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WILEYeBOOKWILEYJOSSEY-BASSPFEIFFERJ.K.LASSERCAPSTONEWILEY-LISSWILEY-VCHWILEY-INTERSCIENCE
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technicaltradingonline
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Wiley Online Trading for a LivingDay Trade Futures Onlineby Larry WilliamsDay Trade Onlineby Christopher A. FarrellDay Trade Part-Timeby John Cook and Jeanette SzwecElectronic Day Trading 101by Sunny J. HarrisElectronic Day Trading to Winby Bob Baird and Craig McBurneyHow I Trade for a Livingby Gary SmithTechnical Trading Onlineby Trader X as told to Jerold RothHow I Trade Optionsby Jon NajarianThe Strategic Electronic Day Traderby Robert DeelTrade IPOs Onlineby Matt Zito and Matt OlejarczykTrade Options Onlineby George A. FontanillsTrade Stocks Onlineby Mark Larson
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technicaltradingonlineTRADER XAS TOLD TO
JEROLD ROTH
JOHN WILEY & SONS, INC.New York • Chichester • Weinheim • Brisbane • Singapore • Toronto
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Copyright © 2001 by J.R. Roth and Trader X. All rights reserved.Published by John Wiley & Sons, Inc.No part of this publication may be reproduced, stored in a retrieval system ortransmitted in any form or by any means, electronic, mechanical, photocopying,recording, scanning or otherwise, except as permitted under Section 107 or 108of the 1976 United States Copyright Act, without either the prior writtenpermission of the Publisher, or authorization through payment of the appropriateper-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers,MA 01923, (978) 750 -8400, fax (978) 750 - 4744. Requests to the Publisher forpermission should be addressed to the Permissions Department, John Wiley &Sons, Inc., 605 Third Avenue, New York, NY 10158 - 0012, (212) 850 - 6011, fax (212)850 - 6008, E-Mail: PERMREQ@WILEY.COM.This publication is designed to provide accurate and authoritative information inregard to the subject matter covered. It is sold with the understanding that thepublisher is not engaged in rendering professional services. If professional adviceor other expert assistance is required, the services of a competent professionalperson should be sought.Material in this book is for educational purposes only. It should not be assumedthat the methods, techniques, or indicators presented in this book will beprofitable or that they will not result in losses. Past results are not necessarilyindicative of future results. This is not a solicitation of any offer to buy or sell.Trading and investing are speculative and include risk of loss.This title is also available in print as ISBN 0 - 471-39421-1.For more information about Wiley products, visit our web site at www.Wiley.com.
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preface
Recently, on one of the network all night news programs, aBritish correspondent gave an example of how the insanity ofdot.com stock prices in the United States had supposedlydriven the British securities market nuts. His example was anold-line, medium-size, consistently profitable corporation.This corporation happened to own a large block of stock in ayet-to-be-profitable, wet-behind-the-ears, dot.com high flyer.The value of this block of stock exceeded the value of all outstanding stock of the old-line company.Think about that. Part ownership of an unprofitable company is worth more than entire ownership of a profitable one.Okay, that’s possible. It has to be, at least according to something called Faure’s Law, which states: “If it happens, it mustbe possible.” Yet is it logical?A closer examination of this case will push logic to its extremes, if not over the edge. What would happen if the old-linecompany split itself into two companies, the second one consisting of nothing more than the dot.com stock. Logically, theold-line company would drop in value, and the dot.com holding company would assume the market value of its sole asset,the block of dot.com stock. Yet, this would not and could nothappen. The old-line company, by divesting itself of this valuable asset, would actually increase in value.Hard to believe? Then look again. The value of the blockof dot.com stock is worth more than all outstanding shares ofv
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the company that owns it. This means that if you take awaythis dot.com stock, the company that owns it should have anegative value. In other words, stock traders have valued thestock of an as-yet-to-be-profitable dot.com company at countless times its weight in gold. On the other hand, they havegiven the old-line, medium-size, consistently profitable corporation, subtracting the dot.com stock, a minus value. Thisvalue would cross over to positive if the old-line company tookall its valuable dot.com stock certificates and burned them forheat. Logical? If you are looking for logic, don’t look at today’sstock market.If you are looking for discussions of price/earnings ratios,do not waste your time looking within this book. You will notfind any, nor will you find the wisdom to explain today’s stockmarket. You certainly will not find a secret method for guaranteed profits. What you will find in Technical Trading Online is asubstantial amount of hard-earned knowledge, knowledge Ipaid for with many long years and many costly mistakes. I amsure that I’m not the first person to tell you that knowledge ismoney, but I may be the first to add that this is especially truein the stock market.If you have as yet to decide if this book is really for you,perhaps I can save you the bother of reading it. Technical Trading Online is not written for people looking to amuse themselves by trading stocks. If you are searching for amusement,allow me to suggest Las Vegas. Not only is Las Vegas far moreamusing than the stock markets, you can probably amuseyourself far longer before eventually going broke. Nor is thisbook written for people interested in trading stocks because itseems the trendy thing to do. Believe me, by the time you perfect your trading skills, something else, surely less demanding,will be the trendy thing to do. One last type of person I woulddissuade from buying this book is the kind looking for “juice.”vi
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If you are literally looking for juice, save a hell of a bundle bybuying a Juicerator©. If you are looking for the type of “juice”sometimes referred to as a rush, allow me to steer you insteadtoward bungee jumping or sky diving. Either of these activitieswill cost you less money in the long run. And if you don’t happen to survive the short run, cleaning up your mistakes will besomeone else’s problem. However, if you insist on both “juice”and profit, robbing banks is probably just the thing for you. Atthe very least, it will offer you more favorable odds than trading stocks.Then who is this book written for? Technical Trading Online is written for those people who come to trading for onesingle, overriding purpose—to make money.This book will add to your knowledge by providing strategies, techniques, and plain tricks that could and should provevery valuable when applied to today’s stock markets. Equallyimportant, it will tell you how to take advantage of variousstores of knowledge and countless sources of data now available online. No book can tell you all you need to know, but restassured, by reading Technical Trading Online, you will gain substantial knowledge not provided by any currently availablebook. I am confident you will come to value the following material far, far more than the price paid for it or the time spentreading it.TRADER XSeptember 2000
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contents
chapter 1the golden rules of stock trading
1
sinners, abandon all hope here
chapter 2the Kinematic Model
13
price/earnings ratios? this ain’t your father’sstock market
chapter 3indicators
41
how to stalk a trend
chapter 4continuation and reversal signals for trends
71
trends: oh, when will they start? oh, whenwill they end?
chapter 5buy and sell signals
85
it’s true!!! buy low, sell high
chapter 6breeds of stock traders
95
who’s your daddy?
chapter 7trading stocks online
107
“this program has performed an illegaloperation”—Windows®
ix
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chapter 8setting up your monitor
117
“you don’t know jack” meets “doom”meets “winky dink”
chapter 9buying and selling online
127
“our business is built on personal relationships”—motto of now defunct brokerage house (the name ofwhich escapes me)
chapter 10online information sources
133
mortgage your house and follow your mouse
chapter 11developing a system
145
at the very least you’ll remember what thehell you did
chapter 12the daily plan
149
if you want to make God laugh, tell Him your plans
chapter 13cases
155
things you won’t find in books, not usually
chapter 14breaking the rules
181
live fast, die young, and have a good-lookingcorpse (in the pauper’s graveyard)
chapter 15conclusion
187
the first million dollars is always the hardest
glossary
193
index
209
x
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the golden rulesof stock tradingsinners, abandon all hope here
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Tempting as it is to be cleverly innovative, let’s start this bookat the basic, solid, ground floor beginning. If you are determined not to learn anything valuable from Technical TradingOnline, even by accident, the most important things not tolearn are the Four Golden Rules of Stock Trading. Fair warningnow: If you do learn them, and subsequently fail to followthem, they will come back to haunt you after every disastroustrading day. There you will be, trying to blame your losses onbad luck, bad advice, bad information, bad fate, bad food, badcoffee, bad influences, bad digestion, bad karma, bad weather,bad genes, bad service, bad air, bad circulation, bad company,perhaps even bad breath. Yet deep down you will know thatthe critical condition of your still-bleeding balance sheet is theresult of disobeying one or more of the Four Golden Rules ofStock Trading. You will refuse to admit this at first, even toyourself. Yet, deep down, you will know.Learning how to trade stocks effectively takes more thanbooks, advice, and practice. It takes time—the more the better.Much of this time will be spent losing money. Yet I strongly believe that if you follow the Four Golden Rules of Stock Trading,you should be able to stretch your capital far enough to startturning some profits.The Four Golden Rules of Stock Trading are:1. Cut your losses.2. Let your profits run.3. Trade with the trend.4. Never average down your losing positions.3
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There is not one of these rules you should find surprisingor suspect. In fact, you are probably thinking that they arepretty much commonsense rules that you would follow naturally. You may be right, but I doubt it. Next time you have a badday at the market, think about these rules again. I can justabout guarantee that you broke at least one of them.
rule 1 cut your lossesTrading stocks is a profession that encompasses the making ofmistakes, if not by definition, at least by the law of averages.I’ve never met a trader who didn’t make mistakes. Please forgive my skepticism that you will be the first.You will make mistakes because trading is not a science.It is an art—an art that is based on judgment, and this judgment is based on knowledge, and this knowledge can neverbe perfect. Fortunately, it doesn’t have to be. Think aboutthis discouraging fact: When trading stocks, you can be right90 percent of the time and go broke. Conversely, think aboutanother all too encouraging little fact: When trading stocks,you can make mistakes 90 percent of the time and still amassa fortune. Sounds like a great business to be in, doesn’t it?Well, unfortunately, the latter is not a business strategy I canwholeheartedly recommend. Still, odd and amazing as thissecond fact may seem, there is a very important lesson in it.Not only must you immediately admit your mistakes, youmust then strive to minimize the cost of these mistakes. Unfortunately, many would-be traders never even learn the firstpart of this lesson.The inability to admit mistakes is no rare malady amongprospective stock traders. It is a virulent, deadly plague. I hopeyou noticed that I said “among prospective” stock traders. I did
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not say “among successful stock traders,” or even “long-termstock traders” because prospective stock traders who do notlearn to admit to their mistakes, do not stay solvent longenough to become successful or long-term traders. The simplecure for this malady is to force yourself to look at the numbers,figure out their effect on your balance sheet, and then, if necessary, reign in your ego long enough to admit to your mistakes.The next and final step is to act as quickly as possible to cutyour losses.Minimizing the cost of subsequent mistakes is, for manypeople, much easier than admitting them after the fact. Thesurest way to do so is to devise an exit strategy even beforeyou enter a position on a stock. For example, you are surethe stock Helium Balloons Unlimited is going to go up. If youweren’t sure, I choose to believe you would not buy it. In anycase, if you are so sure, at the same time you buy it long, makeup your mind to sell it if the stock price drops even 1⁄4 belowyour cost. Sure, you may lose this 1⁄4 in the blink of an eye, butyou won’t lose any more than 1⁄4. An automatic stop loss orderwould be even better. Not only does this make it unnecessaryto depend on your attention span and reflexes, it guardsagainst a far more serious threat, interference from your ego.In case I have not as yet made my point, allow me onemore chance to impress on you the importance of cutting yourlosses. Let’s say some idiot, not you of course, decides thebest thing he can do with his money is use it to make evenmore money trading stocks. What could be simpler? Well theanswer happens to be a different book, much longer than thisone. Lacking the time and space to get into that now, let’s justget back to our idiot. We will assume that, like you, he or shecan read. And that, like you, he had the foresight, or dumbluck, to buy Technical Trading Online. In fact he even, like you,
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read up to this page. That means he read and took to heartRule 1. Ah, if I could only, with confidence, add “like you” tothis last sentence.On his first daring move, our hero takes a one-hundredshare position long on a can’t miss stock with a stop set 1⁄4below cost. When his stock heads in the wrong direction, theautomatic stop closes him out. He takes another position longon another great-looking stock. Unfortunately, this positionends the same way as the first. So do his next fourteen positions in a row. Thanks to the automatic stops, ignoring commissions and other costs, our boy has lost only $200. Now he mightnot have learned anything from this experience, but I’m surethat by then you would have. At a minimum, this beating wouldhave convinced you to suspend trading until you at least triedto finish the rest of this book. And the beauty of this lesson isthat the most this beating could have cost you is $200.Enough real-life adventures, for now at least. The strategies and safeguards for cutting your losses when selling shortare similar to those for buying long. We will get into specificsfor both later in the book.
rule 2 let your profits runRule 1 concerned cutting your losses. Well cutting losses is notquite enough. I have never met anyone who traded stocks withthe objective of cutting his or her losses. Face it, the best wayto cut your losses, ignoring inflation, is to bury your money inthe backyard (preferably at night, preferably when there’s nomoon, but that too is another book, perhaps my next). Cuttingyour losses is a good defense, but if you are not offensiveminded, trading stocks is not for you.Let’s assume, for simplicity’s sake, you always tradestocks in blocks of one hundred shares. Let’s also assume, for6
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reality’s sake, that thanks to automatic stops, you only lost1⁄4 on each of the first eight stocks you bought long. Ignoringcommissions and other costs, your ninth stock needs only torise two points to get you even. Getting even may be satisfyingenough where ex-marital partners are concerned, but it doesnot get the job done when trading stocks. Take my word for it,you will need every 1⁄4 point profit you can get.Technical Trading Online will teach you how to let yourprofits run until you have squeezed your stocks like a lemon. Itwill help you learn to recognize ahead of time the events youshould be prepared for while holding a long or short position.You will end up with a sure sense of when to move your stopsand how tight to set them.
rule 3 trade with the trendHave you ever tried swimming against a current? It may begreat exercise, but it’s no prescription for making progress. Infact, if the current is moving faster than you can swim, it is asure-fire prescription for drowning. Similarly, trading againstthe trend, especially for the novice, is a pretty good prescription for insolvency.Let’s say you have found a stock that you are confident isready for a surge in price. Almost the entire market is losingpoints, and this stock is holding its own. The question is: Whyshouldn’t you buy it?The answer is: Who needs a stock that is going sideways? Itis difficult for traders to gain or retain confidence in a particular stock when they have been drained, however temporarily, oftheir confidence in the market as a whole. Confidence is contagious, but pessimism can be a virulent epidemic. If a stock isholding its own in a falling market, it is not only a good bet thatit will rise in an up market, it is a good investment.7
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The trick is not to commit your capital until it can earn areturn. You want to buy the stock just before or after it startsto rise. How can you be sure when that will be? You can’t.However, a damn good indication of an imminent rise in thestock would be an actual rise in the market. Of course, otherconditions and indicators should be taken into consideration,but the most compelling indicator should be the direction ofthe market as a whole.There are respected strategies for taking positionsagainst the trend, but I feel they should be left to the experienced, expert trader. If you, as a novice, insist on trying someof these strategies, I strongly suggest you restrict your sourceof capital to currently earned profits. This, for the immediatefuture, should prevent you from taking any substantial positions against the trend.To trade with the trend, it is helpful to be able to recognize a trend. I do not recommend the Dow Jones Industrial Average as a primary indicator. It is an average of only 30 stocks,while the New York Stock Exchange lists approximately 3,000stocks. The Dow Jones can and sometimes does mask the actual market trend. We will go much deeper into this subjectlater in the book. We will also cover the various indicators thatwill help you not only identify a trend, but also, of even morevalue, predict a change in trend.I have tried to convince you, using cold logic, to alwaystrade with the trend. Let’s face it, cold logic is not as effectiveas it used to be, and probably never was. So if you are moresusceptible to marketing jingles or New Age homilies, perhapssome warm, catchy, upbeat words will be more effective:“Trade with the trend. The trend is your friend.”Try chanting these sentences during trading breaks. Ifyou can, blurt them out instead of curse words. You may findthat these deceptively simple words, if repeated often enough,8
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will gain religious force. However, I wouldn’t chant them tooloud. Proselytizing can make you one unpopular stock trader.
rule 4 never average down yourlosing positionsLet us assume you get a hot tip about Lead Balloons Ltd.Share price is sure to double to $200 by the end of the week.Luckily, you are able to dive for your keyboard in time to pickup 100,000 shares at a mere cost of only $100 dollars a share,and a dislocated index finger. By the time you relocate yourindex finger, Lead Balloons has unfathomably dropped 10points. If you would have waited a few more minutes, youcould have bought it at $90. $200 minus $90 would have leftyou with an eventual per share profit of $110 when Balloonsreaches its $200 potential. Still, this is no time to be greedy.Your $100 per share profit will be good enough. Even whenBalloons subsequently drops to $80, you decide not to cryover spilt milk. Admittedly, you do feel a twinge of envy a fewminutes later when one of your friends buys in at only $70 ashare. That means she will eventually reap a $130 profit, almost 200 percent. That’s double yours. Pity.However, when Balloons drops to $45, a slight loss of confidence causes you to recheck your information. To your relief,not only does your source stand by his original tip, he is nowpositive that the stock will reach $250. Sure enough, less thantwo days later, Balloons rallies from $45 to $50.If the stock was a bargain at $100, it is surely twice thebargain now. Besides, buying a stock for $100 and selling it for$50 is not the way to get rich, at least as far as you can figureout. Another thing, that 50 percent drop in share price is notgoing to look good in your accounts. However, if you scoop upanother 100,000 shares at $50, your average drop in stock9
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value is miraculously cut in half to only 25 percent. This willmake your eventual profits look even better. Besides, then thestock price need only rise to $75 instead of $100 for you tobreak even.Not only do you scoop up the extra 100,000 at $50, youeventually pick up an additional 200,000 share blocks at $40,$30, $20, and $10. Unfortunately and unfathomably, shortlythereafter, Lead Balloons Ltd. goes broke. Still, you have managed to reduce your average price paid per share from $100 to$35. To your surprise, as an added bonus, you suddenly realizethat you have purchased all outstanding shares. That’s right,Lead Balloons is all yours, lock, stock, and barrel. And as ifthat bountiful bonus weren’t enough, the barrel happens to bea perfect fit.However, despite how well things worked out, I think younow understand that ending up with that barrel was due moreto luck than to skill. Let us hope you never again break Rule 4by averaging down your losing positions.Psychology, and of course we are referring to the pop variety, sells books. So now is the perfect time to include somein Technical Trading Online. Unsuccessful traders invariablylack one or both of two essential attributes—knowledge anddiscipline.You can pick up a good chunk of knowledge by readingthis book, and do so relatively painlessly. Yet, as much as ithurts my ego to admit it, neither this book nor any other will,by itself, give you sufficient knowledge to become a successfulstock trader. It can only arm you with enough background andstrategies to give you a fighting chance to stay alive and activein the market long enough to gain knowledge and turn yourselfinto a successful trader. You must remain determined to addto your store of knowledge, however vast you may judge it tobe, every single day, including days when the market is closed.10
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Discipline is a trait you must develop for yourself. Reinforce and strengthen whatever discipline you already possess,until you are sure that, no matter how stressful the crisis orhow euphoric the mood, you retain enough discipline to holdsway over your emotions and ego. If you lack discipline and areincapable of developing some, forget about trading stocks. Infact, stop reading at the end of this sentence, and try to takethis book back to the store for a refund.In the stock market, everyone makes mistakes. Mistakesmean losses, the financial type. Discipline helps you push yourego aside, and admit to making a mistake. In the stock market,the cost of mistakes is money. The sooner you can admit to mistakes and act accordingly, the less those mistakes will cost you.Costs decrease or eliminate profits. Discipline lowers thesecosts and protects profits, if you have profits. At the very least,discipline lowers costs.I have already admitted that this book does not containall the knowledge you will need to be a successful stocktrader. I have also more or less admitted that I cannot teachyou the discipline you will need, only the reasons that you willneed it. Now here comes the real killer. Neither I, nor anyoneelse, can teach you the right way to trade stocks. Fortunatelyor unfortunately, there is no right way. Each trader’s methodology is as different as his or her DNA and upbringing. Thepurpose of Technical Trading Online is to familiarize you withthe many tools available. You will have to choose among thesetools and among the ways they can be used.
summaryThis chapter should have added to your knowledge. I hope youcan develop the discipline to abide by the four rules it contains. Let’s go over them one more time. Trading with the11
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trend involves the necessary knowledge to identify the trendand the discipline to resist bucking it. Cutting your losses is almost pure discipline. Letting your profits run involves bothknowledge and discipline. Never averaging down your losses isnothing but discipline.I have used cold logic and even a little jingle in trying toconvey the importance of these rules. Now I will try somethingelse—cold fear. The following is a true story. Let it be a lessonto you.Once upon a time there was a very big and well respected company called Capital Management. The capitalunder its management was roughly $100 billion—a sum sizable enough to impress anyone outside of Congress. CapitalManagement managed to lose $95 billion of this little nestegg. How? Not for lack of knowledge. Company employeeshad plenty of that. They were the darlings of Wall Street.They put down sensible positions based on sound knowledge. Yet they started to incur losses.Did they follow Rule 1 and cut their losses? No, they didthe opposite and broke Rule 4. They added to these positionsto average down their losses. As if that weren’t enough, theybroke Rule 3 and traded against the trend.Individual traders have done quite well with mere fractions of Capital Management’s knowledge. What Capital Management lacked was discipline. The only one of the FourGolden Rules of Stock Trading that they did not break wasRule 2. Unfortunately, they did not really obey Rule 2 either.To let your profits run, it is essential that you have profits inthe first place.
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the Kinematic Modelprice/earnings ratios? this ain’tyour father’s stock market
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As I mentioned, price/earnings ratios and the other traditionalways of valuing a company’s stock do surprisingly little to explain price movement in today’s markets. In this chapter, Itake on that task by constructing a general, idealized model ofthis price movement.The only way to make money in the stock market is totake a position. Before you take a position on a particularstock, you have to figure out the trend of the market as awhole, the strength of this trend, and decide if it will continueor reverse. Once you have decided, you must apply Rule 3