of IBM no higher than $51.00When you enter a price with no othernotation, it is automatically an “or better”(price or limit) order.
STOP
SELL 100 IBM 45.00 STOP
Sell 100 shares of my long position if IBMdrops to $45.00 (it is now trading higher at$47.00).
STOP-MOC BUY 1 SPZ3 950 STOP MOC
OCO
Buy 1 contract of December 2003 S&P 500futures if the price is above 950 at the closeof trading (the price was below 950 whenyou placed the order).
BUY 100 MSFT 53.00 OCO SELL 100 MSFT 65.00Microsoft is trading at $57.00 and you arealready long 100 shares. Buy 100 more if theprice drops to $53.00 or liquidate your 100 ifthe price rises to $65.00, whichever comes first.
CALCULATING PROFITS, LOSSES, AND MARGINStocks and futures are quite different. Keeping a record of your profits andlosses can be tricky for futures but very straightforward for stocks.
Stock Profit and LossYou pay face value when you buy stocks. Your cash balance is reduced by thenumber of shares times the share value, plus the commission you pay. Forstocks you pay a commission each time you buy or sell.For example, in a normal stock trade you might buy 100 shares of GEat $40. It costs you $4,000 plus a $10 commission. If you sell those shares at$45 you get $4,500 less another $10 commission. You net $4,490 − $4,010 or$480. You may find it easier to leave the commissions for last, doing thecalculation as $4,500 − $4,000 − $20 = $480. Your return is 12 percent.
FuturesFutures trading is very different from stocks because it always uses leverageand you trade in larger size. If you buy the June 2004 S&P futures (SPM4) at
The Trading Game
85
950, you are buying the dollar equivalent of 250 times the price, 250 × 950 =$237,500. You put up margin of $20,000, which is a good-faith deposit, not thepurchase price. You can actually receive interest on your deposit.If you buy SPM4 at 950 and sell it at 960 you have gained 10 points lesscommission. Each point is worth $250; therefore, you have a profit of $2,500less $10 commission, for a net of $2,490. If you think of the margin as yourinvestment, your return is 12.4 percent. You could calculate your profit usingthe total value of your purchase. You bought (950 × 250 = 237,500) at 950 andsold when the value was 960 (960 × 250 = 240,000) for a gain of $2,500, lesscommissions.
Returns on Stocks and FuturesA $5 move in GE (12 percent) and a 10-point move (1.05 percent of the S&Pprice) in the S&P 500 index futures both yielded a return on investment of12 percent. Yet the S&P made only a small move, while GE moved muchfurther. It looks much easier to get a profit from futures. However, there areno hidden risks trading GE, while the S&P trade has lurking disaster. It’s thesame leverage that gave you the “easy” profit.For stock trades you put up the full value of the share price. No one willever ask you to invest more. Not so in futures. Your margin is not the full priceof what you’ve purchased, only 5 percent to 10 percent of the face value. Forthe S&P trade in the previous example, the margin was 8.4 percent of the contract value. That was a $20,000 margin for the purchase of $237,500 in stocks.If the S&P price dropped to 925 from your purchase price of 950, youwould be losing $6,250 (250 × 25). The rule in futures trading is that, if yourdeposit falls below 75 percent of its initial value, you must replenish the fullmargin. Therefore, your loss of $6,250 brought the $20,000 deposit to $13,750(68 percent) and you now need to deposit another $6,250. Your investment isnow $26,250. If you were to now take a profit of 10 points, your return wouldbe (10 × 250) / 26,250 = 9.5 percent.With futures you gain valuable leverage,but at the risk of having to deposit more if the price goes the wrong way. Thatcan be a big risk.Some additional examples and facts:1. In the trading game, the futures margin for the S&P 500 (SP) will be
$20,000. The margin for Treasury notes (TY) is $2,500 (about 2.5 percent), and the margin for the Euro (EC) is $2,500 (also about 2.5 percent).2. The minimum move for a stock is $.01, or 1 cent. Stocks are no longer
traded in 8ths.
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A SHORT COURSE IN TECHNICAL TRADING
3. The minimum move for the S&P is .05, equal to $12.50.4. The minimum move for the Euro is .01, equal to $12.50. Each purchase is
for $125,000 worth of Euros.5. Treasury bonds trade in 32nds. Each purchase is for $100,000. When the
price is quoted as 102-08, it means 102 and 8/32nds, or 102.25 (in decimal); therefore, a price move from 102.00 to 103.00 is worth $1,000. Aquarter-point change from 102.00 to 102.25 is worth $250.
Selling Short FuturesOne of the advantages of futures is that no one cares if you’re long or short.If you decide that the price is going up, you buy; if you think it’s going down,you sell. In either case you put up the same margin and pay the same commissions. You can profit from a move in either direction.For example, you think the dollar is weakening; therefore, you buy 1 contract (worth $125,000) of Euros at .9850 (981⁄2 cents in U.S. dollars). If theprice of the Euro rises to .9900, you have a 1⁄2 cent profit, equal to $625 lesscommissions. If you think the dollar will strengthen, you sell Euros at .9850.If the price rises to .9900, you have a loss of $625 plus commissions. If theEuro dropped to .9750, you would have had a profit of $1,250 less commissions. There is no penalty and no added cost for selling.
KEEPING A RUNNING RECORD OF RESULTSYou must keep a record of all your trades in a ledger, or trade blotter. At thebeginning of each day you need to see all of your open positions at a glance.You will also want to know your1. Total profit or loss on all closed-out trades2. Average profit or loss per share on closed-out trades3. Profits and losses on open trades4. Total profits and losses on open and closed trades in each stock or
futures market.You must show all profits and losses each day, both closed-out and openpositions. The open positions are marked-to-market at the closing price ofthe previous day, as though they were closed out. For tax purposes it is notnecessary to post profits or losses on stocks that you are currently holding,but you must know the success or failure of your current trades when mak-
The Trading Game
87
ing trading decisions. You can’t wait until you file your tax return to knowhow much you gained or lost. Futures positions have always been marked-tomarket for tax purposes.
Write the Reason for Each OrderIn addition to posting each trade that is filled, write the reason for each orderon the trade blotter (Figure 5.1) at the time it is placed. Briefly explain whyyou’re entering the trade and write your objective on the trade blotter whenyou are filled. When you look back after the trade is over, these reasons willform a pattern.Examples of Reasons for Entering a Trade1. SELL (close out) MICROSOFT 40.00 STOP. Break of most recent low.2. BUY MSFT 73 STOP OCO BUY MSFT 40.00 LIMIT. Buy on breakout of
recent high or buy on a pullback to the downtrend line formed by thethree lows in late May, mid-October, and mid-December.3. SELL (close out) MSFT 68.00 LIMIT. Taking profits below resistance
at 70.4. BUY MSFT MOO. 20-day moving average turned up on previous close.
Stay with the trend.
A Look at the Trade BlotterAfter a week, your trade blotter should look like the spreadsheet in Figure 5.1.Trades are entered in the order in which they occur. Profits and losses aremarked-to-market each Friday after the close. There is a running total of profits and losses as well as the cost of each position and the total capital invested.In this spreadsheet there are six losing trades and six winning ones, but thewinners are bigger than the losers for a net open profit of $3,260 on investedcapital of $51,206. It’s a good start for the week, but it’s only an example.
IT’S TIME TO GET STARTEDNow you’ll need to pick your stocks and print out the charts from one ofthe Internet services. Print out both a long-term chart (at least five years)and a shorter-term period (probably six-months). You may want to download those prices into a spreadsheet using MoneyCentral.msn.com oranother provider.
88
Trader
Sell
ECH2
FIGURE 5.1
Sell
Buy
Buy
XOM
TYH2
Buy
TYC
SPH2
Buy
NOK
01/30/02
Buy
Buy
IBM
Buy
GE
MSFT
01/30/02
Buy
AOL
-1
1
-1
100
100
100
100
100
100
100
100
100
Position
Trade blotter.
01/30/02
01/30/02
02/13/02
01/30/02
01/30/02
01/30/02
01/30/02
01/30/02
01/30/02
Buy
AMZN
Date
01/30/02
Buy
AMR
Entry
Week ending 2/15/02
NamePrice
0.8599
106.297
1115.500
37.950
33.650
22.690
62.320
103.000
36.460
26.700
14.220
25.070
Close
0.8717
107.066
1104.800
38.900
27.900
21.640
60.230
102.890
37.110
26.050
13.410
24.500
0.8825
103.280
1108.000
37.800
27.500
20.500
58.900
99.900
34.900
24.500
10.500
21.900
StopsPL
2690.00754.13(1460.00)
stoptrend
85.00
(585.00)
(115.00)
(219.00)
(21.00)
55.00
(75.00)
(91.00)
(67.00)
MOO
Condition
951.13
2411.13
1657.00
(1033.00)
(1118.00)
(533.00)
(418.00)
(199.00)
(178.00)
(233.00)
(158.00)
(67.00)
CumPL
51206
2500
2500
10000
3795
3365
2269
6232
10300
3646
2670
1422
2507
Capital
48,794
Cash
4,960
P/L
$105,911.13
Equity
The Trading Game
89
First, draw your traditional major trendlines on the long-term chart to getthe big picture of price direction. If the trendline is clearly up, then you’ll belooking at the shorter-term chart to find an entry point to buy. If the trend isdown, you might not want to enter any position at all.You can also display different moving averages on your charts. Try looking at more than one length; for example, show the 50-, 100-, and 200-daymoving averages on the same chart. Look to see which of them fits the pattern of the market best.Compare the moving average trends with your own hand-drawn trendlines. Are they both indicating that prices are moving higher? Considertrading only those stocks and futures whose trendlines and moving averagesare saying the same thing.
Paper-Trading WebsitesSome Internet websites offer the ability to track your orders without actuallytrading. It prevents you from entering an order too late, entering an incorrectorder, or making an error in your accounting. It gives you practice using thesystem. Try looking at the websites for Lind-Waldock and StockTrak.com.Figure 5.2 shows an order entry screen for Tradestation. It’s all intended tobe very simple and fast.Enjoy the game. It’s not real money now, but it will be soon!
FIGURE 5.2
TradeStation order entry screen. They try to make it simple and fast.Image created with TradeStation® 7 by TradeStation Technologies, Inc.
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A SHORT COURSE IN TECHNICAL TRADING
Questions1. Why do you want to choose at least three stocks from three different
market sectors?2. In the price shock of 9/11, which way did GM move and which way did
Raytheon move? Why?3. If the price of Amazon.com is $10 and you wanted to go long 100 shares
at $12, what order would you place?4. IBM is trading at $38. You own 500 shares at $40 and want to buy an equal
amount if it drops to $36. What order do you place?5. You want to buy 250 shares of GE if it rises to $45 and closes above that
level. What order do you place?6. The December S&P futures contract has been in a narrow, sideways
range for three weeks, trading from 950 to 990; therefore, you want to golong above 990 or short below 950 to take advantage of any new direction. What order do you place?7. You bought 200 GE at $30 and the price is now $28. What is your profit or
loss?8. You sold 1 contract of TYZ at 108-16 and the price is now 108-00. What is
your profit or loss?
CHAPTER 6
Channels and Bands
e’re now going to return to charting and expand the single trendline into a trend channel. Channels are useful because they identifythe volatility of price moves. Wider channels show greater pricevolatility. Because price channels add more information to your analysis, youwill be able to add a few more rules to your trading plan.
W
CHARTING CHANNELS1. An upward channel is formed by drawing a line parallel to the upward
trendline, touching the highest high of the same period.2. A downward channel is formed by drawing a line parallel to the down-
ward trendline touching the lowest low of that period.3. You may draw the channel line by cutting off a few extreme high and low
prices, if the new line seems to fit the price pattern best.In Figure 6.1 there are three channels drawn as prices move higher. TrendlineA shows a very uniform rise with slightly increasing daily volatility (the sizeof the daily bar increases as prices increase). A thin channel line is drawnabove prices touching three points, 1, 2, and 3. Near the end of the channelthe price breaks through the top of the channel.The second channel, drawn above the upward trendline B, touches thehighest prices at the beginning and middle of B (points 4 and 5), but is penetrated toward the end of the channel. Volatility is increasing.
91
92
A SHORT COURSE IN TECHNICAL TRADING
6f
Tre
nd
line
C
g
5e
4d line BndTre
321cba
eTr
lind
ne
A
FIGURE 6.1 Drawing channels. Channels are drawn only after the trendline is determined.Trendline A can be drawn across points a, b, and c. You can immediately draw a parallel channelline using the highest point (1) between a and c.
The third trendline, C, is very steep, and the channel line cuts throughmost of the upward price moves near the top of the channel. The channelcould be expanded to allow for the higher volatility at the top of the move, oryou could accept the situation in which you get frequent penetrations of thechannel, yet the channel still represents the price direction and volatility.These charting techniques aren’t perfect. No matter how carefully youplot your trendlines or channels, the market will violate them and thenreverse, as though it knew where you had placed your lines and wanted toshow you that the lines mean nothing. By drawing trendlines that alreadyhave a few penetrations, you prove that you are ready for a few more.
Trading Rules for ChannelsThe ideal channel trade is to buy near the bottom of the channel and sell nearthe top of the channel. That method would have worked well in the firstchannel in Figure 6.1.The first channel could have been drawn safely when the three bottompoints, a, b, and c, fell in a straight line, about one-third of the channel
Channels and Bands
93
length. You could have bought at the time you drew the upward trendlineA, have bought at the time you drew the upward trendline A, sold at the topof the channel three days later, and again bought after another three dayswhen prices touched the trendline again. More buys and sells followed, allprofitable.The second channel offered only one or two chances to trade. If you buywhen the trendline B is formed at point d, you can sell when prices movethrough the top of the channel at $6. Prices retrace to the bottom of the channel once more, giving you another chance to enter, and then move up throughthe top of the channel. This last move is so large that we must consider thechannel no longer intact.The third channel is more of a problem. The first two bottoms, e and f, arevery close together and you may wait until the third low in order to drawtrendline C. If you bought at g and took your profit at the top of the channel,you’ve made the only trade possible.Trading Not Quite at the Top and Bottom of the Channel. It’s unrealistic to think that you can buy right at the bottom trendline, or that you wouldwant to buy there. When prices are dropping to the point where the trendlinewould be drawn, you need to wait to see if prices stop. If they keep droppingthrough the trendline, you won’t buy.To be sure prices have stopped declining, they need to reverse and beginto go higher. It’s only after you see that they’ve stopped that you can comfortably buy. It is normal practice to think of dividing the channel into zonesof 25 percent, or even a lower and upper zone of 20 percent. Anything smalleris too narrow.Your new channel rules become buy in the lower zone of the channel andsell in the upper zone of the channel.
An Important Word on Taking ProfitsProfit-taking should only be used if you are trading quickly. It fights with theability to hold the trend and take advantage of the big profits. In Chapters 2,3, and 4 it was stressed that, as a trend follower, you must have a few verylarge profits to offset the many smaller losses. These large profits are part ofthe fat tail of the distribution—they don’t happen very often. If you takeprofits on a trade, you cut short the extremely large profits that will beneeded for success—you turn a profitable strategy into a losing one.Channel trading is fast; therefore, you can enter on a pullback to a trendline or a breakout, and then take profits based on volatility in the top zone of
94
A SHORT COURSE IN TECHNICAL TRADING
a range or channel. A long-term trader will follow the trend, taking profitsand losses only when the trend finally changes direction.
Redrawing ChannelsChannels will be redrawn in just the same way that trendlines were redrawnin Chapter 2. If the trend changes direction, the channel must also change.Channels are also redrawn when the price breaks through and staysabove the channel top for a few days. Remember that you have a choice ofleaving the channel line untouched and viewing a price breakout penetrationas a false breakout or redrawing the channel to include the top of the penetrating move, representing increased volatility. The channels become cleareras price patterns develop.Figure 6.2 shows AMR, American Airlines’ parent company, in a strong, uniform upward trend. The trendline A drawn along the lows of the move, beginning with the mid-April 1997 and July 1997 points (a, b, and c), is confirmed inSeptember (d), October (e), January 1998 (f), and February 1998 (g) lows.
7eD
n
dli
nTre
6elin
C
ndTre 4 5
3ne
dli
nTre
B
gf
2e
1d
b
ndTre
line
A
c
a
FIGURE 6.2
Redrawing the channels of AMR. Although the channel for this daily chartof AMR is very uniform, it must be redrawn from time to time to account for the increase involatility.
Channels and Bands
95
The first channel line is drawn from the high (1) that came betweenpoints a and b, parallel to the trendline. It does quite well defining the upwardmove. Although it is above the high of April (2) and cuts off the highs of September (3) and October (4, 5), it should be considered intact until December.The penetration of the channel line in December (6) exceeded the previous false breakouts 3 and 4. You might still continue with the original channel line, but you should see this as a continued, natural increase in volatilityas prices move higher. After the December penetration, go back to the previous highs and redraw the channel C to show December as a false breakoutbut the earlier price moves as part of the channel.The same situation occurs in March 1998. Higher prices result in highervolatility, and prices again push through the top of the channel (7). This timeit is too much of a penetration to ignore, and you would redraw the channelline D from the high of December (6), allowing the March high (7) to betreated as a false breakout.
Channels as They Develop for TradingWe’ll take one more look at AMR in the way you would see it if you wereactually trading. This time we’ll take a more recent period, July 2000 throughSeptember 2001, including September 11, just to keep a note of reality (seeFigure 6.3).1. The first upward trendline A is drawn connecting the obvious major low
points a and b. The upper channel line B is drawn parallel to A beginningat the high in between, point 1.2. The channel top is broken on the next move up and peaks at 2 near the
traditional price objective of the channel width measured from the oldchannel top (the distance from A to B added to B).3. We can only watch now until the low at c is made, which is clear after
prices stop and reverse about $3 to $4.4. A new trendline C can be draw slightly higher than the original line touch-
ing the two lows a and c, treating b as a minor false breakout to thedownside.5. A new channel line D is drawn from the highs (2) parallel to the new
trendline.6. The next highs (3 and 4) actual fall on the original channel top, making
the peak at 2 look like a false breakout. Time will tell.
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A SHORT COURSE IN TECHNICAL TRADING
eTrendlin
D
2Trend
line
E
34
dline B
1 Tren
dline C
Tren
dline A
ba
Tren
c
e
d Trend
line
G
Trend
line F
FIGURE 6.3 Trading the channels as they change. It is normal that trendlines andchannels change with price patterns. In this chart there is a classic change of trend from upto down and sell signal—just in time.
7. A price drop to the low d makes everything more complicated. We might
have a downside breakout, moving below trendline C. We can now drawa new downward trendline E from the highest high 2 across the next high3. We draw a downward channel line F parallel to E starting at the low c.8. Prices move higher after d, and we can now choose whether we want to
use the first or second upward trendline. Either one could work.9. Prices fail at point e, right on the new downtrend line, and start declining
again. The next breakout becomes important because the price pattern isnarrowing and it must break out either up or down.10. In August prices break below both uptrend lines A and C, rally briefly
above the newer line, and then start falling. You should be short.11. Persistence and good analysis are rewarded. September 11 causes prices
to drop 25 percent and you’re short. Although prices were heading down,September 11 could have come when the trend was still up. The charting was good but the last profit was luck, not skill. Never mistake luckfor skill.
97
Channels and Bands
ENVELOPES AND BANDSWhile a channel is formed by two rigid parallel lines, an envelope or band willfollow the shape of a moving average trendline, or some other calculated line.It can be very flexible and quickly adjust to volatility changes.
Percentage BandsA common way to form a band is to use a percentage of the moving averagevalue. For example, to get the values of a 5 percent band, one way to do this is:1. Create a 20-day moving average (MA) that will be the center of the band.2. Multiply the current value of the moving average by 1.05 to get the
upper band. If the moving average value is $30, then the upper band valueis $31.5.3. Divide the current value of the moving average by 1.05 to get the lower
band. For a moving average value of $30, the lower band is $28.57. Youmay also multiple by .95 to get the lower band of $28.50.MA20 = current value of a 20-day moving averageUpper band = MA20 × 1.05Lower band = MA20 / 1.05In Figure 6.4, the 5 percent bands get slightly wider as AMR prices rise,reflecting the normal increase in volatility. Prices stay above and below thebands for only a few days at a time.Trading Rules for Percentage Bands. We trade a percentage band thesame way as a channel, buying at the bottom, selling at the top, and exiting inthe middle. It’s a little easier to wait for a penetration of the band using thistype of mechanical approach. We can make the bands narrower or wider sothat prices move through the extremes as often as we choose. If we make thebands a little wider than those we see in Figure 6.4, the number of opportunities decreases, but the timing and profits per trade increase.Volatile Patterns. Percentage bands work best with slow trends and sideways markets where the volatility remains steady. The best example is Figure6.4. Stocks also have periods where volatility increases quickly, and timeswhen prices drop sharply and continue to drop. In Figure 6.5, AMR falls
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A SHORT COURSE IN TECHNICAL TRADING
FIGURE 6.4
Using a 20-day MA with a 5 percent band. We can buy at the bottom of theband, sell at the top, and produce quite a few profitable trades. However, the pattern doesn’talways look this good.
sharply in July and August 1999, remaining below the lower band for twoone-month periods (with a small reprieve in the middle). If we had boughtwhen prices fell through the lower band at $80 (point a), we wouldn’t getout of the trade until the middle of the band is touched in August at $67. Wewould have taken a large loss.This all means that every method has good periods and bad periods.Nothing is foolproof. Bands still seem to be a good idea. What can we do toimprove the way we use bands?One possibility is to change the percentage value of the band when theprices get more volatile. In Figure 6.5 a wider band would allow fewer pricesto break through, but still does not solve the steady drop in July and August.Once prices break through the bottom, we’re forced to hold the trade untilAugust.
Bollinger BandsBollinger bands offer an alternative to using a fixed percentage. A Bollingerband varies in width as price volatility increases and decreases. It makes the
Channels and Bands
99
a
FIGURE 6.5
A 5 percent band during a bad period. During July and August prices breakbelow the lower band and don’t cross above the center of the band until August. Is it just a badperiod for the band, or can we do better?
band fluctuate in a pattern that seems natural to price changes. Bollingerbands try to answer the question, “Are prices high or low in relative terms?”As with the previous bands, a traditional Bollinger band has a 20-daymoving average at its center. The half-width of the band is found by:1. Calculating the standard deviation of the closing price changes over the
past 20 days.2. Multiplying the standard deviation by 2.3. Adding and subtracting the value from the 20-day moving average.
In Excel, the instructions for calculating today’s Bollinger bands arounda 20-day average, where the closing price data is in column A and the pricechanges (A100 − A99) are in column B, are:Upper Bollinger band = average(A81:A100) + 