MarketWatchChicago Board of Options ExchangeCNNFNDailyStocksExciteFederal Deposit Insurance CorpFederal Trade CommissionFidelity InvestmentsFinancial TimesForrester ResearchFundFocusFund SpotGomez AdvisersH&R BlockHoover’s StockScreenerIPO CentralLombardMarketplayerMarket Technician’s Assoc.Microsoft MoneyCentralMorningstarNational Assoc. of Securities DealersNational Discount BrokersNet InvestorNew York Stock ExchangeOnline InvestorPhiladelphia Stock ExchangeQuick & ReillyQuickenQuicken Financial NetworkRealty StocksReutersSchwab, CharlesSEC EnforcementSecurities and Exchange CommissionSecurities Industry AssociationSecurities Investor Protection CorporationSmartMoneySocial Security OnlineStandard & Poor’s Fund AnalystStandard & Poor’s Ratings ServicesStock GuideStockpointSuretrade1040.comThe Motley Fool
671www.briefing.comwww.fundsinteractive.comwww.businessweek.comwww.marketwatch.comwww.cboe.comwww.cnnfn.comwww.dailystocks.comwww.excite.comwww.fdic.govwww.ftc.govwww.fidelity.comwww.ft.comwww.forrester.comwww.fundfocus.comwww.fundspot.comwww.gomez.comwww.hrblock.comwww.stockscreener.comwww.ipocentral.comwww.lombard.comwww.marketplayer.comwww.mta.orgwww.moneycentral.comwww.morningstar.netwww.nasd.comwww.ndb.comwww.netinvestor.comwww.nyse.comwww.onlineinvestor.comwww.phlx.comwww.quickwaynet.comwww.quicken.comwww.qfn.comwww.realtystocks.comwww.reuters.comwww.schwab.comenforcement@sec.govwww.sec.govwww.sia.comwww.sipc.orgwww.smartmoney.comwww.ssa.govwww.micropal.comwww.ratingsdirect.comwww.stockguide.comwww.stockpoint.comwww.suretrade.comwww.1040.comwww.fool.com
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TheStreet.comTechnical Securities Analyst Associationof San FranciscoT. Rowe PriceTreasuryDirectVanguardBrokerage ServicesWall Street AccessWall Street Journal Interactive EdYahoo! FinanceZacks Investment ResearchZD Interactive InvestorWaterhouse SecuritiesA. B. WatleyWeb Street SecuritiesJack WhiteWitCapitalNet InvestorQuick & ReillyCharles SchwabSuretradeVanguard Brokerage ServicesWall Street AccessEmpire Financial Group, Inc.E*TRADELombardNational Discount BrokersAccutradeAmeritradeSee alsoDiscover BrokerageDLJ DirectDatek OnlineDiscover BrokerageDLJ DirectDow Jones MarketsDRIP CentralEmpire Financial Group
www.thestreet.comwww.tsaa.orgwww.troweprice.comwww.publicdebt.treas.govwww.vanguard.comwww.wsaccess.comwww.wsj.comwww.finance.yahoo.comwww.zacks.comwww.zdii.com
Brokerage Houseswww.tdwaterhouse.com 800-934-4134www.abwatley.com 888-229-2853www.webstreetsecurities.com 800-932-0438www.jackwhiteco.com 800-753-1700www.witcapital.com 888-494-8227www.netinvestor.com 800-638-4250www.quickwaynet.com 800-672-7220www.schwab.com 800-435-4000www.suretrade.com 401-642-6900www.vanguard.com 800-992-8327www.wsaccess.com 888-925-5782www.lowfees.com 800-900-8101www.etrade.com 800-786-2575www.lombard.comwww.ndb.com 800-888-3999www.accutrade.com 800-494-8939www.tdameritrade.com 800-326-7507www.freetrade.comwww.discoverbrokerage.com 800-688-3462www.dljdirect.com 800-825-5723www.datek.comwww.discoverbrokerage.comwww.dljdirect.comwww.djmarkets.comwww.dripcentral.comwww.lowfees.com
Section 4The Sharpe RatioAlthough this formula is flawed, it will not hinder the reader to know aboutit and understand it. Believing in it would be quite a different matter, however. The Sharpe Ratio itself is as follows:SR = ( E = 1) sd
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whereE is the expected returnI is the risk-free interest ratesd is the standard deviation of returns.The effect of this inflexible formula is to stick the trader with a measuring tool of little use to the practical trader. It assumes that volatility ofreturns as measured by sd equals risk (the common academic problem).In the inflexibility of the sd calculation, it fails to measure the most important fact in trading, the maximum drawdown, or, the inevitable fluctuationsin gains and losses. Specifically, the greatest expected or experienced loss,the retracement from greatest high to greatest low, and the sequences ofthese experiences.
Section 5Calculating VolatilityTo calculate volatility of a portfolio, first find the difference between eachreturn and the average. Then square each difference and add them together.Divide the sum by the number of returns minus one. This result is knownas the variance. Finally, take the square root of the variance to get thevolatility. Combining these steps into a formula:Step 1: Calculate the average return.Step 2: Calculate the deviation of each return.Step 3: Square each period’s deviation.Step 4: Add them together.Step 5: Divide the sum by the number of periods minus 1.Step 6: Take the square root.
n
∑ (Ri– μ )
σ=
2
i=1
n−1
DIAGRAM 12. Volatility formula. Illustrated is the formula for computing volatility.(1) Calculate the average return; (2) calculate the deviation of each return; (3) squareeach period’s deviation; (4) add them together; (5) divide the sum by the number ofperiods minus 1 to get the variance; (6) take the square root.
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Portfolio Analysis Screens
Diagrams 13 And 14 deal with portfolio risk and profit analysis. Illustratedare the sophisticated quantitative portfolio Profit and Risk reports of DelphicOptions Research as implemented for Standard & Poor ’s trading systems andPrudential Securities to give the reader an appreciation of the depth andcomplexity of professional thinking about risk and portfolio analysis. Theoriginals of these reports were designed by Blair Hull and Lester Loops fortheir own use in market making.
PORTFOLIO RISK ANALYSIS (.30 Filename)OMS+ .30 PORTFOLIO RISK ANALYSIS--STOCK-----DELTAS---SYM POS OPTION TOTAL PROFIT BETAFDXGEHWPLITNSMXRX···*TOT
28003200–6200–67003600–3600
–3063–308956820–40803991
–263110–517–6700–480391
16734126328270010411–882
–6900
–559
–7459
47165
3/24/87$BETA
1.60 –32081.95113741.20 –459591.40 –5698341.45 –210761.0518132···–639444
$DELTA $GAMMA $THETA
10:55:28$RISK
%RISK7.35.322.949.37.08.2···100.0
–70172993–13404–122107–72674835
158136120104–5222080150464186506
–121 18075–16 13000734 566170 122107–169 17436–260 20232
–141969
93000
166 247470
AVERAGE VOLATILITY:.338EQUIVALENT MARKET EQUITY:–419613.40PORTFOLIO PROFIT RATIO:.191PORTFOLIO PROFIT GAMMA RATIO:4.815
DIAGRAM 13. Risk analysis.Key: portfolio risk report. The Portfolio Risk Analysis screen summarizes delta, profit,and several measures of risk for a portfolio of user-specified stocks and options.The screen displays:STOCK SYM = The stock symbol;STOCK POS = The stock position, or number of shares owned;DELTAS TOTAL = The sum of the stock deltas and option deltas;BETA = The stock beta for each stock (implementation pending);$BETA = $The dollar risk due to movement of the general market:$Beta = (Delta × Stock Price) × Beta;$DELT = An annualized risk figure based on Position imbalance:$Delta = (Total Delta × Stock Price) × Volatility;$GAM = An annualized risk figure based on curvature of the position. A positive $Gammaindicates a backspread, and a negative $Gamma indicates a vertical position: $Gamma =Total Gamma × (Stock Price × Volatility);$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock priceremains unchanged;$RISK = The annualized standard deviation of the position based upon a composite of $Deltaand $Gamma;%RISK = Percent of portfolio risk in each position;TOT = Totals for each of the above categories;AVERAGE VOLATILITY = Average volatility for the stocks;EQUIVALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their total deltas;PORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total portfolio risk;PORTFOLIO PROFIT GAMMA RATIO = Total portfolio profit divided by the portfolio $Gammasquared.
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PORTFOLIO PROFIT ANALYSIS (.31 Filename)OMS+ .31 PORTFOLIO PROFIT ANALYSIS3/24/8710:55:28--STOCK-----DELTAS---------------PROFIT-----------$$%SYM POS OPTION TOTAL M TO M TOTAL /DAY /RISK /DY/RISK THETA RISK RISKFDXGEHWPLITNSMXRX···*TOT
28003200–6200–67003600–3600
–3063–308956820–40803991
–263110–517–6700–480391
42316270400653787–407025157293–4431
16734126328270010411–882
2131071500105–18
.93.97.15.00.60–.04
4.313.01.97.002.21–.34
47165
557
.19
.00
···–6900
–559
–7459
926792
–121 18075.16 13000734 566170 122107–169 17436–260 20232
7.35.322.949.37.08.2···166 247470 100.0
AVERAGE VOLATILITY:.338EQUIVALENT MARKET EQUITY:–419613.40PORTFOLIO PROFIT RATIO:.191PORTFOLIO PROFIT GAMMA RATIO:4.815
DIAGRAM 14. Profit analysis.Key: portfolio profit report. The Portfolio Profit Analysis screen summarizes delta, profit,and several measures of profit for a portfolio of user- specified stocks and options.The screen displays:STOCK SYM = The stock symbol;STOCK POS = Stock position, or number of shares owned;DELTAS OPTION = Total delta of the option position;DELTAS TOTAL = Sum of the stock deltas and option deltas;M TO M = Mark to market: Total value of stock and options positions based upon market prices;PROFIT TOTAL = Total theoretical profit for each position;PROFIT/DAY = Theoretical profit divided by the number of days to expiration;PROFIT/RISK = Ratio of theoretical profit to risk;PROFIT/DY/RISK = Ratio of theoretical profit per day to risk;$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock priceremains unchanged;$RISK = The annualized standard deviation of the position based upon a composite of $Deltaand $Gamma;%RISK = Percent of portfolio risk in each position;TOT = Totals for each of the above categories;AVERAGE VOLATILITY = Average volatility for the stocks;EQUIVALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their totaldeltas;PORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total portfolio risk;PORTFOLIO PROFIT GAMMA RATIO = Total portfolio profit divided by the portfolio $Gammasquared.
Section 6Gambler’s RuinReprinted from The Education of a Speculator by Victor Niederhoffer. Withpermission.The classic gambler’s ruin problem, which applies to all speculative situations, can be framed this way. A speculator with initial capital of C plays agame with a casino: he wins $1.00 each play with probability P, or loses $1.00
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with probability Q, which is 1 – P. The speculator plans to stay in the gameuntil his capital appreciates to A or depreciates to ruin at 0. It can be shownthat, in such a game, the speculator’s probability of ruin is:
(Q P) − (Q P)A(Q P) −1A
C
Plugging numbers into the formula, a speculator who has a 60% chanceof winning each play, and who starts with $1.00 and tries to run it to $10.00,will face a 66.1% chance of ruin for the session. Because he has a 33.9%chance (100% – 66.1%) of finishing the session with $10.00, his expected finalbankroll is $3.39. He started with $1.00, so he expects to gain $2.39.The table below summarizes the expected gains for a gambling session,given initial capital C and probability P of winning each day. With a 60%chance of winning, the size of the bankroll becomes critical. By starting with$4.00 rather than $1.00, the speculator increases his expected gain from $2.39to $4.17 — an increase akin to the winning edge held by strong, well-fundedplayers in a poker game. Above a $4.00 bankroll, the decreased risk of ruinis more than offset by the diminished benefit of achieving the $10.00 goal.For example, with capital of $9.00, ruin is very rare, but the upside is only$1.00 ($10.00 – $9.00).A Gambler’s Expected GainCapitalProbability
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
$7.00
$8.00
$9.00
100%90%80%70%60%
$9.007.896.504.722.39
$8.007.887.386.163.65
$7.006.996.846.21+.16
$6.006.005.965.664.17
$5.005.004.994.863.84
$4.004.004.003.943.28
$3.003.003.002.982.58
$2.002.002.001.991.78
$l.001.001.001.000.91
This idealized formulation of the gambler’s ruin problem demonstratesthe tradeoff that arises in practical trading. The speculator wants to betlightly enough, relative to his capital, to fend off gambler’s ruin, but heavilyenough to make his desired rate of return. Unfortunately, the real-life speculator doesn’t know his true odds of winning on each trade, so he can’t lookup the optimum betting levels in a table.When the odds of success are less than 50%, the situation changes.Whereas the player with an edge should bet small, trying to grind outa profit, the player with the worst of it is better advised to go for the homerun, betting the maximum, because this is the only way he can end up awinner. This explains, in part, why casinos have limits on the stakes thatplayers can use against them, and why the exchanges have establishedposition limits on what the public can hold.
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Section 7From the John Magee Market Letters December 15, 1984(by Richard McDermott)
The Elliott Wave Theory: Perspective and CommentsThis week we had the pleasure of attending the December meeting of theMarket Technicians Association of New York.Long-term subscribers will remember the MTANY as the organizationwhich honored John Magee with its “Man of the Year” award in 1978. Thespeaker was Robert Prechter, publisher of “The Elliott Wave Theorist,” aninvestment advisory which bases its forecasts on interpretations of R.N.Elliott’s work on the stock market.Of primary interest to SAS subscribers are Prechter’s comments on technical analysis itself. The Elliott Wave Theory, it must be remembered, is reallyno more than a “catalog” of stock market price movements, laid one on topof the other, so to speak, until a grand, underlying, and enduring pattern isobserved; in short, pure technical analysis. Among Prechter’s definitions andobservations regarding fundamental analysis are the following:1. “First let’s define ‘technical’ versus ‘fundamental’ data … technicaldata is that which is generated by the action of the market understudy.”2. “The main problem with fundamental analysis is that its indicatorsare removed from the market itself. The analyst assumes causalitybetween external events and market movements, a concept which isalmost certainly false. But, just as important, and less recognized, isthat fundamental analysis almost always requires a forecast of thefundamental data itself before conclusions about the market are drawn.The analyst is then forced to take a second step in coming to aconclusion about how those forecasted events will affect the markets!Technicians only have one step to take, which gives them an edgeright off the bat. Their main advantage is that they don’t have toforecast their indicators.”3. “What’s worse, even the fundamentalists’ second step is probably aprocess built on quicksand…. The most common application of fundamental analysis is estimating companies’ earnings for both thecurrent year and next year, and recommending stocks on that basis.…And the record on that basis alone is very poor, as Barron’spointed out in a June 4 article, which showed that earnings estimatesaveraged 18% error in the thirty DJIA stocks for any year alreadycompleted and 54% error for the year ahead. The weakest link, however, is the assumption that correct earnings estimates are a basis for
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Technical Analysis of Stock Trendschoosing stock market winners. According to a table in the sameBarron’s article, a purchase of the ten DJIA stocks with the bestearnings estimates would have produced a ten-year cumulative gainof 40.5%, while choosing the ten DJIA with the worst earnings estimates would have produced a whopping 142.5% gain.”
We enjoyed Prechter’s polished exposition of a technical approach different from our own. As for his observations about fundamental analysis,we simply couldn’t agree more.
Section 8The first cave men, fighting over resources used teeth and claws. The natureof warfare was changed forever when one of the smarter ones picked up atree branch. Then another smart one discovered the principle of artillery andpicked up a rock. Naïve and arrogant traders laughed at Wyckoff’s charts.Market makers on the Pacfific Coast Options Exchange sniggered at BlairHull when he started appearing on the floor with print outs. In the days ofthe wooden racquet squash players hated the arrivistes who appeared withmetal and then composite racquets.No longer. The last to adopt the new weapons is a dead man. Chartsshowed their power and so did Hull’s wonky print outs made with the BlackScholes Model. The losers figured out pretty quickly they needed new weapons. With that dissertation on the epistemology of warfare I present someof my favorite weapons in the following software and Internet sites. Noattempt whatsoever is made to be comprehensive or encyclopedic. On thecontrary, idiosyncrasy is my operating method and no disfavor is impliedto those not included here.For myself, three desktop software packages are powerful and sufficient for all the needs of a technical analyst: AIQ Trading Expert Pro(aiqsystems.com); Metastock 9.0 (equis.com); and TradeStation 2000i(tradestation.com). The reader will find examples of charts sprinkledthroughout this book, supplementing the beautiful hand drawn charts ofMagee. All these packages have the basic requirements necessary for technical chart analysis, basic charting on readily available data and portfolio.I have said before that all the chart analyst really needs is the ability todraw lines on a chart … and then perhaps to see the chart as a line chart,or a candlestick chart or…. And so on and so on. The analyst is soonseduced by the dazzling features, AND the analysis is enriched and mademore powerful. And even if one says (as I do) when he looks at an oversoldtool “What do I need that for? I saw it on the bar chart.” The analyst findshimself wanting to know more about %R. If it worked for Larry Williamsthere must be something in it.
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AIQ – TRADING EXPERT PROAIQ’s package includes an on-screen control panel and scrolling indicatorboxes which are color coded and this information is synthesized in an indicator barometer. Data management is smooth and easy and the user mayuse a system module to create and test his own trading ideas. A panoply ofreports are available to aid the investor. For the trader real time alerts are afeature. A portfolio manager module aids the investor in managing not justthe portfolio but his positions by making stop management facile. An ExpertGuru lurks behind the curtain to aid the user in analyzing situations.
METASTOCK 9.0Metastock 9.0 boasts an impressive array of tools and indicators. “SystemExperts” pop up on demand and can also guide the user through systemstests and explorations. The Experts can also suggest buys and sells. A pointand figure toolbox is a valuable feature. The ability to create and test tradingsystems, with exhaustive and critical data analysis, is a powerful tool. Metastock adapts easily to add ons, of which Slauson’s Powerstrike (the quantitative tool for finding critical support/resistance zones) is a good example.
Tradestation 2000i and Tradestation 8Tradestation 2000i is the standalone version of Tradestation 8. Tradestation8 is a real time on-line package which allows for trading through the Tradestation brokerage affiliate. The package is so powerful that on-line professional and semi-professional users probably benefit by combining their software arrangement with a brokerage arrangement. 2000i requires the user tomaintain his local database, while Tradestation 8 always has the data ondemand. For the creatively lazy (among them the editor) this is an attractivefeature. Systems building and testing has always beeen and remains a powerful feature of Tradestation. With “EasyLanguage” the user may specifyvirtually any system he can think of. And then chat about it with the Tradestation community of traders. This community has contributed to a large database of trading systems and ideas.
The Internet: prophet.netAnd, for the even lazier and more casual investor there is prophet.net anInternet technical analysis site whose free features will fulfill the needs ofthe general charting investor. With powerful interactive charts and portfolioreporting the penurious investor will save many pennies at prophet.net. And,as Mark Twain said, a penny saved is a penny earned. Actually, what didBen mean by that? A penny saved is capital when put to work. A usercommunity and sharing are other attractions. And of course, no local data
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maintenance is necessary. And among its most valuable features prophet.netoccasionally distributes market commentary and analysis by this editor. Allin all prophet.net appears to deserve the continuing awards it has receivedfrom Barron’s and Forbes, as well as Technical Analysis magazine.
The Internet: stockcharts.comOf similar quality, and similarly honored by Forbes and Technical Analysismagazine, stockcharts.com has an additional valuable feature: point andfigure charting. I have not remarked on P&F charting here, but it is animportant technical method, especially for the patient investor. All the otherfeatures are available at stockcharts.com, candlesticks, bar charts, etc. Andthe distinguished analyst John Murphy makes his electronic home there withGreg Morris, a noted candlestick authority. There is also a ”Voyeur” featurewhich allows the user to see what other traders are doing.
A Brief SummaryKnowledge is power. Knowing where to find knowledge is even more powerful. The inquiring investor can keep himself up to date on these sitesthrough the yearly evaluations in Barron’s and Forbes, and the financialpress regularly updates its evaluations of Internet resources.
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appendix EEN9: In a unique act of intellectual generosity Curtis Faith, one of Richard Dennis’original Turtles, wrote a fully articulated account of the trading system used in thefutures markets by the Turtles. This document, which may be found in its entiretyat originalturtles.org is the very model of a modern major general’s trading notebook.(Occasionally Gilbert and Sullivan intrude into even the most disciplined accountof trading systems.) I have a number of systems and procedures manuals like thisin my files. For all intents and purposes they have very similar contents. Faith’sTurtle manual is probably the best written in my experience. And probably the onewith which I am most in agreement.My agreement with the document stems from my preference for “natural” systems, as opposed to “number driven” systems. Chart reading systemsfit naturally over market facts, as a glove over a hand. High/low systems,like the Turtle system and like Dow Theory self-adjust to the rhythms of themarkets. And like all mechanical systems it has its virtues and vices. Theabsolute worst vice of the mechanical trading system is, like a machine runamok, if the market rhythms get on the wrong harmonic the system willtreat capital like a meat grinder treats beefsteak. A bloody sight to behold.Especially when it is your ox being ground.It would be unspeakably rash of me to recommend the adoption out ofthe box of this system. But I strongly suspect that in broad trending marketssome adaptation of it will be very productive.And, I require all of my graduate students to produce such a workbook,and this is the model I give them to emulate.
Chapter 1A Complete Trading SystemThe Turtle Trading System was a Complete Trading System, one thatcovered every aspect of trading, and left virtually no decision to thesubjective whims of the trader.Most successful traders use a mechanical trading system. This is no coincidence. A good mechanical trading system automates the entire process oftrading. The system provides answers for each of the decisions a trader mustmake while trading. The system makes it easier for a trader to trade consistently because there is a set of rules which specifically define exactly whatshould be done. The mechanics of trading are not left up to the judgmentof the trader.
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If you know that your system makes money over the long run, it is easierto take the signals and trade according to the system during periods of losses.If you are relying on your own judgment during trading, you may find thatyou are fearful just when you should be bold, and courageous when youshould be cautious.If you have a mechanical trading system that works, and you follow itconsistently, your trading will be consistent despite the inner emotionalstruggles that might come from a long series of losses