reflection of value in the market. If you buy near themoving average, you’ll be buying value. If you buy below the EMA,you’ll buy undervalued assets. One of the very few scientifically provenfacts about the markets is that prices oscillate above and below value.When you sell above the upper channel line, you sell overvalued assets.
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Question 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 prohibitedAnswers: 1. C and D2. A and F3. B and EThe primary purpose of the Impulse system is that of censorship. Itkeeps traders out of trouble by telling them what they are prohibitedfrom doing at any given time.
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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.Answers:
1. C and E2. A, B, and D
Divergences are more often seen at market tops, as the trend keepsrising out of inertia while its leadership becomes weaker. Spikes aremuch more common at stock market bottoms where they identifyzones of panic liquidation. Whenever NH-NL declines to several thousand below zero, a bottom is close at hand.
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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 commentAnswers:
1. B2. A3. C
A visual diary of a trade must include several components. It isessential to mark technical trade signals or comment on the strategythat led to this trade. A Diary must include a quality rating for everyentry, exit, and the entire trade. Beginners need to record their feelingsduring each trade, but more experienced traders tend to become unemotional about their trades and may skip such comments.
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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 channelAnswer: 1Shorting at $90.71 and covering at $87.99 gained $2.72, before commissions. The channel was $7.89 tall at the time of the trade. The tradecovered 34% of the channel, earning an A grade. It pays to concentrateon points and percentages, and not count money while in a trade.
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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 zonesAnswers: 1. B and D2. A, C, and EThe principle of value buying is “buy low, sell high.” The principleof momentum buying is “buy high, sell even higher.” Value buyingmeans going long when prices pull back to or below value. Buying ona breakout above an important earlier peak is a prime example ofmomentum buying. Notice several additional buying opportunitiesbesides those marked with letters on this chart.
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GRADING YOUR ANSWERS
If a question requires only one answer, you earn a point by answeringit correctly. If a question requires several answers (for example, “Whichtwo of the following four statements are correct?”), rate your answerproportionately. If you answer both correctly, give yourself a point, butif only one, then half a point.31–36: Excellent. You have a good grasp of buying, managing money,and keeping records. Now is the time to turn your attention to selling.24–30: Fairly good. Successful trading demands top performance.Look up the answers to the questions you’ve missed, review them, andretake the test in a few days before moving on to the next section.Below 24: Alarm! Scoring below the top third may be acceptable insome professional fields, but it is deadly in trading. Professional tradersare waiting for you in the markets, ready to take your money. Beforeyou do battle with them, you must bring yourself up to speed. Pleasestudy the first section of Sell and Sell Short and then retake the test. Ifyour grade remains low on the second pass, look up the books recommended in that section and study those as well.
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T W O
HOW TO SELL
Question 37—A Plan for SellingFind the incorrect statement about a written plan for selling:1. It guarantees success.2. It reduces stress.3. It allows you to separate analysis from trading.4. It makes you less prone to react to the market’s zigzags.Answer: 1Putting a plan on paper has a powerful psychological effect on mostpeople, making them feel less dependent on the whims of the market.Writing down a plan and executing it from a sheet of paper helps youreduce tension by separating the jobs of analysis and trading. Still,nothing guarantees success in the financial markets.Question 38—The Three Types of SellingThe three logical types of selling do not include which of the following?1. Selling at a profit target above the market2. Selling on a stop below the market3. Selling in response to the “engine noise” of changing marketconditions4. Selling after feeling impatient about the tradeAnswer: 483
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Every trading plan should include a profit target and a stop. Furthermore, an experienced discretionary trader may exit a trade in responseto “engine noise”—a perception that the market conditions havechanged. On the other hand, selling in response to feeling impatient isamateurish.Question 39—Planning to SellPrior to buying a stock, serious traders ask themselves all of the following questions except:1. How high is the stock likely to rise—what is the profit target?2. How low does the stock have to fall to activate a protective stop?3. What is the stock’s reward-to-risk ratio?4. Should I move my target farther away after the stock reaches it?Answer: 4Buying a stock is akin to applying for a job—you want to know yourresponsibilities and rewards, and decide whether the pay is worth thework. The time to think about moving a target will come later in a trade,and even then only for experienced traders.Question 40—Targets for SellingWhich of the following tools can help set targets for selling?A. Moving averagesB. Envelopes or channelsC. Support and resistance zonesD. Other methods1. A2. A and B3. A, B, and C4. All of the aboveAnswer: 4
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You can use a great variety of methods for setting profit targets. Whilethe range of choices is virtually limitless, two factors are most important. First, you must understand the logic of your target-setting process,and avoid impulsive behavior. Second, you must keep records to helpevaluate the quality of any method.Question 41—A Stock below Its Moving AverageFind two correct statements about a stock that trades below its movingaverage:A. The stock is trading below value.B. It is definitely headed lower.C. It is definitely headed higher.D. If the indicators are pointing higher, the first target is the moving average.1. A and D2. B and D3. A and C4. A and BAnswer: 4A moving average represents an average consensus of value. It indicates the level of value in the current market and its slope showswhether that value is increasing or declining. Nothing is definite in thestock market (except for commissions, slippage, and the fact that anunprepared trader will suffer losses). When the indicators are bullish andprice is below the EMA, that EMA becomes the first target for a rally.Question 42—Moving Averages as Selling TargetsFind the incorrect statement about using moving averages as selling targets:1. Selling at a moving average works especially well on weekly charts.2. Prices tend to oscillate above and below their moving averages.3. It is highly desirable that the distance to the target be longer thanthe distance to the stop.4. When you sell at a target, the sell grade is unimportant.
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Answer: 4Time and again, the weekly charts trump the dailies. As a rule, youwant to put on trades with attractive reward-to-risk ratios. The qualityof entry and exit must be graded for every trade, whatever the reasonfor the exit.Question 43—Regrets About SellingA trader feels intense regret after he sells at an EMA but prices continue to rise. Which of the following statements is correct?1. Regret is good because it motivates you not to exit the next tradetoo soon.2. A strong feeling of regret about exiting early can lead to overstaying the next trade.3. If your analysis is good, you should know not to sell early.4. Leaving money on the table is a sign of a poor trader.Answer: 2Regret is a corrosive force in trading. If you kick yourself today forleaving some money on the table, you will reach out too far tomorrowand probably overstay your next trade. A mature trader creates a planand follows it. He grades his performance and strives to improve it. Hedoes not allow the outcome of a trade he made today to impact hisbehavior in a new trade tomorrow. Leaving some money on the tableis an inevitable part of the game; only a paper-trader or a liar catchesevery bottom and sells at every top.Question 44—The Timing of a Sale Near the EMAWhat is the best time to use an EMA as a target for a rally?1. When prices rally from bear market lows2. In the midst of an ongoing uptrend3. When prices are boiling near their historic highs4. All of the aboveAnswer: 1
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The time to use an EMA as a price target is when prices are belowthat EMA. This is unlikely to happen in an uptrend or near the highs.When prices rally from bear market lows, an EMA serves as a reasonable target for the first rally.Question 45—Channels as Price TargetsFind the correct statement about using channels as price targets:1. A powerful upmove on the weekly charts is the best time to targetchannels on the dailies.2. Uptrends rarely show an orderly pattern of tops and bottoms.3. The best time to go long in an uptrend is when prices hit the upperchannel.4. It does not pay to sell at a channel because prices may rally higher.Answer: 1An orderly pattern of rallies and declines is fairly typical duringmajor uptrends. This is why it makes sense to trade by going longwhenever prices drop to or below value and take profits wheneverthey rise to or above an overvalued zone, as identified by the upperchannel line. It pays to sell when and where you plan to sell. You mayplan to sell a short-term trade at the channel line or hold a smallerposition for a longer, trend-following trade. Whatever your plan, donot change it in the middle of the game!Question 46—Measuring Performance Using ChannelsMeasuring the percentage of a channel height captured in a trade canhelp a swing trader:A. Focus on points rather than dollars.B. Provide a yardstick for measuring one’s progress.C. Set a realistic profit target.1. A2. A and B3. All of the above
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Answer: 3Focusing on money gained or lost in any given trade tends to distract traders. It is important to focus on the quality of trading decisions;paying too much attention to money leads one towards thinking aboutwhat that money will buy, and then the trader loses his focus. The goalis to become the best trader you can be—the money will follow.Question 47—Selling TargetsPlease find statements that match among the following two pairs ofstatements:A. The first target for selling into a rally off the lowsB. The first target for selling in an ongoing uptrend1. At or below value, as defined by moving averages2. Near the overvalued zone, as defined by the upper channel lineAnswers: 1. A2. BThe first rally from bear market lows tends to run into great resistance; it makes sense to set a modest profit target near the EMA. Pricesseldom fall to the lower channel line in an ongoing uptrend; it makessense to buy near the EMA and be prepared to take profits near theupper channel line.Question 48—Reaching for a Greater ProfitAlways reaching out for a greater profit makes a trader:A. More relaxedB. More stressedC. More successfulD. More hyperactive1. A and B2. A and C3. B and D4. B and C
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Answer: 3One of the great psychological problems in trading is that the markets offer endless temptations. With thousands of dollars flashing onevery screen, many traders lose self-control and reach for more thanthey can catch, before losing balance and suffering losses. The powerword in trading, as in life, is “enough.” Using a trading channel to setprofit targets can help establish realistic goals for trades.Question 49—The Top of a RallyFind the correct statement about the top tick of a rally:1. Forecasting it will provide a reasonable target for selling.2. It can be forecast with a good degree of consistency.3. Trying to sell at the top tick tends to be a very expensive undertaking.4. If one can sell consistently at the absolute top, one can also sellshort there.Answer: 3The top tick of a rally is the most expensive tick in the market—fortunes have been lost hunting for it. Here, as with everything else in trading, it is important to avoid reaching for extremes. It is much safer andmore practical to try and take a chunk out of the middle of a pricemove. The less you stress yourself, the better results you’re likely to get.Question 50—Prices above the Upper Channel LineAssume that prices have rallied above the upper channel line; find thecorrect statement among the following:1. A trader must immediately take profits.2. When prices close above the upper channel line for two days in arow, a trader must take profits.3. When prices close above the upper channel line, it means the rallywill continue.4. When prices close above the upper channel line but then fail toreach a new high, the trader should consider selling that day.
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Answer: 4Envelopes or channels provide good targets for short-term trades.Still, occasionally a rally rockets higher, tempting us to hold on fora bit longer than initially planned. A very powerful rally may cause astock to “walk its channel line,” rising along that line for days andsometimes weeks. Still, a short-term swing trader would be welladvised to sell when that rally stumbles and fails to reach a new highafter having risen above the upper channel line.Question 51—Setting Profit TargetsFind the correct statement about setting profit targets:1. Let the trade run as far as it will without worrying about targets.2. There is a perfect profit target for any market.3. The longer your time horizon, the farther away the profit target.4. A moving average provides the best profit target for any trade.Answer: 3A market can move much farther in the long run than in the shortrun—a short-term swing trade needs a close-by target, while a longterm trend trade needs a target farther away. There is no universalmethod that will set a price target for every trade.Question 52—Support and Resistance Zones as TargetsSupport and resistance zones provide attractive price targets for longterm trades for all of the following reasons, except:1. Congestion zones show where the masses of market participants areprepared to buy or sell.2. A trading range represents a general consensus of value amonghuge masses of traders.3. The duration of trading ranges tends to be longer than that of pricetrends.4. A trend always stops at the edge of a trading range.Answer: 4
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A price range represents a huge financial and emotional commitment by masses of buyers and sellers. The composition and the attitude of the market crowd keep shifting, which is why the edges ofcongestion zones tend to be ragged rather than straight.Question 53—A Protective StopUsing a protective stop makes sense for all of the following reasons,except:1. It is a reality check, reminding you that prices can move against you.2. It works against the ownership effect, when people fall in love withtheir stocks.3. It reduces the emotional stress of making decisions in open trades.4. It puts an absolute limit on the amount of dollars you can lose inany given trade.Answer: 4Prior to entering a trade you need to examine the chart and decidewhere you want to get out if that trade starts going against you. Yourdecision is likely to be much more objective if you make it beforeentering a trade. Every trade deserves a protective stop—but a stockmay gap across that level. A stop is not a perfect defense but it is ourbest defense against damaging losses.Question 54—Breaking through ResistanceIf a stock rises to its resistance level, stays there, and then rallies andcloses above that level, it gives us a signal to:A. Go long immediately.B. Get ready to sell short if the stock sinks back into its resistance zone.C. Sell short immediately.D. Get ready to buy if the stock declines towards its resistance zone.1. A or D2. A or B3. B or C4. C or D
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Answer: 2Prices breaking out above resistance may either signal the beginningof a new uptrend or the first step in a fakeout move. If the breakout isfor real, there is no time to waste. It does not pay to wait for a pullback—a rocket that has left its launching pad has no business sinkingback to it. If, on the other hand, your long-term studies point to a topand you think this is a false breakout, it makes sense to wait for a confirmation from prices sinking back into the range. A breakout alonedoes not provide a clear signal—it pays to view it within the framework of your longer-term studies.Question 55—A Trade without a StopA trade without a stop is:1. Permitted only for experienced traders2. A gamble3. A way to be more flexible4. A realistic approach to tradingAnswer: 2A stop is every trader’s link with reality. There are many types ofstops and many methods of using them, but even the most experienced professional trader knows at what level he will exit a trade thatis going against him.Question 56—Changing StopsWhich of the following are allowed during a trade?A. Raising stops on longsB. Raising stops on shortsC. Lowering stops on shortsD. Lowering stops on longs1. A and B2. B and C3. A and C4. C and D
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Answer: 3You may move a stop only in the direction of a trade—up for longsor down for shorts. Moving a stop in the opposite direction in order togive a trade gone bad “more room to work out” is a loser’s game. Youcreated your plan before you entered the trade, when you were moreobjective than during the trade. Once you are in a trade, you areallowed to reduce your risk level but never to increase it.Question 57—Re-Entering a TradeBuying a stock, getting stopped out, and then re-entering the trade bybuying that stock back is:1. A common tactic among professionals2. Throwing good money after bad3. A sign of stubbornness4. A waste of time and money that could be spent on better opportunitiesAnswer: 1Beginners usually take a single stab at a stock and move on to thenext trade after a loss. A professional knows that a good stock is hardto find. He or she uses a tight stop and is not afraid to make severalstabs at a stock before catching an important trend.Question 58—Deciding Where to Set a StopThe single most important question in setting a stop is:1. What is the volatility of the market you are trading?2. How much money are you prepared to risk?3. What is your profit target?4. How many shares are you planning to buy?Answer: 2
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Setting stops is an integral part of risk control and money management. Prior to entering a trade you must decide how much money youare trying to make and how much you are prepared to risk in reaching your goal. Gauging possible profits and current volatility is veryimportant but all questions ultimately boil down to defining what riskyou’ll be ready to accept.Question 59—The Impact of the Last TradeWhat impact should the size of your latest profit or loss have on yourplans for the next trade?1. Trade a bigger size after a profitable trade.2. Trade a smaller size after an unprofitable trade.3. Trade a bigger size after an unprofitable trade.4. None of the aboveAnswer: 4Allowing the results of your latest trade to influence your plans forthe next is amateurish behavior. There is a fair degree of randomnessin the market, making the outcome of any single trade difficult to predict. A professional puts his trust not in any individual trade but in hisor her ongoing performance over a period of time. The pros do not letsomething as relatively minor as the outcome of the latest trade makethem deviate from their thought-out plans.Question 60—“The Iron Triangle”Please match the components of “The Iron Triangle” of risk controlwith their descriptions:A. Money managementB. Stop placementC. Position sizing1. Set it on the basis of chart analysis.2. Decide how much money you will risk in this trade.3. Divide one of the three factors by another.
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Answer: 1. B2. A3. CStops are set on the basis of chart analysis. Your money managementrules will give you the maximum amount of dollars you may risk in thistrade, although you may want to risk less. Dividing this number by thedollar risk per share gives you the size of the trade.Question 61—A Limit OrderA limit order is preferable to a market order for all of the followingreasons except:1. It prevents slippage.2. It guarantees execution.3. It works best for entering trades.4. It is useful for taking profits at target levels.Answer: 2Only a market order guarantees an execution. A limit order, on theother hand, demands a fill at a specific price or better—or no execution at all. It helps you avoid slippage, one of the major but seldomrecognized causes of poor performance among traders. The only timenot to quibble about slippage is when you are trying to get out of atrade that is going against you. That’s why it pays to use market ordersfor stops.Question 62—Soft StopsWhich of the following statements about soft stops is correct?1. They are very useful for system traders.2. They offer a good way to get started in the markets.3. They help avoid whipsaws.4. They are easier to set than hard stops.Answer: 3
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A hard stop goes into the market as a specific order. A soft stop isthe number you keep in your head. System traders must use hardstops, as do all beginning traders. Experienced discretionary tradersmay use soft stops in order to reduce whipsaws. Both hard and softstops take the same amount of work and belong on the same level—their placement is identical, only the execution is different.Question 63—A Stop One Tick below the Latest LowPutting a protective stop on a long position one tick below the latestlow is problematic for all of the following reasons, except:1. Even a small sell order thrown at the market near the lows canbriefly push it below the latest low.2. A bullish pattern occurs when a market takes out its previous lowby a small margin and reverses.3. Professionals like to fade (trade against) breakouts.4. Once the low is taken out, prices are likely to decline much lower.Answer: 4The trouble with putting a stop a penny below the latest low is thatmarkets very often trace out double bottoms, with the second bottomslightly lower than the first. The level immediately below the latest lowis where amateurs cut and run and where professionals tend to buy.Once in a while prices take out the previous low and go into a waterfall decline—but that is an exception rather than a rule. It is essentialto use stops, but there are much better ways to place them than onetick below the latest low.Question 64—A Stop at the Level of the Previous LowPlacing a stop exactly at the level of the previous low can be good forall of the following reasons, except:1. A downtrend often slows down as it approaches the level of theprevious low.2. If the stock declines to its previous low, it is likely to go even lower.3. Stocks often accelerate immediately after taking the previous low.4. Slippage tends to be higher when the stop is at the level of the previous low rather than one tick below that low.
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Answer: 4If you put a stop at the exact level of the previous low and that stopgets hit, your slippage is likely to be lower than in the case of a stop atick below that low. Stocks often accelerate after taking out their previous low, causing greater slippage on stops below. Your risk of awhipsaw increases only very slightly—if the stock falls to that level, itis virtually certain to go a tick lower.Question 65—A Stop That Is “Tighter by a Day”Find the correct statement about a stop that is “tighter by a day”(“Nic’s Stop”):1. Examine the bars that bracket a recent low and place your stop alittle below the lower of those two bars.2. Using a tight stop is not suitable for short-term trading.3. This method is especially useful for long-term position trades.4. A tight stop like this one eliminates slippage.Answer: 1Placing a stop inside the recent trading range is designed for shortterm swing trading. It tells the market to “put up or shut up.” Still, nostop order can ever completely eliminate slippage.Question 66—Trade DurationThe outcome of a trade depends in part on the duration of that trade.Find the incorrect statement about the impact of trade duration:1. Longer-term trades give you the luxury of time to think and makedecisions.2. If a day-trader stops to think, he loses.3. The more time a stock has, the farther it can move.4. Long-term position trades provide the best learning experience.Answer: 4
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Time is a hugely important factor in trading. The more time a market has, the farther it can move, increasing both the profit opportunities and the risk of an adverse move. A trader with a longer-termorientation can stop to think, unlike a day-trader who must reactalmost automatically. The best way to learn to trade is by making manysmall trades; the slower pace of long-