s Compare Two ApproachesThe first approach is that my trading decision was great. I figured it all out.I was right all the way. My trade outcome was a loss because they ruinedit. They knew traders bought the stock, and they brought it down (or keptit from running). When frustrated traders sold, they bought from themcheap and ran the stock back up. There was nothing I could do. They haddeeper pockets, and it was impossible to fight them. They robbed me onthis trade.The second approach is rather than blaming the ubiquitous them, Ican assume that if the trade went against me, then the trade wasn’t right.With this mindset I could assume that I timed my entry incorrectly, or Ihad a wrong trading idea. I had to cut off my loss to prevent it from getting bigger. The market proved me wrong on this trade. It’s over. I wasthen able to move on with my search for the next trading opportunity. My
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trading system assumes losses. Each trade can turn out to be a loser. It’snormal because of the uncertain nature of the market—it works on probabilities, not on certainties. My trading system provides a high enoughpercentage of wins, and no single loss can shake my confidence in thesystem.We can see how mature and effective the second approach is compared to the first one. However, notice that the first way of thinking is psychologically comfortable. It places us in a comfort zone where there is nopersonal responsibility. It makes us feel warm and fuzzy. Of course thereis frustration caused by monetary loss, but we feel comforted by beingwith the majority and by losses not being our fault.Remember what my first impulse was when I found myself in thelosing ESOL trade. I looked for comrades in disaster to ask their opinion. Was it their opinion that I was looking for? Was it a desire to makesure that I was not alone in this? And what was it that I felt after talkingto them? Relief (there are plenty of traders that got caught with me);anger (darn bears that arranged this trap); secret hope (it’s going to beback; if they orchestrated this drop then they should have some purpose;in this case, they apparently want to buy cheap shares and run the stockback).Yes, this approach has always been a killer for a trader’s account,but does this always outweigh our desire for psychological comfort?Apparently it does not. The second approach is the one that mature successful traders have adopted. However, we can feel how less comfortableit is. Undivided personal responsibility with no one to rely on but ourselves does not make us feel good. We try to avoid this cold unpleasantspot. And, if we avoid it, we effectively stop learning.If some unmanageable higher power controls the trade we take, whylearn? It’s easier (and makes more sense since you can’t control anything)to put on the trade and wait for them to decide what to do with it, hopingwe get lucky this time. That’s where gambling entirely replaces trading. Control is lost (or was never there in the first place). And what is it atrader needs to control? We know we cannot control the market. All weneed to control is ourselves, our own behavior. And this self-control iswhat enables us to win in the market. It’s just uncomfortable. It requiresdiscipline; unclouded, unbiased thinking; and the willingness to admitmistakes without ego intervention. Discomfort and profit go hand inhand.Does all that mean that a trader is always uncomfortable and thatmonetary winnings come at the price of constant stress or depression? No,
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it does not. The joy of self-control, of getting the best out of oneself, ofbeing able to pull through is a huge reward. With time, this approach stopsbeing uncomfortable and becomes the only approach that feels right.
THE FAMOUS BRE-X SCANDALAfter a few weeks an interesting thing happened in the stock market fromwhich I learned a lot. I am talking about the Bre-X story. Bre-X was asmall Canadian mining company. A huge gold mine was “discovered” inIndonesia. Soon thereafter the chief geologist committed suicide by jumping out of a helicopter. Then an independent analysis of samples was conducted and revealed them to be fakes. The incident was dubbed the “fraudof the century.” Figure 1.2 shows the huge drop in price followed by thestock being delisted.I got interested in the developing story because of its huge exposure.It was hard to believe that stockholders could be misled on such a huge
FIGURE 1.2The story of the Bre-X stock once the fraud was revealed. (Used with permission of CBS MarketWatch.)
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scale. When the ultimate results of an analysis were pronounced, I learnedanother big lesson (at no cost this time). Anything can happen in the markets. No matter how reliable and truthful information appears, we cannever know all the details surrounding the story, and we cannot figure outthe outcome. I read with great interest of all those investors who were fullof hope only to become desperate as they realized that they had lost a vastamount of money by investing in what they believed was the truth.A thought struck me as I followed that story. Investors started discussing Indonesian maps, comparing them to other known gold minemaps. They talked about methods of taking and analyzing samples, readgeological reports, and tried to find some hidden clues in company statements, CEO correspondence, and the like. They suddenly became specialists in geology and mining. Some of the investors appeared to be wellinformed and knowledgeable. Yet, the outcome was the opposite of whatthey expected. I recently saw a story that was very similar. When somesmall company announced the results of a medical study, many peopleinvested their money in the stock because of the news about the study. Ichecked out the stock and spent a couple of hours reading about it withthose who were interested in it. Conversation ran along these lines: “Italked to a friend who is an M.D. He said it’s huge.” “This technology isthe future.” And so on. The stock price declined, but people continued totalk, convincing others and themselves that there were some evil intentions behind the decline or differents kind of manipulations, like “holdingthe price from running in order to buy cheaper” or just “shorting to hurtthose who bought the stock.” After all, the days of Jay Gould and JamesFisk (gold and railroad stock manipulators of the nineteenth century) andother “manipulators” are widely known.The irony was that all those discussions about product, technologies,and research had little to do with the stock price. Traders were trying todiscuss things they didn’t know much about. Even more important, thosethings had little (if any) impact on the price movement. That was probably the first realization of what I coined as my motto—“Trade what yousee, not what you think”—the motto that governs my entire tradingapproach.
LISTEN TO THE TAPE; IT IS NEVER WRONGThe stock price was telling traders “Get out. You are wrong.” Yet theyheld their position and rationalized their decision. There was somethingclearly wrong with this approach. It led to tied up money and to indefi-
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nitely long holding periods of a position that was supposed to be a shortterm trade. This extended time frame was another indication that something was wrong.I can’t say these lessons led me to the right approach right away. Infact, the opposite is true. I repeated my mistakes several times during thenext year of my trading career. Nonetheless, that was the first time that Ifelt I had touched a very powerful truth. I believe that the first seeds of mycurrent approach were planted at that time.
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CHAPTER 2
TurnaroundSmall and Safe
T
he next several months of my trading were devoted to pure scalping.After the ESOL fiasco, I was afraid to stay in a trade for too long. I wastaking my profits quickly. Considering that with a reduced account size Ihad to trade small, cheap stocks with unsustainable price movements, itwas not too bad a thing. Besides, I was just as fast when I had to cut theloss, which forced me to be more disciplined. This was the case when thefear of new losses worked for me; it made me cut my losses really quickly.Yet, it was not a profitable period overall. I was making insignificantamounts of money and then giving them back. In October 1997, I decidedthat I couldn’t continue to do this kind of trading with an online broker. Itwas taking too long to fill out the form, send in the order, and then get theconfirmation of the fill. I already had some idea of direct access and Level2, and I was using the combination of a quote feed with Level 2 and anonline broker for order execution.In a short while I found decent brokerage. Its routing software madea big difference to me. My scalping became better, and for a while Ithought I finally had gotten a handle on this game. My discipline becamemuch stricter. It became obvious to me that I was taking too big a riskplaying the bigger lots, so I stopped playing 2000 to 3000 shares. I wastrading mostly 1000 shares. And, again, in a few months I had to admitthat I did not have real consistency in my trading.I was able to get in and out very fast; in many instances I could feelthe direction of a stock’s movement for the next few ticks by just watching it on Level 2. And yet it was not enough for consistency. The majorreason for this was (as I realize now) that I had no system. I was still trading small stocks that were getting activity on fresh news; I was effectively15
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trying to beat other traders by getting in and out faster than the majoritydid. If I was right about stock direction, this game worked for me. At thosetimes not as many traders used direct-access brokers as do now.And most of those who did use them didn’t have great routing skills.This allowed me to win “fast-trigger contests,” but there was much moreto trading than that. Scalping is a style of trading that requires traders tobe right on a very high percentage of their entries. That’s where I failed.The lack of a solid approach and impulsive trading of everything thatmoved were what undermined my trading at that stage. I tried applyingdifferent technical indicators but without encouraging results. I had noreal understanding of their mechanics, and I attempted to use them superficially. Trading with no solid system was like trying to build a housewithout a foundation.This was a challenging moment. The problem was that I did not feelcomfortable with any of the traditional technical indicators or combinations of them. When I tried to apply them, I felt that I lost direct connection with the essence of what was happening; my reading was getting tooformal. It was like having a conversation via an interpreter. You understand what is said, but you have trouble feeling the mood of your speaker,understanding the details of the meaning he or she puts in words. At thesame time the only approach that allowed me to get this immediate feelwas pure scalping. I felt trapped in a cycle I needed to break out of. Ineeded a system that would put a solid foundation under my entries andexits, and I didn’t want this system to be as formal as most of the technical studies were. I realized that there was nothing wrong with technicalanalysis; it just wasn’t my way of visualizing things.As usually happens, the right door opened when it was needed. Evenmore than that, this door had always been there. But I saw it only whenthe right moment came. I read my favorite trading book, Reminiscences ofa Stock Operator by Edwin Lefèvre, for a third or fourth time. Unlike theprevious readings, this time I saw much more in it about the actual methodof reading market movement. The words tape reading appealed to me—something in me resonated. Still, the method itself was not described indetail in the book. I could just sense the general principles of it. I neededa more detailed description of this approach.
OPENING A THIRD EYEI searched the Internet for the words tape reading, and I soon stumbledacross a book published in 1931. It was Tape Reading & Market Tacticsby Humphrey B Neill. I read it twice and reread some pages of
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Reminiscences of a Stock Operator. Once again, I got this amazing feeling that I was facing a very powerful truth. The major idea that I got fromthis research was that smart money acts differently from the public andthat there are footprints of smart money’s action. It is possible to readthose footprints and take the right side, positioning oneself on the winning side. This realization was mostly theoretical then. I had no real rulesor formulas as a basis for this idea. But I did feel that I was gettingsomewhere.Meanwhile scalping was actually all I did in my everyday trading.For years to come I became known as a pure scalper, an image thathaunted me long after my trading became much deeper than that. There ismuch more to my trading now than just scalping, but while we are on thesubject, let’s take a look at scalping as a trading style, with all its advantages and shortcomings.
ScalpingScalping is often defined as trading for fairly small gains, like 5–10 cents.I don’t agree with this definition. For me a scalp is a trade in which I donot allow the stock to go against me, no matter at what point of the tradethe stock weakens. For example, suppose I bought stock at $20.05 and itwent to $21 with no downtick, then paused at $21 where the ask gotstronger and the bid weakened because sellers started to nail the bid. Atthis point I am out, and this is a scalp. If the same happened at $20.50 or$20.25, I am out and this is a scalp. I gave no regard for what profit Imade—$0.95 in the first case, $0.45 in the second, and $0.20 in the third.If I bought at $20.05 and the stock never went higher and I bid $20 andgot a hit, I am out with –$0.05. In order to get out and not allow the stockto move against my confidence level, I often had to sell into strength (selling when you can, not when you have to). If the stock broke my confidence level, I was less inclined to believe in its ability to give me a moreprofitable position.Impact of Decimalization. This kind of scalping, selling at the first signof waning momentum, was possible in its pure form while the marketstraded in fractions— 1/16, 1/8, etc. When Nasdaq trading was decimalized, itbecame much harder to count on an uninterrupted move big enough forsubstantial profit. Instead of moving in 1/8– 1/4s which equaled 12–25 cents,stocks started moving in cents with greatly reduced volatility. Still, I consider a trade a scalp if setbacks remain small, within 5–10 cents, whichroughly match 1/16– 1/8 in fractions.
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What Are Scalp Setups? For me, scalp setups are any of the pivotal pointsor usual entries on a valid setup for intraday trading, for example, theintraday low on stock that dumps on bad news and pauses and the intraday high on an uptrending stock that shows signs of a breakout or a bottom of a pullback on an uptrending stock (for shorters, all of this can beapplied in reverse). To initiate a long scalp trade, I want to see signs ofmomentum such as a strong bid, thinning ask, and prints at and/or abovethe ask. Of course, this is not a hard-and-fast rule. Sometimes scalperswill bid the stock while the buying side is still very weak, but their experience tells them that selling is exhausted so they will try to get theirshares from last-minute panicking sellers.Tools and Method of Reading. Level 2 is a must. So is Times & Sales(T&S). I seldom use charts to define the exit point on a scalp. Most oftenit’s Level 2 and Times & Sales. I also don’t normally use any technicalindicators for this style (again, it’s just my personal preference—there aretraders who use stochastic or other indicators when looking for reversal).I’ve found that a chart can be useful for getting an idea about a type ofplay or a certain setup. Then Level 2 and T&S should time the exact entryand exit.Some Psychological Implications. In trading, the reasons for movementare usually irrelevant (“the chart knows better”). In scalping, the reasonsare as irrelevant as it gets. News, hype, short covering, bottom hunting,value buying, technical analysis (TA) setup; any of these reasons are validfor initiating a scalp trade. One day in 1998, I bought a stock on very goodnews. The catch was that while the headline sounded really great, readingfurther would reveal that it was news about a company with the samename but that was not publicly traded. I believed that traders were likelyto identify the company by name and not read the whole article rightaway. The stock went up about 50 cents, and I hit the sell button as soonas someone shouted, “It’s not the right company!”I’m not justifying this method of trading. I use it to illustrate theirrelevance of knowing the reason for stock movement. Scalping is agame of blinking numbers. A scalper knows the pattern of the blinkingand goes with this pattern, ignoring such things as company reputation,value, and so on. They just don’t figure in this ultrashort time frame.People’s behavior at pivotal points is all that matters. A scalper should beextremely cold-blooded, pretty fast on the trigger, have lightning-fastresponses, and have good execution techniques.The stock does what we bought it for, or we are out with no second-
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guessing, rationalizing for staying in it, or changing our plan as the situation changes. Each trade is “self-contained.” It doesn’t matter where theprice of a new entry is in comparison to the previous one. We buy wherethe setup has occurred. A scalper has to be prepared to see a stock goingmuch higher from our sell point, not giving us a setup for new entry.That’s one of the biggest downsides of this style of trading.How Risky Is This Style? There is no simple answer to this question.Scalping is one of the toughest styles to learn, and the risk is fairly big ifyou try to start with it. At the same time, if you have mastered it, scalpingis one of the safest ways to trade since your control over the trade is asclose to absolute as possible.Some Miscellaneous Points about Scalping. A scalper usually buys withbuyers and sells with buyers. If we buy with sellers, our timing has to beimpeccable. If we have to sell with sellers, our timing on the sell side ismost likely off. We need to be extremely precise in our trade picking andentry timing. Our average reward-to-risk ratio is not as favorable as it isfor a good trader operating in a longer time frame, so our percentage ofwinning trades should be higher. It’s one more downside to scalping.It’s important for a scalper to recognize a familiar situation in theblink of an eye. Intuition plays a big role in successful scalping. By nomeans should a beginner try to follow this style. Scalping is something weshould come to only if our personal temperament leads us there. To makescalping worthwhile, one has to play on average 1000 shares at a minimum. So it’s essential to make sure that liquidity is there. Thin issues canbe scalped successfully on small lots like 200 shares, but be aware of execution capabilities. Even a stock with thick levels can be dangerous if ittrades at a very fast pace and with huge volume.A scalper usually generates more in commissions compared to otherstyles of traders. If this is of concern for you, do not scalp. If you do, forget commissions. Scalping is about consistent gains, not about big gains.A scalper has no chance to get rich overnight.Most of the other traders jeer at me about these downsides. Whilesome of them are great friends and traders, the others, who don’t agreewith scalping, consider me some sort of sour taste in their mouth, only tobe scoffed at. This is fine. I don’t trade to prove anything to anyone. Butwhen you come right down to it, my portfolio speaks to my knowledgeand my experience.Of course, there are upsides as well. Good scalpers are very consistent, and their exposure to the market (and that means risk) is very small.
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They are in control all the time. Consistent gains are great for confidence,for support, and for a constant good feeling about oneself. One moreimportant thing to remember is that no matter what the market does(unless it’s just dead), scalps are almost always there. It’s a universal styleof trading, from a market conditions standpoint. It’s also a defensive styleof trading suited well to choppy and uncertain markets.
CONFIDENCE GROWS FROM EXPERIENCEDespite all the confidence I gained from experience, I was still notimmune to the downfalls that the market can create. Two big lessons werewaiting for me down the road. In trading, lessons are usually losses. Thecorrect perception of the losses is extremely important for a trader. If weview a loss as a valuable lesson, then we get some value for our money.This value is knowledge, new experience, and new skill. If we don’t learnfrom our loss, it’s money wasted, and we are doomed to repeat the samemistakes.Both lessons I refer to were of the same kind. Those were my lastbig losses. I never repeated that kind of mistake and never let any loss getout of hand since then. Let’s look at what I did. This kind of mistake isfairly typical.
Trans Texas Gas (TTG)The first trade involved Trans Texas Gas (TTG). This company announced that it had discovered the biggest gas well of the twentieth century. The stock went up 6 points in a matter of minutes. I bought myshares within 1 point of the top, at around $19. The stock went up a bit,topped out, and started downticking. I didn’t take my profit.Why should I? It was a huge gas well! Why shouldn’t I sit out thepullback and wait for the stock to skyrocket? I was expecting furthermove because the news sounded so encouraging. Is this just a stupid kindof mistake that not many traders make? By no means. Time and timeagain, I see traders basing their trading decisions on their evaluation of thenews. A small company announces that its drug got approval to be sold inChina, and traders pile up on the stock because “China is such a hugemarket.”While this might be a reason to play the stock, is it the only reasonto hold the stock? Absolutely not, but that was exactly what I did, and itstill is what many people do. Let’s assume that we buy the stock becausewe like the product announced in the news release. The stock goes up 50
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cents, and we celebrate the profit we made because of our “carefulresearch.” But what if the stock goes against us? We hold our sharesbecause it’s such a great product! It very well could be, but does this reallyhave much to do with short-term price movement? Do we know howmany shares are waiting to be distributed to buyers and for what reason?Can we evaluate the potential ratio of supply and demand? And if it’s possible to a certain degree, does news itself answer these questions? Ofcourse it does not.Needless to say, TTG never reached its former high again. The stockprice slid down slowly. I kept my shares for several days, waiting for thegreat news to be “recognized by the market.” When the stock reachedimportant support, which was indicated by the chart, and broke it, I soldmy shares. The stock proceeded lower, and eventually the companyannounced bankruptcy. It was not easy to take this hit, but the concept ofstop loss was already ingrained in me.It was a big lesson. Nonetheless, it took one more of this kind for meto realize what I was doing wrong. In the spring of 1998, the first sign ofwhat was later called the “Internet craze” surfaced. Although in hindsight,it really had started with the 1995 Netscape IPO (initial public offering).
K-Tel (KTEL)K-Tel (KTEL) shares went from $4–$5 to over $20 on news that the company had started selling its product on the Internet. This run caused hotdebate. The reason for such movement looked weak, and the company’sfundamentals were a subject of mockery by many. I shorted 1000 sharesat $21 before the market opened. In a few hours the stock reached $24 andpaused for a long time. I added 1000 shares short above $23. It had to godown. Weak news, weak fundamentals. Why would the stock go up?Sure enough, KTEL went even higher, and I covered both lots at $29and over $31. The stock closed at around $32. My broker phoned me thatday and said that I had to cover my shares immediately because they hadbeen called in. When I told him I already did, he said I was lucky. He wasright. A gigantic short squeeze took KTEL shares as high as $80. (SeeFigure 2.1.)I lost over 50 percent on this single trade. It was very painful, ofcourse. But, at the same time, I felt that I finally understood somethingvital for my trading. I had the very strong feeling that it would be my lastbig loss. This feeling was correct. Never again did I take such a hit on asingle trade, and the understanding I bought with my loss on the TTG andKTEL trades has served me well ever since.
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FIGURE 2.1KTEL stock adjusted for a 2:1 split. (Used with permission of CBS MarketWatch.)
Learning from ExperienceI realized that all those things I was looking at and using as reasons formy trading decisions were completely irrelevant. News didn’t governprice movement; fundamentals did not either. KTEL was going up and upbecause the majority of people trading did not believe it would. Themajority were taking short positions, and the market acted in a way thatwould hurt the majority. The public was thinking, rationalizing, and analyzing, and the public was wrong. But wait. Was it really wrong?The KTEL price depreciated greatly after the short squeeze wasover, and eventually KTEL shares were delisted from the Nasdaq. (SeeFigure 2.2.) So, was the public right? Actually, yes, it was. Did being righthelp the public make money? No, it lost!Here is the answer. People were looking at something irrelevant tostock-price movement in this particular time frame. It did not matterwhether or not they were right because it was about something otherthan price direction. Even if they were right, it was not what impacted
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FIGURE 2.2What ultimately happened to KTEL stock. (Used with permission of CBS MarketWatch.)
the stock price. Supply and demand did. People were trying to judgesupply and demand from their evaluation of news and fundamentals. Butthe real ratio of buyers to sellers was governed by different factors, andthose factors had to do with the smart money playing against the crowd.The stock market apparently worked in a way that would allow the minority to take the money from the majority. It’s not a conspiracy; it’s notmanipulation—it’s just the way the stock market works. I need to dothings differently from what the crowd does because crowds are not successful in any kind of business. Those who reach the top are those whohave unique vision and the ability to realize that vision. So when you seethe crowd going for something, you want to view the situation from a contrarian’s perspective.After this realization, the pieces of the puzzle were coming togetherfor me, and my motto “Trade what you see, not what you think” was againvalidated. We can think anything we choose of the news, of a company,of fundamentals, or of financials. But the price action is the ultimate truth.For traders to make money, they have to read price action, not all those
PART ONE A Trader’s Journey
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things that surround market movements. By being around other traders ofvarious experience levels, you can see endless variations of those things.Traders all of a sudden become experts in drilling results, medicalresearch, software details, surgical tools, drugs, electronic devices, andbusiness models. You name it, and they discuss it and argue points. Theytry to take something from the information that will help them predictprice movement. But look at stocks, going from $10 to over $100 andback down, during 1999–2000. Did the fundamentals of the companies,business models, or their shares in the market change that drastically inboth directions during 1 year? In some cases, maybe. But I doubt it wasthe real reason for all those movements of such magnitude.Here is another example how our thoughts can take us to a dead end:If the Food & Drug Administration (FDA) approves some new drug presented by a company, stock price rises by let’s say 2 points. Then the priceretreats 1 point. Did the FDA withdraw its decision thereby making thestock drop? Of course not. It was the balance of supply and demand thatimpacted the movement and changed the price levels, while the initialpress release served only as the trigger for traders’ interest. Hence, inorder to trade these movements correctly, you need to read this balance ofsupply and demand.Remember the Bre-X story. Traders were mistaken in their evaluation, and they lost. In the case of KTEL, traders were right, and yet theylost again. Isn’t this proof that traders were basing their decisions ontotally irrelevant things? They were creating some other reality than thereality of stock movement.
THE TERRITORY AND THE MAPJohn Magee made the following analogy in Technical Analysis of StockTrends. There is a territory, and there is a map. Are they ever exactly thesame? Not really. They might be close if the map is good. But they arenever identical.Think of territory as stock movement. The map is what we think ofthe stock movement and what we make of it. If all the reasons that tradersdiscuss have nothing to do with stock movement, then what does? Theanswer is the stock movement itself! This is the only reality of the market.That’s why the market is never wrong. The market just is what it is. It doeswhat it does. As a Zen philosopher would put it, the market is.Let’s return to my trading situation after the two big losses. There Iwas, armed with good discipline, with a new understanding of how the
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market worked, with great execution technique, and with leftovers of mytrading account—just over $10,000.I was now under huge psychological pressure. I could not afford anymore losses. This situation is known as “scared money.” It’s commonlyacknowledged that scared money can’t win. Traders refuse to take stopsbecause they can’t afford losses. Not being able to win all the time, traderslet the next loss get out of hand. This is a vicious cycle. I already understood all this. I realized that I had already survived long enough to workout a solid methodology and correct mindset. Now I had to make it allwork with a ridiculously small line. I knew I had to have extremely strictdiscipline and keep my stops religiously. I decided to work out a wholephilosophy about stops, and I wrote a letter to myself about stops and theirmeaning for me. It was a letter written by a teacher I created in my imagination to me, the student. Here it is, with minor edits.What Is Stop Loss and How Does One Keep It?Let’s start with the very definition of loss. When we pay tuition for college,is it a loss? It isn’t if we get a good job based on the education we paid for.It is a loss if we never apply the knowledge we paid for. What if we pay muchmore for education than a new job can compensate us for? It’s still not a loss,but we paid too much for our education. This is exactly what happens in trading. If we bought a stock based on certain criteria, the trade went against us,and we took our stop, is it a loss? It isn’t a loss if we revise the criteria andavoid the same mistake the next time. It is a loss if we repeat the mistake over