with a protectivestop under today’s open. No action is generally taken during thefirst 30 minutes of trading. As the day progresses, the pivot pointsare narrowed as are the protective stops. As a final requirement ona buy signal, prices must close above both the previous day’s clos-ing price and today’s opening price.
SUMMARY OF MONEYMANAGEMENT ANDTRADING GUIDELINES
The following list pulls together most of the more important ele-ments of money management and trading.
ry
. Trade in the direction of the intermediate trend.
. In uptrends, buy the dips; in downtrends, sell bounces.. Let profits run, cut losses short.
. Use protective stops to limit losses.
. Don’t trade impulsively; have a plan.
. Plan your work and work your plan.
. Use money management principles.
. Diversify, but don’t overdo it.
. Employ at least a 3 to 1 reward-to-risk ratio.
. When pyramiding (adding positions), follow these guide-lines.
a. Each successive layer should be smaller than before.b. Add only to winning positions.
c. Never add to a losing position.
d. Adjust protective stops to the breakeven point.
11. Never meet a margin call; don’t throw good money afterbad.
TOAN AA fLwWN
=Money Management and Trading Tactics 409
12. Close out losing positions before the winning ones.
13. Except for very short term trading, make decisions awayfrom the market, preferably when the markets are closed.
14. Work from the long term to the short term.
15. Use intraday charts to fine-tune entry and exit.
16. Master interday trading before trying intraday trading.
17. Try to ignore conventional wisdom; don’t take anythingsaid in the financial media too seriously.
18. Learn to be comfortable being in the minority. If you’reright on the market, most people will disagree with you.
19. Technical analysis is a skill that improves with experienceand study. Always be a student and keep learning.
20. Keep it simple; more complicated isn’t always better.
APPLICATION TO STOCKS
The trading tactics that we’ve covered in this chapter (and theanalytical tools in preceding chapters) also apply to the stockmarket, with some minor adjustments. While futures tradersfocus on short to intermediate trends, stock investors are moreconcerned with intermediate to longer term trends. Stock trad-ing places less emphasis on the very short term and makes lessuse of intraday charts. But the general principles remain thesame for analyzing and trading markets—whether they’re inthe futures pits of Chicago or on the floor of the New YorkStock Exchange.
ASSET ALLOCATION
The money management guidelines presented in this chapterrefer mainly to futures trading. However, many of the princi-ples included in that discussion relate to the need for properdiversification in one’s investment portfolio and touches onthe subject of asset allocation. Asset allocation refers to how aperson’s portfolio is divided among stocks, bonds, and cash410 Chapter 16
 
(usually in the form of a money market fund or Treasury Bills).It can also refer to how much of one’s portfolio should be allo-cated to foreign markets. Asset allocation also refers to howone’s stockholdings are spread among the various market sec-tors and industry groups. And, more recently, it deals with howmuch of one’s portfolio should be allocated to traditional com-modity markets.
MANAGED ACCOUNTS ANDMUTUAL FUNDS
Managed accounts have been available in the futures markets forseveral years and have provided a vehicle for those wishing to putsome money into futures but lacked the expertise to do so them-selves. Managed accounts have provided a sort of mutual fundapproach to futures. Even though managed futures accountsinvest in all futures markets—including currencies, commodities,bonds, and stock index futures—they still provide some measureof diversification from bonds and stocks. Part of the diversifica-tion is due to their practice of trading from both the long and theshort side. Another part comes from the commodity portionitself. However, the ability to devote some of one’s assets to com-modities was made even easier during 1997.
Oppenheimer Real Assets, launched in March 1997, is thefirst mutual fund devoted exclusively to commodity investing. Byinvesting in commodity-linked notes, the fund is able to fashiona commodity portfolio that tracks the Goldman SachsCommodity Index, which includes 22 commodity markets. Sincecommodities often trend in opposite directions to bonds andstocks, they provide an excellent diversification vehicle. Properdiversification requires spreading one’s assets among marketgroups or classes that have a low correlation to each other—inother words, they don’t always trend in the same direction.Commodities certainly fit that criteria.
We point these things out for two reasons. One is to showthat the areas of money management and asset allocation are verymuch intertwined. The second is to show that the markets them-Money Management and Trading Tactics 411
selves are very much intertwined. In the next two chapters, you'llsee how closely linked the futures and stock markets really are,and why it’s important that stock investors keep informed ofwhat’s going on in the futures markets. Chapter 17 will introduceyou to intermarket technical analysis.
MARKET PROFILE
We couldn’t leave the subject of intraday charts without introduc-ing one of the most innovative approaches to intraday tradingcalled Market Profile. This trading technique was developed by J.Peter Steidlmayer, a former floor trader on the Chicago Board ofTrade. Mr. Steidlmayer’s approach has gained an enthusiastic fol-lowing over the past decade, especially in the futures markets.Market Profile can, however, be applied to common stocks as well.It’s not an easy approach to grasp. But those traders that have doneso give it very high marks. Dennis Hynes, an expert in MarketProfile trading, explains the approach in Appendix B.  
Stocks and Futures:Intermarket Analysis
   
When the first edition of this book was published in 1986 the sep-aration of the commodity futures world from the more tradition-al world of stocks and bonds was already starting to break down.Twenty years ago, commodities referred to such things as corn,soybeans, porkbellies, gold, and oil. These were traditional com-modities that could be grown, mined, or refined. Dramaticchanges took place from 1972 to 1982 with the introduction offutures contracts on currencies, Treasury Bonds, and stock indexfutures. The term “commodities” gave way to “futures” sincebonds and stocks were hardly commodities. But they were futurescontracts. Since then, the world of futures trading has blendedwith that of traditional stocks and bonds to the point that theycan hardly be separated. As a result, the technical analysis meth-ods used to analyze the different financial markets have becomemore universally applied.
413414 Chapter 17
On any given day, quotes are readily available for dollarfutures, bond futures, and stock index futures—and they oftenmove in sync with one another. The direction those three marketsmove is often affected by what happens in the commodity pits.Program trading, which occurs when the price of the S&P 500futures contract is out of line with the S&P 500 cash index, is aday-to-day reality. For those reasons, it seems clear that the moreunderstanding you have about the world of futures trading, themore insight you will gain into the entire financial marketplace.
It has become clear that action in the futures markets canhave an important influence on the stock market itself. Early warn-ings signs of inflation and interest rate trends are usually spottedin the futures pits first, which often determine the direction stockprices will take at any given time. Trends in the dollar tell us a lotabout the strength or weakness of the American economy, whichalso has a major impact on corporate earnings and the valuationof stock prices. But the linkage goes even deeper than that. Thestock market is divided into sectors and industry groups. Rotationinto and out of those groups is often dictated by action in futures.With the tremendous growth in mutual funds, and sector funds inparticular, the ability to capitalize on sector rotation into winninggroups and out of losing ones has become much simpler.
In this chapter, we’ll deal with the broader subject of inter-market analysis as it deals with the interplay between currencies,commodities, bonds, and stocks. Our primary message is howclosely the four markets are linked. We’ll show how to use thefutures markets in the process of sector and industry group rota-tion within the stock market itself.
INTERMARKET ANALYSIS
In 1991, I wrote a book entitled Intermarket Technical Analysis.That book described the interrelationships between the variousfinancial markets, which are universally accepted today. The bookprovided a guide, or blueprint, to help explain the sequence thatdevelops among the various markets and to show how interde-pendent they really are.