that were so optimistic above the 4,500 level raised plenty
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of cash by institutional traders that when it was ready to go back to thebuying at lower levels, they could do so.Who would they be buying these stocks from? Obviously, it wasthose traders that they sold these stocks to at higher levels. Capitulationset in this time near the 3,000 level, nearly 40-percent off its highs. Whathappened next was institutional contrary buying from the 3,300 to the3,000 levels, while traders were panicking and selling stocks that haddeclined so much in value. As I write this book, we are currently overthe 4,200 level in the Nasdaq. That is a 40-percent climb off those lowsand guess who profited from these moves? It was institutional tradersas well as those traders that understood how to benefit from a macrosense of tape reading. The adages of “buy when there is blood in thestreets” continue to hold true. Sell when panic buying sets in, is secondin this equation.
THE MICRO VIEWApplication of this macro knowledge to a micro view is both fascinatingand necessary if one wants to understand intra-day price movements. Aswe discussed, beliefs about stock prices change with every up-tick anddown-tick. This change in beliefs in our gainer and dumper stocks creates the oscillations that we see within the first few hours of the tradingday. As these oscillations narrow, beliefs about the stocks tend to settlein general and tight ranges as traders aren’t willing to change or producea new set of beliefs on unreadable price action that is not supported byany interest. Remember that interest is defined by volume and pace, andif there is very little of either, then it will be harder to ascertain the direction of a stock, especially if we are unable to identify key market players in these stocks.Now that we understand how the perceived value of a stock canproduce a decision on whether to enter or exit the issue, let’s apply a fewmicro scenarios of stock moves. Stocks that are being accumulated tendto be presented in a fashion of steady buying and no major pullbacks. Acontinued volume increase on buying and very little selling volume onadvances would show that buyers are still stronger than sellers, astraders are still willing to bid the stock higher. If there is any increase instrong selling volume, accumulation would be signaled by the strong selling being absorbed with no major price pullback. In this case of accumulation, most of the selling is simply done by online traders ordaytraders that are looking for faster profits.
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Institutional selling is generally not included in this scenario as thestock continues to be based on steady volume and move higher on someincreasing volume. The opposite of this case in distribution is whenstocks move lower on slow selling and very little buying enthusiasm. Noinstitutional buyers are involved, and any online traders or daytradersthat may buy are easily absorbed by the institutional sellers of the stock.We tend to speculate that accumulation is occurring in advance ofexpected news or other catalyst events that will move the stock higher.We tend to speculate that distribution is in advance of an expected negative catalyst or negative rumors. Many times, we will not find out thetrue reason for such moves at all. Other times, we will receive the newsor reason either the following day or within the week. Although I don’tbelieve in conspiracy theories or market manipulation to the extent thatmany would like us to believe, accumulation and distribution can beobserved in obvious circumstances.ENGA of late is a perfect example. It moved higher from near 11 to14 on no news and steady volume. The next morning it announced newsthat made the stock gap higher by 3 points in pre-market.What do you suppose happened next? Right, those that accumulated at the levels nearer 11 are now distributing the stock to those retailbuyers that are buying the news either on the gap up or on the first climb.The stock sold back down near 11 in the next two days. Those that boughtthe gap and got stuck in on the news probably sold nearer this 11 to 12level as they realized they fell for this move. This is assuming they didnot keep a stop discipline.My favorite news event is the stock upgrade. Many times, I will seea stock upgraded by a brokerage house only to see him sitting on the Askof the stock filling clients’ orders. There are two ways to interpret this.First of all, he has accumulated shares at much lower levels and wantsto sell the shares to the public on the upgrade. This would make sensebecause if the firm was interested in continuing to accumulate shares atlower prices, why would they upgrade the stock and cause a price jumpin which they would have to pay at higher prices? The second way tointerpret this is that they are in a stock at lower levels and want to profiton the upgrade news but also want to provide some liquidity to clients’orders. If they have several large clients that want in the stock, they canfacilitate more orders of this stock by soaking up retail buying, in essenceselling their own inventory to retail traders, and then transferring theirclients’ order to buy at a lower price to their own account to cover theshares they sold at the higher price. More on this later.
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THE PRICE SPIKE—PANIC SELLING PRINCIPLESAnother principle of tape reading has to do with the panic selling or pricespike of an individual stock. Increasing volume and a price advancewould signal a continuing uptrend of the stock. This is relatively obvious as increasing prices bring in more buyers and possible short covering. The more buying, the better the chance the stock has to move higher.However, as volume decreases and the price advance slows, this signalsthe end of the move as the buying begins to wane. This is what we referto as the top of an oscillation. This is where we elect to go short or beginto practice our exit strategy for long positions.On the opposite end is large volume and price declines. This wouldsuggest a continued downtrend as selling begins to create nervousnessto those that are long and they also begin to sell, as they can’t stomachmore loss than they already have experienced. Remember that beliefs ofthe value of a stock determine a reaction. In this case, at each down-tick,the belief that more loss will cause more pain will make a trader exit atthese lower prices so as not to lose more money. As selling pressurebegins to wane on lessening volume, this is a sign that we are at the bottom of the oscillation.Application of this knowledge on the micro level is fascinating aswe begin to look for that belief in the stock that is common. On anadvancing issue where volume comes in very heavy and the priceadvance is fast, we have to assume once again that these late-to-the-partyretail traders are caught up in the excitement of the stock. Who are theybuying the stock from? Right, those in from lower levels before this pricespike. As the price spike signals the possible end of the move, smarttraders will look to exit the long positions into this strength.If retail traders are the last buyers of the move on this price spike,then they will have no choice but to sell at lower levels as the “real” buying is not willing to take this stock higher. This distribution means a resistance level has been set in on the price spike and the stock begins to pullback on both the distribution as well as the frustration selling by thosethat bought the stock near the top of the oscillation. We profit by eitherbeing in the stock at lower levels and selling into this strength or by waiting for the buying pressure to wane and for volume to decrease andattempt a short trade. Again, it is very important that we know our execution abilities.I have seen stocks like BAMM that go from 4 to 40, or AVCO thatwent from 3 to 30. Although these stocks obviously exhibited a waningbuying pressure at some point in the move to higher levels, trying to
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short those tops were both dangerous and, for a few, career ending. Justbecause a stock pauses and the signal for the end is near, executing thatshort or exiting that long position has to be understood from an execution risk standpoint. Understanding this tape reading information is beneficial but will not provide 100-percent in accuracy. In those times that itdoes not provide an accurate read and we enter the position, we have tobe able to exit that position with the least amount of loss as possible.Know your execution abilities when reading the tape.Again, the opposite side of the price spike is the panic selling. Justas we had in the explanation of the market capitulation, individualstocks have fast selling that signal that the bottom of the oscillation isabout to occur. The common belief that this stock is not going to stopfalling creates panic selling as everyone scrambles to exit with a leastamount of loss, or by those that do not want to deplete any remainingprofits left over in the stock that they bought at lower levels. Nothing ismore frustrating than seeing a multi-point gain turn into a small profitor, worse, a loss. As the selling of the stock increases in pace and thenthe volume begins to decline while selling pace starts to wane, it is at thispoint that we begin to look for a reversal and for the stock to reverse andmove higher.This point in time would be a suggestion for an entry for a long position or to cover the short position if you read it in this fashion. Togetherwith the understanding of the gainer and dumper group and how to playtheir overreactions, understanding the reasons for how and why stocksmove in this fashion should provide a better understanding of when toenter and exit trades. Bottoms or tops of oscillations are key areas to identify, and by reading the specific price action in such a way relative toincreases and decreases in volume and price direction, this will aid youin knowing when those key areas occur.When playing such tops and bottoms of oscillations, it is importantto understand that when oscillations narrow and momentum in stocksslow, the identification of entry and exit areas becomes more difficult. Ifthe momentum is slower, there is no increase or decrease in volume andprice spikes or panic selling that we can gauge entries and exits for. Inthese situations, our trading becomes a relatively lower percentage.During this period when market pace slows, traders tend to guess on thedirection of stocks since there is no readability in the momentum. Stockstend to sit in narrow ranges, not providing much interest for buyers orsellers to enter the stock.Now Market Makers are usually just making the spread on slowbuying. There is no active directional participation from which to trade.
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Therefore, for playing the tops and bottoms of oscillations, there has tobe an identifiable momentum by which to ascertain points when thestocks pause at specific levels and have cause for a meaningful reversal.I say meaningful in the sense that the stock will offer enough opportunity to risk a trade on the stock. If the potential is outweighed by the risk,either in limited potential or by execution risk, then the reason for thetrade becomes less intriguing, or we would back off this trade.One more note on slowing momentum is that we often see slowdrifting of a stock in either direction. Again, with this accumulation ordistribution, we can identify key players; trading this kind of momentum isn’t necessarily a negative. However, if we were looking for momentum trading, then watching a stock slowly selling lower would negatethe reason for the identification. For us to risk a bottom oscillation trade,we want to identify the point by which fast selling turns into a pause andreversal. On slow momentum, the stock always looks paused and therefore finding the real bottom is much more difficult to ascertain. Thus, ifwe want to understand how to read slower momentum stocks, we areforced to look into the deeper issues of tape reading.
THE MARKET MAKER EFFECTTo move deeper into tape reading, we have to understand how to viewkey players at specific price levels. This is a necessity of trading slowermomentum stocks because we are not relying on fast momentum to offerus profits. Instead, we are relying on information about perceived intentions of what Market Makers are doing.Understand that Market Makersand institutional traders are not going to be too hip on showing us theirintentions. Otherwise, their intentions would never be fulfilled becausetraders could potentially ruin their plans for orderly distribution oraccumulation. These traders, when accumulating or distributing ordersfor themselves or their clients, want the stock to move orderly so that theyare not paying too much for the stock, nor selling at prices that aretoo low.If they flashed intentions to buy 1 million shares of stock andtraders knew this, then people would be buying like crazy at this pointin anticipation that this 1-million buy order would push the price up aswell. This would make the institutional trader have to buy one millionshares at a higher dollar cost average. On 1 million shares, this can cutinto profits in a big way. Therefore, they are very concerned to mask theirintentions and for the most part, we don’t know the exact intention. Even
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if we see a few things happening that suggest a Market Maker is a netbuyer or seller, we never know how much of the order he still has to fillor if he’s already done. Therefore, we have to watch for a combinationof basic tape-reading principles according to the idea of accumulationand distribution in conjunction with what a specific Market Maker mayor may not be doing.Previously, I discussed a Market Maker or institutional trader thatwas willing to facilitate an order for clients by becoming support or resistance at key price levels. I noted the example of the upgrade in which aMarket Maker would sit on the Ask, sell shares out of his own inventoryto retail traders, and then transfer the clients’ order to the Market Makerinventory to cover those shares sold. In this scenario, everybody wins.Let me explain why. If you are a fund manager that wants to sell 200,000shares of XYZ stock, you don’t want to go on the open market to buy atuncertain prices. Nor do you want to display your intention to buy thismuch in stock to other traders. Otherwise, they may see this order andtry to get in the stock as well. This pushes up the price of the stock, andyou will pay more for the stock by not hiding the true intention in somemanner. Many use INCA in this case to facilitate large orders, but for thepurposes of tape reading, the following information is useful.You want to sell 200,000 shares of stock and feel that if you use INCAor some other trading service to mask this intention, you may not get theprice you want. Therefore, you will call your favorite Market Maker tofacilitate this order for you. What he will do is agree with you on the priceor prices at which to transact this order for 200,000 shares.To make this explanation simple, let’s suppose that the stock is trading at 40 on the Bid price by 40.05 on the Ask price. Your quote screenwould show 40 ⫻ 40.05. The Market Maker feels he can reasonably facilitate your order for 200,000 at 40. If this price is agreed upon, the MarketMaker will now attempt to sell 200,000 shares at 40.05. This would identify the Market Maker to those that are able to see this on the Level 2screen as the ax of the stock.This is because the Market Maker is not letting the stock trade higherthan 40.05 before he fills his order of 200,000 shares. The reason he wantsto sell 200,000 shares at 40.05 is because he will be buying your sell orderfor 200,000 shares at 40. If he buys 200,000 at 40 and sells that sameamount at 40.05, then he stands to profit a gain of $10,000 (200,000 x .05)for his trouble and risk involved in facilitating the order for you at 40. Ifhe sits on the Ask at 40.05 and absorbs all the buying, once he gets to200,000 shares, he will then transfer the block from your sell order to hisaccount. Covering the 200,000 he just sold and a block of 200,000 shares
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will cross the tape or possibly in some other combinations, such as fourblocks of 50,000 each, all at the price of 40. Normally, the transferredblocks will be at the inside Bid price or sometimes lower.Once a trader identifies the Market Maker as the ax and then seesthese blocks move across the tape, that trader would expect them to liftoff the Ask and for the stock to move higher. This makes sense becausethe Market Maker is not a true seller of the stock, meaning he doesn’twant it to go lower, and that the stock should rise as soon as he lifts offthe inside Ask if he is the only real seller at the price level of 40.0625. Hewas not a real seller and was simply facilitating an order for his clientthat was beneficial to him because he sold his stock at 40. If the stockmoved to 39.50 during this facilitation, he wouldn’t have cared. Theyboth agreed on 40 as the price. Because the Market Maker agreed on 40,his risk is that his absorbing the buying would create nervousness andthe stock would fall. If the stock had fallen below 40, then he would beselling stock at a lower price than he bought it from the client. In this case,the Market Maker loses money on the trade, assuming the majority ofthe shares sold is under 40.This is the risk Market Makers take and the reason that they arecompensated for their trouble by profiting from the spread. Many wonder why the Market Maker would accept such a risk. The reason is thatthe commissions and fees derived from these numerous orders from bigclients result in a lot of trading profits over time. The institutional tradersand fund managers will enjoy the collaboration in that they know theycan rely on the Market Maker to facilitate their order at better prices thanthey feel they can obtain, and the Market Maker profits by continuing tomake the spread on these orders. It is a partnership of sorts in which bothgain in the transaction. As for tape reading, this is why we want to identify the ax of a stock in such a case.Remember that if a stock is slow-momentum and under accumulation, we will want to figure out whom the net buyer of the stock is thatis accumulating and also any ax of the stock that may be hindering theclimb. If we enter into a position on a slow stock and can identify the axand the net seller, if there is any action in either of these two participantsthat would negatively affect the price against me, I would be moreinclined to exit the position with surest profits. If one or both of these participants continue to raise their Bids and offers in an orderly manner, thenthe continued accumulation may not be over, and I may want to holdlonger. Either way, this type of tape reading is a very beneficial way togauge the direction of a slow-momentum stock and provide more viabletrades to your trading plan.
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The basic setup in a slower stock is to: watch for the ax at the insideAsk price to be identified by absorbing the buying, then look for blocksto cross the tape at or below the inside Bid price, and then watch for theax to lift off the Ask. If this happens, you may elect to hold the stock ifyou are in from lower levels or you can enter into the stock for a quickscalp-type move.The opposite case is true for a Market Maker that has been identified as providing support in a stock. Suppose you, as a fund manager,come to me, the Market Maker, and want to buy 10,000 shares of stock.I will facilitate this order for you at 40.05, and you agree to this price. Iwill then go on the Bid at 40 and buy 10,000 shares worth at 40 from retailtraders. Once the 10,000 shares are bought, I will then sell you my 10,000shares at 40.05, basically transferring your buy order to my account andprofiting $500 (10,000 ⫻ .05) for my trouble. Once I transfer your orderto my account, you will see a block of 10,000 across the tape at the Askprice and for me to drop off the best Bid. If a trader is short the stock inthis case, he will be glad to see that I am not a true buyer of the stock(providing support) and when I drop off the Bid, this might provide moredownside potential.The most common question is why doesn’t the ax just lift his priceand sell at higher levels. This is quite a simple answer if we understandthe reasons of why the ax is really the ax. The ax is not a Market Makerthat wants the price lower so he can buy at cheaper levels. This is oftena very wrong comment that is made in many chat rooms. Obviously, ifthe Market Maker wants to accumulate shares, the lower average price,the better, but for purposes of tape reading, the answer is easier toexplain. If I agree to buy your shares at 40 and I believe that I will nothave any trouble filling this order at 40.05 for 200,000 shares, I will stayright here to assure myself that I fill the whole order and not risk the stockmoving lower, creating a loss.If I move up a level higher, I will be competing with other marketparticipants at those prices to sell, and in this case, I may not be able tofill the whole 200,000-stock order. My initial purpose is to facilitate theorder in a fast, beneficial, and relatively certain manner. The purpose isn’tto get greedy and see how many more .15’s I can squeeze out of the orderfor my own benefit. Obviously, if I can I will, but if higher price levelslook like too much competition to fill the order, I will stay where I canassure myself I can fill the whole order. This action identifies a key playeror ax in this scenario. This is only something a trader can view by watching a Level 2 screen relative to the Time of Sales information that comesacross the tape.
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Again, tape reading isn’t just watching prices going across theticker. One has to understand who is doing the buying and selling andfor what purpose. On the macro view, institutions are usually buying lowand selling to retail traders and vice versa. They are selling at the highswhen the markets are showing signs of a panic buying and then accumulating shares on panic selling. On the micro view, we are looking forpace and price action relative to increases and decreases in volume andprice direction. We are also looking for block trades to cross the tape andidentify who the supporting Market Makers are or who the identified axis. We are trying to figure out what those blocks mean and how can weeither profit more by doing so or taking surest profits if what we believeis a negative on specific price action.Tape reading goes far deeper in understanding than just readingthe ticker tape buys and sells ratio. Learning to read the tape in relationto the previous information provided will give you a much bettersense of why markets and stocks move and how to best profit from thisunderstanding.
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RULES OF A TRADERWhen traders move from the world of investing to the realm of shortterm trading, the psychology and mindset behind each approach tendsto become mixed and, if not separated, can cause problems while carrying out your trading plan. However, although the shift from investingto this new way of trading demands some changes in strategy, some common traits need to be reiterated relating to money management and astrict stop loss regiment. When I first began trading for a living, theadvice by those I was most closely associated with provided the onlyrules that pertained to investing. Two of the most detrimental phraseswere that “it is only a loss when you sell it” and “stocks always comeback.” Although these statements do have some truth to their reasoningin certain issues, the application of this to active trading is the primarycause of failure to many aspiring traders.The mainstay of investing has been to trade the markets in the fashion of Warren Buffett. Buy strong companies and hold the stocks foryears. Although I have very little argument from such a strategy that hasobviously worked well over the long term for him and his shareholders,this type of reasoning can crush the active trader. This mainly stems fromthe fact that when we trade short-term, we are trading stock symbols, notcompanies. We are trading the reactions that traders have to price movements for numerous reasons. Nothing of this has to do with long-termfundamentals, P/E ratios, and valuations. Traders are more tuned in toreasons why stocks move in the absolute short term. This can be fromseconds to minutes in some cases and in others lasting several days.However, rarely is an active trader’s position held for more than acouple days. The active trader looks for the points in time when there isa disagreement in the perceived value of a stock, causing the greed andfear variables to enter into the stocks movement. Although perceivedCopyright © 2002 by Mtrader.com.Click here for Terms of Use.
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value is always going to differ and give basis to a stock market’s existence, the prevailing price will always be in agreement. Simply put, thecurrent price of the stock is right where it should be. Whether someonethinks that is too high or low will always be a disagreement.For example, in 1999 we had two opposing views on Amazon.com(AMZN). Amazon was trading somewhere in the 200’s and an ongoingprice target war between two analysts was taking place. One analystdowngraded the stock with a price target of $50, while the other analystupgraded the stock with a price target of $400. People often refer to astock as undervalued or overvalued; the real answer is that a stock is neither. The current price of the stock is the absolute price and therefore itsvalue is the current price. Perceived value will continue to differ, causing traders to buy and sell stocks while creating the necessary fluctuations for momentum traders to capitalize. If everyone agreed on value,then stocks wouldn’t move, as they would sit at that value until something in the company’s “formula” changed to make the value different.Since momentum traders are making decisions based on this disagreement of value, they have to trade with the assumption that “thestock won’t always come back to their price.” This assumption willdemand that a trader cut his loss immediately, thus going against thephrase that a loss is only a loss until you sell it.Momentum traders need to realize the need for taking losses is apositive rather than a negative aspect of trading. Not all stocks do comeback and, in some cases, wipe out a trader’s portfolio in as little as onetrade if they do not keep their losses small. The most frustrating occurrence for a trader is to sell for a small loss and then see the stock turnand eventually offer a profit. However, for as many times as this happens, again, it only takes one stock that doesn’t come back to offer a profitthat wipes out a trader’s portfolio. Taking small losses is known as a strictstop loss regiment.
STOP LOSS DISCIPLINEStops will manifest themselves in a few ways: mental stops, trailing stops,and auto stops. Each has their place and importance, as well as theirdrawbacks. When I first began trading, I had to use purely mental stopsto execute my decisions. This meant that I was unable to place a live orderinto the market with my broker that would be executed once the pricehit my stop. I had to simply pick my point of stop loss and once the price
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was there, I had to execute that order at that specific period of time.However, during the SOES period when they still ruled the executionworld, it wasn’t much of a problem as Market Makers were showing liability sizes that made executing against them fairly easy. Therefore, Inever felt the need for having to place a live order for a stop loss. I simply had to pick the point when I wanted to exit and, a good percentageof the time, my exit was executed at or very near my desired price.Today, however, mental stops demand a higher degree of Level 2understanding, as well as execution routing, since it’s not as easy as justentering the SOES order. With liability requirements requiring MarketMakers to execute a minimum of 100 shares, the way we route our ordershas to be taken into effect. Without a Level 2 screen, we do not knowwhich Market Makers or ECNs are showing with regards to specific sizes.This makes mental stops a bit more difficult when we have to make asplit-second decision about keeping a mental stop.More to this point, mental stops aren’t much of a consideration forthose that are efficient at executing their trades. Most traders I know thatare efficient at executing all use mental stops and either exit into strengthor pick the best route at or slightly below inside prices. There really isnot much of a need for auto stops when a trader can automatically keeptheir mental stop at the best price that they feel they can exit at.The benefits to using mental stops are that you can begin to tradein a more “at-the-moment” manner. This means that as the stock movesor doesn’t move, your belief system of the trade can dictate the exit strategy and you can then exit as you see fit. Not having to enter in a stoporder and then cancel and re-enter may save you some time in theapproach to the exit. Your mind is more free to assess the stock at specific points in time when your belief system changes and you can exitthe trade accordingly.The negative side to this is obviously the ability to exit your tradeif you are feeling somewhat underconfident about your execution skills.I find the reason many traders give for not entering a trade is the fearthat they won’t be able to exit if they have to at a reasonable price. Withmental stops, this fear will not be alleviated until one has confidence inone’s execution ability to keep that tight stop loss. As for developing thisconfidence, simply trading safe stocks from an execution standpoint ortrading and watching fewer stocks at a time will help to alleviate theproblem. If one trades a stock with a wide spread that jumps up anddown in half-point increments, the execution risk is high, no matter howgood one’s execution ability is. If a trader is trading a tight spread stock
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with stable moves, then keeping a tight stop loss is much easier to do.The obvious option for those that are uncertain of their execution ability is the use of an auto stop.Auto stops simply let a trader enter in a price to exit, should theprice of the stock move to this price. If the price is hit, the trade is executed and the trader is out of the trade with minimal execution effort.Although I see auto stops as beneficial in certain cases, I personally findthem to be more of a hassle than a benefit. Let’s discuss ways in whichan auto stop will not be beneficial.Market Makers have their own agendas to stock moves, none ofwhich has to do with executing auto stop orders solely for the purposethat they force you to lose money or give back profit. Stocks movebecause of buying and selling pressure due to “fear and greed,” not because there are “x” amount of stop orders at certain price levels. MarketMakers do not drop their bids to take these out, nor do they conspire tomake this event happen. However, as the stock moves to the price of theauto stop, chances are that it will be executed a high percentage of thetime. Sometimes this is what we wanted, sometimes not.In the case that the stock is selling down relatively fast, maybe toofast to keep a mental stop at this price, this auto stop may be good.However, if the stock drops to the price of your auto stop but no real selling hits the stock, you are executed when the stock is really no longerfalling. In the latter case, the mental stop is more useful. In the formercase, if the auto stop is executed, then maybe the auto stop is the bestchoice. I also know that auto stops work best in cases when a traderabsolutely has to leave the computer for whatever reason, but they donot want to close the position. Whether I agree with this process or not,I have no real preference. I tend to close all positions that I am not watching, but in some cases, I can see where an auto stop wouldn’t be a negative thing. Having to leave a position that is showing relative stabilityisn’t that bad of an idea as long as it is known that anything can happenwhile you are away. Traders like myself tend to develop iron bladdersfor the less “pressing” emergencies.Moving back to the reality of the issue, executing both entries andexits is not a mechanical idea. It is something