<s> TRADING ONMOMENTUM
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TRADING ONMOMENTUMAdvanced Techniquesfor High-PercentageDay Trading
KEN WOLFFWITH CHRIS SCHUMACHERAND JEFF TAPPAN
McGraw-HillNew York Chicago San FranciscoLisbon London Madrid Mexico CityMilan New Delhi San Juan SeoulSingapore Sydney Toronto
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AcknowledgmentsIntroduction xi
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Chapter 1The Basics 1The Start of It All 1The Essentials 6Chapter 2Getting Started 9Education 9Trading Mentality 21Chapter 3Tools of the Trade 31Traditional and Web-Based Brokerages 31Electronic Direct Access Trading Firms (EDATs)Order Routing Methods 35Advanced Tools of an Active Trader 44Charting Software 49News Services 50
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Chapter 4The New Market Momentum 53The New Players 53Institutional Momentum 55Technical Analysis Momentum 58Online Trader Momentum 58Smart Money, Informed Money, and Dumb Money 63Theme Momentum 70
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Chapter 5Predictable Momentum 73Predicting Momentum 73Chapter 6Predictable Patterns
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Niche Patterns 91Gainer Pattern 93Dumper Pattern 106End-of-Day Gap Plays 111News Patterns 113Chat Room News Hypes 117Patterns to Avoid 118Identifying Short-Term Tops and BottomsUpside and Downside Potential 121Core Methods 124Chapter 7Indicators
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Indicator Stocks 125Picking an Indicator Stock 130Trends 131Chapter 8Market Dynamics
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Market Dynamics 133Two Phases 134The Players 136The Moving Parts 138Trading the Market 146Mid-Range Rule 148Mid-Morning and Afternoon 150The End 150The Specifics 151Example Scenarios 157
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Chapter 9Tracking 163Building a Tracking Diary 163Analyzing the Data 167Forming Expectations 170Relating Market Dynamics with TrackingTracking Summary 175Wrap-Up 175
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Chapter 10Time of Day 179Delayed Quotes 181Numbers 184After-Hours and Pre-Market Trading
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Chapter 11Identifying Trading OpportunitiesTape Reading 190The Market Maker Effect
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Chapter 12Rules of a Trader 203Stop Loss Discipline 204Trailing Stops 207Money Management 210Golden Rules of Trading 211Chapter 13Personal Accountability and Trading AttitudeTrading Attitude 224
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Chapter 14Momentum Investing 231How and Why I Began This Longer-Term Approach 231The Principles of Momentum in Investing 233The Law of Participation 238The Market’s Influence on Momentum Investments 241Defining the Market 242Interpreting the Market 247Momentum Investment Exits 247Pre-Market Gaps 249Closing Combinations 251Epilogue
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Glossary 257Resource List 261Index 263
A C K N O W L E D G M E N T S
We would like to thank Ela Aktay of McGraw-Hill Professional Publishingfor giving us the opportunity to write this book and Beth Brown fromMacAllister Publishing Services for her efforts during the productionprocess. Without your untiring efforts, this book would not have been possible. We also want to thank Victor Jung, a fantastic partner and goodfriend for his remarkable efforts in the production of this book and technically on a day-to-day basis in the chat room pits. And Steve Demarestfrom MB Trading for his friendship and constant encouragement.Finally, a warm and grateful thanks to the thousands of traders, bothpast and present that have graced the cyber halls of Mtrader.com andRealityTrader.com over the years. You have helped us create an explosive online revolution that has literally changed the way traders are educated and enter the trading arena. With your help, we have literallychanged the face of online trading, helping us shift the power of tradingdecisions from brokers to individual traders. Your enthusiasm, thirst forknowledge, and quest for education were the reasons we wrote this book.
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I N T R O D U C T I O N
The face of the stock market has changed forever. With the introductionof the online trader, the market exploded in late 1996, creating volatilityand momentum previously not thought possible. From this, the spawning stocks like Qualcomm, Yahoo, Iomega, and Cisco, only increased theinterest of the everyday American to join the ranks of the do-it-yourselfinvestors and traders. Instant wealth was created and it seemed as if themarket could only keep going up. No matter what a trader did, it washard losing money as the market continued to climb to new heights everyday. This added more members to the online trader ranks as rags-toriches stories were on the news and in almost every conversation on thestreets.Then the bubble popped in March of 2000 just after the Nasdaqpeaked over 5,000. Massive panic hit the streets as stocks continued toplummet and those instant millionaires saw their paper profits disappearalmost overnight. When the market didn’t immediately recover, this further added to the exodus, creating a downward spiral to the likes neverseen in the history of the stock market.For the everyday momentum trader, the period from 1996 to Marchof 2000 was like shooting ducks in a pond. Stable predictable patternsthat repeated over and over again were the norm. All one had to do wasfind a pattern or method that worked and ride it for months on end, overand over again. After the crash in March of 2000, the face of the marketchanged forever. Although the market actually had more of the mainingredient of volatile momentum required for a momentum trader, thepatterns and methods that previously worked for months on end,changed on a daily basis. What worked yesterday, didn’t work today.This new dynamic and ever-changing market took, by some estimates,40 percent of the short-term traders out of the market, permanently.Those traders who learned to change tactics in this new changingmarket, not only survived this new market momentum, but also profited handsomely. The two required traits in the market for a momentumtrader are momentum and volatility. The period after the crash in Marchof 2000 actually showed more of these two traits, yet the majority ofmomentum traders lost in what was actually a better market conditionto profit in. Why? For one simple reason: they failed to change tactics andmethods as the market changed. They continued to do what worked yesterday, but not today. This is the purpose of this book: to teach you the
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techniques and methods that actually do work in this new market, howto exploit the new momentum, and how to profit handsomely from it.A momentum trader doesn’t care what a stock will do next month,next week, or even in the next hour, only how it is currently reacting. Bytrading only what the tape is currently showing, it removes the guesswork of what will happen in the future. Momentum trading is uniquein that it takes advantage of the predictable, repeating momentum cyclescreated by the vast majority of inexperienced traders and investors.These patterns tend to repeat themselves over and over again becausethey are caused by two very basic emotions: fear and greed. Inexperienced traders overreact to the momentum created by news, hype, orcyclical market swings caused by these two basic emotions.By understanding the root causes of these emotions and the abilityto recognize the predictable momentum they generate, professionalmomentum traders exploit patterns that tend to repeat themselves overand over again. The ability to recognize the root causes and the indicators signaling that a pattern is about to repeat itself enables a successfulmomentum trader to enter a trade just as the momentum is starting, andexit sometimes just minutes or seconds later as the momentum slows andturns. By riding waves of continuous momentum, it creates opportunityfor tremendous gains not available to investors or longer-term traders.The vast majority of those who enter into the momentum tradingarena end up losing in the end for the simple reason they do not educatethemselves prior to jumping into the shark filled waters with other seasoned professional traders. This book is designed to give the reader apeek into these advanced methods, the psychology, and unique tools previously only available to a professional momentum trader and level theplaying field.Although Ken Wolff and Chris Schumacher use the same basic coremethods, you will find that Ken concentrates primarily on Level 1screens, using rhythm, pace, indicators, and market dynamics to identify momentum shifts. Chris uses these techniques as well, but takes itone step further by discussing many of the methods available on theLevel 2 screen to enhance these techniques. Many find Level 2 confusing and do not use it at all, whereas others say they cannot trade without it. So, whether you are using Level 1 or Level 2 screens, both arediscussed in detail throughout the book. You will find that these two techniques do not conflict with each other, but build on each method. As youprogress through the chapters, it is important to fully understand the concepts being discussed before moving onto the next chapter as each chapter builds on the preceding chapter.
Introduction
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STRUCTURE OF THE BOOKThis book is divided into three main parts. Chapters 1 through 3 coverthe basic concepts of the market as well as the tools of the trading gamethat you must be familiar with to level the playing field with seasonedprofessionals. You will learn about Market Makers, online teachingforums, and order-routing methods. You may or may not want to participate in online chat rooms, but they have unquestionably become amajor force in the market and can dramatically impact the movement ofcertain stocks. Without understanding these forces, you are playing withone eye closed to the reasons behind those moves. Finally, the advancedtools of an active trader will be discussed.The next section, Chapters 4 through 8, is an in-depth look atmomentum, its root causes, and key factors in identifying who the market players are behind it. By understanding who is responsible for themomentum and the psychology behind the forces that push and pull onthe market, you will then be able to spot predictable momentum patterns.This section explores several niche patterns that tend to repeat themselvesover and over again in certain market conditions. You will also learn tospot certain stocks, called indicator stocks, that tend to lead the movementof the general market and give you an edge on what the market is aboutto do. It will also give you specific methods of assigning a mathematicalscore to each of the major causes of market momentum, creating a matrixthat enables you to determine how certain patterns will react under thesedifferent market conditions.Chapters 9 through 14 examine specific methods, rules, and mindsets that are an absolute necessity for every successful and profitabletrader. It explores how the time of day you trade is just as important ashow you trade and how to create the proper mindset to ensure you donot fall for the most common pitfalls that take most traders out of thegame. The section titled “The Golden Rules of Trading” spells out clearcut rules that I have spent years developing. If you read nothing else, readthese rules.The book concludes with a discussion on what I call momentuminvesting, a unique form of trading that takes the best of two distinctlydifferent forms of trading: momentum trading and investing. No matterwhat your form of trading is, this section will enable you to capture theexplosive gains of momentum trading while participating in the slower,longer-term trades of investing.
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THE BASICSThis chapter will discuss the genesis of the stock market and provide youwith a quick background of the different exchanges and the players whocontrol it. Without this understanding of who controls the trades andtheir motivation behind the scenes, traders cannot fully participate in themarket with open eyes. An in-depth discussion in Chapter 3, “Tools ofthe Trade,” will explore the different brokerage and execution servicesavailable. The last topic covered will be the type of equipment requiredto participate in the new electronic trading world.
THE START OF IT ALLWhen individuals asked how the market was doing many years ago, theywere referring to the Dow Jones Industrial Average. The Dow JonesIndustrial Average, or Dow, is a basket of 30 stocks that is perceived asindicative of the stock market as a whole and its relative strength orweakness. The index includes stocks such as Alcoa (AA), Boeing (BA),Caterpillar (CAT), General Electric (GE), and Walt Disney (DIS).The Dow Jones Industrial Average was introduced by Charles H.Dow in May of 1896 and at first was not widely followed. Charles Dowbegan with 11 stocks to try to apply a visualization of the market shortterm trends. It was a very simplistic approach and one that we may scoffat in current times. However, it was a key building block to how we viewthe markets today. In 1916, the index was expanded to 20 stocks and thenin 1928, to 30 stocks. Periodically, stocks are removed and replaced withnew ones, but they are all leaders in their industry and are widely held.Later in 1929 came the Utilities and the railroad average was renamedTransports in 1970.Copyright © 2002 by Mtrader.com.Click here for Terms of Use.
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With the advent of the Internet age, the Dow has seen some changesin its lineup. In the latter part of 1999, Intel Corporation (INTC) andMicrosoft Corporation (MSFT) ousted Union Carbide (UK) and Chevron(CHV) and were the first two Nasdaq-related issues to be included in theAverage. Many new indices are available now such as the Russell 2000,Nasdaq, Wilshire 5000 Total Market, AMEX, and Standard & Poor’s 500.Basically, each analyst follows a different spectrum of the market andeach of these indices represents a more specific set of sectors or stocksthat are included. For example, the Russell is a measure of small caps,whereas the Wilshire is representative of the entire marketplace.With the explosion of online trading in the past decade, many market participants are now keeping a close eye on the Nasdaq and the S&P500. The Wilshire 5000 has also been watched as a close indicator as it issuggested to be representative of the whole market. Today, when someone asks how the market is doing, we need to clarify which one as eachone tends to have a life of its own. One day the Dow may be up 120 pointsand the Nasdaq down 150 as each has its own character and differenttypes of stocks it represents.These indices are all made up of stocks that are traded on exchanges.Several exchanges are available, but the two most notable are the NewYork Stock Exchange (NYSE) and the National Association of SecuritiesDealers Automated Quotation (Nasdaq). The NYSE registered with the U.S.Securities and Exchange Commission in October of 1934 as a nationalsecurities exchange. In 1971, the Exchange was incorporated as a not-forprofit corporation.The NYSE is an open auction system located in a 36,000-square-footfacility. Institutions and retail investors are represented by Exchangemembers in which they call out bids and offers for stock in specific locations on the physical trading floor. The laws of supply and demand govern the price for stocks in this Exchange. The NYSE uses a marketspecialist whose job is to keep a fair and orderly market in the issues thathe or she has control over.Orders to buy and sell are sent directly to the specialist either electronically or from the agent representing institutions and retail investors.The benefit to having all order flow to a single specialist is the presenceof liquidity. This ensures that prices do not fluctuate in a less thanorderly fashion. This is intended to provide the individual with openaccess to several potential buyers and sellers to get the best price that youcan for your transaction. In contrast to the specialist system, the Nasdaqmarketplace uses a totally different system.
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The Nasdaq opened to the world on February 8, 1971, in responseto Congress asking the Securities and Exchange Commission to conducta study of all securities markets in the late 1960s. The SEC, after findingthe Over-The-Counter (OTC) securities markets unknown and fragmentary, offered automation as a solution. This challenge was set forth to theNational Association of Securities Dealers, Inc. (NASD) for implementing theprogram.Throughout the mid-1970s and 1980s, several key enhancementswere made to the Nasdaq system. Inside quotations were displayed thatoffered the best Bid and Ask prices visually. This narrowed the spread(difference between the Bid and the Ask) in the majority of the 2,500Nasdaq stocks at that time. The Small Order Execution System (SOES) wasintroduced to automatically execute small orders against the insideprices. Finally, in 1997, the SEC approved the Nasdaq’s request to beginquoting stock in spreads as narrow as 1⁄16 to produce better prices.Whereas the NYSE is an actual trading floor, the Nasdaq is a huge computer network that has fueled the trading frenzy that has emerged overthe past 10 years.
MARKET MAKERSIn the Nasdaq marketplace, instead of specialists providing liquidity andorderly pricing, Market Makers assume this role. Market Makers areindependent dealers that actively participate for order flow. They displayquotations that are indicative of their willingness to buy and sell at certain price levels. Over 500 market-making firms provide the needed liquidity in the Nasdaq marketplace.This liquidity provides investors with supply and demand toenhance an immediate and incessant trading atmosphere. Market Makersparticipating in this type of trading are required to follow basic rules setforth by the SEC. They must provide a reasonable two-sided market inthe issues that they make a market. They do this by disclosing their buyand sell quotations. They must honor their quoted prices against liability orders and report the trading in a timely manner per regulations. Theymust also display both quotes and orders according to the regulations inthe Order Handling Rules developed by the SEC.Basically, four types of market-making firms are available. They areretail, wholesale, regional, and institutional. Retail firms employ a retailbrokerage network that caters to individual investors. They tend to facilitate order flow for their clients to provide liquidity for the price of the
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stock to ensure stability. Wholesale firms exist to trade shares for institutional clients. They also act as an agent for broker-dealers that are notregistered Market Makers in a particular issue but need to fill an orderin that stock for their own clients. Wholesale firms tend to be an important facilitator for the other three types of firms.The institutional firm provides service to pension funds, mutualfunds, insurance companies, and other types of money management entities that want to execute large block orders. The regional firm tends tofocus on only companies and investors in a certain region of the country. This allows them to provide more in-depth analysis of companies inthat area for their clients.Since 1971, the Nasdaq market has split into separate markets. TheNasdaq is now made up of the Nasdaq National Market, The NasdaqSmallCap Market, and the OTCBB (OTC Bulletin Board). The NationalMarket lists over 4,400 companies. This National Market contains issuessuch as Microsoft (MSFT), Dell Computers (DELL), Intell (INTC), Cisco(CSCO), and other large and widely known companies of the world. TheSmallCap Market has about 1