bound was sharpand decisive.The Fed began to lower interest rates, the economy was still doingwell, and international economies began to benefit a bit from loweringcentral bank policy. Stocks continued to rise and those who sold near thelows had to buy back in at higher prices. Now we have smart moneyprofiting and dumb money paying for their tuition but now becomingmore informed about market events and possible underlying reasons formomentum. Now dumb money continues its cycle to become informedmoney. The informed money cannot wait to see this event again so theycan profit the next time.For 2 long years the informed money waited. In April of 2000, wesaw a very sharp pullback in the marketplace after an incredible rise inthe Nasdaq from 1998 lows. We were at near 1,500 in the Nasdaq duringthat 1998 low. We hit a high over 5,100 in the Nasdaq just 2 years later(see Figure 4-5).Internet stocks continued to rise, but a new sector began to fly. Thebio-tech sector had amazing climbs with some stocks moving from the40s to over 300. The rises in these stocks were incredible. We slowlytopped above 5,100, pulled back a bit, and then failed on that retest ofthe highs in the Nasdaq. What happened next was clearly ugly as wetrended to near the 3,000 level over the next 11 weeks. However, theinformed money was begging to see this event about to unfold, while thedumb money was incredibly destroyed as it occurred. This marked, inmy opinion, a national personal wealth catastrophe for the newer tradersto the market.In times of market corrections, much of the underlying greed andexcess speculation is wiped out as traders’ portfolios become more riskaverse. Many of these traders pull away from concept companies withuncertain futures and look to reallocate their risk to more solid growthcompanies with real earnings or straight dividends. In April of 2000, wesaw the majority of Internet and bio-tech companies off some 50- to 80percent from their highs as continued nervousness hammered thesestocks.
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Institutional traders were raising cash and selling stock on anystrength. We saw many unsustainable rallies leading to the 3,000 level.A redistribution of stock clearly occurred as active traders were buyingstock from the institutions on the way down. Eventually, institutions willbe accumulating the shares again from those who can’t take the pain ofthe loss and sell at lower levels. Then markets stabilize and resume theirclimb.The two periods were interesting in that the reasons behind the corrections were different. As we noted earlier, in 1998 we had a global crisis with Asia and Russia providing much of the catalyst for the sell-off.The Fed stepped in with interest rate cuts and the IMF was approvingbailout funds for struggling economies. Long-term capital received itsangel and only a month later, traders were back to buying up shares asinterest rates kept falling. As we approached late 1999, we had differentfears. Initially, many were looking for a sell-off prior to the New Year onY2K concerns. We saw very little selling as we approached the New Year,
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and basically it was a non-event in that nothing major happened to endthe world or provide a global computer breakdown.After the New Year celebration was over, the markets powered tonew highs on a very strong market volume, creating excess in the wealtheffect that was worrying the Fed as inflation concerns were growing. TheFed had increased interest rates six times in a row and was slowing theeconomy. The slowing economy and acceleration in inflation was causefor concern as traders who bought in above 4,500 on the Nasdaq, andheld, faced a rough road as we neared the 3,000 level on lingering fearsof uncertainty as the economic outlook grew larger.Two totally different reasons for uncertainty and fear lead to themarket declines. Those who were unaware of the reasons for the momentum to the downside refused to accept that the trend was lower, and themarket itself took care of their closed-mindedness. Those who wereaware of the reasons behind the momentum were able to either minimizeloss or lock-in surest profits. Again, the paradigm of the smart andinformed money was succeeding over the dumb money.Now that we have explained two of the major forces behind today’snew market momentum, it is important to understand that although ashift in portfolios from broker-managed to self-direction is occurring, theold style of money management is still the largest force in the marketplace.Although active traders are able to affect price movements in certainstocks to a varying degree, the action of the market is still controlled byinstitutional money. This requires that active traders understand andrespect their control so as not to negate their effect on their own thinking.The latest figures of online trading suggest that one of the largestonline brokerage firms holds nearly $50 billion in their client’s assets. Thisseems very impressive until we research the traditional style brokeragefirms such as Merrill Lynch that manage over $1.5 trillion in assets.Evidence suggests that the old style of investing is still not going anywhere anytime soon. Therefore, we must not fool ourselves into thinking that the online traders are in control of the markets and be aware thatinstitutions are still the big players. They will continue to be big enoughto move sectors and stocks on a much grander scale than online traders.To discuss the new market momentum, a trader has to understandthat although institutions still control markets, online traders havebecome more involved in individual stocks that they deem worth participating within. Market participants cannot simply ignore active onlinetraders but have instead planned ahead to take advantage of the situation. For example, Market Makers are selling order flow and continuingto take profits from the spreads in stocks. They are also learning to maskintentions much better than the professional traders so as not to have any
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unexpected price spike or sell-off that would worsen the price for theirclients on entry or exit. One of the better examples of how online traderscan affect a stock price is shown in a stock report newsletter.Recently, an investment newsletter mentioned the stock AgilentTechnologies (A) as a top focus stock (see Figure 4-6). This report hadbeen hailed in previous weeks as something that could move stocks.Basically, traders would receive information about several stocks in thisnewsletter and one or two stocks would have very positive commentsregarding top focus picks. Once the report is released, active traders rushto read the newsletter and find out which stock or stocks are being toutedin the newsletter. Once they figure this out, they rush to their orderscreens and try to get in ahead of the pack. Agilent Technologies was sucha stock.Within 30 minutes of the release of the newsletter, the stock hadjumped over $10 a share. In these circumstances, online traders who haveaccess to this information in real time can clearly benefit from the pricespikes if they are early enough to get in near the price that it was at asthe news came out. If online traders had to call their broker to place atrade, they may very well have been filled at a much higher price afterthe stock took off on the news, leaving anyone who was late to the newsto just watch. Again, although institutions are able to move markets andindividual stocks, online traders are continuing to add to the momentumin individual issues.To be fair, the online trader really needs to be segmented into at leasttwo classes. Some online traders simply do a few trades a year for thedecrease in trade costs. These traders do not enter and exit trades withina few minutes, nor do they constantly watch every tick of the market.They are more passive to their trading with a defined short- and longterm plan. The other group, however, is far more interesting as they aremore active.As we discussed earlier in the book, active traders are commonlyreferred to as daytraders or momentum traders. They tend to use directaccess brokers and are in and out of stocks many times a day everyday.Their risk management skills often relate to exiting stocks quickly to avoidsustaining big losses and they rarely hold stocks overnight. They eitherbased their decisions on tape reading, technical analysis, or simple naiveté,depending on where they are in their trading curve. These tradersare many times blamed for stock moves to the upside and downside inparticular issues. These comments, which you will see on CNBC and othermedia sources, are only partly correct.
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We explained that institutions control trillions of dollars of assetsand have the ability to move the market more than any online tradersdo. Certain stocks in the market have an enormous amount of marketparticipation in each stock as well as a large float relative to demand andsupply. Sector leaders are characteristically these kinds of stocks. CiscoSystems (CSCO), Dell Computer (DELL), and Intel Corporation (INTC)are examples of stocks with enormous floats and incredible marketparticipation.Online traders do not have the power to move these stocks out ofnormal ranges. There simply isn’t enough money spread around to thesestocks on any given day to make them move abnormally from onlinetraders. When a report is given that daytraders are selling off a certainstock or that active traders are running a stock up and that stock is onewith plenty of market participation and a sizable stock float, then thoseoffering that report are misrepresenting the real reason for the move.
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Stocks that online traders are able to provide momentum in arestocks that have a relatively low float and some fresh news or hypeattached to it. Clear examples of this kind can be seen when one checksthe charts on Multiple Zones (MZON), K-Tel (KTEL), Books-a-Million(BAMM), and Xybernaut (XYBR). All of these stocks had released somekind of news that was favorable at that time and the stocks spiked hardon added momentum. More familiar is the quick rise in these stocks followed by the sharp fall back to original levels as those active traders beginto sell shares into strength or short the stock as the stock begins to showsigns of weakness. Thousands of these kinds of stocks exhibit this actionevery year. This is mainly due to the active traders moving into the stock,driving the price up, and then immediately selling the stock as it beginsto top or into strength. The stock then makes a reversal to the downside.
THEME MOMENTUMNew market momentum continues to be fueled by the theme of the dayas well. Over the past 3 years, we have seen some incredible moves instocks because they were simply a part of a hot theme at the time. Forexample, 3 years ago, all a company had to do was announce that theywere going to build a Web site and the stock would rise fast as activetraders nailed it. Eventually, we moved through themes of Pokemonstocks, China stocks, and Fuel Cell stocks. Active traders watched eachtheme closely during these times of interest. These traders, for quick profits, jumped on any stock that was tied to the latest theme. However, eventually these themes and newsletter plays will begin to fade as theincreased amount of traders entering the same stock tends to destroythe play.Remember that market momentum includes basically three facetsof traders: institutional, online, and daytraders. Institutional traders tryto fill clients’ orders at specific price levels. When stocks begin to spikeup or down unexpectedly, it makes it harder for these traders to fill theorders at those price levels. Let’s take the Agilent Technologies (A) in theprevious example. Suppose a client of theirs wanted to make a purchaseof 100,000 shares at no worse than $85 a share. When the stock receivesthe newsletter momentum, the client may not get his or her order filledas the stock is now trading over $90 a share and the client becomes upsetat the inability to get the price that he or she wanted.
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Furthermore, the institutional trader is unhappy that the institutionwas unable to fill the order. This is because they lose out on the commission of that trade that went unfilled as well as the possible loss of thatclient if the inability to execute trades consistently occurs over a specificperiod of time. They are traders the same as we are. If they aren’t able toget excellent prices for their clients, their clients may look elsewhere. Thisis akin to us switching brokers when we are fed up with poor executionsand missed trade fills.Therefore, if institutional traders find it hard to enter and exit tradesbased on newsletter momentum, then pressure may be on the newsletter writer to release their report at times that will not cause such amomentum run up during the day. For instance, they may release thereport before or after the market opens or over the weekend. This waythe market can have more time to digest the news before the stock opensfor trading and may provide ample opportunity to enter the stock beforeit jumps. Although this obviously will not cure the whole problem, thepoint is that these newsletter plays tend to die out as other methods forrelease are implemented to produce a more orderly trading environmenton the stock.The reason that news alerts and other fast momentum plays tendeventually to fade is due to the increased amount of traders in theseplays. The more traders that enter the trade on the way up, the more theyare forced to take faster profits. They are selling these stocks muchquicker, and are trying to exit before other traders exit. Eventually, thestocks do not react enough that even the small scalpers will enter thetrade and the stocks receive no attention. The risk versus reward for theseplays becomes greater in risk, and traders leave these plays alone untilthey begin to show strength again. Usually, they tend to die out as traderslook for other areas of momentum.A great example of this from 1999 is what was called a Dayinvestoralert. Dayinvestor was a site that mentioned breaking or relatively freshnews about stocks on their Web site. The Dayinvestor alert would thenbe posted to other chat rooms and bulletin boards and active traderswould jump on the alert. The stock would climb anywhere from a.50-point to a full point on average and traders would exit within thatprice range. However, as traders began to notice that the profit potentialwas only near a .25-point and then .03 of a point and then nothing, theyleft the Dayinvestor alert alone. It simply wasn’t able to provide the samereturns as it did previously. This alert potential lasted several monthsbefore it died out; it is a great example of how online traders and day-
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traders can affect stock movements. However, this again shows howthese types of stock patterns die out quickly.Those who understand the new market momentum and how itworks will be able to adjust their expectations per trade as they see thesetradable patterns come and go in the marketplace. A wise trader learnsto recognize and exploit these patterns. Pattern recognition and how toexploit them will be discussed in a later chapter.
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PREDICTABLE MOMENTUMIn this chapter, we will discuss gauging the predictability of momentumand then discuss how other active traders attempt to take advantage ofthat momentum. Although this is not meant to be an endorsement ofthose methods, it provides the reader with an understanding of whatother active traders are doing and why stocks react the way they do. Wedo this just as a professional football team studies the tapes of the competition to understand how their actions will affect the game as a whole.Specific methods on how to exploit predictable patterns and momentumwill be given in later chapters, fully explaining the Mtrader methods.
PREDICTING MOMENTUMWe discussed in the prior chapter several causes of momentum. We discussed the effect of the vast capital base that institutions have on the markets and on individual stocks. We elaborated on the effect that onlinebrokers and daytraders have on individual stocks but still do not haveon the capital base that can move markets or sectors. They can certainlyadd to the momentum, but it is a following trend rather than a creatingtrend.Fortunately, by analyzing momentum in sectors and individualstocks, we can reasonably create expectations for individual trades.Momentum provides predictability in these stocks that traders can relyon with confidence to enter positions. Obviously, predictability utilizesa statistical approach and although no approach to active trading is ever100-percent effective, predictability does increase the chances of successin individual positions.
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Over the years, I have seen many new scientific eurekas to trading.I have seen technical programs based on statistical research with regressions and standard deviations. I have seen the use of stochastics andcharting that utilizes moving averages for key entry and exit points.Literally thousands of ways are available to trade the market. The keyto these programs is predictability and placing the averages in your favor.Most of these programs should boast a near-70-percent effectiveness intheir programs with a strict stop loss discipline if they are to be worththeir salt.I have seen traders with a 50-percent success rate who continue tosucceed in the long term simply due to taking larger gains and smallerlosses per trade. The main point is putting the odds in your favor.Momentum provides these odds as it pertains to a herd mentality. Theherd can consist of institutions, online traders, and active traders togetheror separately. It is the herd that makes stocks move.
VOLUME AS A FUNCTION OF PREDICTABILITYThe best way to measure predictable momentum is by the volume of thestock. Many programs offer different measurements of volume. Examplesare average daily volume, sudden volume increases or decreases, andtotal daily volume. An important difference must be distinguished earlyso as not to confuse predictable momentum with the simple rise and fallof a stock.Many times I will see on bulletin boards and in chat rooms the mention of a stock that is trading higher by a point or two on volume of about200,000 shares. A lack of volume tends to exacerbate moves both up anddown. This means that any sudden rush of buying or selling can movethe stock a few points on very few trades. A good example of this actionwas found in Sonic Foundry (SOFO) (see Figure 5-1).The stock had come down to about $9.50 a share from a high near$65 a share post-split price. The average daily volume on this stock wasunder 200,000 shares and its float was about six million shares. After coming down off its highs to the low near 9.50, the stock began to make areversal taking it as high as 23 in just under two weeks. The volume stillnever moved much over 350,000 shares a day until a big jump to near750,000 shares when the stock reached that 23 price level.The point is that on an average of about 270,000 shares for a week,the stock moved nearly 13 points higher. This type of action is great forthose who are long the stock from near the 10 level. However, for activetraders, this type of stock is highly dangerous. Lower volume suggestsilliquidity in the stock that provides enough buyers and sellers at tight
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price levels in which to execute a trade. For every 50,000 shares that canmove the stock up 2 points, another 50,000 shares can move the stockdown 2 points. Furthermore, the execution of trying to exit 1,000 or 2,000shares in an illiquid stock becomes more risky. For example, let’s look atSOFO on the way down.On May 10, 2000, SOFO moved down 4 points on 224,000 shares ofvolume. As the stock was falling, the spread on the stock was very wide,at times a 1⁄2 point.If I were long 1,000 shares at 21 and the best price to sell the stockat is 20.50, then I would be facing a loss of $500 right away without anymovement yet. Let’s assume the stock received some profit-taking pressure again and 50,000 shares of sell orders came through while I was stillholding it long. Those 50,000 shares could easily move the stock downanother point to a best exit price of 19.50. Now I’m facing a loss of $1,500on relatively light volume. If 19.50 is too much pain to take, I decide totake a loss for $1,500.
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I enter my exit order and the order is sent to the markets. The MarketMaker on the best Bid is only showing a liability of 100 shares and is nota true buyer. Therefore, he fills 100 shares of my order and moves off thebest Bid and now the best Bid is 19. Now I’m facing a loss of nearly $2,000and my exit order still isn’t fully executed because I still have 900 sharesleft. The Market Maker at 19 fills 500 of my exit order and lowers hisprice too.On a total of 200,000 shares traded, the stock has dropped 2 1⁄2 pointsfrom my entry price and cost me a loss of anywhere from $2,000 to $3,000.Although these stocks can move higher on lower volume, they can certainly fall just as fast. This is not the type of predictability that momentum traders are looking for.Predictability must be weighed against the risk of the execution sothat when a stop target is hit, one has no trouble in executing that stopprice. Trying to fill an exit order on an illiquid stock is considerably morerisky as we saw in the previous example. Any strong selling while nobuyers are present can move the stock down 2 and 3 points in no timeat all. Exiting the stock on a long position into strength is easy becauseplenty of buyers are willing to buy your shares that you want to sell.On the other side is the possibility that you are selling to a limitedbase of buyers and driving the price lower to make it attractive enoughthat they will finally step in and fill your whole sell order. In an illiquidstock on lower volume, this can easily cost a loss of multi-point potential. For active traders, these kinds of losses must be avoided if the plancalls for a more strict stop loss adherence.
VOLUME AND PACEMany traders will look at the rise from 9 to 23 and consider this momentum. Although the rise is certainly great to see for those who are holding the stock long, this isn’t the momentum that provides predictability.For momentum to provide predictability, we like the volume to move ona pace that is moderate to fast. The pace of a stock is the trades per second or minute. This is usually a visual presentation on a Level 1 screenthat is reflecting the time and sales ticker. Using Real Tick software, I amable to see a shading effect for every trade on the stocks that I have listedand I like to think of the pace as those joining a party. The more participants you have in a short period of time, the better the party. Volumeindicates interest in the stock and the pace of the trades indicates the current interest in the stock. A fast pace with volume indicates enoughmomentum by which to trade.
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For example, let’s assume a company receives pre-market newsthat they are in a deal with Microsoft in which Microsoft will take a 30percent stake in them. Yesterday, the stock closed at 20 and today is beingbid up in pre-market trading to 23 on total volume near 2,000,000 shares.At first look, we see the volume and easily see that the interest is presentbecause of such huge volume. However, we look a level deeper and seethat four 500,000 blocks went off, totaling the two million shares.Although the interest from the volume is certainly present, the momentum is not because the amount of traders interested in the news was nomore than four institutional type buys.Therefore, we need to distinguish volume from pace. Pace is the rateby which trades are happening. We want to know if there are 60 tradesper second, 300 trades per second, and so on. Two million shares of volume on 10 thousand trades is much better potential for predictablemomentum than four 500,000 trades equaling the same amount.
The next aspect of momentum is price action. A stock that trades two million shares in a day but only has a range from 6 1⁄4 to 6 1⁄2 is not a momentum stock. The volume and interest are present. The pace is great as a lotof trades occurred to form the high volume. However, the stock did notmove a bit, providing no profit opportunity. We see this somewhat oftenin small stocks with large floats or on companies that are bought out ata certain price level. An example of this was Novell Inc. (NOVL) (seeFigure 5-2).Novell Inc. (NOVL) made a great move from 1998 when it was inthe single digits to over $40 a share. Recently, the stock has pulled backto single digits and is now looking rather stuck. The volume each day isexcellent in the near-5-million-share average area. The price range, however, was no more than a 1⁄2-point in the last week of May 2000. The floaton this stock was 299 million shares. With so much stock traded each day,the interest is certainly there, but the momentum is weak, providing little opportunity, as explained with the narrow intra-day range.
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PREDICTABLE TRADE VOLUMETherefore, for a stock to have predictable momentum, it must havelarger volume. I like the stock to have at least 50,000 shares of volume inpre-market trading. Within the first 10 minutes of the trading day, I liketo see the volume at 200,000 to 500,000 shares traded. After the first hour
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of the trading day, I like to see volume nearer 1 million shares traded.I feel this type of volume provides enough predictability for momentum.In addition to the volume, I like to see the pace of the trades at close to45 to 60 trades per minute. This lets me know that there is enough interest in the stock that is indicative of the volume reading for the day.Finally, the stock must create a large enough intra-day range thatwill offer enough potential. This intra-day range is where the unknownof the trade occurs. We develop our expectations reasonably to take profits at key price areas based on how much of a range we expect will bemade. Sometimes we expect a range of 10 points to be made, whereason other trades, we may feel only one point will be available. In each case,we must develop a plan of entry and exit relative to these expectations.Momentum defined as a rate of change in the pace of trades entailsseveral tradable options throughout a trading day. Momentum accelerates and decelerates within tradable ranges that key us into entry andexit areas. A slow momentum stock can provide the same profit potential as a fast momentum stock. The profit potential is the same, but thetime it takes for that profit potential to be realized is different. This iswhere understanding momentum and setting reasonable expectations in
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each trade enables a trader to take more profits out of a trade and keeplosses small when the trade does not perform to expectations.Active traders are indifferent to the pace of momentum as long as itoffers a reasonable amount of potential for profit. I have seen traders holda daytrade from 9:30 A.M. EST to 4:00 P.M. EST because the trade offereda nice, slow, consistent climb all day long with very little selling pressure.I have also seen traders hold a stock for no more than 30 seconds becausethe momentum and price action was such that exiting the stock intostrength was the proper exit strategy. Whatever the momentum, as longas the trade is performing to expectations, it can be held. When themomentum shows a conflict in expectations, then it is time to assess howmuch of the position to exit and at what levels. The following section provides a few examples.A slow momentum stock will certainly test your patience. Activetraders tend to want their profits and want them now. Typically, in thiskind of trade, a stock will make a very slow move upward with severalmarket participants selling a lot of shares on the way up to fill clientorders while supporting the stock on the opposite side of the trade. Theinterest in the stock will be a steady flow of volume with a few surgesin volume as traders see certain Market Makers adjust their price levelsand elect to trade the stock for a quicker scalp type play. The slowmomentum stocks offer three different possible trades. The first trade isthe buy and hold trade.The buy and hold trade will entail a trader entering the trade nearthe absolute top or bottom of the day. Let’s assume that we are going longin this situation. As the trading day begins, a trader will look for a bottom at nearly the beginning of the trading day. Typically, he or she willlook for any selling pressure to wane, the Bid level to strengthen, andthen an up-tick in the price of the stock to confirm the reversal to theupside has occurred.Often the stock up-ticks right at the open, at which point tradersmay elect to go long immediately. Once the stock is entered on this bottom, the stop price will be placed at the price that the stock failed to breakbelow. For example, if a stock bottomed off of 20 and up-ticked to 20 1⁄8,then the stock’s stop price is no worse than 20. The reason for the tradeis that the expectation for 20 will not be broken to the downside. If selling is at 20, then traders will exit the trade with a small loss.After the trader enters at the first up-tick of the trading day, he orshe will begin to monitor stock participants who may be supporting thestock as it rises. Conversely, the trader will be also be looking for market participants who impede the rise of the stock. We call these market
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participants the ax of the stock. They are not allowing the stock to movehigher in price at a faster rate. A Market Maker may do this for manyreasons and none of which you may find explained in an unmonitoredchat room or bulletin board service. Many refer to the axing of a stockas some sort of Market Maker manipulation in which they drive the priceup or down to hurt retail and active traders. Although Market Makersclearly have many intentions, focusing on active traders is one of theirleast priorities. They are filling orders for sizes in the six figures. For themost part, they could care less about my 1,000-share order unless it helpsthem fill their client’s order.Typically, Market Makers will try to fill orders in a way that isadvantageous to their clients so that they receive more orders. They makemoney on the spread of the stock as well as on commissions by fillingclient orders in a timely and advantageous fashion; receiving moreorders allows for increased revenue. Their priorities lie within their owninventory and executing client orders. Active traders are less importantunless they are being used to fill these orders. The comment that MarketMakers are driving the price down to buy it back cheaper is one of comical relief for me at times.This assumes that Market Makers purposely hurt active and retailinvestors solely for their own amusement. Again, we are last on their listof priorities to see this action as a solid explanation for why stocks movethe way they do. Do not blame Market Makers for your profits and losses.They have no idea who you are, nor do they care. They are filling an orderfor 100,000 shares on which they make commissions and profit on thespread. We will show you a few examples of this later in the book. Fornow, just realize that Market Makers are more concerned with otherthings than what active traders are doing.
COMPETITION MENTALITYThe following section describes how many traders actively trade andtheir logic behind their moves. It is not intended to provide a cookbookof methods that I use, but simply to understand how others can affectthe movement of a stock. Specific methodology will be given in laterchapters describing the Mtrader method of playing predictable patterns.Getting back to the buy and hold trade, traders will watch to seewhat these market participants are doing in the individual stocks toassess if they are true buyers or sellers and whether or not this stock haspotential to continue an upward move. Much of this