<s> The CompleatDay Trader II
Jake Bernstein
McGraw-Hill
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Bernstein, Jacob, date.The compleat day trader II / by Jake Bernstein.p- cm.Continues: The compleat day trader.ISBN 0-07-094501-21. Futures. 2. Futures market. I. Bernstein, Jacob, date.Compleat day trader. II. Title.HG6024.A43B478 1998332.64’'5—de21 98-5656cIP
McGraw-Hill £2
A Division of The McGraw Hill Companies
Copyright © 1998 by Jake Bernstein. All rights reserved. Printed in theUnited States of America. Except as permitted under the United StatesCopyright Act of 1976, no part of this publication may be reproduced ordistributed in any form or by any means, or stored in a data base orretrieval system, without the prior written permission of the publisher.
2345678910 DOC/DOC 90321098
ISBN 0-07-094501-2
The sponsoring editor for this book was Stephen Isaacs, the editing supervisor wasCaroline R. Levine, and the production supervisor was Suzanne W. B. Rapcavage.This book was set in Palatino by Victoria Khavkina of McGraw-Hill’s ProfessionalBook Group composition unit.
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McGraw-Hill books are available at special quantity discounts to use aspremiums and sales promotions, or for use in corporate training pro-grams. For more information, please write to the Director of Special Sales,McGraw-Hill, 11 West 19th Street, New York, NY 10011. Or contact yourlocal bookstore.Contents
Preface xiAcknowledgments xiii
Perspective on Day Trading: Observations,Claims, and Caveats 1
Why Day Trade? 2
Day Trading, Discipline, and Persistence 5Day Trading: Advantage or Disadvantage? 6As You Read This Book 7
The Importance of Self-Discipline 8
What Do I Mean by Discipline 8
A Review of Market Timing Indicators 13
Traditional Moving Average Indicators (MA) 14Variations on the Theme of Moving Averages 15Stochastics (SI) and Relative StrengthIndicator (RSI) 16Chart Patterns and Formations 18Parabolic 19ADX and DMI 20Cycles 21Seasonals 23Momentum/Rate of Change 26Market Sentiment Indicators 27Breakout Methods for Day Trading 29vi
Contents
3.
Day Trading: Art or Science 33
An Issue of Discipline. 34When Art and Science Diverge 34Art versus Science: What to Do? 36Day Trading: The Good, the Bad, and the Ugly 37Most Trading Systems Just Don’t Work 37Commissions can “Eat You Alive” If Your TradingMethod Is Marginally Successful 38Professionals Win, the Public Loses 38Do You Have Protection Against Bad Price Fills? 38Misinformation and Disinformation RunRampant 39Traders Love S&P Trading but Most Traders LoseinS&P 39Futures Options: Reality and Myth 39Insiders Still Reap the Rewards 41Your Odds of Success Are Worse NowThan Ever 41Computers: Help or Hindrance 42
The 30-Minute Breakout 45
Basic Method 45
Additional Parameters 47
Stop Loss and Trailing Stop Loss 49
What to Expect 49
Analysis of Test Results 52
Which Markets Are Best? 53
Risk and Reward: Reality and Rationality 55
Day of the Week Patterns 63
Examples of Key Date Seasonals 64
Using Day-of-Week and Specific Date Price Patternsfor Day Trading 68
Day of Week, Date, or Day in Month? 71
Day-of-Week Patterns with Timing 72
Trading Systems: Pros and Cons 77
The Purely Technical Trader 77
The Purely Fundamental Trader 78
The Techno-fundamental Trader 79
The Intuitive Seat-of-the-Pants, Guts-and-GloryTrader 807.
10.
11
12.
Contents viii
Power of the Inside Day 81
Inside Day Example 82Inside Days and Trend Change 82Reviewing the Rules 83
System Testing and Optimization: Friendor Foe? 87
Why Test Trading Systems? 88
Test Your Trading System 88
Optimization 92
A Rational Approach to System Development 94
Emotions, Traders, and Markets 95
Develop Your Rules 97
Systems Trading, Discipline, and Profits 100
A Few Good Ways to Lose Money Trading the FuturesMarkets 101
How about Some Positive Suggestions? 107
What Markets to Day Trade? 111
Trading Volume 112
Volatility 114
The Double-Edged Sword 114
Changing Conditions 115
Can Commodity Spreads Be Day Traded? 116Recommended Spreads for Day Trading 117
Closing and Openings 119High/Low/Close Relationships 120Open/Close Relationships 122
Developing a Trading System on the Open versusClosed Relationship 123
Gap Methods for Day Trading 135A Day Trader’s Dream = 135Oops! 136
How a Basic Gap Buy Signal Is Established 139How a Basic Gap Sell Signal Is Established 139Psychology of the Gap Trade 140
The “Best” Gap Trades 142
Pragmatic Considerations in Trading Gaps 143viii
Contents
13.
14.
15.
16.
Variations on the Gap Trade Theme 144
Period of Gap Comparison—Multiple-Day GapSignals 145
Intraday Follow-Up of Gap Trades 153
Accumulation Distribution OscillatorDerivative 155
The Ideal Situation 156Accumulation/Distribution Theory 158Using the A/D Oscillator 159
The Advance/Decline Derivative (ADD) 162
The Importance of Orders 169
What You Should Know about Market Orders 170Market-If-Touched (MIT) Orders 171
Fill-or-Kill (FOK) Orders 171
Stop Orders 172
Stop Limit Orders 172
Good-Till-Canceled Orders 172
One Cancels the Other (OCO) 173
Using Orders to Your Advantage 173
The Psychology of Day Trading 179
Patience, Impatience, and Temperament 180
Personality Traits of the Successful Day Trader 181
The Dangers of Being Meek 183
A Few Thoughts about Self-Control 184
Some Additional Thoughts about Day TraderPsychology 185
A Successful Day Trader Needs Discipline 186
Willingness to Accept Losses 188
The Ability to Avoid Overtrading 189
The Ability to Specialize 190
Beginning with Sufficient Capital 191
The Ability to Use News to Your Advantage 191
Taking Advantage of Brief Price Surges 192
Sticking to Your Daily Goal 193
Using Market Sentiment to Find Day-TradingOpportunities 194
The Day Trader’s Rules for Success 197
Determine Your Orientation—Know YourDirection 198Contents ix
Don’t Be Surprised If You Lose Money at First—SomePeople May Never Succeed 199
Expect the Least, Not the Most 200
Shut Out the Input of Others—Play Your Game byYour Own Rules 201
Take Your Losses When Your Signals So Dictate—Don’t Make Excuses! 201
Your Goals as a Day Trader 203
Don’t Exit Trades Too Soon =203
Don’t Hold a Profitable Day Trade Beyond Its IdealExit Point 204
Don’t “Force” Day Trades If There Are No Signals 204
Hesitate and You Lose! 205
Keep a Record of Your Trades—the Good, the Bad, andthe Ugly 205
Don’t Day Trade Unless You're Properly Informed 206
When in Doubt, Stay Out 206
You Can’t Succeed Unless You Do Your Homework 206
Keep Close Track of Your Results 207
More Complicated Is Not Synonymous with MoreProfitable 208
The Danger of Market Myths 208
The Dangers of Pyramiding 209
Avoid Inactive Markets 209
Don't Run with the Lemmings 210
Watch for Day-Trading Opportunities Following MajorEvents or News 210
The Value of Correct and Timely Price Data 211
A Few Thoughts about Commissions and Brokers 211
17. FAQs (Frequently Asked Questions) 213Afterword 221
Index 227Preface
When I wrote The Compleat Day Trader in 1995, I felt that the sci-ence and art of day trading had come of age. Given the increasedprice volatility and technological advances in the delivery andanalysis of market-related data, it was clear to me that therewould be numerous opportunities for the day trader. And this hasindeed been the case. Yet the other side of opportunity is risk.With increased potential for profit comes increased potential forloss. My sense of the markets is that more traders than ever beforeare either day trading or have a desire to day trade. Do not, how-ever, confuse or equate an increase in the number of day traderswith an increase in the percentage of traders who actually win atthis high stakes game. I believe that day traders and aspiring daytraders need more effective tools to help them navigate the evermore treacherous market waters. My goals, therefore, in writingthis new book on day trading were as follows:
= To present and discuss some of my latest day-trading systemsand methods
= To share new ideas and to amplify on existing ideas for effectiverisk management both from the standpoint of market methodol-ogy and trader psychology
= To suggest new and promising directions in day trading tech-niques
= To fine-tune techniques and methods I have previously dis-cussedmii = Preface
I believe that I have exceeded my original goals. I believe thatthis book offers several powerful tools as well as numerouspromising concepts for further exploration.
The book you are about to read contains a variety of differentmethods and systems for day trading. Take the time to learn,study, and track the methods. Then, after you have learned thetechniques that appeal to your senses and your pocketbook, begintrading with them. But don’t plunge into the markets before youhave spent some time learning the methods. And when you startyour trading, please make certain you understand the risks as wellas the rewards of day trading. Be certain to start with sufficientcapital and practice all the necessary discipline your methodsrequire.
Finally, do not labor under the misconception that day tradingis easy. Although there are several distinct advantages to day trad-ing, it may be true that from the standpoint of self-discipline, daytrading is more difficult than position trading. You cannot daytrade your way to riches with little effort. Day trading takes work,work, and more work. It requires discipline, attention, organiza-tion, and commitment. Success as a day trader does not fall out ofa magazine or a book.
I hope that the tools in this book and in my Compleat Day Traderwill help you, and I wish you success in your venture. If I can beof assistance, please contact me at the following address:
jake@trade-futures.com
For new developments in my day-trading research visit the fol-lowing Internet location:
http://www.trade-futures.com
Jake BernsteinNorthbrook, IllinoisAcknowledgments
The amount of research that went into the production of this bookwas enormous. Without the assistance of system-testing softwareand valid historical data my task would have been impossible tocomplete. Accordingly, I wish to extend thanks to the followingindividuals, firms, and organizations for their valuable assistance:
= Commodity Quote Graphics of Glenwood Springs, Colorado,for permission to reprint charts from SYSTEM ONE, their out-standing quotation/graphics hardware and software program.The CQG software is especially useful in day trading. It hasbeen one of my most valuable day-trading tools for many yearsand it continues to serve me well.
Mr. Bill Cruz of Omega Research in Miami, Florida, and hisexcellent staff for their continuing assistance and for permissionto use reports generated by their excellent system testing soft-ware program, TradeStation™. This highly developed andadvanced program makes the intensive task of historical testingand system development effective and efficient. It is well-suitedto the needs of all day traders.
Mr. Glen Larson of Genesis Financial Data is due many thanksfor his constant supply of historical daily and tick-by-tick data.The development, evaluation, and testing of day-trading sys-tems, indicators, and methods are impossible without accuratetick-by-tick data.
xiiixiv
Acknowledgments
FutureSource is due a word of thanks for permission to repro-duce charts from their excellent trading software.
I am also thankful to all traders who have touched my life withtheir opinions, suggestions, systems, methods, and timing indi-cators.
My dedicated and hard-working office staff are also commend-ed for their persistent efforts in the production of this book. I amnot easy to work with. I change my mind too easily and tooquickly although all turns out well in the long run.
And finally, many thanks to my family for their patience andwillingness to give me the time I needed to complete this impor-tant project.
Jake BernsteinThe CompleatDay Trader IIA Perspectiveon Day Trading
Observations, Claims, and Caveats
Beware that you do not lose the substance bygrasping at the shadow.AESOP
Now more than ever, day trading is both a viable as well as apotentially profitable venture that is open and available to alltraders. While day trading was once the fiercely guarded and vir-tually exclusive domain of the professional trader, significantadvances in the speed of communications and in computer tech-nology have made it possible for the average trader to participatein and to win at what I consider to be “the fastest game in town.”No longer does the floor trader have exclusive rights to the spoilsof day trading. Virtually any trader, armed with knowledge, atrading system or method, and sufficient starting capital can com-pete effectively in this high stakes game.
However, the possibility of profitable day trading is nothingmore than an unattainable dream if the rules and procedures ofthe game are not properly understood, learned, and applied. It isthe rare individual indeed who is capable of achieving the disci-pline and persistence that are among the prerequisites for successas a day trader.Chapter One
In order to achieve this end, the following inputs and ingredi-ents must be present (not necessarily in order of importance):
= Knowledge of trading terms, methods, systems, and indicators= Sufficient starting capital, all of which must be risk capital
= One or more viable, tested, effective, and operational tradingsystems, methods, and/or indicators
« The time, patience, and persistence to effectively and consistent-ly implement the indicators, systems, and/or methods
« The discipline to follow through on trading signals
™ The discipline to take losses and profits when so indicated bythe system or method being used for day trading
I will dispense with preliminary definitions and explanationsrather quickly. This book is intended for traders who already havean understanding of the markets and of trading basics. Experiencein trading would also be helpful. Therefore, please do not considermy cursory treatment of any subject herein to be a denigration ofits importance. It is merely an indication that the information iseither too basic or that it has been discussed in my other books.For those seeking an introductory text on day trading, please notethat the basics of day trading have already been discussed in mybook The Compleat Day Trader (1995). This book provides a thor-ough examination of day trading rules, procedures, and basicprinciples, as well as several trading systems or methods.
Why Day Trade?
If you plan to take the time, energy, and effort to day trade, itwould be a good idea to know why. The mere attraction or sexappeal of day trading is insufficient reason to get involved in thisintensive, frequently time-consuming, and potentially costly ven-ture. The most obvious answer to the basic question “why daytrade?” is “to make money.” But the motivation to trade is notoften simple. In order to day trade profitably, it is important tofirst understand and acknowledge what motivation, if any, existsabove and beyond the simple profit incentive.
Given my own extensive experience in day trading, as well asmy observation of other day traders over the years, here are somethoughts about why one might want to consider day trading:A Perspective on Day Trading 3
The Profit Potential. This is clearly the most obvious reason.Given the wide market swings that are now commonplace inmany of the futures markets, both domestic and foreign, manyopportunities are available within the time frame of a single trad-ing day. In addition to the wide price swings, the intraday markettrends are often persistent. By this I mean that once a market trendbegins within a given day, that trend tends to persist. Clearly thisis not always the case. Market trends can and do reverse withinthe time frame of a day, but there are systems, methods, and pro-cedures by which the day trader can take advantage of suchchanges or, at the very least, protect his or her position when suchchanges in trend occur.
In S&P 500 futures, the quintessential day traders’ market, priceswings of over 1000 points within the day time frame are relative-ly commonplace. This is a $2500 trading range, which is certainlylarge enough for the day trader. Figure 1-1 shows a daily pricechart of S&P 500 futures for the period from October through
 
Figure 1-1. S&P 500 futures October-December 1997 showing days (marked “X”) of 1000-pointrange or larger.4
Chapter One
December 1997. I have marked an “X” by each day that had atrading range of 1000 points or more. As you can see, there weremany such days, all of which provided ample and potentiallyprofitable opportunities for the day trader.
Large daily trading ranges also occur regularly in Treasurybond, coffee, Swiss franc, British pound, and Japanese yen futures.The petroleum futures markets have also had large daily tradingranges but with less frequency than the markets cited above. Inaddition to these markets, a number of European futures marketshave had large daily trading ranges. Hence, the opportunities forday trading exist in many different markets both domestically andabroad.
Naturally, where there exists the opportunity for profit, there isalso the risk of loss. Even the least experienced trader understandsthat there is a risk of loss, but it is imperative that I underscore thisrisk lest any readers conclude that day trading somehow involvesless risk than position trading. :
The Challenge. Yet another very viable reason for day tradingis the challenge of the game. Although this is clearly a secondarymotive to the profit incentive, many of us derive considerable per-sonal satisfaction from a venture that can both make us moneyand satisfy an intellectual or competitive need at the same time.When a trader is new to the markets, the main goal is survivalwith the hope of profit: Once the game has been learned, the goalis profit as well as mastery.
The challenge of successful day trading is one that has luredmany a trader over the years. And many traders have been left inthe ashes of ruin as a consequence of playing the game with faultytools or without discipline. Therefore, to a given extent, the abilityto day trade profitably with consistency is a measure both of anindividual's ability to understand the markets and to developprofitable tools based on these understandings, and then to putthese understandings into action.
The Fame. The lure of fame cannot be ignored as one of the rea-sons traders undertake day trading as either a hobby or as a profes-sion. Hopefully, the ego of the trader as well as the need for famewill not overshadow the desire to make a profit. But fame as a daytrader cannot be achieved without profitable trading or systemdevelopment. Let fame be the least of your goals as a day traderlest the need overshadow the commitment and the methodology.A Perspective on Day Trading 5
Day Trading, Discipline,and Persistence
There can be no profit, no success, and no fame unless the traderhas first mastered the self-discipline and persistence that areessential ingredients to profitable day trading. These skills areintrinsically intertwined in the psychology of the trader. My expe-rience has taught me that the single most important aspect of anytrading method, whether for the long-term, intermediate-term,short-term, or day trade, is the psychology of the trader. Withoutfunctional psychological tools, the best trading system in theworld will be subject to the whims, fears, and hopes of the trader.The psychologically weak trader will undermine the system, andthe result will be loss after loss.
My work with trader psychology dates back to 1968. The yearshave taught me well. I have learned that unless a trader has mas-tered his or her psychological ability to apply the rules of a sys-tem, no method or indicator will be effective. The lack of self-dis-cipline will eventually take its toll in the form of losses. This willincrease the trader’s frustration, resulting in less discipline andmore losses.
Systems cannot work and will not work unless traders allowthem to work. The undisciplined trader will commit a multitudeof errors, some conscious and others unconscious, that will under-mine success. The errors will be those of omission as well as com-mission. Having been educated in clinical and behavioral psychol-ogy, I am well acquainted with the limitations of the trader andwith the psychological roadblocks that traders constantly throw intheir own paths.
In fact, I have written extensively on this subject. The Investor'sQuotient, originally published in 1980, and The Investor'sQuotient—Second Edition, published in 1993, have continued to bebest-sellers over the years. Traders the world over have read bothbooks. The many letters and calls I have received in response tothe books have confirmed my assertion that without an effectivepsychological orientation to the markets, a trader is doomed tofailure from the start. And this is especially true in day trading,where decisions must be made quickly.
Traders must be willing to realize their limitations, and theymust learn and apply strategies to.overcome them. While there arethose who will disagree with me, I feel strongly that trader psy-chology is just as important as an effective trading system orChapter One
method. Without both elements present in the correct measures,success will not come easily, if at all.
While many of you may choose either to ignore what I havesaid or to sidestep it entirely, I do sincerely believe that to do sowould be the worst mistake you could make. Although it isimpossible to completely discuss in one brief chapter what takesseveral books to explain thoroughly, I will do my best to acquaintyou with the pitfalls that plague all futures traders, limiting theirsuccess.
Day Trading: Advantage or
Disadvantage?
For many years day trading has been considered to be the mostspeculative of futures trading activities. I believe that this is a mar-ket myth that has been perpetuated by those who are unable today trade or who are afraid to do so. The fact is that the day traderis in an advantageous position. The successful day trader under-stands the limitations of what can be achieved within the day timeframe. The day trader is, therefore, the quintessential speculator.While the task that confronts the day trade is a formidable one, therewards can be fabulous.
I see the day trader as a skilled surgeon, a sharpshooter, a racecar driver. The day trader is focused on finding the correct target,taking aim, pulling the trigger, and bagging the prey. As merce-nary as this may sound, that’s what all futures trading is about.The profitable futures trader will keep his or her powder dry, tak-ing aim only at the most promising targets. But the most promis-ing targets for the day trader are not always those that have thegreatest profit potential. The day trader must be careful to takeaim at opportunities that have both profit potential as well as ahigh probability of success. This necessity serves as an advantageto the day trader. It requires the day trader to be highly selectiveabout the markets that are traded, as well as the trades that areentered.
The day trader is also at an advantage in terms of time frame.Since a day trade is, by definition, a trade that is completed with-in the time frame of one day, the day trader is forced to exit bythe end of the day either at a loss, at a profit, or at breakeven.This limits the profit potential, but it also limits the potentialloss. Since one of the worst blunders a trader can commit is toA Perspective on Day Trading 7
ride a loss beyond its required exit point, being forced to exit atthe end of a day will limit losses better than any other method Iknow.
Traders have an inherent predisposition to ride their losses andto take their profits quickly. Examine your own trading history ifyou doubt what I am saying. You will likely find, as I have, thatyour worst losses are those that were not taken when they shouldhave been taken. As a day trader you will take your losses quickly.Hence, the day trader has a distinct advantage over the positiontrader, and it is an advantage that may be considerably moreimportant than any of us is willing to admit.
Another advantage of day trading is that it allows the more effi-cient and effective use of margin. Since positions are closed out atthe end of the day, there is no overnight margin requirement.Provided that the day trader is using a profitable system, marginwill not be a problem. This means that starting capital can besomewhat less than what is required for position trading.
Finally, the day trader benefits from the fact that overnight priceswings will not affect the day trader. We live in a time of immensemarket volatility. An open profit of $5000 in an S&P 500 positioncan turn into a $4000 loss overnight. A profit of $5000 on a daytrade that is closed out at the end of the day is a real profit: onethat cannot disappear by a sharply higher or lower opening thenext day as a result of national or international events. This, to myway of thinking, is one of the greatest advantages for the day trad-er. Not only does it prevent the loss of an open profit, but it alsomakes for good sleeping conditions for those of us who enjoy rest-ing quietly in bed at night far niente.
As You Read This Book
All futures traders must be consistent, efficient, adaptable, andpersistent. These are the most important qualities that a futurestrader can develop. However, because day trading is uniqueamong the many different avenues that are open to traders, daytrading has its special brand of psychology. Some of the systems,methods, and indicators I will discuss in this book have theirunique caveats and considerations.
Please take notes carefully as you read this book. From time totime I will suggest specific methods that you may use to overcomeyour limitations and to maximize your strong points as a day trad-8 Chapter One
er. These are not necessarily listed in any one chapter or locationin the book. They are scattered throughout.
The Importance of Self-
Discipline
Chapter 15 discusses the psychological and behavioral issues thatlimit success in futures trading; however, before you begin tostudy the systems and methods I have developed, you will need ageneral overview of the qualities that facilitate or enhance prof-itable trading. The first among these is discipline.
Certainly by now you've heard the word discipline hundreds ifnot thousands of times. It is probably one of the most effete termsin all of futures trading. The problem is that merely saying theword is one thing; understanding its true definition operationallyor on a behavioral level is a far more important thing.
What Do I Mean by Discipline?
Discipline is
= Not merely the ability to develop a trading plan and to stay withit, it is also the ability to know when your trading plan is notworking and, therefore, knowing when to abandon it.
a The ability to give your futures trading positions sufficient timeto work in your favor, or for that matter, sufficient time to workagainst you.
= The ability to trade again once you've taken a loss or a series oflosses.
« The ability to ignore extraneous information and to avoid inputsthat are not related to the system you are using.
= The ability to maintain reasonable position size and to avoid theemotion that leads to overtrading.
= The persistence required to maintain your trading system and tocalculate the necessary timing indicators consistently, eithermanually or by computer.
= Above all, however, discipline is the ability to come back to thetrading arena every day, regardless of whether you have won,lost, or broken even the day before.A Perspective on Day Trading 9
You can see, therefore, that discipline consists of many differentthings. Discipline is not any one particular skill, but many. Perhapsthe best way to understand trading discipline is to examine someof its component behaviors. Let’s look at a couple of these.
Persistence. This is, perhaps, the single most important of allqualities that a trader can possess. Futures trading is an endeavorthat requires the ability to continue trading even when resultshave not been good. Because of the nature of markets and tradingsystems, bad times are frequently followed by good times, andgood times are frequently followed by bad.
Some of a trader’s greatest successes will occur following astring of losses. This is why it is extremely important for traders tobe persistent in applying their trading methods and to continueusing them for a reasonable period of time. Those who quit toosoon will not be in the markets when their systems begin to work;those who quit too late will run out of trading capital. Therefore,while persistence is important, it is also important to know whena trader has been too patient, remaining in the game when it istime to quit.
If persistence is so important, then how does the trader developit? While the answer is simple, the implementation is not. Beingpersistent develops persistence. While this may sound like a circu-lar answer, it is truly not. The only way to be persistent is to forceyourself initially to do everything that must be done according tothe dictates of your system or method.
Try this if you’re having difficulty: Make a commitment to atrading system or method. Follow through with that approach fora specific amount of time, taking every trade according to therules or, if the system is subjective, attempting to trade the systemwith as much consistency as possible. If