ences that can make metrade. Boredom is not a reason to trade. Being down for the day is not areason to trade. The market doesn’t care about my being up or down. Itgenerates profitable opportunities regardless of what I want. I wait for themarket to create a situation I can recognize. I am not eager to find thetrade. I will know when it comes along. I don’t have to be in the marketall the time. I sit and wait for the right opportunity. My money workswhen it’s in a trade that exploits a profitable opportunity. My moneyworks when it’s sitting on the sidelines being ready for the right moment.You can use these mantras or design your own for your specificproblems. Their repetition really helps instill good habits and tune up yourmindset. In early chapters we discuss a trading journal as a way to pinpoint a specific mindset problem. A combination of such diagnoses withmantras creates a powerful way of troubleshooting your trading.
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CHAPTER 8
Rules for and the Mindset of a Mature TraderThe Dos and Don’ts of Trading
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here are times when I think I could write a manual on trading that wouldtake just a few paragraphs. In fact, after I went through all the hassles oflearning to arrive at such simplicity, it is difficult to remember anddescribe all the hassles. A very brief explanation wouldn’t be too helpfulto newer traders, since they need to be informed about the process oflearning. I’ve discussed my trading history, my experiences, my tradingeducation, my tricks of the trade, and my horror stories. Now I’d like topull it all together.Trading should be natural and easy. Don’t force anything, and don’tfight the market or yourself. Perfect trading is like breathing. You inhaleand exhale, enter and exit. Be calm and relaxed. Look for recognizableopportunities. Be focused and alert. Detach yourself from the heat ofaction. Be an observer and wait for opportunities to find you. Don’t tradewhat you can’t read. Don’t think you have to trade everything. There arejust so many opportunities that fit your personality, your ability to read.Take those, and ignore the others. Don’t try to be a universal trader whocan trade any type of market on any given day.Don’t fight. Trading is not war. The market is not after you. It has noidea you exist. In fact, it has no ideas at all. Stock doesn’t know youbought it. It does its thing—just go along with it. The market is your boss.Obey it and get paid, or rebel and get fired. You don’t fight the ocean; youswim in it. If you find yourself in a current that takes you in an undesirable direction, you don’t try to change its direction. Look for anothercurrent.Don’t guess. Don’t personalize the market. Don’t expect the marketto care. It doesn’t care. It’s not hostile. It’s not friendly. It exists. That’s83
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it. You are free to engage or not. Trading is ultimate freedom. You are freeto decide when to go in and when to go out. The market is an endless flowof opportunities for profit and loss. It’s for you to choose. The market presents opportunities to you. Be open to perceive them. Be open-minded asthe market talks to you in its language. There is just one language of themarket. It’s the language of price, volume, and pace. Any tool you use toread the market is derivative of that original language. All the junk surrounding this direct conversation between you and market, like rumors,tips, analysts’ opinions, other traders’ opinions, can only distract you fromthe reality of price, volume, and pace.Forget that your money is at stake. Money in a trading account is justa tool for making money. Preserve your tool. You need it in order to makemoney. By taking stops, you preserve your tool from grave damage. Themarket is not certain; it works in probabilities. Hence, stops are unavoidable. Take them with no hesitation when the market says you are wrong,and your tool will survive to serve you another day. Admit when you arewrong. Now and then, a stock will shake you out and reverse. Don’t let itforce you into ignoring stops. You can always reenter a position, but youcan never get back your loss. Each loss carries a lesson, and it’s up to youto assign the price to that lesson. Do not pay more than you have to. Thinkof your trading as a whole, as a never-ending process. Don’t put too muchsignificance on any one trade; it’s just one of many. Allow yourself tolose, and move on.Do not take a trade out of revenge or because you need money. Themarket has no memory or knowledge of you. It’s just a giant pool ofactions of other traders. It’s not going to reward you just because you needto be rewarded. You are the one who is in charge. You have the power totake the money out of the market or to lose it to market participants.When traders engage in market activity, they put their money in abig pot. From the moment they start a trade, this money is faceless andnobody’s. Anyone is free to take it if his or her skill allows. By puttingmoney in the pot, each player assumes the risk of losing it. This risk is balanced against the opportunity to take the money from the pot. You assumethis risk; you put your stake on the table, like everyone else. Never feelguilty about taking money from the pot.Understand that risk is inherent and a natural part of trading. Youaccept the risk when you move from a less volatile commodity (money)to a more volatile one (stocks or whatever market vehicle you choose totrade). You do that because this volatility is what you need in order tomake money. With opportunity comes risk. You can’t get one without theother.
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Trading can and often should be boring. It’s normal. You are not init for excitement. It’s okay to spend hours sitting in front of your screendoing nothing. This is not a job where you get paid by the hour. You getpaid for doing the right thing. The right thing to do is often to stay awayfrom the action. If you want excitement, look for it somewhere else. Learnto find the joy in self-control. Accept the boredom that is a part of goodtrading.Never think, “I know what the market is going to do.” You don’t.Nobody does. Think, “I know what I am going to do in any scenario themarket presents.” Determine your action for any possible scenario. This isyour ultimate freedom and protection. The market can do nothing to yououtside of your set of if-then scenarios. In every one of those, “if ” is formarket action and “then” is for your response. You cannot control whatthe market does, but you can control and should adjust your response.Decide what it is you are going to trade. If it’s a trend, follow itsdirection. If it’s a range, fade it. Buy high and sell higher in an uptrend.Sell low and cover lower in a downtrend. Buy low, sell high in a range. Ifyou play a trend reversal, don’t do it on price alone. You need a more solidreason to buy than, “It’s cheap enough,” and a more solid reason to shortthan, “It’s too expensive.”Define your signals. A signal generated by your system is the onlyvalid reason you have for making a trade. The rest is emotions. Don’t letemotions dictate your business decisions. When your trading system generates an entry signal, take the trade with no hesitations. When your trading system generates a sell signal, close the trade. If you question yourtrading system, test it on paper. Don’t trade if you’re testing.Establish your level of aggressiveness. Know your trade-offs. Ahighly aggressive approach maximizes your profit in cases when you areright but reduces the number of cases when you are right. A conservativeapproach allows you to be right more often but diminishes your profitpotential in each case.Stay flexible. Modify your trading system to correspond to marketchanges. Adjust your level of aggressiveness and the setups you choose tothe kind of market you are dealing with. Constantly check whether whatyou are doing matches market conditions.Define what a sucker is. Suckers think they are smarter than the market. Suckers think they can figure it out. Suckers think there are secret systems and indicators. Suckers think they can avoid losses. Suckers don’tapply stops because they know they are going to be right. Write down allthe traits of a sucker and read them often to see if you spot any such traitsin yourself. Don’t be a sucker.
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Define how a winning trader thinks. Write down all the traits of agood trader and read it often to see if you are there yet. Use this comparison to see where your weaknesses are and what you need to work on. Bebrutally honest with yourself. Everything you don’t tell yourself, you willhear from the market, and it won’t be pleasant talk.Whatever happens to you in the market, it’s never the market’s fault.It’s not the market maker or specialist’s fault. It’s not the mysteriousmanipulator or evil short seller. It’s always you. You make the decision.You implement it. You engage and disengage. Accept full, undivided,absolute responsibility. Be your own person. Don’t complain and don’texplain. With responsibility comes control. Gain total control of yourself.Trading is the ultimate exercise in self-control. This is a cold and uncomfortable feeling at first—the feeling of being alone in your castle. The joyof having your edge and being the best at it will come and compensate youfor that discomfort. The feeling of great self-control, of total power overyour own actions, will be a great reward for all your efforts. Be the master of your universe.Learn self-irony. Don’t take yourself too seriously. You don’t haveto prove anything to others. Be the first to laugh about your mistakes.Unburden yourself of the pressure of trying to be perfect. Excellent isgood enough.
PART TWO
Trading System
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CHAPTER 9
Tape ReadingRevitalization of a Lost Art
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art One of the book describes Vadym’s journey as a trader—fromnewer trader to reality trader. This part of the book describes our tradingsystem. We talk about criteria we use for entries and exits, and about ourmethod of reading price movement. We go over the major principles oftape reading and show how they help to identify the forces behind thescenes. We also show how we build the setups—the logic that lies underthis process. This part will not only help you understand our setups, but itwill also help you build your own. We describe our setups and explainhow they should be played. We go over the concept of stop-loss placementand trailing. In this part, you will see examples and real schematic charts.When there is no symbol of the stock in a chart, it means that the chart isan example, created manually to illustrate the idea in the text.Finally, we present numerous examples of real trades with detaileddescriptions of trade development. We want this part to be somewhat of a“pulling it all together,” so we describe not only particular trades but alsothe logic, philosophy, and psychology of every move.
ONE SIZE DOESN’T FIT ALLYou need to keep several things in mind. First of all, by no means do weconsider our system to be “the one and only.” There are many of them outthere. Some work today and will frustrate their users tomorrow. Some suityour personality and risk tolerance; some don’t. You already know fromour discussion of the edge that eventually the only system that is going towork for you will be the one you create for yourself, either from scratch89
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or by applying your own spin on something that already exists. What wedescribe is ours. We have taught many traders this system. They use oursystem either in its pure form or in their own variations of it. You will seeour system and you will also see how it’s built. As a result, even if yourultimate approach is totally different, you will still be able to use ourmajor ideas. In addition, the principles of tape reading will be helpful foryou no matter what system you use. What we describe is not a system thatworks for a year or two and then fades away. The major principles of thisapproach stem from the things that never change, since human reactionsto market events have not changed in hundreds of years.Second, what you will see is fairly simple. We are not fans of overcomplicated systems that rely on dozens of indicators. When we sayuptrend, we mean a series of higher lows and highs. When we say downtrend, we mean a series of lower lows and highs. You do not necessarilyneed a formal indicator to see whether there is a trend; a simple look at thechart is usually enough. You don’t necessarily need any calculations orindicators to see the strength of a trend; the steeper an angle, the strongerthe trend. A working system isn’t necessarily cumbersome, oversophisticated, and incomprehensible for anyone but those with a Ph.D. in math,chemistry, philosophy, and economics. It should be transparent for you, oryou will trade on “black box” tips. At the same time, don’t be fooled bythe system’s simplicity. This is the kind of simplicity you arrive at aftermany complications.You will also notice that this system is more the reading of certainvisual formations than of certain numbers and their relationships. Weoften hear that a “real” trading system should be quantifiable. This is notnecessarily the case. Attempting to tie your action to quantified indications can easily lead you to a search for the Holy Grail. As we discussin Part One, art is as important an element in trading as is science. Andthere is no place for the word always in trading. Chart readers use visualformations to make their decisions. Everyone knows about flags, pennants, and the like; those are visible formations. Similarly, our setups arecreated when a certain formation takes shape on the chart, not when onenumber exceeds another. This can be complemented by some indicators.Third, this is an intraday trading system. Principles of reading arepretty much the same for any time frame. You need to apply them to theone you trade in. But we are intraday traders, so each of the examples youwill see is happening within a single day. Also keep in mind that it’slargely a trend-following system. It performs well in a trending environment and leads to a diminished percentage of winners and lower returnsin ranging markets. This doesn’t mean that you need a strong trend
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throughout the day to use this system. The market often produces severaltrends within 1 day. From the point of view of a trader operating in longertime frames, each trend is just a noise, but an intraday trader switches easily from long plays to shorting or from longer holding times to 20–30 centscalps. Don’t forget also that no system works in every market environment. Narrow ranges and choppy movement are conditions a traderavoids.Fourth, while tape-reading principles are the same for any market,there are many fine distinctions in each market’s mechanics. Our personalexperience is limited to the Nasdaq, and the fine details concerning timeconsiderations, price ranges, and other pieces of mosaic could and will bedifferent for other markets. You will see references to the NDX as a general directional indicator, but Nasdaq futures may be used as well. Also,if you trade a stock that moves in conjunction with a particular sector, youcan use this sector index to gauge broad strength. All this does not meanthat this system will not work with different markets. You just need toknow the specifics of your trading vehicle.Fifth, this is mainly a trend-following system. It’s based on thepremise that the trend continues until it reverses. Until you see clear signsof the reversal, you need to play in the trend direction. There are tworeversal setups that we tend to use as reasons for an exit strategy ratherthan an entry strategy. In these cases, we identify that the trend has alower probability of continuing from these points.We will mention confidence levels. A confidence level is simply alevel between the current price and the stop price that allows us to gaugewhether the trend of the stock is still intact given our time frame. If thestock breaks this confidence level on any kind of retracement, then wenormally look to exit the trade on the movement in the direction of thedominant trend to get a better exit price than what a stop price would giveus. (See Chapter 11 for details.)Finally, no matter what system you use, ours or someone else’s oryour own or a combination of these, always remember that no systemworks by itself. It’s you who makes it work. It’s you who follows the rulesor breaks them. It’s you who patiently waits for the valid signal or reactsimpulsively on everything that moves. It’s always the trader!
DISCOVERING WHAT TAPE READING REALLY ISThe principles of tape reading date back nearly 400 years to the beginningof commodity speculation. Whenever there is disagreement on the perceived or intrinsic value of a product, there is cause for speculation about
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where that price will move. Principles of tape reading take you right to theheart of this speculative arena. They match price movement to crowdbehavior in the form of a rate of volume.Tape readers see price movement in relation to the rate of volumeand can determine when the footprints of stock action are made. Tapereading allows one to understand the actions of the minority and eventually the majority when it climbs in. These principles are applied to anindividual security’s behavior and to the broader market trend’s behavior.Why a stock is moving is not an issue. The evaluation is concentrated onwhere it is moving and how far it can move in that direction. Trading tipsoften don’t pan out, and news creates countertrends to what is deemedlogical. This is where tape reading saves us from our ego and ourselves.The truth of stock movement lies in the tape, not in our ego.Over the past years, we have watched thousands of traders bring newmethodology to the marketplace. There is literally a system for everyspeculative tool available. A few of these systems are quite good, and others are just plain ridiculous. However, with the advent of the great bullmarket of the 1990s and Internet mania, even the mediocre system couldproduce fairly good results assuming it didn’t dictate going short on anynew high. This is where the beginners’ understanding of market reality,which was far from true reality, lead them to great losses. This is whathappened during the bear market of Nasdaq in 2000–2002. What workedeven 1 year ago doesn’t necessarily work today in the majority of thesesystems. However, it is clear that one system has stood the test of time.More interesting, no one had been teaching it.Tape-reading principles, having been around for 400 years, haveseen every possible market there is, and they continue to produce consistent results in bear and bull markets. As you can see, Jesse Livermore’sprinciples and understanding of market behavior need to be taught to thetrading community, but not in a way that we have ever seen before.With something so universal that has stood the test of time, it’snecessary to revive an in-depth understanding of how tape-reading principles can take us to the root of price and rate of volume. They show usthe footprints of the minority and how to capitalize on the irrationalityof the crowd when it finally figures out what the minority alreadyknows.The next section may be somewhat too basic for an advanced reader.However, we would like to take you through the entire logical chain toshow you how tape-reading principles give us the correct approach to themarket.
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ARE YOU THE MAJORITY OR THE MINORITY?Tape-reading principles suggest that the majority is usually wrong. Theidea of tape reading is based on the obvious fact that, in the markets, onlya handful of players take the money—from the majority. The market usually moves in a way that hurts as many players as possible. The path ofleast resistance is opposite to what the majority expects. To define thedirection that the crowd does not want or expect means to define the waythe market is going to move. The mechanics of this phenomenon are quiteobvious when you think of this in the following terms.Imagine a situation in which everyone has bought a certain stock.There are no more buyers. What happens when people decide to liquidatetheir positions? Obviously, they won’t be able to find another buyer untilthey offer the stock at a price that is far lower than the price the last tradeoccurred at. This creates a snowball effect in which players decide tounload their holdings, some because their targets are reached and othersbecause their stops are hit.The direction changes to the opposite—opposite of what? Not onlythe opposite of the previous trend but also the opposite of what all theplayers that bought the stock expected. They were buying the stockbecause they expected a further advance. In this hypothetical situationwhere everyone has already bought this stock, you will see overwhelmingly positive and optimistic opinions about the stock. It’s very importantto understand since this is what makes stocks reverse to the downsidewhen the situation looks the brightest and to the upside when everythinglooks totally dark.Indeed, this example is extreme. In real life it’s impossible for 100percent of the participants to have bought a certain issue. Still, it illustratesthe idea that at some point the correlation between those who want to takea position and those who have already taken it creates an imbalance tosuch a degree that potential sellers outweigh potential buyers at any givenprice. That’s where expectations of the buyers are no longer valid andtrend reversal occurs.Add to this the fact that every buyer who has already taken the position becomes a potential seller. Now the picture becomes crystal clear.The chain of events is simple. There are not many players who have anestablished position at the first stage of the move. Thus, there are notmany potential sellers who are waiting for the price to rise. The path ofleast resistance is up, so the minority starts accumulating shares. Then theprice movement attracts attention and more players get in. The crowd discovers the gem, and aggressive buying hits the stock. As the majority hits
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the stock, too many players are in and too many potential sellers are lurking. Distribution by the early buyers starts, while the lack of new buyersleaves the stock with no support. Ultimately, late buyers are left holdingthe bag.
MARKET IRONYWhat we have just described is a major law of all market-related events.The same mechanics work with setups that become too popular. Theycease to work when they are followed too widely. Any inefficiency orwindow of opportunity created by the market exists until it’s discovered by the majority. SOES (Small Order Execution System) banditsused a new direct-access SOES to exploit inefficiencies by market makers that were not used to being this open to added liability due to theirrequirement of having to maintain an orderly two-sided market. TheseSOES bandits enjoyed their window of opportunity until the crowdsdiscovered their strategy. So-called ECN arbitrages were taken out ofthe game even faster. When a CNBC commentator said that it wasprobably time for the masses to learn how to short stocks, the marketstaged a staggering 500-point bounce the very next day, July 24, 2002,after months of steady decline! This example will be a classic for yearsto come.Let’s get back to price movement. Evidence of accumulation anddistribution in the market at levels where the minority (smart money) isparticipating to a greater degree is often masked to the public until thetime is right. Then positions are unloaded as the majority catches on. Thiscan be seen in numerous examples in any given week or month. The market is a discounting mechanism by which the majority usually enters andexits at the wrong time. The major idea is that the public is the last to participate, so when the public comes to buy, there is no one left to buy fromthem. Thus, majority participation creates the final stage of the movement,which is followed by a reversal. The same happens when the majoritysells in aggregate. There is no one left but buyers. Note that when we say“masked,” we don’t mean anything conspiratorial. It’s simply recognitionof the fact that smart money tries to act in a certain way and tries to control the impression its action makes. On the other hand, the public acts inan unorganized way, driven by chaotic emotions.We see examples of this during times of capitulation, where themajority creates selling pressure that is so strong that it exhausts selling.The majority participates in this aggregate selling phase as a crowd.Meanwhile, the minority (smart money) finds the point where the major-
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ity sells. When selling becomes exhausted, the smart money reverses andgoes long. The same thing can be seen on the long side, where the majority feels as if it has missed out on a major market or stock move and can’tstand to see it rise more without it. This brings in majority buying andeuphoria, until buying becomes exhausted. The minority then begins todistribute shares to the crowd buyers from positions it has accumulated atlower levels.The best example of this can be seen in the 1998–2000 move fromNasdaq 1500 to 5100 and then back down to 1600 and back up to 2300.Euphoria took the market to 5100, and capitulatory events, not to thedegree we saw in 1998 but still strong, took the market to 1600. Then, asthe market consolidated during the accumulation phase near 1600 as themajority was still selling, the market began to move upward, discountingthat the worst of the economic and business cycle was over. The minoritythen began to distribute shares as Nasdaq neared the 2200 level, as themajority began to feel as if it was missing out on the resurgence of the bullmove.
THE ACCUMULATION/DISTRIBUTION RELATIONSHIPThis cycle of accumulation and distribution favors the minority who canread the tape of the market and participate at levels that feed off the usualignorance of the majority. It may not be fair, but it’s how the game isplayed. Tape-reading principles allow you to watch how the minority isparticipating and then how to profit from when the majority creates theherd movement, which signals a short-term stop to the current trend.As we defined the role of the smart money and the public in the pricemovement, we must now learn to distinguish their action. The major difference that allows us to distinguish the action of smart money from thatof the public is the character of price movement and volume changes. Asa rule, smart money action can be seen as a slow, gradual price movementwith steady or slowly increasing volume. The public’s action is characterized by hysterical and parabolic price spikes, almost vertical movementwith a sharp volume increase.Let’s pause here and define the way we progress from this point tobuild a sound trading system. We know how to distinguish the smartmoney action from that of the public, and we want to position ourselveson the smart money’s side. In order to realize this in practical trading, wemust establish principles that allow us to see different combinations of theprice and volume changes and their meaning. The next element we needis timing so as to allow us to find particular entries. This part is solved by
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setups that govern our points of entry and the direction we take. Setupsalso provide us with the structure that shows us where the stop should beplaced because this structure will show also the signs of the trade failure.And, finally, after our position is established, we read the tape to find themoment when the movement becomes exhausted, in order to liquidate theposition. We will take you through the system, building in this order.Careful readers will find that, by using this methodology, they will be ableto create their own setups, trading systems, or modifications of an existing system. The value of this skill is hard to overestimate as the marketchanges make us adjust while we are constantly tweaking different elements of our strategy.There are six principles that will allow you progress in your tapereading skills. They are discussed in the following pages.
Major Principle1. Euphoria/Capitulation. An acceleration in the price advance, almostvertical movement accompanied by a volume surge, is usually not sustained and indicates the end of this stage of the move (euphoria stage).(See Figure 9.1.) This is a perfect example of how the majority is usuallywrong as it lets greed overtake fear. This is often the last stage of themove, as the majority finally sees what everyone was trying to hide andjumps on the bandwagon. Distribution takes place by smart money. Sinceour understanding of the tape principles dictates that the majority is usually wrong, it is time to unload positions or at the very least, not get caughtup in the buying frenzy that usually signals the top of the move. Ask yourself how many times you bought the top. We prefer not to count them (onboth hands and feet), as we move through our learning phase regardingtrue market reality. This is a feeling of unbearable pain from missing thetrain, from standing on the sidelines while “the entire world is makingmoney” that causes those late entries on a parabolic stage of the move—and those entries are being punished severely.An acceleration in the price drop, almost vertical movement accompanied by volume surge, is usually not sustained and indicates the end ofthis stage of the move (capitulation stage). (See Figure 9.2.) Once again,tape-reading principles save us from our ego and misunderstanding ofmarket behavior. The capitulation scenario is the opposite of euphoria.The majority is selling in aggregate during the phase where fear overtakesgreed. In this case it’s still the same unbearable pain; this time it is thepain of holding the plummeting stock that causes this screaming reaction,“Just get me out!” Traders or investors just don’t care anymore. They
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FIGURE 9.1The euphoria stage of a trade movement. (RealTick graphics are used with permission of TownsendAnalytics, Ltd.)
want to forget this stock. Their pain has reached the threshold where theirloss has exceeded all expectations and effectively numbed all their feelings but “sell and forget!” The smart money waits for this level of sellingto slow down and looks to support the stock for a trend reversal by establishing a position favoring the long side or by covering portions, if not all,of its short positions.
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FIGURE 9.2The capitulation stage of a trade movement. (RealTick graphics are used with permission ofTownsend Analytics, Ltd.)
In our practical, intraday trading this principle serves two purposes.First, we use vertical spikes with a volume surge to liquidate our positions, selling our shares into a buying frenzy or covering our shorts into asharp sell-off. This effectively puts us on the side of the smart money aswe ride the trend while it’s slow and get out when the crowd comes in.You can see how this corresponds to the ideas we discuss at the beginningof this chapter and how those ideas tie into practical reading of the market movement. By using this price/volume correlation, you can positionyourself on the right side, trading against the majority instead of being apart of the losing crowd.Many traders we taught over years have told us that this approach ofliquidating their positions into price/volume spikes entirely changed theway they traded and made their trading orderly and more profitable. Ithelped them cure the problem of selling too soon, since they stopped taking little profits just because they had some measly 10-cent movement intheir favor. This also helped them solve the problem of holding too long,which allowed profits to evaporate. Instead they started selling or partialling out into those spikes, which brought nice structure to their trading.
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Second, we start hunting for a trend reversal when we see hystericalmovement. We talk more about this in Chapter 10. For now, let’s say thatthis kind of play is based on the same idea: When the movement becomesparabolic and the volume surges, it is an indication of majority action.Since the crowd is last to act, we can assume that the trend is about toreverse.
Supporting Principles2. Trend Beginning (Aggress