our entry is usedas our protective stop while our exit is the Bail Out or the first profitable opening after entry technique.This does make money, $73,468 with 80 percent accuracy on 651 trades. On average, the system makes$7,000 a year and would require a $13,000 bankroll to net the 70 percent a year gain. The drawdown ofonly $10,031 is quite good for such a basic system. A problem can be seen in that the average profit pertrade is only $112.86; this needs to be higher. The data set is from 1990 through August 1998.Any idea how we might accomplish such a lofty goal? For now, let's try our basic TDW (Trade Dayof Week) strategy to see what happens if we only
Figure 4.1 A trading model that works.
62
Figure 4.3 Trade day of the week: Tuesday.
63
Figure 4.5 Trade day of the week: Thursday.
64
Figure 4.6 Trade day of the week: Friday.take buy and sells on certain specific days. To get a sense of this, Figures 4.2 through 4.6 show the buys foreach day of the week, then the sells for each day, and finally we put together the best buy/sell days for aworking model we can actually trade.The listings indicate the best days to buy have been Tuesdays and Thursdays, whereas the best selldays have been Wednesdays and Thursdays. Figure 4.7 shows that if we restrict trading to just these days,we don't make as much money, only $56,43 7, but just about cut the number of trades in half and boost ourprofits up to $173 on average, a number worth trading for. Your lesson here is that the Trade Day of Week(TDW) can make a big difference in your system's performance. Best yet, the drawdown plummets to only$3,500 from $10,031 and the accuracy jumps to 84 percent. This is a big improvement, as explained in thediscussion of money management in Chapter 13.
65
Figure 4.7 Restricting trade days makes a big difference.
66
A Look at Volatility In the S&P 500Does this concept have application for the S&P 500?Although there can be no doubt about this technique working with a 50 percent volatility expansion, wecan improve on it a great deal. How? By using something we already know about, the impact of TDW. Thenext set of data shows the volatility breakout performance by each day of the week for
Figure 4.9 Trading on Tuesdays.
67
Figure 4.10 Trading on Wednesdays.the S&P 500. The exit is the same as with the bonds shown earlier. Clearly, some are days better than othersto trade. Figures 4.8 through 4.12 show the buy signals by day of week; Figures 4.13 through 4.17 showsell signals by day of week.Figure 4.18 shows trading on just the more influential days. The best days to be a buyer were all daysexcept Thursday and Friday, while the best sell day was Thursday, with Friday a push, but it is used in thefollowing listing. This is not a bad system, it "made" $227,822 with 75 percent accuracy on
Figure 4.11 Trading on Thursdays.
68
69
70
1,333 trades and had a very small drawdown of only $13,737. I would prefer a larger average profit pertrade than the $170 shown here.An astute, thinking trader should be asking questions like, "Could we use a closer volatility expansionnumber to be a buyer on the more bullish days and a farther away entry value on the days that don't work sowell with the 50 percent value? And how about our exit, would it pay off to hold longer on the morebullish/bearish days?"
71These questions can continue indefinitely, but do need to be asked to optimize performance. Proof thatresearch pays off is offered by Figure 4.19, which shows the use of the preceding rules, except that the buyentry comes at 40 percent of the previous day's range added to the open, the sell entry at 200 percent of therange subtracted from the open. There is a big difference here; while it actually makes a little less money($14,000), the accuracy goes to 83 percent, the average profit per trade is escalated to $251, and our numberof trades is reduced by 46 percent!
Separating Buyers from Sellers to Find Volatility Using Market SwingsA third way to measure potential volatility expansions comes from looking at price swings over thepast several days. Mike Chalek deserves credit for this concept with a system he designed and labeled,"Talon." The basic idea is to look at the various swings price has taken from one point to the next over thepast few years. There are many such points to study.The ones I have chosen for this next glimpse into market activity, measure the amount of pricemovement from the high 3 days ago to today's low. That is Step 1. Step 2 is to take the swing distance fromthe high 1 day ago minus the low 3 days ago. Finally, we will use the largest of these values as our basicvolatility measurement to begin the process of designing a filter or price cushion to add to tomorrow'sopening for buying or subtract for selling.The system does okay; it makes money as the following results on the S&P 500 from 1982 to 1998demonstrate (see Figure 4.20).
72The rules are to buy at 80 percent of the swing value above the opening and sell at 120 percent of the swingvalue below the opening. Use a dollar stop of $1,750 and my bailout exit. This makes $122,837 from 1982to 1998 with an average profit per trade of $228.
ResultsAs always though, the question becomes, can we do better? Our last attempt at doing better was to useTDW as our filter to substantially improve performance. We will now go beyond this and bring in afundamental consideration-the impact of bond prices on stock prices.We will now try this concept as a filter (Figure 4.21). The rule is quite simple, we will only take buysignals if the closing price of bonds is greater today than 5 days ago, and only take sells if bonds are lowerthan 3 5 days ago. Our reasoning is well founded in the somewhat common knowledge that higher bondprices are bullish for stocks, lower bond prices bearish.What a difference this makes! An average profit per trade goes from $228 to $281 while our drawdownplummets from $13,025 to only $5,250. Best of all though is that in the original "nonfiltered" trades we hada largest losing trade of $8,150, whereas with the bond filter the largest loss was only $2,075!
73
One Step FurtherYour education is nearing completion if you are wondering what happens in this model if we onlytake signals on the best TDWs while the trend of the Bond market is giving us bullish or bearishconfirmation?Again, the results speak for themselves: by combining all these ingredients we increase our chances orodds for short-term trading success. 'Notice the number of trades is substantially reduced, this means ourexposure is less, but our average profit per trade increases. Our profits decline to "only" $76,400 but theaverage profit per trade jumps to $444, drawdown stays about the same at $5,912 but the percent ofwinning trades goes to 90 percent.What we have done here is filter out trades that are not backed by all three of our conditions. Filteredtrading for short-term swings will put you a light year-or two-ahead of all the rest of the short-term traders.There is an extra advantage here; by using filters you are placing demands on the market, demands thatmean you will not trade every day, demands that naturally force you to trade less, not more. Active tradersare usually losing traders. Those of us who pick and choose our spots to speculate are more inclined tocome out winners as we have tipped the scales in our favor, which is what intelligent speculation is allabout.
Chapter 5
The Theory ofShort-Term Trading
In the short term, theories work, but in the long term, give way to reality
Now that you have an understanding of how markets move from point to point and the basic strategyof how to best take advantage of these swings it is time to examine the theory of what we are doing so I canthen take you back to practical application.Our basic concept or working theory is that something causes explosive market moves. Theseexplosions put the market into a trend phase, and these trends, for our purpose, last from 1 to 5 days inmost markets. Our object is to get aboard as close to the start of this explosion as possible.Which gives rise to the questions, "What causes these explosions in market activity, when are theymost apt to occur, and is there anything here we can use to pin down the time and place of these moves>?"Succinctly stated, those are the problems I have dealt with most of m, life. Long ago, I recognized thatif I could not identify a problem there was no way on earth I could find its solution. You now know theproblems so let's look for some solutions. Let me hastily add that I do not have all the answers to thisgigantic puzzle. There is nothing like losing to bring you to your senses, to teach you that you are not sodamned smart, that you need more education. I still have losses, plenty of them. so I too, still need moreeducation. And always will.The biggest "cause" of these moves is probably news. But we have trouble trading on news because,first, the news can change as quickly and as unpredictably as the weather. News, or changes in worldevents and marketplaces, can be random; thus, the markets wobble around from one unknown news eventto the next.75
76The drunken sailor analogy mathematicians have used is most likely due to news knocking prices backand forth. Second, we may be the last guy on the food chain getting such news so we receive it too late.Third, there is nothing we can look at or observe that tells us what specific future news might be. Fourth, myyears of trading strongly suggest that those who are close to the news usually position themselves prior tothe announcement. (Note: There is not one group taking advantage of news; the group varies from source tosource.) Bankers might have inside news about the T-Bond market, but not on Cattle, whereas feedlotoperators might have that data, but nothing on Bonds. There is not an Illuminati controlling all news sources.While Mel Gibson's character Jerry Phillips was right on in the movie Conspiracy Theory, do not extend thattheory to the markets.While I was writing this book, a book about some of my archeological exploits, The Gold of Exodus, byHoward Blum (New York: Simon & Schuster), was discussed in several magazine and newspaper articles. Inone of them, where I lived was stated incorrectly as was my occupation, my age, the type of car I drive, andmy description of what the book is all about' In short, if I can't believe what I read about myself from areporter who personally interviewed me, I suggest you probably can't trust much of what is written aboutOrangejuice, Oats, and Oil.The supposedly prestigious Wall Street Journal is no exception. In early 1998, they told readers theirsource inside the Federal Reserve System was certain the Fed Open Market Committee was about to raiseinterest rates. Six weeks later when the Fed released their notes on the meeting, we learned the truth, theyhad voted 11 to 1 to not raise rates! On at least two occasions, reporters of the Wall Street journal have beenfound to be touting stocks they, themselves, had already acquired a position in. Television is not exemptfrom this same problem; CNBC's lead "Inside source" Dan Dorffinan is no longer on air for the sameallegations of misleading viewers. A few years back, even Ralph Nader was caught, or rather his motherwas, by the Securities and Exchange Commission, selling short stocks in General Motors and a tire companyjust before Nader attacked them with his consumer complaint law-suits. So what else can we look at if wecan't really examine news'"Price action! Charts” scream technicians and most short-term swing players. The nice thing aboutprice action, as reflected on charts, is that there are plenty of things to look at and analyze, the most commonbeing (1) price patterns, (2) indicators based on price action, and (3) the trend or momentum of price. Not socommon, and the fourth one of my big tools, is the relationship one market may have on another. Rememberthe S&P 500
77system and how much better it was when we required that bonds be in an uptrend? That is an example ofmarket relationships that I discuss in detail a little later on.Our final and fifth set of data to key off of comes from following the crowd most often found to bewrong. On a short-term basis, the great unwashed public trader is a net loser. Always has been, always willbe. The figures I have heard bandied about over the years are that 80 percent of the public lose all theirmoney, be they stock or commodity traders. Thus coppering their wagers should lead us to those short-termexplosions and profits. There are various ways to measure the public; these are called sentiment indicators.The two best ones I know of are surveys of the public done by Jake Bernstein and Market Vane.For short-term traders, I prefer Jake's because he actually calls 50 traders after the close each day tofind out if they are bullish or bearish on any given market. Since these are short-term traders, and bydefinition usually wrong, we can use them as a guide of when not to be a buyer or seller. I will not usethem exclusively as an indicator to buy or sell, but as a tool that should not be in agreement with my ownhand-selected trade. If the public is excessive in their selling, I don't want to be a seller along with them. Imay not always fade the public, but I sure don't want them on my side of the table.Market Vane takes sentiment readings from newsletter writers as opposed to short-term traders; thustheir index appears to be better suited for a longer-term view of things.Well, there you have it, the five major elements I have found that can help with ferreting outshort-term explosions. We will overlay these "tools" or events on market structure to enable us to hopaboard up and down moves. Since all these tools can be quantified, the logical procedure is to convert theseobservations and tools into mathematical models. The next leap of logic traders make is that since math isalways perfect (two plus two always equals four), there must be a perfect solution to trading andmathematics can provide the answer.Nothing could be more distant from the truth. There is not a 100 percent correct mechanical approachto trading. There are tools and techniques that based on observation usually work, but the reason we losemoney is that we either reached an incorrect conclusion or did not have enough data to make a correct one.So math is not the answer, mechanics is not the answer The truth of the market comes from ampleobservations, a dose of correct logic, and correct conclusions from the data at hand.I am telling you this right up front so you do not get lulled into the idea that speculation is a game ofblindly following the leader, a system. or absolute approach. If any one thing is certain about the marketsit is that things change. In the early 1960s, an increase in money supply figures was considered verybullish and always put stock prices higher.
78For whatever reason, in the late 1970s and early 1980s, an increase in money supply figures, as releasedfrom that largest of all privately held corporations the Federal Reserve, put stock prices down. In the 1990time period money supply is barely looked at or felt in the marketplace. What was once sacred becameapparently meaningless.One of the markets I trade the most heavily in, Bonds, traded totally different after 1988 than prior tothat date. Why? Prior to October of that year there was only one trading session, then we went into nightsessions and eventually almost a 24-hour market. That changed trading patterns. What is more confusing toresearchers is that "in the old days" the Fed released reports on Thursday that had huge impact on Friday'sBond prices. This effect was so great a popular novel used it as the central theme of a Wall Street swindle.As I write this, in 1998, there are no Thursday reports, hence Fridays look and trade differently now.If you are to do me any favor as a reader of my work, you will not only learn my basic tools but alsolearn to stay awake and current to what is happening. Great traders, which I hope you become, are smartenough to note and respond to changes. They do not lock themselves into a "black box" unchangeabletrading approach.One of the truly great traders from 1960 to 1983 was a former professional baseball player, Frankie Joe.Frankie had a great wit and a deep understanding of his approach to trading. He was quite a guy, sharp as atack and a delight to talk with. After we had developed a three-year friendship, he revealed to me histechnique, it was to sell rallies and buy back on dips in the stock market. That is all there was to it; no more,no less. This was a great technique during that time period, it amassed a fortune for Frankie.Then along came the most predictable, yet unpredictable, bull market of all time triggered by RonaldReagan's tax and budgetary cuts. It was quite predictable that the bull market would come about. What noone realized was that there would be no pullbacks along the way as we had seen for the previous 18 years.Not even one of the greatest traders of all time, FrankieJoe. He kept selling rallies and was never able tocover on dips; there just weren't any. Eventually, he became so frustrated with losses and the lack of success(like all great traders, he was also compulsive about winning), that he apparently committed suicide.What works, works in this business, but often not for long, which is why I so admire ballerinas, theystay on their toes.
What Is Wrong about the Information AgeFundamental principles do not change-that is why they are called fundamentals. "Do unto others asyou would have others do unto you," was good advice 2,000 years ago and will be good advice 2,000years
79from now.The principles I'm laying out in this book are enduring; I have lived with them for close to 40 years andhave literally made millions of dollars trading.Yet, were I to fall into coma today and wake up 10 years from now I might not use the exact samerules with these fundamental principles. Whereas fundamentals are permanent, the application andspecifics do change and will vary.Technology has become king, speeding up every facet of life. We can now learn about anything faster,communicate faster, and find out about price changes faster. Indeed, we can buy and sell faster; get richquicker; go broke faster; and lie, cheat, and steal at unbelievable speeds. We can even get sick or healedfaster than ever before in the history of the world!Traders have never had so much information and so much ability to process this information, thanksto computers and to Bill and Ralph Cruz, who invented the first and best workable software, SystemWriter, which evolved to Trade Station. Thanks to these products from Omega Research, average joes likeyou and me can now test market ideas. For more than 10 years now, thanks to Bill's foresight, it has beenpossible to ask just about any question to find the "truth of the markets."But guess what? This technical revolution in the age of information has brought no concomitantbreakthrough to the world of speculation. We still have the same numbers of winners and losers. Guys andgals with state-of-the-art computers still get blown out on a regular basis. The difference between winnersand losers is largely based on one simple turn of events, winners are willing to work, to notice changes, andto react. Losers want it all without effort; they fall for the pitch of a perfect system and an unchanging guruor indicator they are willing to follow blindly. Losers don't listen to others or to the market; they areunyielding in their minds and trades.On top of that, they consistently fail to abide by the fundamental of successful business, which is tonever plunge, to manage your money as well as your business by getting rid of bad deals and keeping thegood ones. Me? I will stick to the fundamentals, as taught, with a healthy willingness to adapt to change.When I stay flexible, I do not get bent out of shape.
E. H. Harriman's Rule of Making MillionsThe Harriman family fortune, which endures to this day, was created in the early 1900s by "Oldman Harriman," who had started his career as a floor runner and wen on to become a major banking and
80brokerage power. He made a $15 million profit in 1905 from one play in Union Pacific. This speculator kingfocused on just railroad stocks, the hot issue of his era.In 1912, an interviewer asked Harriman about his stock market skills and secrets. The trader replied,"If you want to know the secret of making money in the stock market, it is this: Kill your losses. Never let astock run against you more than three-quarters of a point, but if it goes your way, let it run. Move your stopsup behind it so that it will have room to fluctuate and move higher."Harriman learned his cardinal rule from studying trading accounts of customers at a brokerage firm.What he discovered was that of the thousands upon thousands of trades in the public accounts, 5- and10-point losses outnumbered 5- and 10-point gains. He said, "by fifty to one!" It has always amazed me thatbusinesspeople who have tight control and accounting practices in their stores and offices lose all controlwhen it comes to trading. I cannot think of a higher authority than E. H. Harriman, nor a more enduring ruleof speculation than what this man gave us in 1912.Like I said, fundamentals don't change.
Chapter 6
Getting Closerto the Truth
Beginning proof the market is not random and our first -key- to market explosions.
Losers of Any game typically lament that either the game was rigged. or it is one no one can beat; thus, theirfailure is excusable. Well, the game of the market has been beaten by many people for many years. So whileI have read the laments of the academicians such as Paul Cootner in his classic, The Random Character ofStock Prices, whose morose verdict is that prices cannot be predicted: past price activity has no bearing onwhat will happen tomorrow. or next week for that matter. This is true, he and a host of other apparentlynontrading authors suggest, because the market is efficient. All that is to be known is known and thus alreadyreflected in current prices. Therefore. today's price change can only be caused by new information (news)coming to the marketplace.The bottom line of these authors is that returns from one day to the next are independent, thus price isimpacted by random variables which accounts for the notion that prices move totally by random, thus defyprediction. Believing in this random walk means acknowledging that the market is efficient, that all isknown. Obviously, you do not accept this concept; you spent hard-earned money on this book thinking thatperhaps I. can teach you, something most other traders or investors do not know.
81
82You are right! Cootner and his crowd apparently tested for dependence on future action of price in aone-dimensional approach. I suspect they may have tested future price change based on some sort of movingaverages, thus while looking for the right direction, they used the wrong tools.If there is no dependency on price action, over a long time period, 50 percent of the days a marketshould close higher and 50 percent of the time lower. It is supposed to be like flipping a coin-the coin has nomemory. Each new toss is not biased by what went on in the past. If I were to flip such a fair coin onTuesdays, I would get the same 50/50 heads and tails as I would by flipping on any other day of the week.
The Market Is Not a Coin FlipIf the Cootner theory is correct and market activity is random, then a test of day-to-day price changeshould be easy to establish. We can start with a very simple question: "If market activity is random, shouldnot the daily trading range, each day's high minus the close, be just about the same regardless of which dayof the week it is? "Also one should ask, "If all price action is random, would you not expect the daily change, regardlessof being up or down, just the absolute value of daily changes to be about the same for each day of the week"And finally, "If price is random, is it not true that no one day of the week could or would show a strongbias up or down'-" If the market has no memory, it surely should not matter which day you flip the coin ortake your trades. The truth is it does matter, a great deal.Instead of listening to the theorists, I went to the market to see what it had to say. I asked the precedingquestions and many others to see whether there is dependency from one day to the next or one pattern or pastcertain price action that consistently influences tomorrow's price past the critical random walk point. Theanswer was clear; the market does not reflect Cootner's claim. Tables 6.1 and 6.2 prove my point.
83
I have sampled two of the biggest, and thus you would think the most efficient markets, the S&P 500, ameasure of 500 stocks, and the United States Treasury Bonds.My first question was, Is there a difference in the size of the range for different days of the week? Next,Does the distance change from the open to the close, depend on the day of the week? And finally, I looked atthe net price change each day. In Cootner's world, all these questions should produce a homogeneousresponse; there should be no or little variance.For the S&P 500 Tuesdays and Fridays consistently had daily ranges larger than any other time period.For the Bond market, Thursdays and Fridays had the largest daily ranges. Could it be that not all days arecreated equally?You bet, or had better bet, because the second column for each market shows the absolute value of theprice swing from the open to the close also varies widely. In the S&P 500 the largest open to close changetakes place on Mondays at an average of .631 while the smallest takes place on Thursdays with -.044.In the Bond market the difference is even larger Tuesdays saw the largest open to close change, .645and the smallest on Mondays with -.001!.Finally, check out the last column to see that in both set s of data for the S&P 500 Fridays have anegative value and in Bonds, Monday and Thursday show negative changes for these days. Cootner shouldsay this is impossible, in an efficient market one day should not be pre-disposed to rally or decline morethan any other. The market tells us otherwise, some days of the week are in fact better for buying or sellingthan others'I want to drive this point home: Cootner and his crowd apparently did not test for day of the weekdependency. I conducted a study where we asked the computer to buy on the opening each day and exit onthe close. I ran this test on all the grain markets (not shown). While not a trading system on its own, the dataopens a door and gives us an advantage those who put this book back on the shelves don't have. The datamakes clear:All the grain markets have a pronounced pattern of rallying more on Wednesdays than any other dayof the week.
84
Go ahead, check it out, what happened to that random walk? Sure looks like it gets stuck onWednesdays in the grains. What is evident here is an advantage to the game. Granted, it is small, but casinoswork of an advantage of usually 1.5 percent to 4 percent in most of their games of random chances. It is thattiny percentage, played often enough, that builds all those hotels and subsidizes the buffet lines.Although the grains, especially Soybeans, offer some short-term trading opportunities, this is beingwritten at the turn of the twenty-first century, and there are more explosive short-term markets to focus on:the S&P, T-Bonds, the British Pound, and Gold. The first two are the best for us short-termers andshort-timers.Table 6.3 shows the impact the day of the week has on price changes in these markets. Again,traditionalists would argue there should be little if any differences assuming price change is random. Whatwe find is that the trading day of the week does indeed produce a bias of future price activity, a bias we canturn into profitable trading.One of my favorite short-term trading advantages is Trading Day of the Week (TDW). My focus hereis the price change from the opening of the day to the close as opposed to just close to close. The reasonshould be clear to you, the day for a short-term trader begins on the open and, at least for a day trader, endson the close.Table 6.4 shows the results of such a study where the Bonds or S&P 500 were purchased on the openand exited on the close each TDW.Table 6.4Open-to-Close Change in Price by Day
85Random walk theorists should be gasping for their last breath about now. Here's a thumbnail sketch, theBritish Pound rallies off the open 55 percent of the time on Wednesdays and "makes" $18 per trade."Makes" is in quotation marks because after commissions and slippage are taken into consideration notmuch is left, but the pattern sheds light on a market bias we can develop into tradable material.Gold has rallied 52 percent of the time off of Tuesday's opening making -$3, while things are notmuch better with Tuesday buys on the Bond market; 47 percent winners and an average of -$3 5 per trade.The biggest display of this bias comes from the S&P 500 (Figure 6.1). This is where I first discovered thebias and have traded it since 1984. On Mondays, this kingpin of volatility has closed above the opening 57percent of the time with an average profit of $109! Bond traders should note the open to close change onMondays has been positive 55 percent of the time with an average gain of $53.In case you are wondering about the close-to-close relationship, it is shown in and again the bias oradvantage to the game becomes apparent. Study them for yourself.Table 6.5 shows the results of buying on the opening and exiting 3 days later. Any remaining randomwalk enthusiasts will tell you we should not be able to find any differences between days of the week overa 3-day period. An efficient market should wipe that out. Yet when we look at just the best performing dayof each week, based on the open-to-close change, we see a large bias and taste the sweetness of knowingmarkets are not totally random. The only random market was Gold; the rest of the markets I studied beatthe random walk. Bonds and the S&P 500 led the way showing some decent profits.
86Table 6.5Best Trading Day of Week with a Three-Day Hold
TDW does make a difference and can give us a workable bias to trade with. There are numerous waysto begin milking this cow, and you probably have already thought of some on your own. Certainly, it is abias you want to understand, and consider, for any market you are going to trade on a shortterm basis.Earlier, I said the open is critical; if we start to expand or move away from the opening, price willprobably continue in that direction. Now I will demonstrate one such approach. We will combine ourday-of-the-week bias with one simple rule; buy on the opening of the bias day + X percent of the previousday's range. We target our bias day, and buy that day at an expansion off the opening price. Our exit issimple; we hold the trade to the close and take our profits/losses at that time. (There are better exittechniques, which I will get to later.)The S&P 500 results of buying the opening Monday +.05 percent of Friday's range are prettyspectacular for trading just one day a week (see Figure 6.2)! This approach shows a net profit of$95,150 with