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volume that portends a fast recovery and a long markup phase.Sure enough, there is, and you are ready to make your move.The third morning after the break high, MWD starts asteady rise. Day traders, rapacious eyes on their one- and fiveminute charts, the scent of momentum in their nostrils, baretheir fangs and pounce. You, of course, hold your ground andtry to hide your disdain. This is made easier by your stronghunch that before the closing bell, you too will take a positionin MWD. Yet you intend to do so in a civilized manner, and tohold that position for the long haul. Right now you want to seeif this stock can keep its strength when the day traders waddleaway with their stomachs full.By late afternoon, the day traders have cashed out for thesession, bragging about their profits, while stock price continues to rise. Overnight, swing, and position traders have provided enough demand to meet supply, and a touch more toboot. The overnight traders saw MWD’s strength, looking as ifit would close at or near its high for the day. They figured thatthis strength will carry over into the next day, with a goodchance for a gap opening. A few minutes from the closing bell,MWD equals its break high. You’re sold, taking a position, for1000 shares and the long haul.
case 2For the sake of convenience, and to save you the bother of flipping through figures, we will examine this next case in retrospect. For the sake of realism, we shall play close attention tothe corresponding stochastic and RSI.Let us assume that you are a swing trader. If you had happened upon Johnson & Johnson’s (JNJ) chart ( Figure 13.5) onAugust 2, 1999, and if you also happened to have read that finebook, Technical Trading Online, then you would have surely161
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figure 13.5 case 2, chart 1
Source: Used with permission of Omega Research.
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caught one very clear buy signal. On the stochastic, percentage K is crossing percentage D in the oversold area. Youquickly check the RSI for confirmation. Unfortunately, the RSIis well above the buy zone. Also, volume has held fairly steadythe last few days, adding nothing to your vast store of knowledge. You check the price chart looking for a trading range.You see something that could eventually turn into a tradingrange, especially if you stare at it long enough. That gets tiring, so you decide to just wait and see if these hen scratchingwill in fact turn into a trading range, one that will arrive withfar stronger confirmation. This decision ends up costing you avery handsome profit. JNJ starts out on what will turn out tobe a thirteen-point climb. You watch it shaking your head,mumbling, “That’s life in the jungle.” At least it did not costyou a cent of savings. Still, you have been staring at this stocka long time. It’s about time you made some damn money off ofit. Besides, since you were a kid you must have used a millionof Johnson & Johnson’s Band-Aids. Determined to get something out of this stock, you wait calmly for the chart gods tosend you another sign.You get just that on August 18. Percentage K, the solidline of the stochastic crosses percentage D just inside theoverbought zone. JNJ is about to close weak, at or very nearits low. Seeing that it is also about to test its last high, you geta real itch to go short. Looking for confirmation, you see thatthough the RSI is heading south, it isn’t near the sell zone. Experience tells you not to go short on the information you canderive from the chart. Yet a little voice in your head tells youto forget confirmation, that this stock is headed south, that itis time to get some money out of it. Now if you had the RSIeven close to the buy zone, then you would tell that annoyinglittle voice where to go. You don’t. You won’t. You side with thelittle voice over experience, selling 100 shares short. A quick163
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glance at your money market account inspires the quick placement of a 1⁄2 point buy stop.The next day, JNJ gaps open down and drops precipitously as the little voice whispers, “I told you so.” Well this wasthe last time that day that you heard from the little voice. JNJrecovers and closes close to its opening price. The next dayyou are tempted to cover your short, but fight successfullyagainst a fall into temptation. This matters little, because pricerises enough to set off your 1⁄ 2 point automatic buy stop andcloses you out. This shuts up the little voice, leaving you wondering, “Whose damn voice is that, anyway?” Over the nextfew days, you congratulate yourself on setting that automaticbuy stop as you watch JNJ shoot up ten points.Now this damn stock that is making everyone rich, actuallyowes you money. You are even more determined to make something off of it, which incidentally can be a very costly attitude,one well worth avoiding. In any case, you make up your mind togo by the chart the next chance you get. That chance comes aweek later, on August 26. JNJ is about to close weak, at or nearits low for the day. Just the day before, the RSI took a mouth watering fall out of the sell zone. Today the stochastic is giving youa sell signal. You take it, selling short.A few days later the stochastic comes close to giving youan oversold signal. Still, it is not close enough to make youcover, especially without confirmation. On September 17, thestochastic gives you a strong, unequivocal oversold signal,but again the RSI fails to lend confirmation. In fact, it might beheading back up. You decide to hold tight, but with your fingeron the eject button.On September 24, you press that eject button on a veryprofitable trade. The RSI is in the buy zone and the stochasticlooks poised to confirm. It does, the very next day. A nice rise
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in price comes along with it. So does the urge to go long. Atthe same time you decide to take out your pencil to draw asupport line between the lows of August 6 and September 24( Figure 13.6). It comes out nice and flat, so you go ahead anddraw a parallel line through the high on August 25. This surelooks like a trading range to you. Now the stochastic and RSIreally seem to be screaming at you to buy long. You do justthat, going back to the well one more time. You even go rightout to buy two packages of Band-Aids, fueling the upturn withsome of your ready cash.Now remember that pompous position trader from Case 1,just the type of snob that would turn his nose up at anythingless than a markup or markdown phase. As a matter of fact, if Iremember correctly, he happened to be you. Well he has beenwatching JNJ too. Don’t be fooled by that nose in the air. Assoon as no one is looking, the nose comes down and he is gladto sneak onto the swing trader’s battlefield to take a strong yetsurreptitious position in such a nice fat trading range.Then it happens, possible trouble. On October 12, onlyhalfway up to the resistance line you are expecting it to reach,JNJ pulls back a little. Also, you don’t like the stochastic crossing so close to the sell zone. Still, it wasn’t in it. If the RSI is giving a signal, it’s in Greek. You decide to hold tight. Besides,your pompous position trading old self seems hardly to havenoticed the dip.On October 15, after three more days of decline, you areclose to bailing out. Two things stop you. The stochasticlooks as if it is heading for a crossing in the oversold zone.More important, a large drop in volume accompanies this decline, giving you confidence that it is only a short-lived reaction. In credit to your astute trading sense, that is exactlywhat it turns out to be.
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figure 13.6 case 2, chart 2
Source: Used with permission of Omega Research.
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By October 25, stock price starts scraping along the resistance line. The stochastic yells, “Sell!” and the RSI whispersit. Well you the swing trader, and your high and mighty formerself, the position trader, have both profited nicely. It is time tocash in and go to our next case.
case 3Now you will see why we hurried through the last case. Thenext three cases are on day trading. Whatever prejudices youmay have against day traders, you have to admit that these ferrets and otters are entertaining. Nobody holding a bottle of Ritalin ever caught up to one of these moving targets. As anadded bonus, you will see that many day trading techniquesapply equally well to position and swing trading. If you can keepup, you may learn something.Now that I am taking you through a simplified day of trading, it is time to mention that the large majority of successfulday traders divide their days into two sessions—9:30 A.M. to11:30 A.M. and 1:30 P.M. to 4:00 P.M. They avoid 11:30 A.M. to 1:30P.M. because of the drop in volume during this period, thus making a bad situation even worse by dropping volume even further, which in turn decreases liquidity and accents aberrationseven more. For example, if a 10,000 share buy order hits thefloor around noon, there probably won’t be enough sellers tokeep supply in balance with demand. The lack of volume alonewill probably push up the stock’s price even on a down day.This phenomenon is commonly referred to as the noon balloon.Successful traders seek certainty, not uncertainty.The cases that follow involve typical trades. An accomplished trader may handle dozens of similar ones in a day.And he can handle hundreds just like them between those
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much talked about and seldom experienced killings. Sinceyou took the first two cases, I’ll take the next three. Thatdoes not mean you can relax. We are going to be moving fast.Hold on to your hats.May 14, 1999 is an ordinary day for the stock market. Wemeet it with a game plan:1. Examine the groups, looking for longs in the stronggroups and shorts in the weak groups.2. Determine the trend.3. Take a position with the trend.4. Decide on an exit strategy.5. Take the loss or let the profits run, preferably thelatter.You snap on the television to CNBC. The first thing youwant to know is whether the S&P Futures are up or down. Asusual, the laws of the universe interfere. What you hear instead is that the Commerce Department has released the business inventory figures and the Labor Department has comeout with the Consumer Price Index. The expected CPI numberswere +.04 percent/+.02 percent. The actual numbers came inat +.07 percent/+.04 percent. CNBC adds that these numberspoint to a resumption of inflation. Now I could pad this bookwith at least five more boring pages explaining why. No doubtyou are among that large majority of people who judge abook’s value by it’s weight. Well allow me to point out that notone bookstore in this wide, wide world has a butcher’s scalealongside the cash register. Books are like airplanes—thelighter the better. So just follow my advice. When CNBC saysthat those figures way back at the beginning of this paragraphpoint to a resumption of inflation, take their word for it. Why168
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would they lie? Besides, the day trader is more interested inthe effect of the news than the news itself. Of course thereshould be a predictable cause-and-effect relationship betweenthe two. Just don’t bet on said predictability.It so happens that on May 14, a lot of professional futurestraders did take CNBC’s word for it and acted accordingly.These boys do not like inflation, not at all. Their previous optimism was replaced by pessimism. They not only sold the S&P500 Futures that they were long, they shorted additional ones.These pros know what they are doing, so you would be advisednot to spend too much time wondering why. Do so, and you maymiss a very profitable ride.H.L. Camp and CNBC come out with Fair Value, peggingit at 4.76 over. Translated, this means that if the S&P Futurescontract is valued at 4.76 over cash, then the cash to futuresrelationship is where it should logically be. An imperfect relationship with an illogical gap large enough to contain alocked in profit would of course arouse the arbitragers. Theiractivity should narrow the gap in the direction of Fair Value.If said activity fails to do so, and the gap widens, the computer generated programs will come riding on in like thecavalry. Believe me, you want to be riding with them, notstanding in front of them.Our TV talking heads tell us that the computer buy programs will kick in if futures over cash hits 7.24. Now this figure is the reason they invented pens, pencils, and computerkeyboards. Write it down and keep it in front of you. If the costof futures goes to 7.24 over when Fair Value is 4.76, then theprice of the stocks involved makes them look like a bargain bycomparison, even to the computers. If they do not crash fromthe excitement, the computer programmed traders will immediately commence buying the stocks and selling the futures.This is no time for the day trader to be taking a nap.169
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Our TV talking heads also tell us that sell programs willenter at 2.48 futures over cash. Allow me to avoid specificshere and merely state that this will trigger the exact same response as futures over cash hitting 7.24, only bass ackwards.Do not worry if you don’t completely understand this process.Believe me, after you have lost a few hundred thousand dollars, it will begin to sink in.Back to the boards. Well S&P Cash had closed the day before at 136756, while S&P Futures closed at 1375. Today S&PFutures opened at 1350, a gap down of 25 points. Against yesterdays close of S&P Cash, futures are worth less. Somethinghas to give and it is S&P Cash. When the market opens at 9:30A.M., the S&P 500 Index drops to 134761. Here it is May 14, summer coming on strong, and despite this the market is headingsouth.Well Rule 3 is, “Trade with the trend.” Obviously, thetrend is down, but that does not stop us from looking for confirmation. At 9:48 A.M., we’ve got 414 advancing issues/1943 declining. No ambiguity about those figures. I’m raring to takesome short positions, but good breeding and discipline forceme to check some indexes. At 9:50 A.M.:109979436967731694332328134657
Dow Jones IndustrialsDow Jones TransportsDow Jones UtilitiesComposite IndexS&P 500
−11054−5519−345−4301−2085
If that was not confirmation, nothing is. It is time to checkout the groups:ConsumersSemiconductors
DownDown170
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Heavy ConstructionEntertainmentAirlinesAutosToysSoftwareHealthcareRestaurantsFootwearAdvertisingFinancialsOil DrillersGoldReal Estate TrustsComputers
MixedDownDownDownDownDownDownMixedDownDownDownUpUpMixedDown
We have quite a choice of down groups in which to searchfor stocks to short. Let’s try airlines. Within this group, American Airlines (AMR) looks very weak (see Figure 13.7). It closedat 74, and gapped open down 11⁄ 2 at 721⁄ 2 . At 9:42 A.M. it makes alow of 7115⁄16.I refuse to get into a drawn out psychological explanationhere, so just take my word for it that those traders who boughtAmerican Airlines long at the opening bell expected it to go upnot down. Well it didn’t. Now, most of these traders will behappy to get even by bailing out 721⁄ 2 or close to it. This makes721⁄ 2 a line of resistance. To short, we have to wait for an uptick,and we want to do so on a bounce anyway. However, if AMRbreaks that line of resistance by beating its opening price, allbets are off.At 9:52 A.M., we get the bounce we are waiting for in AMRand the market as a whole. AMR goes up to 72 3⁄ 8 , just below
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figure 13.7 case 3
Source: Copyright Reuters Limited 2000.
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resistance. On top of that, its stochastic is giving a sell signal.And the S&P Futures are getting weak again. This points to another wave of selling.If we are going to get off the fence at all, the time is now.We sell AMR short at 723⁄ 8 , with a 3⁄8 buy stop above the entry.This places the stop at 723⁄4, 1⁄4 above that 721⁄ 2 opening priceresistance line. Now it’s time to wait and watch. (See Figure13.7 for graphs of share price, volume, stochastic, and RSI.)9:54 A.M.
10:02 A.M.10:20 A.M.
AMR drops to 7115⁄16, then starts a slow, gradual rise that does not come close to the stopat 723⁄4.Share price has dropped further to 711⁄2 .Looking good. Wait and watch.Indicator checks reveal:Advances 475/Declines 2108S&P 500 Cash 134160S&P 500 Futures 134650Futures Over Cash 4.90
Buy programs will trigger at 7.24. This bears carefulwatching, especially as to direction of movement. Betterstart thinking about risks vs. rewards, and conditions forbailing out.RSI is on the rise, coming out of an oversold positionand indicating a likely bounce.10:22 A.M.
AMR is starting to move up. Its stochastic isheading north. Time to take your profits.Close out position by covering short at 717⁄8 .
Your profit is 1⁄ 2 point times 1000 shares, which equals$500 less commissions. Admittedly, this is not quite enough toretire on. Still, you have paid for this book, with enough left
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over for a second-hand laptop computer. Sure, you anticipateda lot more, more than the market wanted to give you. Never,never try to take more than the market wants to give you. Themarket, not your needs or wants, determines when you shouldtake your profits. This has been a typical trade. Its results arenothing to be ashamed of. In fact, you have more capital nowto cover your losses and keep you in the game until one ofthose few and far between killings comes along. While you arewaiting, remember that the stock does not respond to thetrader. The trader responds to the stock.
case 4On May 18, 1999, following two down days, the marketopens:10849791085347133949133949
Dow Jones IndustrialsPrevious Day’s CloseS&P 500Previous Day’s Close9:38 A.M.S&P CashS&P FuturesFair Value Futures Over CashBuy ProgramsSell Programs
1339261343504.336.722.04
9:40 A.M.984 Advancing issues/887 Declining issuesThis slightly bullish bias should pry your eyes opena tad.
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Trader’s Index ( TRIN) 0.91This indicator is also slightly bullish. There could bea rally in the making.Better find a strong stock in a strong group. We may begoing long very soon.TelephonesComputers
StrongStrong
Tel Mexico ( TMX) looks interesting. (See Figure 13.8.)9:44 A.M.TMX makes high, pulls back, breaks high.Buy TMX at 845⁄8 with a 3⁄8 sell stop at 841⁄4. ( Note that stopis below last trough.)Watch and wait.9:54 A.M.1219 Advancing issues/903 Declining issuesTraders Index ( TRIN) 0.79Both indicators are getting stronger. So is your blood’sadrenaline content.10:10 A.M. (See Figure 13.9.)TMX makes high, pulls back, then tests high. The highpasses the test and TMX fails it.Yet the Dow Industrials and the S&P 500 are still goinghigher.Yet stochastic and RSI are both screaming overboughtand to sell?Go with the failed test of the high and the stochastic andRSI. Sell at 851⁄8 for 1⁄2 point profit.
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figure 13.8 case 4, chart 1
Source: Copyright Reuters Limited 2000.
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figure 13.9 case 4, chart 2
Source: Copyright Reuters Limited 2000.
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TMX looks like a good short, but both the Dow and S&P500 are still up. The advance/decline is still positive.You might make some money by breaking Rule 3 andtrading against the trend, but you’ll flunk this daytrader’s course.
case 5On May 18, 1999, the same day as Case 4, but a few hourslater, Alan Greenspan, head of the Federal Reserve Bank,speaks for a few hours. As usual, no one can figure out whatthe hell he says. Also as usual, yours truly is the only personwilling to admit his ignorance. The market gives signs of reversing downward.2:15 P.M.Advancing issues 1388/Declining issues 1491.The trend has reversed.Find a short, quick.Oops! I did say quick. Sell programs hit, and yours trulymisses the ride down. Maybe there will be a bounce Ican catch.2:26 P.M. (See Figure 13.10.)Merrill Lynch (MER) breaks low, rallies back, and thenturns down again. Too bad I missed the 2:05 P.M. sellshort signal, a failed test of a high. Missing the nextone, the break in support, is even more embarrassing. No time to worry about that now. Short at 797⁄8with a 3⁄8 stop at 801⁄4.
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figure 13.10 case 5
Source: Copyright Reuters Limited 2000.
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2:32 P.M.MER is falling, a little bounce, then resumes downward.Protect profits by lowering stop down to 783⁄ 8 .2:49 P.M.MER makes a low and tests it, giving signs of bottoming.Think about covering short. 775⁄ 8 looks like a good placeto do it.In the meantime, just watch and wait.2:53 P.M.MER is developing a base.Time to cover short at 773⁄ 4.11⁄8 point times 1000 shares gives a profit of $1125.The five cases we covered were typical trades. Of courseall trades do not end profitably. Those that don’t do limiteddamage if your stops are in the right places. If you want an example of a losing trade, just imagine one of the previous casesbeing stopped out. Then again, make a few trades and you willhave no need to imagine.
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chapter 14
breaking the ruleslive fast, die young, and have agood-looking corpse(in the pauper’s graveyard)
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Chapter 2 contained the Four Golden Rules of Stock Trading. Istand by them. Still, it is important that you become familiarwith trading techniques that break these rules, if for no otherreason than to be able to spot their effects upon the market.Realistically, I know some of you will, despite my advice, trythese techniques. I would equate this to running a red light atthree in the morning. The streets are deserted. No one is insight. Without any cross traffic, you don’t have to worry aboutan accident. There seems no chance that a cop lies in wait.However, there is only one way to be sure—run the light. Yet isyour gain of a minute or two really worth the chance? If you decide it is, don’t go looking for sympathy if you get caught.Whatever odds you bucked, they would have been better ifyou had obeyed the rules. The same is true for the Four GoldenRules of Stock Trading.No one day trades stocks very long before hearing theterms “fade the opening” or “short the gap.” This refers to apopular technique that involves trading against the trend in arising market. Let us say that pre-opening, cash to futures isa quite bullish 20 over. You can bet that more than one stockwill open with an imbalance of demand over supply. To attractthe necessary supply, they will gap open. This means openingprices will be higher than the previous day’s closing prices.In Figure 14.1, at Point 2, we see that our particular stockopened at $84. This is $4 dollars higher than the previous day’sclose at Point 1. This price jump will entice some profit takers tosell and increase supply. Some other traders are sure to jumpon this gap and sell short at $84. This is called fading theopening or shorting the gap, which also increases supply. This183
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figure 14.1 fading the opening4
S84
23
S801
increased supply should drive down the share price, to Point 3in Figure 14.1. Clearly, these traders are breaking Rule 3, Tradewith the Trend. Like our friend who runs the red light, they mayvery well get away with it. Then again, they may not. For a myriad of possible reasons, share price may instead rise along thedotted line to Point 4.However, let us say that share price does drop as plannedto $83 at Point 3. You personally would never think of tradingagainst the trend. The market is bullish and you are buyinglong or playing the wallflower. What have you learned from theexample illustrated in Figure 14.1? One thing you should havelearned, unless you are into roller coasters, is not to getcaught up in the hoopla and jump in to buy at the opening bell.What is the point of riding this stock down from Point 2 toPoint 3? The place to jump on is right after confirmation, justpast Point 3. Not only do you save a point on the purchaseprice, your entire ride is up. And you probably won’t have towait long. The reversal after Point 3 often occurs within 20minutes of the opening bell.184
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Another possibility, and a nice one, is that you had boughtthe stock the previous day for some now obviously brilliant reason, and you kept an overnight position. Even if you are confident of a further rise in share price after a small fade, you couldstill make a case to sell near Point 2, then buy back again justafter Point 3. However, you better keep your eyes glued to yourmonitor and your fingers resting on your