, ask: What returnswill I need in order to generate sufficient income? Is my starting equity sizeor bank roll inclusive of my living expenses? Are my expectations on thatreturn realistic on a constant basis?These questions are important because they will help you to determine
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which type of investment vehicle and which type of diversified tradingstrategies you can incorporate into your trading repertoire.
RISK PER TRADEA most important yet simple thought process that a trader can start with islearning how to determine how much equity to put into any one trade or position. How much to risk per trade is a concept that many novice traders failto realize until it is way too late. They end up learning the exact wiring instructions on a regular basis to their brokerage account; the real hard casesend up remembering those instructions by heart. Once you learn and havethe confidence to trade a system or follow a trading plan with a set of conditions and specific rules, you still need to have an effective method for riskcontrols. I would start by considering how much risk per trade I should useby looking at my overall account size, then at the market’s volatility and liquidity conditions, and then at a certain percentage of the overall account ona percentage basis. Let me show you what I mean; and when we go overvarious stop types and methods later in the book, you will be able to bettercomprehend my meaning. If a person wanting to start a day trading account begins with $10,000 and uses a 10 percent risk factor per trade basedon the overall beginning equity size, if the first five trades go bad, then heor she has lost 50 percent of the overall account. Therefore, it is imperativethat traders learn different techniques to protect their trading equity. Investors also need to know the number of positions with which they shouldstart in connection to the account size and the point at which they add onto their contract lot or position size. In Chapter 11, I will go over a methodto help you determine answers to those questions. Then you will have a better understanding of a proper ratio and the point at which you should startto increase your trading size.
NUMBER ONE TRADING FOCUS—RISK MANAGEMENTAs most trading books will explain, risk management is the key to survivaland what trading is really all about. While it may sound like a cliché, thehard truth is that consistently profitable trading, in my opinion, significantlydepends on proper risk taking and risk management combined. Winningtraders follow a tried-and-tested plan based on rules or on a defined set ofcriteria. Winning traders recognize the importance of risk management andof money management. As I stated in my first book, the common denomi-
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nator among losing traders was that most guess and hope and usually say,when asked about placing a stop-loss or taking a profit, “I’ll think about it.”Always remember that when trading with a set of rules, you will neverbe 100 percent right. But if you do not follow a set of rules, you increasethe odds of being 100 percent wrong in your trading. If you manage yourtrading risks and execute promptly on the trade signal, then you increasethe odds that you will be successful. When trading, your mind can playtricks on you. You start to anticipate a buy signal only to act on a false signal. You need to learn when and how an actual signal is generated andwhat and when you should trigger the action to initiate a trade. When youare trading market signals by a predefined set of rules and a set of criteria,then the mind cannot play tricks on you. When a signal says buy, then buy;when a signal says sell, then sell. It’s that simple. Generally speaking, frommy experience, if a trader says, “I am tired of this,” and decides not to takethe signal, that ignored signal is the one that becomes a big winner. If youhave traded before, you may relate to that syndrome. For day traders instock or stock index futures, this usually happens in the last hour of thetrading session!
DIVERSIFICATION IS THE KEY TO SUCCESSThis observation was written by Peter L. Bernstein in his book Against theGods, The Remarkable Story of Risk (Wiley, 1996):All of the tools we use today in risk management and in the analysis ofdecisions, from the strict rationality of game theory to the challenges ofchaos theory, stem from the mathematical developments that tookplace between 1654 and 1760 with two exceptions: In 1875 Francis Galton, an amateur mathematician, discovered regression to the mean;and in 1952, Nobel Laureate Harry Markowitz, then a young graduatestudent at the University of Chicago, demonstrated mathematicallywhy putting all your eggs in one basket is an unacceptably risky strategy and why diversification is the nearest an investor or businessmanager can ever come to a free lunch. That revelation touched off theintellectual movement that revolutionized Wall Street, corporate finance, and business decisions around the world; its effects are stillbeing felt today. (pp. 5–6)With that notion came the concept of exploiting diversification bymeans of spreading investment and risk capital in various markets, such asstocks, bonds, real estate, precious metals, and commodities. There are
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various methods to trade those investment vehicles through the use of realestate investment trust (REIT) mutual funds, exchange traded funds(ETFs), and other derivatives products, like single stock futures, stockindex futures, and options. There are simple and complex strategies evenmore so with the use of options and inter- and intramarket spreading or pairtrading opportunities. We will cover some sophisticated strategies in thisbook as well as basic investment strategies to help you create your own retirement fund.
HABITUAL WINNERS FOLLOW TRADING PLANSTraders need to consider new techniques that will allow for increased profitability and ways to reduce risks. This book will demonstrate how you canidentify conditional changes in the markets and how you can utilize mytechniques in certain setups and triggers based on an approach to usingcandle charts and pivot point analysis that may be different from what youhave encountered before.You will learn which leading price indicators are the best to use, plusprofessional chart-reading techniques and how to apply this knowledge tomake trading decisions based on facts rather than on opinions. You wouldbe surprised at how many times I am asked what my “feeling” is on the market. I can feel upset, I can feel warm, I can feel cold; but I just can’t feel themarket. I can see the price action and can act on a shift in the momentum,and I can determine that the market is currently in an uptrend or a downtrend or in a consolidation phase. I certainly can’t feel the market.I want to walk you through some top chart patterns or setups and triggers so that you can develop a trading plan based on a testable trading system. This will be a method with a complete set of rules that do notarbitrarily change. You will be able to use these concepts in many differentmarkets and in different time frames. This book will go into more specificrules and explanations of setups and triggers than my first book did. Notonly was that first project, The Complete Guide to Technical Trading Tactics: How to Profit Using Pivot Points, Candlesticks, & Other Indicators,a great introductory book that touched on several trading concepts, but itwas the first work that introduced traders to the concept of integratingcandlestick charting with pivot point analysis. Some of the principles inthat first project will be used here, but this book will cover in greater detail how to apply and use those methods so you can learn to make moneywith the triggers. I would suggest that you get that book if you have not already done so, as there are many great tips and suggestions described inthose pages.
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In this book, I want to teach you what to search for when chart reading.I am not going to go into detail on every specific candlestick chart patternbecause I generally only use them to help identify where the market closesin relationship to the open or the past price points, such as the high or lowpoints, rather than rely on them to signal a trade based on traditional chartformations.I believe that, like many things in life, the more you repeat positive actions, the more you will experience and receive positive reactions. In trading, that translates to simply following rules, waiting for signals totranspire, and then acting on those signals, rather than anticipating that signals will form. When signals trigger a buy, then go long; when a signal triggers a sell, then exit the long or go short. As I stated earlier, following a setof rules will not guarantee that you will be 100 percent right in your tradingresults; but by not following a set of rules, your chances increase that youmay be closer to 100 percent wrong in your trading results. One must learnto cut losses and let winning trades ride. It sounds like a cliché to tradingveterans; but the fact is that it is so simple, yet it is so hard to do. By accepting this process of learning some simple principles and then followinga few sets of rules, which I will go into in this book, you become a bettertrader; and that may translate into becoming a more profitable trader.One trait I have noticed that most novice traders possess is that theytry to overanalyze and overcomplicate matters. In order to help simplifyyour thinking, remember this: There are only four common denominatorsthat each of us has equal access to—the open, the high, the low, and theclose of any given market, in any given time frame. There are two other values to measure: volume and, for futures traders, open interest. However,even these two elements cannot be finalized or completely calculated untilthe close of each trading session. Therefore, it is important that you realizethat the close is the single most important aspect when using and applyingall forms of technical analysis studies.So no matter what market or trading vehicle you are trading—whetherit is a stock, a futures or commodity market, a stock index, the forex currency markets, or even an exchange traded fund, you need to watch theclose of the time period in which you are trading to capture a clue in orderto initiate a trade, manage the trade, and learn the right exit spot. Always remember that the close is the most important element and what mattersmost to focus on when trading. It is the relationship of the close to pastprice action and to the high, the low, and the open that will help measure orweigh a value of a given market at any given time. Therefore, you can get amore accurate gauge of what to do. In trading terms, the choices you haveare to buy, to sell, to spread off, or to do nothing and hold onto your cash.Sometimes not knowing what to do translates into not entering a position.Remember that being in cash or standing on the sidelines is a trade, too.
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Once you grasp the understanding that it is the close that shows youwhat the current market value is, then you should have a clue as what yournext trading decision should be. If you learn to act on the close for yourtrading decisions and on triggers, that information will help stack the oddsin your favor that you are going with the current flow or in the right marketdirection. That includes any time period for which you are trading. Thatmeans if you are a day trader using a 5-minute period, you cannot act on anintratime period signal. You need to wait for the five-minute period to conclude before acting on a trigger. The same goes for a 5-minute, a 60-minute,a daily, a weekly, or even a monthly time period.The clues for which we as traders are looking are what we need to initiate a trading decision and are what I define as a trading trigger, which willbe explained later in the book. Once you understand how markets work,understand simple charting techniques, and have a fundamental workingknowledge of indicators and what dictates increases or decreases in valuesof a given product at a given time (such as supply and demand factors) andhow that is represented on a chart, then you will have gained a better edgein the market and will have stacked the odds of success in your favor.There is one flaw in any system, and it is generally from the executionside rather than from the construction side of the system. To be specific,most traders who lose while trading a system fail to trade by the signalsgenerated by that system. Either they fail to act once the signal is generated, or they anticipate that a signal will be generated thus acting on afalse signal.It is imperative that once you read this book you learn that you mustwait for the actual signal to trigger, and that occurs in most cases by theclose of the time period in which you are trading. Even when a system generates a losing trade, it will signal a trigger to get out. You must act on confirmed signals rather than on anticipation of those signals or, moreimportant, on your personal hunches.Once you have a working knowledge of the markets and the confidencein what the possible outcome of those triggers might be, working with a fewsetups and signals will allow you to find a trading opportunity; and then youwill be able to apply the appropriate strategy. You can diversify tradingstyles, such as integrating a day trade into a position trade, utilizing an option strategy, or applying the information on various trading vehicles.I talked about this concept of “finding opportunity, then applying astrategy” in my first book: I called it playing the Monte Hall game, Let’sMake a Deal. Look behind door number one, and review the risk rewards;then look at the strategy behind door number two, and review the risk andrewards there; and then finally open door number three, and see if thatstrategy appeals to your analysis of risk and rewards. Remember, you candetermine, if an opportunity is longer term in nature, to use an option strat-
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egy (such as an outright long call or put); a ratio back spread; or, if the bestopportunity exists taking a position in a stock, a stock index future or possibly an ETF or a holding company depositary receipt (HOLDR).
INVESTMENT VEHICLESThere are all types of trading and investment vehicles. Some are slightlymore complex than others, and some offer increased leverage, such as futures and even forex currency markets. Some have short life spans due toexpirations, such as an option or a futures contract. A trader or an investorneeds to examine his or her personality profiles, tolerance for risk, personaltime availability to devote to trading, and the time objective or turnover forachieving specific profit objectives. Once those are determined, then he orshe needs to choose the right trading vehicle or a mixture of asset classesin order to apply a trading strategy.Therefore, it is important to have several different types of trading accounts for taking advantage of various investment products and levels ofrisk, such as long-term retirement versus short-term speculative trading opportunities. A stock account will allow you to trade stocks, stock options,mutual funds, and ETFs.A futures account will allow you to take advantage of the many opportunities of various commodity markets and options, in addition to day andswing trading the highly liquid stock index futures markets such as theDow, Standard & Poor’s (S&P), Russell 2000, and Nasdaq 100 contracts.Some futures brokerage firms even have access for spot foreign currencytrading on their trading platforms. I have been in the futures and tradingbusiness since 1978. I trade my own money, I have been a broker, manageda brokerage firm, owned a trading firm, but, most of all, I enjoy trading myown money. In fact, the principles I am sharing in this book are the sametechniques that I have taught my family. Remember that my father used tothink commodity trading or day trading was like gambling. But at age 71, hestarted gaining an interest in what I was doing, especially as he saw thefruits of my labors. More important, he witnessed the trading successes myson was also achieving and started to see that the pattern of what I wasdoing was teachable. In 2002, I had my son start a retirement stock accountwith what I call a core position of select stocks. One such stock was General Electric, which he purchased at 24.60; another stock I had him purchase was Rambus at 5.62. In both cases, he made out extremely well. Infact, if you know stocks, you may recognize that those prices were darnclose to the exact lows in 2003. Let me tell you it was not by chance or luckthat I had picked those prices; it was by using the methods I am going to describe in this book.
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Incidentally, here is how my son got hooked on day trading: In early2005, he was watching me on one of my appearances on CNBC. My son isself-employed; he owns cellular phone stores and sells satellite dish systems. He keeps the television on in his stores to show customers the satellite systems. After watching my appearance on CNBC, he left the televisionon; later that day, he started listening to Mad Money—the Jim Crammershow. Anyway, my son started trading his own stock account.He called me one day to ask my opinion on a particular stock. That’swhen I found out what he was up to. Now, my son is pretty smart; but therewere several things he was not familiar with, for instance, what a stop-lossorder was. As you might imagine, I was insanely furious with him for notknowing important yet basic concepts of trading. After I got through yellingat him, his mom (my wife) got hold of him; after that conversation, one ofmy trading courses was shipped out FedEx, and he quickly studied. He gotback on the right track, gained an interest, and learned how to trade by myset of rules and by looking for such trading patterns as a high close doji(HCD) buy signal and a low close doji (LCD) sell signal. Both of these specific setups and triggers are covered in this book. The next course of actionwas to get him set up with the right markets to day trade and to open theright brokerage account to meet his needs for both his short- and long-termobjectives. Now this is what I taught my son, and he has been consistentlyimproving in his trading ever since. That is what my Dad saw, and he foundmerit in my methods. Therefore, I hope this solidifies your belief thattraders can and do make money trading in the markets. Just find the rightmethods with which you are comfortable, stick to the trading rules (such aswaiting for the triggers, rather than anticipating and acting prematurely),find and investment strategy (such as day, swing, or position trading), andthen get confident that you are applying the right strategy with the rightproduct (whether it is stocks, futures, options, foreign currencies, or forexmarkets). You have the potential to become a successful trader once youhave these conditions mastered. The next process is finding the right software product and brokerage firm.I have been in the industry for over a quarter of a century, so I knowwhat to look for in both trading firm and software that suit my needs. I havethe experience to know that not all trading companies are equal. The plaintruth about it is that some companies are just better than others. Remember the debacle of REFCO? These guys were a behemoth in the futures andspot foreign currency trading business. They had a ton of talented people,some who are ex-employees of mine and some who I consider friends. Inever did trade through them. Mainly, I was happy elsewhere. But as theyears passed, REFCO just became too big. I like personalized service, andI don’t need a company to provide me with daily research. You need to findout what appeals to you and how to make a brokerage firm work for you.
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It’s not the other way around. Keep in mind that a brokerage firm should beconsidered an employee—it works for you! I have a rating sheet for my subscribers of my advisory service of the pros and cons of several brokeragefirms. If and when you are looking for a brokerage firm and want to see aratings consensus, just visit www.nationalfutures.com, where I can giveyou a heads up on the pros and cons of several trading firms and the onesthat I have accounts with. You can use it to find out which one fits yourtrading needs. As I say, some are better than others. Trading expenses suchas commissions are important, but dealing with a cheap deep-discountcommission brokerage firm that has no backup support does not suit myneeds. A solid company that has competitively priced commissions, a loyalsupport staff, and pleasant customer service is what I look for. I like onethat actually answers the phones and takes care of an issue immediately;that is the ideal company to do business with, and there are many of them.That is the information I share on my web site.
FX—FOREXYou may be familiar with or have heard the term foreign exchange market,which is known as the spot forex or FX market or foreign currency market.It is an over-the-counter foreign currency market. You can trade foreigncurrencies against the dollar, which is knows as the cross, such as the eurocurrency versus the U.S. dollar; or you can trade pairs, which is two separate foreign currencies traded against each other, such as the euro versusthe Japanese yen. It is a 24-hour marketplace in which most companies donot charge commissions; rather, a spread on each side of the bid-and-ask ofa trade is taken. Traders like this feature because they feel it is a “pay as yougo” cost of doing business.This book will go into explaining several investment vehicles, such asstocks, futures, options, and forex. I want you to realize that the technicaltrading patterns, setups, and triggers I will teach and explain in this bookare applicable to all of these trading vehicles.
STOCK TRADING OPPORTUNITIESStocks offer opportunities to long-term investors based on a company’sperformance. There are many advantages and disadvantages when tradingstocks. Some feel that stocks should be a buy-and-hold investment vehicle,and I agree to some extent. I believe the world and business move in cycles,as does any industry or business sector. Investors need to monitor which
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sector or industry is hot or running cold, as the dot-com bubble demonstrated. Since we can learn from history and a picture speaks a thousandwords, let’s go over a few chart examples if you want to know more aboutthe disadvantages of investing in stocks. If you were invested in these companies, had a bad experience, and do not want to be reminded, just flipthrough these next few pages. If you are new to the investment world andwant to know how fast fortunes and retirement accounts were lost, just askinvestors who bought Enron, WorldCom, United Airlines, Kmart, and FAOSchwartz just before these companies filed for bankruptcy. And that is justa few of the companies that took major dives. There are those investorsthat are hanging onto hopes of their stocks coming back to life, companieslike Lucent, as shown in Figure 1.1. Lucent Technologies, Inc., engages inthe design and delivery of systems, services, and software to communications service providers, governments, and enterprises worldwide. It willtake a lot more patience to see this stock come back to life. This stock wasgoing to be the next IBM of the telecommunications world, which goes toprove that you can’t believe everything you hear.
FIGURE 1.1RealTick graphics used with permission of Townsend Analytics, LTD.
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CANDLESTICK AND PIVOT POINT TRADING TRIGGERS
Then there was the new age revolution of fiber optics. Remembers JDSUniphase? This company provides communications test and measurementsolutions and optical products for telecommunications service providers,cable operators, and network equipment manufacturers. The company operates in three segments: Optical Communications, Commercial and Consumer, and Communications Test and Measurement. As Figure 1.2 shows,this stock has just never come back to life.Then there are some companies that had investors gleaming with joy—that there was never a chance those stocks would drop, but drop they did.However, not all stories have bad endings. Take a look at Rambus, Inc., acompany that provides chip interface products and services. Its memory interface products include XDR memory interface, RDRAM memory interface, and DDR controller interface technologies, which provide an interfacebetween memory chips and logic chips. Figure 1.3 shows that there is lifeand hope for some stocks, this one included.One more darling from the Internet craze was Red Hat, Inc., which provided a competitive operating system to Microsoft. Red Hat has related
FIGURE 1.2RealTick graphics used with permission of Townsend Analytics, LTD.
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FIGURE 1.3RealTick graphics used with permission of Townsend Analytics, LTD.
software and services based on open source technology for various enterprises. Its products include Red Hat Enterprise and Linux Red Hat Application Solutions, which include software for managing web content andsoftware development. The Linux systems and storage availability was asure thing for investors, one of those “can’t lose” propositions. As Figure 1.4shows, that is not how Wall Street saw it in the long run or how it rewardedthe stock price. However, there is hope; and as you can see, the stock isspringing to life. The examples here illustrate how investors need to watchover their own investments. The markets generally overreact both on ralliesand on declines. Sectors and business cycles change; competition can forcecompanies to lower prices, thus resulting in lower profit margins. Businessmodels, consumer spending habits, and the leadership or management of afirm can change. That can have a direct impact on and can change themorale and the business structure of a company. And that is what can affecta company’s bottom line.The dot-com implosion and stock market crash did not wipe out allcompanies; and, of course, some companies fared better than others. Agreat example of bringing a company back to life is, without a doubt, AppleComputer, Inc.! This company manufactures, designs, and markets per-
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CANDLESTICK AND PIVOT POINT TRADING TRIGGERS
FIGURE 1.4RealTick graphics used with permission of Townsend Analytics, LTD.
sonal computers and related software, services, peripherals, and networking solutions worldwide. The company’s products and services include theMacintosh line of desktop and notebook computers. It was the introductionof the iPod portable digital music player, accessories, and services thathelped propel this company into a killer performer and one of the bestcomeback stocks from the dot-com and stock market peak in 2001. SteveJobs is the cofounder and CEO of Apple; and as I stated a moment ago, it isleadership and motivation that can help inspire a company to great fortunes, as Figure 1.5 shows.When you look at a strong performer of a stock in a specific sector,traders and investors are obviously looking for appropriate risk/reward opportunities to trade that stock. There are many choices and various strategies to employ. This is the selection process of what we do in “findingopportunities and selecting the right strategy.” Once again I call it the “let’smake a deal” game. What we are doing is simply looking for the best strategy that maximizes our level of expected returns while minimizing ourrisks. We are looking for the optimal trading strategy. Traders can examineand weigh what is the most apropriate risk/reward perspective:
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FIGURE 1.5RealTick graphics used with permission of Townsend Analytics, LTD.
• Door Number One: Could be an outright stock purchase with a selective stop-loss.• Door Number Two: Could be utilizing the options market. That can bean exciting and worthwhile exploration of a simple purchase of a calloption to utilize leverage or the use of a more complex strategy, such asa bull call spread, or a hedging program, such as a collar strategy. Thelatter uses the premiums collected from the sale of an out-of-the-moneycall option to purchase a close-to-the-money put option, which in turnprotects the price erosion of an underlying stock position.• Door Number Three: Could be taking a trading opportunity by implementing a spread strategy, which would involve buying one stock andselling short another. This is a sophisticated strategy and one that beginners should study extensively prior to implementing. However, ifyou enjoy following and understanding who and what the competitor isin a specific sector or industry group, this could be your cup of tea. Selecting the right stocks requires extensive research and a good workingknowledge of the fundamentals of that sector or industry. After all, you
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are looking for one company to outperform the competitor, so youneed to know as much as possible about that business.Trading decisions and correct stock selection involve more than looking at a chart and a few technical indicators. I believe it helps to look a little deeper in expected earnings forecasts and price-to-earnings (P/E) ratiosto see if the stock is expensive or cheap relative to current prices. Calculating P/E ratios is an easy concept; for example, if a stock is trading at $40per share and has an earnings of $4 per share, the P/E ratio would be theprice of the stock divided by the earnings—$40/$4, or 10 times earnings.
SPREAD TRADING TIPSIf you decide to take advantage of a spread trade, you should realize that itis a risky business. You could be on the wrong side of both markets. Sincespreading involves selling short one stock and simultaneously buying another stock, if the price goes in the opposite direction of both trades, youcan lose on both sides of the trade. Selling short is a hard concept for manytraders, both novice and experienced, to grasp. Believe it or not, there aresome folks who are not aware that you can sell first without owning the security. Short selling means you are betting that the price of a given productwill decline; therefore, you would be selling first without owning the underlying product with the hopes of buying back later at a lower price. Selling short is considered highly speculative for stock traders; the processinvolves “borrowing” the stock from the brokerage firm, if the firm has thatsecurity in inventory. Shorting stock is very similar and should not scare investors. It is a very simple concept; in fact, it is just the opposite for longs.You want to buy low and then sell out later at a higher price. With shorting,you are selling first and buying back later, hopefully at a lower price to generate a profit.There are certain restrictions; for one, you need to set up a margin account with your brokerage firm. Another restriction carries potential execution risks: Due to Securities and Exchange Commission (SEC)regulations, there is what is known as the “uptick” rule. The uptick rule wasestablished in the 1930s to prevent a bear market raid on a stock. In orderto execute a trade, the stock needs to trade at a price higher than the preceding transaction price in the same security. For example, if you wantedto enter a spread by selling Dell Inc. and buying Apple, you would havebeen anticipating or looking for Apple to outperform Dell’s price gains. Orif both stock prices decline, you would want Dell to decline more thanApple. But in order to effectively execute that strategy, you would want to
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enter the sell side of the spread first because there are no restrictions on entering the long side, just on the short side of the transaction. Let’s say youenter the long side first without confirmation that you were filled on theshort side; if the market on the position you hold—the long side—goesdown and if both markets moved in tandem, you would need an uptick onthe short side in order to be in the spread. Imagine if you went long first andthe stock dropped. Then when you are finally able to execute the shortside, the market has plunged. That would translate into an actual loss. So ifyou do not get filled first on the short side, the worst that can happen is thatyou lose a trading opportunity. This is a great example of why traders havethe obligation of knowing all there is about the market they trade in. As youcan see in Figure 1.6, Dell has moved in the same direction as Apple, butApple has outperformed as a price leader. The spread opportunity betweenthese two computer manufacturers, long Apple and short Dell, would havegenerated a tidy profit.Another example of a spread opportunity within competitors