reality. So it is with us. I know. I've spent the last 2-3 years carefully recordingconversations with losers and winners getting inside their heads to discover not only trading styles, but alsotheir beliefs. You have read about some of the traders I modeled in books and magazines. Some of thewinners are more private. But, what a discovery! There are major difference in how winners and losers playthe game.Perhaps my most fascinating discovery was that there are also major similarities between these sets oftrader. Let's look at them first.What They Share in Common ...Both winners and losers were found to be consumed by the idea of trading. It is their life. Winner or loser, it istheir passion, and they are extremists. The biggest loser I know plays with the same intensity and energy asany of the winners. So, scratch off desire or motivation as the ingredient that makes the difference.
231Another commonality I uncovered was that both camps had few close same-sex friends. The men had, atmost, one strong male buddy, ditto the women. Win or lose, it looks like passionate commodity traders are notgreat social mixers.The point of being extremists that I touched on earlier permeates their lives. Both groups seemed to go toextreme lifestyles and beliefs. They see the world as black and white in most categories with very few grays. Iassume this is what gets the losers in so much trouble ... they absolutely commit to trading, but since they aredoing the wrong thing to begin with, their disasters have been pretty big-or steady.And Their DifferencesFirst, let's look at the losers. This is what I found they share in common:Most of all them are into the idea of turning $10,000 into $1,000,000, the quicker the better. Quick andsubstantial profits are a goal. All had internal dialogue "chatter" with themselves about their trades frombefore entering a position to days after exiting!All losers spoke of having anxiety pushing them into a trade. They could not refrain from taking a trade ...sitting on the sidelines with no position is apparently unbearable for these people. They are happier when theyare in a trade, win or lose, than not being in a trade. They seemed addicted to having the rush of tradingpumping thorough their blood stream.Two other common points revolve around trading decisions and money management. Losers pay littleattention to money management. One boldly told me, "This game is not about money management it is aboutbeing right and wrong." I also observed few of them would stomach a look at their equity ... their accountbalance. They were amazed someone actually looked at it daily as they did not see what that had to do withgetting into winning positions.Finally, they all asked me if I knew of anyone that really made a living at this. They seemed veryuncertain that anyone could. They lacked the belief ... even face of the evidence from countless fund managers... that profits are made rather consistently.Now for the WinnersWhere do I begin this? My surprise was that the winning traders asked me as many questions as I askedthem! The losers asked very few questions. None of the winners traded options. They all had a form of moneymanagement and were all technical traders. To a man and woman, they could all recount one big loss thatseems embedded in their mind that they will not let happen again ... ever. So, they use stops and speak of"kicking out trades just because they weren't doing anything. Thus, there is little internal "chatter" withthemselves about their trades.
232A big difference is that winners fix their attention on a very small number of key "favorite" markets.One winner has only traded Soybeans-nothing elsesince 1956. The losers seemed to change markets, andgurus or newsletters about as often as I get slippage. While the winners do (or buy) a lot of research whichthey study the losers seemed to be looking for a personality to bail them out or make their money.All the winners totally believe they will make money and simply refuse to let bad things happen to them.They have an aura of protection around them, they just don't do dumb things in the market. They are amazedmore people don't do what they do, they realize it has lots of pressure, but believe anyone of reasonableintellect can do what they do.
Chapter 15
Just What Does Makethe Stock Market Rally?
Charts don't move the markets. The markets move the charts.
I will answer that question. But first let me say- that it is impossible to know at all times why the marketdoes what it does. Unlike other aspects of our lives and occupations, the market deals us unstable data. Dayafter day-.Some say astrology, is what really moves prices. Could be. Last week. every commodity on the boardwas down, but Why. should that be- It is, not intellectually feasible to have Gold and the Bonds down at thesame time or the meats and the grains. Yet it happens. Time after time, I have seen this phenomena.Others say trend or speed resistance lines are what moves the market. The Gann crowd has their angles,origin points, and so on; now I for one don't believe in them. Yet time after time I have seen markets top thebottom right where these electric tools said they- would.Then, of course, there are fundamentals. Sometimes bullish news“makes" the market rally; just as often, though, the market declines following positive news and ralliesafter bad news'It is no wonder that no one I have known in my vears of trading has, consistently predicted what themarket would do. Invariably-, the hottest most brilliant hands turn cold. I do not accept that this is a case of233
234"them" getting "us." It is a case of dealing with unstable data.Fortunately though, we can make money trading as there are a few indices, patterns, and techniques thatwill make money Not always,One of the better of these is the powerful impact that interest rates have on stock prices. This is not a newconclusion. In my 1969 book, The Secret of Selecting Stocks, I discussed Will Go, and index I created backthen to give an idea of future stock trends based on yields (yields are impacted by interest rates).An easier way of looking at the problem is to monitor the price of Treasury Bonds against the S&P 500..Not only is it easier, but thanks to the computer we can see what, if any, relationship exists between thesemarkets.
Logic 101I had a great logic professor at the University of Oregon, Albury Castell. Many of you used his books inyour logic and ethics classes. His class was the most stimulating one I took, outside my major, in four years ofcollege. Looking back on it, I would also say it has been the most useful in life after college.Have you ever thought about how much "stuff" we teach kids, or had taught us, that we never, ever use'All that math, and 90 percent of us actually only use about 10 percent of it. When's the last time you squared acircle or cuddled up with a copy of Beowulf? Or forgot and ended a sentence with a preposition? I suspect allthis forced feeding of education is why we are not very "street smart" and fall prey to well-argued fallaciousarguments and have been easily misled by market gurus.
These Words Are My BondBack to Logic 101. One of the first rules of logic is that you cannot predict A with A. Yet day after day,we market analysts use price to predict price. Oh, we might cover it up and say we are predicting price with anoscillator or a moving average, or trendline. But the simple truth is we are using tools created from price topredict price. Dr. Castell. would flunk 90 percent of technicians.Here is something really wild ... the tabulation displayed in Figure 15.1 showing $141,792.50 profitsfrom trading the S&P 500 was accomplished without ever once using the price of the S&P! These buy signalswere given in a fashion that said when conditions A in data A happens then and only then buy long in data B,the S&P. Given the average profit per trade of $1,750, which is 2.20 times greater than the average loss and a
235drawdown of less than 13 percent of monies earned, I think it is safe to conclude that data A is highlypredictive of data B.
Figure 15.1 S&P 500 buy signals based exclusively on bonds.
A Look at Data A and Data BThese results were attained by buying the S&P 500 (market on close) any day that the Bond marketclosed higher than the highest high of the last 14 days.The trade was exited in one of two fashions; either a trailing stop of the lowest low of the last 17 days-inBonds-or a 3,000 stop from the point of entry.Thus, when Bonds break out of a 14-day channel, buy the S&P, exit at a dollar loss or a 17-day channelbreakdown in Bonds. Here is an even more important point ... channel breakouts in the S&P make for verypoor systems. Yet, channel breakouts in Bonds obviously have a strong impact on stock prices.Now here is what is really fascinating. A 14-day breakout of S&P prices on their own produces amiserable track record. In fact, there is little to offer a trader taking channel breakouts in this market. The"best" numbers are between a 15- and 20-day break. But even then, while money is made, the drawdown isinsufferable and most the profit comes from one large winning trade.
236
237On the other hand, it does not matter too much which channel breakout you use in Bonds to trigger anS&P entry ... they all make money. Most rather nicely.As an example, I offer the tabulations in Figure 15.2, the result of using a 14-day Bond market breakoutfor your entry and exiting at the lowest low of the last 12 days in the S&P. We will use the Bonds to get uslong and protect ourselves with S&P price data.Finally, those of you who have gone to my seminar will find that very short-term Bond channel breakouts(in conjunction with what we know as 1/1 bailout) produce outstanding results. In the last year, somethinglike 42 out of 49 trades were winners with an average profit per trade of $527. Figure 15.2A shows thistechnique. While the profits are less at $88,055, you may be attracted to the high accuracy at 82 percent.
Let's Break Some Bad HabitsThree things lead to the demise of commodity traders: a bad system, no money management, and ... badhabits.Bad habits-no, that's not the name of a rock group your kids listen to (it would probably sell a lot ofrecords though). What do I mean by bad habits? Well on analysis, it breaks down into two areas.The first area includes the bad habits you already know about. On the West Coast, the lackadaisicalattitude we sometimes assume can mean not going to bed early enough to be alert at 5: 10 A.M.-every singleday of the year. On the East Coast, it may mean putting off your morning work until just before the openingbell.Worse yet, we may not maintain our health and balance with the noncommodity world, the one we live inwith our families and friends. But those bad habits are the ones we know of, deal with, and fight with all thetime in our total sense of living as well.The second area involves the real bad habits. In the business of trading, these are the habits, we havelearned thinking they are right (or good habits) when nothing could be further from the truth.Bad habits ingrained in this fashion become operating rules that are the very building blocks for what wethink is success, but since the foundation is wrong we can never create profits. Aynn Rand was right: alwayscheck Your premise.The most common bad habit I have seen in traders-good and bad ones-is the inability to react correctly tomarket action. There is nothing outside market action, other than what we ascribe to it ... that's the rub. Whenyou input something "overlaid" on the market action, you are telling the market instead of listening.
238The most common form of doing this is a very bad habit-you want to sell strength. Or, just as bad onceyou see a very strong market-say limit up-that little voice inside your head tells you to await a pullback-not tochase this move and that it must come back.In short, it scares the hell out of you to buy new highs, sell new lows.
How to Break Bad HabitsI know of only two ways to break bad habits. The first is to repeat, time and again, the correct action tobuild up a Pavlovian response that brings about the right action.The other way is to have an intellectual understanding that the bad habit is wrong and replace the"knowledge" with correct data ... the truth. So here are two doses of market truths.
Truth 1Buy when a market closes on or near its high; sell when a market closes on or near its low (limit up/downmoves see a continuation of surge).Yes, I know, it is really tough-intellectually and emotionally-to buy or sell up or down limit moves. Butthe truth is lots of money can be made in so doing. Here, let me show you: I went into System Writer andasked a simple question, "If price today closed in the upper 65% of the day's range, what would happen if Ibought on that close and exited 5, 10, 15, and 20 days later?" The results are shown in Figure 15.3. With astop for protection, this information is powerful. In all markets, this basic strategy made money as thefollowing table depicts.Even more staggering is that, as explained in an article I wrote for Futures magazine a year ago oncandlestick charts, I took the "most bullish" candlestick formations and exited in the fashion described here.In the test,
Figure 15.3 Buy S&P 500 market on close if close is above 65% of range for the day.
239none of the patterns worked across all markets. Yet, here, one simple pattern, produces profits on allfronts? Egad.... buying incredibly strong markets is a good habit.This is strange stuff. In our guts, we want to sell these strong days and buy the weak ones. You got it, weall like a discount. But, in this business of trading, discount leads to bankruptcy.If any one good habit separates the pros I know from the public, it is their willingness to buy strength.Bill Meehan first tried to break me of my bad habit of buying pullbacks many years ago, and I can vouch itdoes not take a person that long to unlearn. Fix into your mind that strength is power and a market needspower to continue its trend.To further get this point through our thick skulls, I will add that the best "chartist" buy signal I know ofis when the price literally goes off the top of your chart, so you have to add chart paper. That is the ultimatebuy.
Truth 2Buy new higbs/sell new lows.If I had to guess, my guess would be that more money has been made by buying new highs and sellingnew lows than with any other techniques known to traders. The converse is equally true; more has been lost(forever and ever) selling new highs, buying new lows.Usually we see a new high and-if not long-decide to bypass the trade or await a pullback. That is wrong,real wrong as the following study reveals. This study only bought breakouts to new X day highs! It, thecomputer, did what the public and poorly "trained" trader can never do.This truth is confirmed by the computer. The next set of data in Figure 15.4 shows what happens iftoday's high is less than the highest high of the last X days and price makes a new high tomorrow, which putsus long buying a new X day high.
Figure 15.4 Buy a S&P 500 breakout of the highest high last x daysexit 13 days later $3,500 stop.
240Again, we exit some days later. A $3,500 stop was used. We are chasing strength to buy. Buying newhighs is a successful strategy. The preceding is not a system, rather an illustration to drive home theimportance of letting strength lead the way. Most traders are frightened or intimidated by excessive strength.Thus they do not buy, or worse yet, sell short.As it has been said, the race or the fight, may not always go to the biggest, the fastest, or the toughest.But, my friend, that is the way to bet.
Comments on Setting Stops-Dollar Loss and UnpredictabilityThere are only two givens to this business, first, you must control loss; second, price is highlyunpredictable. The goal of system development is to create the ultimate money-making machine that, like anoil well, just keeps pumping out profits. Although you may never attain that goal, you can acquire an amazingamount of insight into correct trading from system development.
What Is the Purpose of a Stop?Correct stop placement provides an example of what system development has taught us. We use stops forone and only one reason-to protect us when our system fails. Systems fail all the time; if that potential liabilitydid not exist, stops would not be needed. Stops are our defensive shield and what they protect us from is theunpredictability of (1) our system and (2) the market itself.The game of trading involves so much unpredictable behavior that stops can hurt you, if they are tooclose. Indeed, the closer your stop, the more times "they will have gunned for you," the more you will bestopped out, and the more paranoid you will become. Since no trader I have met can predict down to a gnat'seyelash (due to all the random activity of price), our stops must be beyond-or past-random fluctuations. Theymust be far enough away that if they are hit it will be because of real-not random-activity. That is Lesson 1.
Now Comes RealityHere's the next important thing about stops: since their purpose is to defend against ruin, they need to alsobe based on money management principles. As an example, here is the same S&P 500 Day Trading systembut with three different stops.
241Figure 15.5 uses a $500 stop, then a $1,500 stop and finally a $6,000 stop. There are some hugedifferences here we need to explore. Keep in mind this is the exact same system, all that's changed is theamount of risk we are willing to accept as determined by the stop.
Figure 15.5 S&P system with $500 stop.With a $500 stop the system actually loses money, $41,750 to be specific! Our accuracy at 2 6 percent onthe 510 trades suggests this is certainly not a very good system.Or is it? The next tabulation shown in Figure 15.6 reflects the same system, that is the exact same buyand sell entry rules, but uses a stop loss of $1,500. What a difference the stop makes! The accuracy screamsup to 56 percent and we turn a losing system into a winner taking profits from a negative $41,750 to a positive$116,880, close to a $160,000 change. Gee whillikers, could there be something to this stop loss stuff afterall?Our next test of the system is to use a $5,000 stop. Does this improve the performance? Well, yes and no.It does make more money netting $269,525 and the accuracy gets boosted up to 70 percent. But we pay for it.Notice in Figure 15.7 how the largest losing trade gets bumped up to $5,920 as opposed to $2,045 with a$1,500 stop. Worse yet, the average losing trade was $1,263 with a $1,500 stop and rises to $1,661 as the risk
242amount increases while the average winning trade at a $1,500 stop is $1,371 and only increases to $1,477 asthe stop backs off.
Figure 15.7 Same S&P system with $6,000 stop.
243The problem is that when you get tagged with the larger stop you can drop too much of your bankroll,$6,045, on just one trade. This is a critical point. If you don't want to risk more than 5 percent of your accounton any one trade on a $100,000 account you can trade only one contract with the $6,000 stop, while the$1,500 stop allows you to trade two contracts which effectively doubles the profits on your $100,000 account.This may not sound like much but when you use my money management formula the results are dramaticallydifferent.The lesson you have learned, I hope, is that dollar stops are far more effective than the whirling dervishesof technical analysis.
Chapter 16
Closing Comments
I have shared a lot of my life with you in these pages and most all of U-hat little I know about themarkets. And, while this book is my gospel of trading. it should not be your gospel. You need to implementwhat I have that works for you, twist it around, come up with better ideas and new approaches, but thebasis I have presented here is sound, workable trading material.In this chapter, I wrap this all up with some comments on how to use my material, or anyone else's:This is not a black-and-white business."But you said ... Page 63 says to ... This line crossed that one ... lt*s trading day of the month 11,shouldn't 1 . . . " Those are typical comments I hear every day from readers of my books and illustrate animportant part about being a winning trader.It Is just Like LifeNot only is this business not black and White, neither is life. We all know that (I think), yet astraders we want absolutes so badly that we absolutely forget to think. For example, math is an absolute, butwhen applied to the imperfect world of stocks and commodities, it reverts to being a tool that simply gives
245
246more clarity and definition to the imperfections. Please, never forget that above all else, speculation is athinking business. If you are not good at thinking, or at least at getting correct answers, I suggest that youlook for the off ramps.This problem begins with a wish or hope that there is some be-all automatic/systematic approach totrading. The two greatest bits of bad information so-called advisers and authors such as myself foist on thegreat unwashed masses is either extreme and continual bearishness, or the belief that somewhere, someplace,there exists an absolutely perfect system-that there is precise cadence, order, and structure to the markets.These are the two great myths of speculation.Yes, there are times to be bearish on stock and the economy, but there's an entire camp of newsletterwriters making a pretty good living by deliberately pandering to fears of gloom and doom, of another 1929... starting tomorrow. I know these folks; I have appeared at the same symposiums with them, and I haveseen them consistently bearish, in one case, since 1962, One of these "Negative Nellies," in a privateconversation told me there was a huge market of investors who feared the future, actually believed thingswere falling apart quickly and it was his business to flame these fires. He added, "It's easier to sellsubscriptions to these people, they are an easy-to-target market, and if I'm wrong on stock picks, it doesn'tmatter, performance does not count, it's reaffirming their belief that they want to hear."This crowd is full of pontificators, good people who have overanalyzed everything and concluded thefuture for the United States, and the world, is behind us. And yet, even the most cursory study of history willestablish one dominant fact; our condition and lot in life is constantly getting better. Yes, there are somedowns, but they are far outweighed by the ups.There is another side to this coin, the "cosmic trader" who is convinced there is an explanation forevery market high and low, that every up-and-down tick in price is fully explainable, and usually for a prettystiff fee payable up front to them! When I was young and ignorant of the ways of the market, and my fellowtraders, I fell for this pitch. After all, these people had a track record of success and could explain away allthe market moves that had taken place in the past.Usually the foundation for this belief is based on the legend of W.D. Gann, I have already written aboutthe "legend" and that it was just a good dose of showmanship mixed with some winning trades, a bit abraggadocio and an aggressive public relations man. Again this is not my opinion, but facts as related to meby F.B. Thatcher, the advance man for old W.D.The more time I spent in outer space with this crowd, the more losing trades I saw. Although theirexplanations of the past were brilliant, their forecasts of the future were right about one time out of twentyand, naturally. that's the one they talk (brag) about in all their advertisements. There is no
247reality here; the fact they were dead wrong in the past did not prevent or harness them from againattempting to predict the future! Accuracy, making money, has nothing to do with their life-it is all about"proving" their mumbo-jumbo works. I have been on the speaking circuit with these folks as well, andhave come to have little respect for this crowd, with some exceptions.Of the thousands of traders applying this cosmic logic, I have only seen two do well, Arch Crawfordand Jerry Favors. Two out of thousands is not a great batting average. In addition, Arch and Jerry are notonly exceptionally smart people, but well-trained, experienced traders who use more than just oneapproach.The bottom line problem with the "all can be known" thesis is that it causes you to throw away fear,to place your convictions, and money, on a thesis, not what is actually going on in the market. If your focusis the market, what is happening now, and not a belief that stock or commodity prices must do something,your chances for success will skyrocket:A perfect system or approach does not exist. Never has, never will.If there were such a thing as perfection in this business, then that would mean (1) the markets containno random inputs and (2) someone else would have already found the magical solution and own most of thefree world by now. Since we know the markets do have a high degree of random influence fromever-changing news, weather, traders' outlooks, and that even the best traders and funds tap out, we mustrealize that the markets are not to be traded with a 100 percent mechanical approach. Things change.Does this sound strange coming from someone who has just about spent his entire adult lifedeveloping systematic approaches to trading', Probably so, and it should not be taken to mean all my work,or systems and such, don't work:Life is a judgment call, but that call is based on having data and systemsto make life work better. So it is with trading. I need a systematic approacb to get me into and out of trades, I need absolute stops, and I sure asbeck need precise entry rules.But above all, I need to use some judgment of when to use this "stuff." Let's look at an example fromreal life.If you are driving down the road and a truck is dead ahead of you in your lane, do you stay in that laneor swerve across to the empty lane where you are not supposed to be? The rules are clear, you are not
248supposed to be over there. The system says don't do it, but reality is an 18-wheeler coming toward you inyour lane. Do we follow all the rules of safe driving, or do we adapt to the situation at hand? Survival is afunction of adaptation.Reality rules. On the road, in the markets:The first rule of life is to survive; the second rule is that all rules can be broken if that supports the firstrule.Speculation follows the same rules we use for life; they are integrally the same. Successful trading isthe art of using knowledge (systems) at the right time. This means when it is time to use the system or rule,you check for an oncoming 18-wheeler. That is what thinking is all about. We do need systems of living andsystems for trading. But it is not mandatory that you follow all systems exactly all the time. The reason isthat systems do not adapt to any new bits of reality. That is what our mind is for, to observe, to record, tonote changes, and then to develop an optimum use of the system.If you do not know what to do as you are trading, you must follow the rules because they will keep youalive. If you like market conditions and they fit what your rules suggest, go for it; if the rules don't fitconditions or conditions don't fit the rules . . . pass. You don't have to trade every day. The object of havingsystems and rules is to run them to your best advantage, and not to let them run you.I wish you well, I wish you good luck and good trading, and most of all I remind you to rememberthose three little words:Always use stops.
Index
AAccuracy, 199Active traders, 73Adams, Richard, 108Adaptation, 247-248Advisory services, 205Aggressive trading, 2, 170Amateur traders, 2 13Athletics analogy, 209Average profit per trade, 60
BBabcock, Bruce, 114Bad habits, 237-240Balance, in price and time swings, 47-55Bar charts, 11, 13 1. See also specific types oftradesBearish markets, 3 7, 70, 72, 77Bearish trades, 246Behavior of Prices on Wall Street, TheMerrill 120Belief system, 4-5, 202-203,228Bernstein, jake, 77, 114Bias, trading on, 85-88Bond marketdaily range breakouts, 61long-range days, 34-35Oops' pattern, 116-117, 120patterns, 97-99stock prices and, 72Bottoms, 37-39, 55, 133Breakouts:smash day patterns, 105specialists' trap, 109volatility (see Volatility breakouts)
Brie, Doug, 58British Pound, 84Bullish markets, 70, 77-78Bullish patterns, 95-96, 98, 101Buy setup, smash day, 101Buy signals, 109, 115-117Buy swing, 12 3
cCasinos, 166-167, 172. See also Gambling:Games of chanceCastell, Albury, 234Chalek, Mike, 1Channel breakouts, 235Chaos, 12. 19Charting, generally', 11-13, 19. 43,, 60Chartists, 12-13, 15, 93Chase, Henry- Wheeler. 16Clinton, Hillary, 227Close, holding strategies and,Close-to-close relationship, 85Closing, hiigh/low. 39Commoditiy Futures Trading Coinmision(CFTC), 1Commodity- Research Bureau. 208Commodity Timing-,Commodiity Timing articles:Art of Fly--Fishing Revisited. The. 193Athletics Are Such a Parallel to Trading209Beating Them to the Punch. 2 18-22 1Boston Marathon. 1996. 191Broken Nose, Cauliflower Ears. and BadTrades, 2 2 3Difference Between Winners andLosers. The. 2 3 1 -2
250
index
Commodity Timing articles (Continued)Doing the Wrong Thing ........... It's SoEasy, Isn't W, 190Don't "Show Me the Money