a trendline that hasless lag than a moving average. Less lag means that you can react faster tochanges in the direction of prices. Double smoothing does this by averagingthe momentum rather than the prices.Momentum is speed. It shows faster movement and more sensitivitythan prices. If you take the first difference in prices (a one-day momentum),then you speed up price movement. If you then average the momentum, yousmooth out the prices and slow down the speed. First speeding them up andthen slowing them down results in no lag.However, a momentum indicator that is smoothed once is still not quiteenough. If we now average the new result, we are averaging something thathas already been averaged. We have smoothed it twice. For convenience weuse percentage smoothing rather than a moving average. Figure 15.13 showsMicrosoft with 20-day and 40-day momentum indicators in the center panel,and a double smoothing of the 20-day indicator in the bottom panel. The
FIGURE 15.13 Double smoothing of Microsoft. The 1-day differences in Microsoft pricesare smoothed once using a 20-day period and the result is smoothed again using a 20-dayperiod. The resulting trendline does not have the lag of a moving average. In this case, thedouble-smoothed line is not yet as smooth as we would like it to be.
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double-smoothed indicator begins with the one-day price differences andsmoothes them with a 20-day period (smoothing value of .0476). It thensmoothes the new values by .0476 again.This first example of double smoothing does not produce a trendline thatis as smooth as a moving average. It also has different value than the originalprices; therefore, it can’t be plotted along with prices in the upper panel.That’s not a big problem because we only need to see the direction of thetrendline to decide whether prices are going up or down. Most important, thenew double-smoothed line does not have a lag. The highest point and lowestpoint of the trendline in the bottom panel correspond to the highs and lowsof the price chart.
Smoothing the Final Smoothed IndicatorBy starting with the 10-day momentum rather than the 1-day momentum (thefirst differences), we can smooth the indicator even further without addingany noticeable lag. We follow these steps:1. Calculate the values of the 10-day momentum.2. Smooth the momentum values using a 20-day percentage smoothing.3. Smooth the values in step 2 using a 20-day percentage smoothing.
The result appears in Figure 15.14. The double-smoothed trendline in thebottom panel is much smoother using the 10-day momentum rather thanthe 1-day momentum. It is now possible to use the simple turns in the trendline for buy and sell signals. At the same time, only a very small lag is introduced. This method was developed by Bill Blau and deserves your attention.
TRADING GAME TIPSThe most reliable MACD signals are divergences. They don’t occur oftenenough, but they are worth waiting for. After that, look for the normal sell signal (the MACD line crossing the signal line) when it occurs at a high value orafter a noticeable price run.Use more than one technique. You’re still learning what methods arebest. Try using both a moving average and support-resistance. Keep track ofthe MACD, looking for divergence. Look for a volume spike. You need towatch everything before you settle on a few choice methods.
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Sell when indicator turns down
Buy when it turns up
Sell when it turns down
Buy when it turns up
FIGURE 15.14 Double-smoothed 10-day momentum. Using a 10-day momentum insteadof 1-day creates a much smoother trendline (bottom panel) without the lag normally associatedwith moving averages.
TRADING GAME #3We’re now going to trade the way it’s really done. You’ll be able to go long orshort, add to your positions, and take off part of your size. Trade as much asyou want to, but be sure to watch your risk. Be careful of the futures positions; losses in the S&P can add up fast. You’ll learn to manage your positionsize and your risk.You’ll want to keep watching a few active stocks, but also ones that givediversification. Try a pharmaceutical, a defense stock, Wal-Mart, and anenergy company. Continue to trade the S&P futures, but now add crude oil(CL) traded on the New York Mercantile Exchange. Crude oil futures giveyou a macro picture of price direction and a little excitement when theMideast pot is stirred.The new rules are:1. Begin with no positions. Begin a new spreadsheet for your accounting.2. You now have $1,000,000.
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3. You will trade four stocks (your choice) and two futures, SP and CL.4. You may trade any size on any trade. You may add or remove partial
positions.5. You must state your current position before each new order (e.g., NP,
L 5000, S 1000).6. Each new order or partial position must be entered on your accounting
as a new trade (e.g., buy 5000 RTN, and then buy 2500 RTN are two separate lines).7. You may go short stocks (there is no uptick rule and no borrowing
money; use of capital will count as though a short position was a longposition).8. You must keep an accounting of your capital used for trading and your
free capital.9. Try to evaluate the return-to-risk ratio for performance as the game
proceeds.10. Profits and losses will be important feedback in deciding if you are trad-
ing correctly.11. Don’t risk more than 5 percent of your investment on a single trade.
That’s bad management.12. Be thoughtful about your position size. You could lose everything.13. There will be no commissions.14. No day trading!
15. Your accounting should now be perfect. Know your positions and knowyour current account balance, including open profits and losses. That’scalled marked-to-market daily.16. Enter your orders clearly. If an order is not what you intended but is a
valid order, it will be executed! Be careful.17. Don’t forget: We are trading, not investing.
Questions1. When contrary opinion indicates that the market is oversold, do you
(a) buy immediately, (b) sell immediately, (c) use a timing indicator togive you a specific buy signal, or (d) use a timing indicator to give you aspecific sell signal?2. What is the greatest disadvantage of the Bullish Consensus indicator?
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3. Explain the raw stochastic in words.4. Name the three stochastic calculations from fastest to slowest.5. What is the primary difference between the stochastic calculation and
momentum values?6. Explain the chart pattern that gives you a bullish stochastic divergence
signal.7. In a stochastic bearish divergence, the second stochastic peak should be
lower than the first by at least what value?8. The Relative Strength Index is a ratio of what two values?9. Explain the steps need to create a double-smoothed trendline using a
10-day momentum.10. What is the advantage of double smoothing?
C H A P T E R 16
Managing YourEntry and Exit
t is not only important that we know when to enter and exit a trade; wealso must know how much to trade, and whether to enter the entire position at one time or feed that order into the marketplace.Let’s say that you plan to buy $10,000 of IBM. What choices do you havewhen you enter? If IBM is trading at $50, you can buy 200 shares all at onetime or 100 shares now and another 100 tomorrow or next week. You couldbuy in lots of 50 or 25 over a single day or spread the order out over a week.Is one method better than another?
I
AN AVERAGE PRICE OR A BETTER PRICE?It’s always safe to get an average price. If you’re concerned that you’ll buyIBM at $50 today and it will drop to $45 by the end of tomorrow, then youcould just wait. Most likely, you’re not sure that it will drop. If the employment report comes out favorably and the economy looks strong, then IBMcould even jump to $60 by the end of today.If you don’t know what might happen in the next two days but you havea strong opinion that IBM will be going up, then average into the position. Toget an average price, you buy equal amounts over equal time intervals. Ifyou plan to buy 200 shares, then you buy 50 this morning, 50 this afternoon,50 tomorrow morning, and the last 50 at tomorrow’s close. You now have areasonable approximation of an average price.When you’re trying to get an average price, breaking up your order intosmall pieces and feeding it into the market is the simplest way. You don’t
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need to do it one share at a time. If you separated your 200-share order intoeight parts of 25, you would get very close to the average.
THE MAGIC NUMBER IS 4Whenever you are thinking of scaling into the market, remember that themagic number is 4. If you are trying to get an average price, you need tobreak your order into at least four equal parts. If you are trying to get a better than average price, then you cannot divide your order into more thanthree equal parts. Four or more equal parts gets you close to an averageprice, three or less gives you a chance to get a better than average price.The best scenario is to buy your entire position at one time at the lowestprice. We would all like that, but it’s unrealistic. Therefore, you decide howlong you have to enter your position, a few hours or a few days, and look foropportunities during that window. Let’s say that prices are trading in a rangefrom $35 to $40 and you expect good news to move prices through the $40level to $50. It’s Monday morning and you think this will happen by the endof the week after dividends are announced. The price is now $38. What areyour choices?1. You could buy one-third of your position now, one-third on today’s close,
and one third sometime tomorrow, for an average price.2. You can wait for prices to test the low of $35, placing a buy order for your
entire position at $35.50. However,what happens if you are right andprices move straight up to $50, never pulling back to $35? You’ve missedthe move.3. You can buy one-third now, one-third at $35.50, and one-third at $40.10 on
a break above $40. That’s a bit better because you are sure of getting twothirds of your position at $39.05. If prices drop instead of rally, you havetwo-thirds of your position at $36.25. The only time you have a full position is if the price pattern is exactly as you predict—first declining to support, and then rallying up through resistance.How realistic is case 3? Not very. If we knew how prices were going tomove, we wouldn’t need all this planning. It’s difficult to forecast whereprices will be in a few days; it’s even more difficult to predict the patternprices will take to get to that goal. There is a very small chance you will beable do both.
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Try the average price method. In the example above you might buy twoof the three parts by averaging into the trade, and then add the third part ona breakout through $40 in order to have a confirmation. In that case you raiseyour average price, but have the comfort of knowing that you were rightabout your prediction.Some traders would wait for the breakout before entering any of theposition. They get a worse price but a better chance of success. Other traderswould enter the entire position between $39.75 and $39.90 looking for thebreakout and trying to get free exposure from the jump through $40—a littlemore risk, but a lot more reward.
ENTERING TRADESLet’s look at the different ways that you can enter a trade. We’ll cover entering your entire position at one time, scaling down, averaging into a trade, andadding additional positions on profits.
Entering Your Entire Position at One TimeEntering your entire position at one time is the simplest method and theeasiest to follow. Entering at one time could get you the best or the worstprice. Over the long term it probably averages out. You should keep a recordof the current price at the time you get the buy or sell signal in order to compare it with the actual price you received when you entered the trade.Entering at one time should serve as a benchmark. That is, you need toprove to yourself that another entry technique is better before you use it.
Scaling DownScaling down is a traditional investing technique that hides the fact that youentered at the wrong price. The way it works is that you buy 100 shares ofCisco at the current price of $20 because it has declined to a support level.You think it has reason to rally back to $30. Instead, Cisco drops through support to $18. Instead of closing out the trade because it’s going the wrong way,you buy another 100 shares, giving you an average price of $19. Cisco continues to fall to the next support level at $15, and you buy another 100 shares.Your average price is now $17.67 and your loss is $2.67 on 300 shares; however, if the price gains only $3 you have a profit. Let’s look at the good andbad points of this method:
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• You need to decide the final size of you position in advance. You can’tkeep buying as prices move lower. At some point you’ll run out of money.• Let’s say you will add to your position twice so that your initial entry isone-third of your potential investment. If prices immediately movehigher, then your analysis is correct and you profit on one third of youravailable investment but never add more. If prices move lower, thenyou’ve figured this wrong. You continue to add to your position andincrease your losses.• Your greatest profits come from prices dropping after the first entry,stopping right after you’ve bought your maximum investment, thenturning up, and continuing up. The success of the method is based on badtiming.• You don’t have a stop-loss; therefore, you have no risk protection. Wheredo you get out and say that you were wrong?There is something wrong with a trading plan based on the expectationthat you will be wrong. If you couldn’t figure out where the first entryshould be, then why would you be right even after you are fully invested at alower price?Scaling down is a technique that works when markets always go up andyour broker has told you to buy at a bad price. If you’re a trader, you get outwhen you’re wrong.
Averaging into a TradeUnlike scaling down, averaging into a trade is a plan to enter the entireposition but assumes that we can’t know the best single point to enter. Inorder to get an average price, we enter equal amounts at equal time intervals.Four or more entry points will get you close to an average price over a fixedtime interval. Once a trading signal occurs and you start your averaging, youalways execute the entire size with one exception: If an exit condition occursbefore you are entirely in the position, then you stop entering and exit.This method is safe unless you are a fast trader and entry timing is critical. Then you must enter the entire position at one time.
Adding Additional Positions on ProfitsThe opposite to scaling down is adding additional positions on profits. Thisis also called pyramiding. The most common ways to add positions onprofits are:
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• Add as soon as you have profits.• Add on secondary entry signals (for example, a new breakout from acontinuation pattern).• Add on a pullback to a support level following new profits.The quantity that you add is very important. Your choices are:• Add as much as you can using your profits.• Add a percentage of your profits.• Add a smaller amount on each new signal (a normal pyramid).• Add the same amount as your original entry size (an equal pyramid).• Add an increasing amount on each subsequent entry (an inverted pyramid). In this case you must draw from additional capital.Adding when you have profits capitalizes on a good trading decision. It’salso a good way to turn a profit into a loss. When you add to your position, ittakes a smaller reversal to eat up all your profits. The inverted pyramid is theworst case, but all pyramiding is risky. Every time you build your position therisk of loss increases as the end of the move gets closer.
Common Trading SenseIf you want to add to your position, common trading sense goes as follows:1. Add smaller amounts at each secondary entry point.2. Each secondary point should be a valid signal (e.g., a breakout) or a clear
timing point.3. Your exit point must be adjusted so that the new entry cannot turn the
entire trade into a loss.4. Don’t add more than twice after the initial entry. Your risk becomes too
great.
EXITING TRADESThere are also choices when you exit a trade. It isn’t necessary to get out ofthe entire position at one time; however, you still may find that a hasty exit isthe safest strategy.
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Exiting the Entire Position at One TimeAs with the entry, this is the simplest method and serves as a benchmark. Ifyou want to try another approach, you should prove to yourself that the othermethod is better than exiting all at one time.
Scaling Out with ProfitsThis method allows you to target an average exit price, but spread out the levels at which you will exit. You can never be sure where prices will stop beforeturning. This method of fanning your target price level will let you capturemore profits and reduce risk. Follow these rules:1. Calculate your profit target for the current trade. This should be based on
volatility so that it’s closer when prices are quiet and farther when themarket is active.2. Fan out your profit target into at least three separate prices, where the
three prices average to your original profit target. For example, if youentered IBM at $50 looking for $55, then exit one-third of your trade at$54, $55, and $56, or even better, exit at $53, $55, and $57. The sooner youstart getting out of your trade, the sooner you have profits in your pocketand lower risk. Once you’ve taken profits at $53 and $55, you only haveone-third of your position at risk. If prices reversed back to your entrypoint of $50, you would still have most of your profits. If you only get onethird at $53 you’ve done better than if prices had reached $54 and thenreversed back to $50.3. You can take profits on different amounts at different prices as long as
they all average to your original target. Instead of taking one-third of yourprofits at three levels of equal separation, you might take 20 percent at$53, 50 percent at $55, and another 30 percent at $56, giving you an average of $55.We can only estimate where we think prices will go. Fanning out your targetis a realistic and sound strategy. You don’t need to be exact about the amountsand prices, just so they come close to you target.When you have three levels to exit a long position, you also can exit anyone of those levels if you think that volatility is falling and the price move isstalling. If you’re wrong and prices start up again, you will take your profitsat two more levels. Getting out a bit early on one of the parts won’t matter inthe final profits, but it’s a good move if prices start down.
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Scaling Out with LossesReducing the position as prices move against you will control the size of yourloss, but there are some complications that need to be considered:1. You can only scale out of your trade when prices move against you if you
also plan to scale back into the trade. You believe that the trade is stillsound but your entry price was bad. You reduce your risk until pricesreach a support level or begin to rise.2. If you remove part of the position and then prices reverse and become
profitable, you are profiting with a smaller position than the one onwhich you lost. You need to know in advance where you will add backyour positions.3. You can always plan to add back the positions when the current holding
becomes profitable. That’s a confirmation that prices are moving theright way.4. Scaling out and back in works best for long-term trend-following sys-
tems that have an orderly pattern in the generation of profits and losses.In that case it is similar to “trading the equity curve.” When the trend isn’tworking, your equity is dropping and you lighten up on your position.When your equity starts to rise, then the trend is successful and you addback to your position. If you don’t plan to add back to your position thenyou should get out of the trade completely.
TRADING GAME TIPSYou made the wrong trade. Every trader makes mistakes, even buying whenyou meant to sell. Don’t try to manage the position; just get out. It’s the wrongtrade, and you can’t manage it correctly. It will distract you from other tradesand eat up your time. Close out the trade as soon as possible, and get on withyour life.The time of day to trade. There are two reasons to select the time of dayto trade. Volume varies considerably during the day. The greatest volume isnear the open; the second greatest volume is at the close. After the open theorder flow steadily drops until its low point in the middle of the day. Manyof the traders are off the floor—some actually eat lunch. During the middleof the day orders dribble in. If one large order hits the market, it could pushprices higher or lower but have very little meaning with regard to pricedirection.
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The open and close are the two most likely times to show the high or lowof the day. If prices open and start to drop, then the open is most likely to bethe day’s high. The middle of the day is the next most likely time to be a highor low. Prices drop from the open and quiet at midday while there is littleactivity. When traders come back onto the floor and activity increases, theymay move prices higher again. Then the midday price becomes the low.If they move prices lower, then the close becomes the low.
Questions1. What is the best technique for getting the average price on a buy order of
1,000 shares over two days?2. If you are trying to get the best price, in how many parts should you
divide and execute your order?3. What are the greatest advantages and the greatest disadvantages of scal-
ing down?4. What is the name of the technique that requires buying equal amounts as
you increase your profits? Explain the risk of this method.5. Explain the reasoning behind scaling out of a profitable position (as a
short-term trader).
C H A P T E R 17
Volatility and PortfolioManagement
O
ther than price itself, volatility is the most important single pieceof information for the technical trader. Volatility equals risk. Thelarger the prices swings, the greater the volatility and the greater
the risk.Volatility can be used to decide where to take profits and where to placeyour stop-loss order. It also is used to determine the number of shares to buy.The goal of a trader is to achieve the highest return for the lowest risk.Volatility will be used to measure the risk.
MEASURING VOLATILITYVolatility is a measure of price movement. Volatility can be measured andinterpreted in a variety ways, but one meaning is universally understood:Higher volatility means higher risk.
Four Basic Volatility MeasuresBefore we can use volatility, we need to measure it. The four most commonmethods (shown in Figure 17.1) are:1. The change in price over N days (Figure 17.1a):
Volatility(today) = price(today) − price(N days ago)
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(a)
(b)
High
Ptoday
LowPN-days ago
Largest price fluctuationVolatility = highest high of past N days −lowest low of past N days
Change in price = Ptoday − PN-days ago
(c)
(d)
1
Volatility = average true range over past N daysapprox equal to average daily range
2
3
54
7
8 9
6
1110
Volatility = sum of individual price changes,taken and positive numbers
FIGURE 17.1 Four volatility measures. (a) Change in price, (b) largest price fluctuation,(c) average true range, and (d ) sum of absolute price changes.
2. The largest price fluctuation (price range) over the past N days (Figure
17.1b):Volatility(today) = highest high of the past N days− lowest low of the past N daysUsing an Excel spreadsheet, you can substitute max for the highest highand min for the lowest low.3. The average true range over the past N days (Figure 17.1c):
Volatility(today) = average of the daily true range from N days ago to todaywhere average true range can include the previous closing price if thereis a gap opening. This is explained in the next section.4. The sum of the absolute price changes over the past N days (Figure
17.1d):Volatility(today) = sum from today to N days ago ofabsolute value(price(current day) − price(previous day))
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Adding absolute price changes gives you the length of the path taken byprices over the past N days.True Range. The true range measures the daily trading range so that itincludes yesterday’s closing price when there is a gap opening. This is animportant feature when measuring volatility. For example, if Amazon closedyesterday at $10 and opened today at $11, traded up to $12 without goinglower than $11, and then closed at $11.50, we would have open, high, low,and closing prices of $11.00, $12.00, $11.00, and $11.50. If you measure volatility using the daily trading range then we have the high of $12.00 less the lowof $11.00, giving a range of $1.00. However, that doesn’t reflect the realvolatility because prices jumped from yesterday’s close of $10.00. The volatility is really $2.00, not $1.00.The true range is the largest of the three combinations:1. High(today) − low(today)2. High(today) − close(previous day)3. Close(previous day) − low(today)
If the prices today (T ) and the prices yesterday (T − 1) are:(T ): high $55.00, low $53.00, close $53.50(T − 1): high $51.00, low $48.00, close $51.00then today’s true range is $4.00 while the normal range calculation is $2.00.
Which of the Four Volatility Measures Is Best?You will find that each of the four ways to measure volatility will be useful:• In securities, most risk is measured simply by taking the standard deviation of the daily price changes.• When you are deciding where to take profits based on volatility, you’llwant a multiple of the average true range.• When you want to compare one market to the other or find the relativevolatility of the stock you are trading, the most descriptive measure is thesum of the price changes.• Using the total path of price movement recognizes that a stock thattrades from $15 up to $20, back to $15, and up to $20 again is morevolatile than one that trades from $15 to $20 only once (see Figure 17.2).
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FIGURE 17.2
(a)
(b)
The price pathtells the most about volatility.Although both price paths have thesame high and low, and start andend at the same points, (b) is morevolatile than (a) because of its morefrequent fluctuations.
The Theory of Stock Market VolatilityTraditional thinking by securities analysts is that in the stock market, pricevolatility is lognormal. That is, when prices increase, the volatility alsoincreases at a more or less predictable rate. We can see that in most chartswhere the stock traded in a wide range (see Figure 17.3). Charting servicessuch as TradeStation provide the ability to display a semilog chart at theclick of a mouse. The importance of this lognormal relationship is thatrisk increases as price increases. Your trading method must accept largerrisk at higher prices.An Example of a Lognormal Calculation. For those of you who haveused log tables or can program formulas into Excel, the following examplemay be helpful. We use the spreadsheet math function natural log, Ln, tochange actual prices to lognormal prices. Over the long term and under average market conditions, the relationship between actual price changes andvolatility is expected to be:|price(T ) − price(T − 1)| |price(S ) − price(S − 1)|≈Ln(price(T ))Ln(price(S ))where the vertical bars (|| ) represent the absolute value (the positive value)of the number inside the bars.This formula says that the absolute value of the change in price on day Tdivided by the natural log of the price on day T is approximately equal (≈)to the change in price on any other day, S, divided by the natural log of theprice on day S.For example, if the price on day T is $20 and the price on day S is $40,then the natural log of prices on those days are Ln (20) = 2.99 and Ln (40) = 3.99.If the volatility is $1.00 when P = 20, then the volatility is expected to be $1.23when P = $40. In equation form:Volatility at price(T ) = 20 volatility at price(S ) = 40≈Ln of price(20)0000Ln of price(40)000iii
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(a)
(b)FIGURE 17.3 Comparing Nasdaq on different charting scales. (a) Equal prices scale (top),(b) semilog scale (bottom). The equal scale shows extreme volatility at the highest prices duringthe first half of 2000; the semilog scale shows only a small increase in volatility similar to themore volatile weeks when prices reached relative lows during the price decline. The semilog scaleconfirms the theory that prices have a predictable increase in volatility as they move higher.
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If the volatility at $20 is $1, then the volatility at $40 is $1.23. Note: Whenusing a spreadsheet for your calculations, the function Ln is not the same asthe function Log.
HOW TO MAKE YOUR TRADING ADAPTTO CHANGING VOLATILITYEnough of the theory. The best way to use volatility to improve your tradingis to make your profit-taking objectives and your stop-loss targets get closerand farther away as volatility decreases and increases.
Changing Profit Targets Based on VolatilityIf AOL is trading in a $1 range each day, you might want to target a short-termprofit of $2. That would be reasonable if prices moved in one direction forabout three or four days. If AOL was much more volatile, ranging $4 in oneday, then an equivalent profit target would be $8. More important, if volatility dropped to $0.50 then a profit target of $2 would take much longer toreach and you’ll want to set your goal at $1