technical analysts, but it works, pretty well in fact. That is only a partial answer. WhenI traded commodities 20 years ago one of the traders would sell soybeans every time there wasa full moon. I saw him the other day. I don’t think it was successful. If there is no logicunderlying an indicator, beware - it may stop working.In fact there is a perfectly good reason why the Coppock indicator is a valuable tool. Over thelast 30 years, periods of economic contraction have tended to be relatively short. In 1963 theeditor of Investors Chronicle modified the indicator by basing it on weighted price changes over12 months. Since the stock market is known to look ahead, a 12 month indicator might wellprovide reasonable results. Forget about recovery time from bereavement. The Coppockindicator is effectively a 12 month weighted momentum indicator.The strength of the indicator is that it turns slowly. Markets often have secondary highs or lows.The NASDAQ peaked on the 9th March 2000, and fell steeply. But on 24th May 2000 it starteda massive rally of over 1200 points or 41% in 7 weeks, and even by the end of August 2000 itwas trading 38% higher than its May lows. With hindsight we know that it was a false dawn.But I don’t know any chart techniques which would have kept one out of the technology marketin the summer of 2000 - except for the Coppock indicator which gave a sell signal in April 2000and gave its first buy signal at the end of November 2001.Buying the NASDAQ at the end of November 2001 would have proved profitable for barely afew weeks. Since 9th January 2002, the NASDAQ has fallen steeply. Anyone trading theNASDAQ with the use of the Coppock indicator will be cursing. But it is a long term indicator,and it is typical for a Coppock signal to have a delayed effect. I don’t use it or my proprietarylong-term moving averages to initiate positions. I do find them useful to establish a bias as abackdrop to my short-term trading. Moreover, like all indicators it is not infallible, as investorshave found out this year.
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At the beginning of every month, Investors Chronicle publishes its computation of the Coppockindicator for worldwide markets.
C) Bullish Percent chartsThese are point & figure charts but I deal with them here because they fit better with long-termmoving averages and Coppock (from a swing trader’s point of view). The books of A.W. Cohen,Michael Burke and Tom Dorsey wax lyrical about the bullish percent indices. The NYSEBullish Percent Index was invented by A.W. Cohen. It is an analysis of the percentage of all thestocks listed on the NYSE whose charts have a bullish formation. Relevant conclusions aboutthe state of the markets can be drawn from the charts not only of the main NYSE bullish percentchart but also from bullish percent charts of the various sector indices. For a fuller treatment ofthis subject, buy one of Tom Dorsey’s books. Bullish percent charts are undoubtedly a valuabletool for technical analysts, although they can’t be used for the sort of close timing that is neededin swing trading.But even for swing traders, they can provide a backdrop, a bias about the overbought/oversoldnature of the market which is useful. Unfortunately there is no source in the United Kingdomfor such charts on local markets. I keep an eye on the bullish percent charts of the US marketswhich I find on www.stockcharts.com.
D) CandlesticksCandlestick charts are very popular. At first I was deeply suspicious of a technique which hadalluring names for its chart patterns such as ‘dark cloud cover’ and ‘morning star’. It seemed tome I was being sold the wrapping rather than the content.But there is no doubt that further useful information is imparted by the use of the opening levelof a stock, and its relationship to the subsequent close which gives the dark body or the whitebody on a candlestick chart. Personally I don’t use candlestick charts, but that’s only because Ihave enough on my plate. There is a danger of developing ‘indicatoritis’ if one looks at too manyindicators or different types of charts. It must surely be right to stick to a clear andstraightforward method which best fits one’s risk profile.
E) Relative StrengthWhen trading individual equities, it virtually goes without saying that the best results are goingto be obtained by buying shares which are relatively strong vis-à-vis the market, and by avoidingthe purchase of shares which are relatively weak vis-à-vis the market. Likewise selling short ashare which is relatively weak compared to the market will be a substantial improvement on173
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selling short a share which, though it may be declining, is relatively strong compared to themarket. Most modern software has a relative strength indicator which will allow you to examinethe relative strength of a share. You will notice one thing immediately when you look at arelative strength chart. Shares have periods when their relative strength waxes, and other periodswhen it wanes. It can be quite tricky to decide whether a share is about to end its period ofrelative strength/weakness. I offer no solution. One can apply trend lines or moving averages oreven point & figure charts to the relative strength chart. It can also be useful to apply the RSIindicator to such a chart which will tell one when a period of relative strength or weakness isoverdone.In the end, it seems to me that it is largely a matter of impression. I tend to assume thatprevailing relative weakness or strength will continue (unless the RSI suggests otherwise). Ifthere is a brief blip in the relative strength chart, I will ignore it. A definite change in the relativestrength position of a share will become apparent eventually, although its longevity alwaysseems to me to be open to doubt.In the end what I really use relative strength for is to avoid buying shares which are currentlyrelatively weak, or selling short shares which are currently relatively strong.
ConclusionI am perfectly aware that I could have undertaken a more comprehensive treatment of otherindicators, but there is a danger in a book like this of information overload.
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TACTICS FOR LTBHs• Limited use of swing charts• Using options & charts to enhance returns• Tailpiece
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Limited use of swing chartsI make this brief pitch to long term buy and hold investors. Let’s assume you have no interestin going short of the market. You also have no interest in trading in and out of all the variousswings. There is a hybrid stance. You ought at the very least to be interested in avoiding thedamage done to your holdings by bear markets. You could use the FTSE index swing chart toliquidate your long position whenever a short term downtrend is signalled (or you could hedgeyour long positions on the futures market). I have devised 2 plans.Plan A1. Sell when the swing chart signals a change of trend to the downside. Use a 2% stop.2. Lower your stop to entry point once the market has moved 2% in your favour.3. Re-enter the long side once your stop is hit or when the swing chart signals a changeof trend to the upside.4. Ignore any signals in December after the 7th of the month.Plan B1. Sell only when the swing chart signals a downward linear phase. This has the immensebenefit of avoiding all the false change of trend signals, but it does also mean that youwill miss part of the downward move.2. Use a 2% stop.3. Re-enter the long side once your stop is hit or when the swing chart signals a changeof trend to the upside or after the market has gone down 15%, whichever occurs soonest.I have chosen 15% arbitrarily to try to capture most worthwhile downtrends. You couldchoose a different figure if you wished.4. Ignore any signals in December after the 7th of the month.ResultsYou will be better off in any year in which the market closes down, like 1994, 2000 and 2001.I trust I do not need to demonstrate this.You will also be better off in any year which contains one substantial downtrend even if themarket closes up on the year. A typical example is 1998, as set out below. The FTSE began theyear at 5135 and ended it at 5941, but in the summer there was a large fall triggered by theRussian debt default and the collapse of Long Term Capital Management.
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Plan A
Plan B
24.04
Sell at 5849Stopped out at entry point
06.05
Sell at 5971Buy back at 6044 for 1.2% loss
12.06
Sell at 5776Stopped out for 2% loss
30.06
Sell at 5868.Stopped out for 2% loss
24.07
Sell at 5914Buy back at 5323 (26.10)
20.08
Sell at 5647Buy back at 4800 (2.10)
Net
8% gain
Net
11.8% gain
These gains come in addition to the gains made from long term buy and hold in 1998. The FTSEwent up 15.6% in 1998. By returning a further 11.8 %, Plan B enhanced returns by over 75% to 27.4%.Long term buy and hold can be a better strategy than Plan A or Plan B. In any year in which themarket has no substantial short-term downtrend, but does have a sideways trend (which usuallycauses small losses when using swing charts), buy and hold would be a better strategy. A goodexample is 1995.
Plan A
Plan B
1) 13.01
Sell at 3018Stopped out for 2% loss
1) 30.01 Sell at 3005Buy back at 3025 (2.02)
2) 20.01
Sell at 3003Stopped out at entry point
2) 03.03 Sell at 3032Buy back at 3048 (14.03)
3) 27.02
Sell at 3014Buy back at 3048
4) 10.10
Sell at 3496Stopped out for 2% loss
Net
5.1% loss
Net
1.2% loss
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fig 11.1You can see from the chart that the FTSE went sideways for the first 2.5 months of the year. Itthen had a huge bull market which was brilliantly caught by the swing chart. There weremultiple profitable swing trades until mid-October when the bull market stuttered and thenrecovered. The long term buy and hold investor was 20.4% better off at the end of 1995, butfollowing Plan A would have left him only 15.3% better off (because of the small losses inJanuary and October) and following Plan B would have left him only 19.2% better off.
Using options and charts to enhance returnsIt isn’t a secret but it might just as well be for all the use that is made by private investors of thetraded options market in the UK, particularly as regards writing options. Haven’t you evergnashed your teeth at the size of the cheque you have to write out to pay an insurance premium.Why not be the one who extracts the premium? The virtues of buying options are well knownand well understood by most investors. But writing options appears to intimidate many.This section of the book does assume some knowledge of the phraseology associated withoptions. It intended to be purely a brief glimpse of option writing strategies. For a fullertreatment of this subject, visit www.global-investor.com/books or any other bookseller on theworldwide web and buy a book on the subject.There are about 90 odd stocks in the UK in which there is a traded option market on LIFFE(London International Financial Futures Exchange). They mostly cover the biggest 90178
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companies listed on the London Stock Exchange, although there is a significant number offallen stars left over from the technology bubble who have dropped out of the FTSE 100. MostLTBHs will have a proportion of their holdings in the blue chip stocks in which there is anoption market. Each option is a contract for 1000 shares (apart from the AstraZeneca contractwhich is 100 shares). Each option has premiums listed for a range of prices and for 3 expirymonths. The expiry months are 3 months apart. The grantor/seller/writer of an option receivesthe option money up front so he can earn interest on that sum whilst waiting for the option toexpire or be exercised by its owner.The two main components which influence the price of an option premium are the time left toexpiry and the underlying volatility of the stock.The following strategies should be considered:a) Naked puts
Writing naked puts is a more cautious way of trying to catch falling knives a.k.a. buying a stockwhich you think has been unjustifiably bombed. By writing a naked put at or slightly below themoney, the writer/grantor/seller of the put effectively takes a long position below the currentmarket price.It is trite that markets overshoot and undershoot fair value in the course of bull and bear markets.When a crisis unfolds, some investors want to buy put options as protection against further falls.If they get in early enough this is a sound course, but all too frequently the point at which mostput options are bought is the very bottom of the market (which is why technical analysts look atthe put/call ratio - see www.stockcharts.com). The unfailing usefulness of this ratio has led oneAmerican wag to describe option buyers as the "dumb money at its dumbest". It’s not faircomment on the whole, but it is often seen to be true at market peaks and troughs.The key to success with granting naked puts is to assess when the market is within about 25%of its long-term or at least intermediate term (3-4 months) lows. You could do that byfundamental analysis or by gut instinct. Or you could do it by using a chart showing the RSI.Remember though that the RSI says nothing about value. It only speaks about overshotmomentum, which can be corrected by a small countertrend correction. Or you could use thelong tail down point & figure chart formation shown on page 118. I remarked that I thought itwas a formation that represented simply a highly risky form of bottom fishing, since one columnof 3 Xs up, after (at least) 20 Os down did not seem to me to prove that any sort of bottom hadbeen made. But that was from the point of view of the swing trader. Tom Dorsey rightly advisesthat you should stop yourself out if the share does make a new low. I find that shares dofrequently make a slightly lower low, so I don’t use the formation to swing trade.The LTBH investor is less concerned about ‘temporary’ paper losses. The LTBH who grants anaked put must first have a point of view that he would like to hold the shares for the long-termand that if they spend a while under his purchase price, it is of no major concern.179
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The point & figure chart of Aviva is instructive.
1
4
2
3
fig 11.21.
It gave its first sell signal on 24th April 2002 at 755p, but its downtrend really gatheredpace on 5th June 2002 when the FTSE crashed through 5000, suggesting that the priceaction of the first 5 months of the year was massive top formation. At the same time,Aviva gave a repeat sell signal at 630p.
2.
Just 9 days later Aviva had fallen 20 Os, but this was far too early in the downtrend to belooking for a bottom. Short-term downtrends do not last 9 days.
3.
But by 15th July there was a second long tail down and by this point it was at leastpossible that the market had reached a low at 375p. As Aviva reversed upwards through390p (giving a long tail down buy signal), you could have granted the October 360 putsat 32p or even the April 2003 puts at 56p.
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When granting naked puts as a proxy for going long of the market, it is best to choose the nearestexpiry month, because the time value of the option erodes more rapidly as expiry approaches.Effectively the LTBH investor would be buying Aviva at 328p if the option were later exercised(360p-32p). In fact Aviva did fall thereafter making a low of 318.5p on 24th July. It is a virtualcertainty that the buyer of the option would not have exercised it. Aviva spent only 1 day below328p, and you will often find that weeks and weeks elapse before the holder of a put optionexercises it. So if the option is never exercised the LTBH investor will have earned a return of8.8% in 3 months - an annualised return of 35%. Even if Aviva had languished below 328p fora few days and the option had been exercised, you can see from the chart what happenedthereafter - plenty of scope for profits.Provided the LTBH investor has correctly identified that the stock is within about 25% of itslows, it will not matter if the option is exercised and the stock spends a considerable timeunderneath his purchase price. There will be little rallies which he can use to write covered calls(see below), further lowering the net cost of purchasing the shares.Granting naked puts is particularly appropriate in times of great market turbulence whenvolatility increases. That is why at the end of September 2001 and July 2002 after the markethad made its lows, I recommended in Investors Chronicle that readers should grant naked putoptions. The charts had yet to give a buy signal, so I could not recommend outright purchases,but oversold readings were so extreme that some sort of a bounce was inevitable and volatilityhad increased so much that many option premiums were running at an annual rate of over 30%,giving investors a huge cushion.b) Writing covered call options
This is the easiest money you’ll ever make. Why there aren’t legions of private investors writingcovered calls I don’t know. Writing a call option at a strike price somewhat above the prevailingmarket price gives the buyer of the option the right, but not the obligation to demand the sharesfrom you in return for payment of that price. If you don’t own the shares you have written anaked call. If you do own the shares, they cover the call option you have written.Simple covered callsLet’s stay with the chart of Aviva. Aviva had a spectacular bounce of 81% off its July 2002 lows.Let’s imagine you bought the shares for the long-term at 525p either on the way up or the waydown.4.
Then Aviva gave a sell signal as it hit 525p on 28th August 2002 (fig 11.2). The highestpoint of the move was 581p, and after the sell signal one could legitimately infer thatthere was significant resistance at 581p, and that the market consensus was that Aviva wasoverpriced at that level. The LTBH investor could have sold the 550 January 2003 callsat 45p as the sell signal was given.181
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The call options will not be exercised (broadly speaking) until Aviva rises over 595p, whichwould mean the market consensus had altered.If the chart signal is an accurate reflection of the market consensus and that consensus holdsuntil January, Aviva will languish below 595p and probably below 525p until after January. Thepassive LTBH will simply have to take whatever life offers. You, the proactive LTBH investorwill have enhanced your returns by 8.6% over the 4.5 months by pocketing a premium of 45p(45p divided by 525p), which is equivalent to an annual rate of 23%. If Aviva falls back to thelows at 318.5p you will still of course be showing a loss, but you are the one who wanted tohold the shares for the long term. Your loss, however, will be cushioned by the 8.6% returnyou’ve already received, and come January, when the options expire worthless, you will be ableto repeat the exercise.Of course if in January 2003 a. the shares are at 318.5p, you will have to wait for a rally, because the premium onselling calls at 550p or even 500p will be negligible (but the pyramiding strategy belowdeals with that problem too).b. the shares are bobbing about in the mid 400s, you will be able to keep granting 550pcalls in the share, and pocketing the premium until you reach the conclusion that the bearmarket is over.If you have a call option outstanding at the same time as Aviva gives a buy signal at a lowerlevel, you buy back the call option at a profit and continue holding the shares for the long term.Now let’s see what happens if everything goes wrong. Aviva has fallen after giving the sellsignal. But supposing it then regroups in the mid 400s and suddenly surges over 600p beforeJanuary 2003. Suppose the chart doesn’t give a clear enough buy signal to act on, or it does butyou’ve been too preoccupied with other matters to catch the buy signal. The owner of the optionwill exercise the option, and call the shares off you and you will be Aviva-less. A disaster you’ve made a profit of only 13.3% (595p divided by 525p), plus the interest you earned on theoption premium, in less than 4.5 months (annualised rate 35%) when you could have made more(because the shares are now over 600p). If all your disasters end in annualised profits of 35%,you are going to be very rich.Pyramiding written callsIt’s all very well dealing with market prices which are more or less current. But a few LTBHinvestors will point out: What happens if I bought Aviva at 800p in January 2002. They may be470p at beginning of September 2002, but if I write a covered call at 550p and the shares riseover 600p, all I’ve done is guarantee myself a large loss. And since there won’t be any sensiblemarket in the Aviva 800p calls, what do I do?You could pyramid your call options provided your holding is sufficiently large (4000 shares).182
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This is how the pyramid works. You want to sell your Aviva shares for 850p. You are nevergoing to take a loss however long it takes. Grant 1 contract (1000 shares) of Aviva January 2003550 calls. If the options expire worthless, you’ve enhanced your returns. If Aviva rises to 550pin say November 2002, your call option will be trading at a loss. You buy the January call optionat a loss and grant 2 contracts of April or October 2003 650 calls which will offset the cost ofbuying back your 550 call. Aviva keeps on rising. It gets up to 650p by February 2003. Fearfulof having the shares called off, you buy back your 650 calls, and grant 3 contracts of January2004 750 calls, which subsidise the cost of buying back the 650 calls. Still Aviva surges up to750p. You buy back the 750 calls. You now grant 4 850 calls and you’d be quite happy to seethe shares called off.Supposing Aviva falters. It never gets to 750p. After getting to 650p it falls back and oscillatesbetween 450p and 650p for years. If you didn’t use the traded option market, you would lookon in frustration. But, if you are pyramiding, every time the call options expire worthless youcan repeat the exercise by granting more out of the money calls.It can be done as mechanically as I’ve described or you could use a chart to finesse the market.Every time Aviva gives a sell signal, you sell/write/grant call options. Every time it gives a buysignal, you close your option position and watch the value of your holding increase until the nextshort term-sell signal appears.
TailpieceSince implied volatility rates are typically about 16%-18% in London (which means that at-themoney option premiums are similarly priced on an annualised basis), and nearly double that intimes of crisis, the market is offering you magnificent returns in return for writing options.Patience is required. It can be something of a lengthy process, but then, as an LTBH investor,you are used to that.There will come a time when prolonged prosperity leads to a prolonged bull market like 19821999 when you have to worry less about sell signals because every dip is a buying opportunity(even when it doesn’t seem so, like October 1987). But until you’re convinced that such a periodhas started, you may think that a proactive approach to downward lurches is called for.
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12
SUMMATION• My approach - a summary• Mistakes to avoid• Final word
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My approach - a summary
1.
Look at long term indicators to determine the broad long-term trend.
2.
Top down. First determine the short-term trend of the relevant marketindex (FTSE, Dow, NASDAQ etc.) by analysing swing charts andpoint & figure charts. The swing chart has primacy.
3.
When trading index futures and options, the swing chart is myprimary guide.
4.
When trading stocks, the point & figure chart of the individual stockhas primacy over its swing chart. Look at sector charts as well, andrelative strength. Use FTSE swing chart as a filter (don’t trade againstthe trend!).
5.
Integrate point & figure and swing charts.
6.
Use the weekly RSI as a filter. In most cases, do not establish a newlong position if the weekly RSI is overbought or a new short positionif the weekly RSI is oversold.
7.
Be swift to protect any position by raising stop loss to entry point assoon as is reasonably sensible.
8.
Freewheeling approach to taking profits. Remember Baruch. Watchthe RSI.
I have covered all of these matters in detail in the preceding chapters.
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Summation
Mistakes to avoidThere are plenty of errors for swing traders to make. I trust no-one makes the error of failing toactivate their stop losses. Misreads are rare but they do happen. Missed opportunities throughdoubt or disbelief are common, but are not too damaging. They do prove why back-testing isonly of limited value. My publishers are very keen for me to tell readers exactly how profitableswing trading is. It’s impossible to say. It depends on the trader’s discipline. It is entirelypossible to make a living out of swing trading.Five significant errors spring to mind. I stun myself when I repeat these mistakes! Is it hubris?Am I a dolt? I take comfort from the observation by Warren Buffet that there are some lessonsyou just need to keep relearning - a much cosier way of expressing things. Experience will meanthat you seldom commit these errors, but they are very difficult to eradicate completely.1. Licking one’s wounds
W.D. Gann said there was no need to be in the market all the time. That is, of course, correct.But since trading inevitably involves making some losses, your net profit can be severelyaffected by halting trading after a series of bad signals. Lo and behold, the signal you decide tosit out turns out to be a successful one which only adds to your misery. The simple truth is thatyou have to become case-hardened to losses. Take adversity on the chin. Of course when youdo make a series of losses the right thing is to scale down your trading.2. (Over)Trying to get losses back
This mistake has cost me more money than any other. As recently as September /October 2001I was doing a refresher course in the cost of making this error. September 11th had cost me achunk of money, and reading the market well, I recovered some money on the oversold readingsof 21st September. I waited for the big bounce which was a certainty to happen so that I couldgo short for a re-test of the lows. I had no preconceived views about new lows being made. Infact I rather doubted it, but it seemed a racing certainty that the market would at least movelower after the first big bounce in order to test the buying support, to make a higher low. So Ishorted the market in twice the size that I would normally do, trying to get back the balance ofmy September 11th losses. The market didn’t go down. Result: Instead of a ‘normal’ size loss,I had a double helping.When you try to ‘get it back’ you invariably take risks that you shouldn’t and it almost alwaysworks out poorly. It is difficult to be patient in an activity where instant results are a materialpart of the attraction.
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3. Frustration with sideways market action
This is a cousin of the ‘trying to get it back’ error. The FTSE index in the first 4 months of 2002moved sideways. Using my modified swing charts, the net result in the first 4 months of the yearwould have been a small loss. I felt the frustration as keenly as anyone. But it is a mistake to tryto force the pace. Taking on more risk to compensate for months of sideways action is nothealthy. It is quite normal for the swing trader to achieve nothing in terms of net profit for longperiods. Sure enough a terrific downtrend unfolded in June and July.4. Forgetting that the trend is your friend
I know there are those who use sentiment indicators to trade counter to the trend, but I virtuallyalways trade with the trend. As set out above, my first question is: What is the broad overalltrend? This determines the measure of caution with which I approach a trade. The next question,even when trading individual equities is: What is the short-term trend of the relevant marketindex?This may sound obvious but you’d be amazed how often even experienced traders fail to applyit. Quite often, after a long downtrend, a market will move sideways in what appears to be anobvious basing pattern. One’s intuition is that the market does not want to go down any more.A small gauge point & figure chart may confirm the impression of basing. The market thenmoves higher. Many traders will leap on board and buy. But if there is no reason to suppose thatthe main short-term trend has changed, what the trader should be doing is hoping for the marketto go up, but not trading it to go up, so that he/she can re-establish a short position. It is a doublepunishment when you lose money by buying into a downtrend.The error of trading counter to the trend is made because after many years of experience you'llfind that your intuition is fairly reliable. And it is one of the most intellectually seductive thingsto do - to call a rally in the market, through sheer experience, when the majority of participantsare selling. It can be a difficult fault to resist, and I confess that on occasions I have been unableto resist it. I have found that trading against the trend based on intuition and experience yieldsreasonable results if all you are counting is the number of winners and losers. The trouble is thatbecause one is smart enough to know that trading against the trend is dangerous, one takesprofits very quickly and the profits turn out to