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STUDY GUIDEFOR
SELL AND SELL SHORT
Dr. Alexander Elderwww.elder.com
John Wiley & Sons, Inc.
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STUDY GUIDEFOR
SELL AND SELL SHORT
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BOOKS BY DR. ALEXANDER ELDERTrading for a LivingStudy Guide for Trading for a LivingRubles to Dollars:Making Money on Russia’s Exploding Financial FrontierCome into My Trading RoomStudy Guide for Come into My Trading RoomStraying from the F lock: Travels in New ZealandEntries & Exits: Visits to Sixteen Trading RoomsStudy Guide for Entries & Exits
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STUDY GUIDEFOR
SELL AND SELL SHORT
Dr. Alexander Elderwww.elder.com
John Wiley & Sons, Inc.
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Copyright © 2008 by Dr. Alexander Elder. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.All charts unless otherwise noted were created with TradeStation.Copyright © TradeStation Securities, Inc. 2000–2007. All rights reserved.No part of this publication may be reproduced, stored in a retrieval system, ortransmitted in any form or by any means, electronic, mechanical, photocopying,recording, scanning, or otherwise, except as permitted under Section 107 or 108 ofthe 1976 United States Copyright Act, without either the prior written permission ofthe Publisher, or authorization through payment of the appropriate per-copy feeto the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923,(978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com.Requests to the Publisher for permission should be addressed to the PermissionsDepartment, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201)748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.Limit of Liability/Disclaimer of Warranty: While the publisher and author haveused their best efforts in preparing this book, they make no representations orwarranties with respect to the accuracy or completeness of the contents of thisbook and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by salesrepresentatives or written sales materials. The advice and strategies containedherein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable forany loss of profit or any other commercial damages, including but not limited tospecial, incidental, consequential, or other damages.For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at(800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.Wiley also publishes its books in a variety of electronic formats. Some contentthat appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.ISBN 978-0-470-20047-6Printed in the United States of America10
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CONTENTS
About This Study Guide
vii
Section One: Questions1 How to Buy, Manage Risk, & Keep RecordsQuestions 1–36
3
2 How to SellQuestions 37–86
21
3 How to Sell ShortQuestions 87–115
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Section Two: Answers and Rating Scales1 How to Buy, Manage Risk, & Keep RecordsAnswers 1–36Grading your Answers
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2 How to SellAnswers 37–86Grading your Answers
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3 How to Sell ShortAnswers 87–115Grading your Answers
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What’s Next?
131
About the Author
133
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ABOUT THIS STUDY GUIDE
I
t feels exciting to discover an attractive stock and watch it go vertical after you buy. It is just as exciting to see it collapse soon afteryou short. This joy is only a small part of the game.You can expect to spend the bulk of your time doing your homework. At times you might scan a long list of stocks and not find anything particularly attractive. At other times you may find a stock thatyou like but your money management rules will not allow you to buy.Or you can put on a trade in moments but spend half an hour documenting it in your diary. The toil of homework takes up the bulk of aserious trader’s time. Whoever said “success is 10% inspiration and 90%perspiration” must have come through Wall Street.I created this Study Guide to help you prepare for the road ahead.My goal was to point out some of the best opportunities, flag some ofthe worst risks, and get you into the habit of tracking your performance. I often say to my students, “Show me a trader with good records,and I will show you a good trader.” I hope this Study Guide will helpyou acquire the habit of asking hard questions, testing all ideas on yourown data, and keeping good notes.This book is divided into three sections. The first focuses on buying,managing money, and keeping records; the second on selling; and thethird on selling short. Each section, in turn, consists of two parts. Inthe beginning, there are textual questions, and towards the end thereare visual questions, with charts that require you to make tradingdecisions. Each section concludes with a scale to help you gauge yourperformance.vii
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About This Study Guide
I took great care in crafting the answers in the back of the book.I wanted to go beyond merely saying that A was right and B waswrong—I wanted to explain the reasons behind the answers. Becauseof these extensive comments, the Answers section of this Study Guideserves as an extension of the main book, Sell and Sell Short.Please do not rush through this book. Trading is a marathon, not a100-yard dash. Take your time to think and work through a few questions each day. After you have worked through the entire Study Guideand rated your performance, put it aside for two or three months, thenpick it up again and retake the tests to see whether your grades haveimproved. Trading is like so many other serious pursuits—the more youput into it, the more you will get out of it.Trading is a lonely business, which is why I encourage traders toconnect with others and share research and learning. Some of my students have become good friends, and here I want to acknowledge thecontribution of Jeff Parker, a camper and a member of the Spike group.He reviewed and critiqued both Sell and Sell Short and this StudyGuide. Jeff is a very kind guy, but an extremely hard man to please.He made dozens of critical comments which helped me improve thisbook. This manuscript would have been finished sooner and with lesspain if I had not shown it to Jeff, but the book came out better thanksto him. Now, by picking up this Study Guide and facing its hard questions you have made the same choice as I did. When we expose ourselves to the risk of criticism, we become stronger.I cordially wish you success in your trading career.Dr. Alexander ElderNew York City, 2008
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S E C T I O NO N E
QUESTIONS
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O N E
HOW TO BUY,MANAGE RISK,& KEEP RECORDS
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hen I sat down to write a book about selling, it soon becameclear that it had to begin with a section on buying and allthat relates to it. Beginners buy when some vague tips float their way.Experienced traders know that serious buying requires seriousresearch.Scanning the stock market and researching individual stocks is veryimportant, but analysis alone will not make you a successful trader.Serious buying requires good money management. There are simplemathematical rules that tell you how much risk you may accept on anyindividual trade as well as on all your open trades combined. Thosewho violate risk limits have a very short life expectancy in the markets.There are certain psychological rules that can help you make yourlife in the markets less stressful and more satisfying and profitable. Andthere are certain highly desirable ways of record-keeping that will helpyou grow into a mature and successful trader.You have to buy well in order to sell well.That is why, before we discuss selling and shorting, you need toanswer important questions about psychology and money management, buying decisions, and record-keeping.Please do not rush as you work through this chapter. A house is onlyas strong as its foundation. Please answer these questions with a greatdeal of thought and record them on the Answer Sheet on pages 4 and5. Re-read the appropriate sections in Sell and Sell Short if you miss anyanswers.
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Questions
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Answer SheetQuestions
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Answer Sheet, continuedQuestions
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Questions
Question 1—The Stress of Holding a PositionHaving bought a stock, most people find themselves in the least stressful position if that stock:1. Rises slightly2. Skyrockets3. Declines slightly4. CollapsesQuestion 2—Your Trading EdgeYour trading edge can come from:1. Fundamental analysis2. Technical studies3. Discipline4. All of the aboveQuestion 3—The Three Great DividesThe three great divides in trading include all of the following, except:1. Technical vs. fundamental research2. Trend vs. counter-trend trading3. Relying on TV news vs. an advisory service4. Discretionary vs. systematic tradingQuestion 4—Price and ValueFind the incorrect statement about the relationship between price andvalue:1. Values change slowly, prices change fast.2. Studying earnings reports and industry trends allows you to discovervalue.3. Moving averages help define the value zone by tracking publicconsensus.4. Price equals value at any given moment.
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Question 5—Fundamental and Technical AnalysisWhich of the following statements about fundamental and technicalanalysis is incorrect?1. A fundamentalist calculates the value of the business that issued astock.2. Having precise information about the fundamentals tells you exactlywhich way a stock is going to go.3. A technician looks for repetitive patterns in price data.4. A pure technician does not care about earnings or corporate news;he only wants to know the stock ticker and price history.Question 6—Trend vs. Counter-Trend TradingAll of the following are advantages of trend trading over counter-trendtrading, except:1. Greater profit potential per trade2. Lower commission expense3. More time to make decisions4. Lower stress levelQuestion 7—System vs. Discretionary TradingSystem trading has all of the following advantages over discretionarytrading, except:1. Knowing in advance what profits or losses to expect over a periodof time2. Less emotional involvement in every trade3. A greater degree of freedom4. A method for handling the uncertainty of the markets
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Questions
Question 8—Technical ToolboxA technical trader uses a toolbox of indicators in his or her decisionmaking. Find the correct statement among the following:1. Selecting the tools that give the signals you want is a sound practice.2. The more tools, the better the toolbox.3. “Five bullets to a clip” allows you to use only five indicators.4. The best indicators are well known, and a trader should use them.Question 9—New High–New Low IndexFind the incorrect statement about the New High–New Low Index:1. NH-NL confirms uptrends by reaching new highs; it confirms downtrends by falling to new lows.2. The signals of NH-NL are symmetrical at tops and bottoms.3. Bearish divergences of NH-NL warn of impending market tops.4. Downspikes of NH-NL often identify important market bottoms.Question 10—Trading PsychologyFind the incorrect statement about trading psychology:1. If you set your technical system just right, you need not worry aboutpsychology.2. The mind of a trader continually filters the incoming information.3. Wishful thinking causes traders to “see” non-existent technical signals.4. A bullish trader is more likely to overlook sell signals.Question 11—Trading DisciplineTraders need discipline because the markets present an endless paradeof temptations. Please identify the incorrect statement among thefollowing:1. People with a history of poor impulse control are likely to fail intrading.2. AA (Alcoholics Anonymous) provides a useful model for dealingwith market temptations.3. If you have a good trading system, discipline is not really an issue.4. Some traders have personality flaws that make them destined to fail.
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Question 12—Dealing with LossesMany traders feel ashamed of their losses. Please review the followingstatements and find the correct one:1. In training, punishments are more effective than rewards.2. If you have taken several right steps and one wrong one in makinga trade, you should punish yourself for it.3. Successful traders love the game more than the profits.4. It does not pay to keep records of losing trades.Question 13—OvertradingTrading a position that is too large for one’s account will lead to all ofthe following, except:1. Less spontaneity and greater stiffness2. Less calm and adaptability3. Fear of pulling the trigger4. A greater focus on the marketQuestion 14—The 2% RuleA beginning trader with a $20,000 account decides to implement the2% Rule of money management. He finds a stock quoted at $12.50 anddecides to buy it, with a price target of $15 and a stop-loss order at$11.50. The maximum number of shares this Rule allows him to buy isclose to:1. 9002. 4003. 3504. 200
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Questions
Question 15—Modifying the 2% RuleAn experienced trader with a $2,000,000 account decides to modify the2% Rule and cap his risk per trade at 0.25%. He finds a $9 stock whichhe plans to ride to $12, while putting his stop at $8. The maximumnumber of shares his Rule allows him to buy is:1. 2,0002. 4,5003. 5,0004. 12,000Question 16—The 6% RuleFind the statement about the 6% Rule that is correct:1. It will protect your account from a drawdown caused by a bad trade.2. It will protect your account from a drawdown caused by a series ofbad trades.3. When losses begin to mount, the best response is to trade moreactively, to trade your way out of a hole.4. The 6% Rule needs to be applied after putting on a trade.Question 17—The Top Two Goals for Every TradeWhat are the top two goals for every trade?1. Make money and test a new system.2. Face the challenge and feel the joy of victory.3. Make money and become a better trader.4. Test your discipline and the ability to implement a plan.Question 18—Learning from ExperienceThe best way to learn from experience is:1. To make lots of trades2. To keep good records3. To discuss your trades with friends4. To review your brokerage statements
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Question 19—A Record-Keeping SpreadsheetWhich of the following must be included in a basic record-keepingspreadsheet?A. Gross and net P&LB. The grade of each tradeC. Slippage on entry and exitD. Source of every trade idea1. A2. A and B3. A, B, and C4. All of the aboveQuestion 20—Trading MistakesWhich of the following statements about trading mistakes is incorrect?1. Intelligent people do not make mistakes.2. Making mistakes is inevitable when you learn and explore.3. Repeating mistakes is a sign of impulsivity.4. Keeping a diary helps you learn from your mistakes.Question 21—Trader’s DiaryFind the correct statement about the Trader’s Diary:1. There is no need to rush documenting your entry if you plan to fillin the diary after you exit.2. The diaries of losing trades tend to be more valuable than those ofwinning ones.3. It is essential to create diary entries only for your best trades.4. An active trader who cannot document all trades can pick andchoose what trades to document.
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Questions
Question 22—Diary EntryThe diary of an entry into a trade must include all of the following,except:1. The reason for making this trade2. The buy grade for long or sell grade for short trades3. Charts of your trading vehicle at the time of the entry4. The trade gradeQuestion 23—Trading Plan vs. DiaryWhich of the following describes the difference between a Trader’sDiary and a Trading Plan?1. Contains charts in two timeframes.2. The charts are marked up to identify buy or sell signals.3. The document is named after the stock ticker.4. Buy or sell grades are recorded.Question 24—The Monitoring ScreenThe window for monitoring stocks in your trading software shouldinclude all of the following, except:1. Key market indexes2. Your open positions3. The stocks you consider trading4. The stocks you have exitedQuestion 25—Comments on the ScreenKeeping your comments about your open positions on the screen isuseful for all of the following reasons, except:1. It reminds you how long you have been in a trade.2. It helps you see whether you are winning or losing in an openposition.3. It helps you keep track of your profit target and stop-loss order.4. It helps you measure your performance.
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Question 26—Pinning a Chart to a Wall“Margret’s method”—pinning a chart to a wall and marking the tradingsignal for which you will be waiting—has all of the following advantages, except:1. It forces you to clearly express what price or indicator action youexpect.2. It keeps you from forgetting a plan.3. Removing the charts from the wall if your plans change helps keepyour mind fresh.4. Keeping charts on a wall ensures that you will act when the time isright.Question 27—A Trial-Sized OrderWhich of the following statements about a “Chihuahua trade”—a trialsized order designed to draw your attention to a trading opportunity—is correct?1. There is little difference between an electronic alert and an orderfor a handful of shares.2. Chihuahua orders are good for placing stops.3. Getting a fill on a Chihuahua order forces you to make a decision.4. Once you have a fill on a trial-sized order, you must bring that tradeup to full size.Question 28—Grading Buys and SellsFind the incorrect statement about grading buys or sells:1. The closer you buy to the low of the bar, the better your grade.2. The closer you sell to the low of the bar, the better your grade.3. Selling above the midpoint of the bar earns a positive grade.4. Buying in the lowest quarter of the bar earns an excellent grade.
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Questions
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Question 29—Grading Completed TradesFind the correct statement about grading completed trades:1. Money is a good measure of the quality of each trade.2. A long-term trend trader can use channels to measure the quality oftrades.3. A trade capturing over 30% of a channel earns an “A.”4. A trade capturing less than 20% of a channel earns a “D.”Question 30—BuyingFind the incorrect statement about buying:1. The principle of value buying is “buy low, sell high.”2. The principle of momentum buying is “buy high, sell even higher.”3. The upper channel line identifies the level of depression and thelower channel line the level of mania in the markets.4. Momentum trading works well in runaway trends.Question 31—ValueBBB
CA
A
Figure 1.31
A
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Please match the following descriptions with the letters on the chart:1. Value zone2. Below value—consider buying3. Overvalued—consider sellingQuestion 32—The Impulse SystemE
F
D
AB
C
Figure 1.32
The Impulse system tracks both the inertia and the power of marketmoves. Some software packages allow traders to color price bars inaccordance with the Impulse reading. Even on a black-and-white chart,a trader can tell what color any of the bars should be in accordancewith the Impulse rules. Please match the following comments on theImpulse system with the letter bars on the chart:1. Impulse Green—buy or stand aside; shorting not permitted2. Impulse Red—sell short or stand aside; buying not permitted3. Impulse Blue—no position is prohibited
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Question 33—The Signals of NH-NL
A
B
C
D E
Figure 1.33
The weekly chart of New High–New Low Index (NH-NL) can helptraders anticipate important turns in the stock market. Please match thefollowing comments on NH-NL with the letters on the chart:1. A spike identifies an unsustainable extreme and calls for a reversal.2. A divergence identifies the weakness of the dominant crowd andcalls for a reversal.
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Question 34—A Trade DiaryA
Day’s high 6.87, low 6.86Long 1000 @ 6.71Entry grade 84%
C
Feels hardto buy whenprices areso low. . .
Impulse
B no longer Red!
Figure 1.34
This chart comes from a Trader’s Diary and illustrates an entry into atrade. Match the following with the letters on the chart:1. A technical comment on a chart pattern that led to a trade2. A performance rating3. A psychological comment
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Questions
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Question 35—Grading a Trade
ChannelShort 4.9.200790.71
Channel
Cover 4/12/200787.99
Figure 1.35
This chart shows one of the trades in which I was piggybacking a Spikepick. The weekly chart is not shown here, but you can see bearishdivergences of MACD Lines and Force Index on the dailies. The question, however, is about grading this trade: in at 90.71, cover at 87.99,upper channel line at 91.56, lower channel line at 83.67. What is thetrade grade?1. Trade Grade A: Over 30% of the channel2. Trade Grade B: 20–30% of the channel3. Trade Grade C: 10–20% of the channel4. Trade Grade D: Below 10% of the channel
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Question 36—Value Buying vs. Momentum BuyingEC
D
A
B
Figure 1.36
Take a look at the letters on this chart and identify which representvalue buying or momentum buying zones.1. Value buying zones2. Momentum buying zones
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T W O
HOW TO SELL
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ou have bought a stock, and now it shows a profit. Taking yourbroker’s statement to a store and showing it to a clerk will notbuy you a bag of groceries. You need to decide when is the right timeto sell your position and convert paper profits into real money. Shouldyou sell right now, and take your money off the table? Should you letyour trade ride and maybe make a lot more money later? And what ifyou let your trade ride but the stock reverses and your profits meltaway?Selling—the essential step of taking profits or cutting losses—must bedone in a serious and businesslike manner. You need to know how toset profit targets for the stocks you buy. There is no guarantee that thestock you bought will go up, which is why you need to decide whereto dump it; this decision must be made before you get into a trade. Youneed to know how to set protective stops.After buying a stock, you need to bracket it with both profit-takingand stop-loss orders. You have to be prepared to adjust both with thepassage of time. You also need to decide whether to sell your entireposition at once or take partial profits and let the rest of the position ride.As you work through the questions in this section, please be sure tolink every answer to your own experiences as a trader. Keep referringto your diary, which you should have begun keeping by now. Sellingis the longest part of this Study Guide, with the largest number of questions. The topic is so important that you must make sure you earn ahigh score, taking and retaking this test if necessary.
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Answer SheetQuestions
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Answer Sheet, continuedQuestions
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Trial 1
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