ooth the value of the 10-day momentum using a selectedpercentage.(c) Smooth the value of step b using another selected percentage.10. What is the advantage of double smoothing?
It produces a smooth trendline with less lag than a comparablemoving average.
Answers to Chapter Questions
Chapter 16
303
Managing Your Entry and Exit
1. What is the best technique for getting the average price on a buy order
of 1,000 shares over two days?Divide the order into four or more equal parts and enter the buyorders spread out over equal time periods. The more parts, thecloser to the average.2. If you are trying to get the best price, in how many parts should you
divide and execute your order?One.3. What are the greatest advantages and the greatest disadvantages of
scaling down?The greatest advantage is that you will get a better average price.The greatest disadvantages are that there is no limit to the riskand you will miss the price move by only having part of yourposition set.4. What is the name of the technique that requires buying equal amounts
as you increase your profits? Explain the risk of this method.Pyramiding (an equal pyramid). The risk is that you have the largestposition when prices reverse, and you can lose all of your profits ina very small move.5. Explain the reasoning behind scaling out of a profitable position (as a
short-term trader).Price movement can be unpredictable in the short term. Scaling outover a range of prices allows you to target an average price butaccept the fact that price movement may fall short of that target, orgo significantly farther. Scaling out gets the same average result ifall levels are reached, and captures some profits and reduces riskif prices fall short of your target.
Chapter 17
Volatility and Portfolio Management
1. What is the best single word that describes a price shock?
Unpredictable.2. Give three ways that you can protect yourself from a price shock.
304
ANSWERS TO CHAPTER QUESTIONS
(a) Be out of the market.(b) Trade with low leverage.(c) Diversify so that you have less exposure to a market that experiences a price shock.3. What happens to the correlation between stocks, and even futures
markets, when there is a major price shock? Why?The correlation disappears because investors all react the sameway—they pull their money and move to a safer investment.Therefore, every market reverses direction as money leaves.It’s not the stock, it’s the money flow that causes correlation.4. We know that any one day can be more or less volatile then the next.
Under normal conditions, do prices get more volatile when they go upor down? Specifically, what about IBM, the Euro, crude oil prices, andTreasury notes?(a) IBM gets more volatile when it goes up. Volatility follows thestandard lognormal relationship. Volatility is lower at lowerprices and higher at higher prices.(b) There is no “high” or “low” price for foreign exchange, there isonly “equilibrium.” That’s where the price of one currency interms of another currency (for example, the yen denominatedin Euros, or the Swiss franc in U.S. dollars) is at a fair value. Wecan see this because volatility drops and prices move sidewaysin a narrow range. The currency price is stable. When an eventaffects either currency, the cross-rate will move higher or lowerand the volatility will increase in either direction. That represents instability. If the event was temporary, then prices willreturn to the level of equilibrium. If it is a permanent changecaused by an interest rate change, then prices will eventuallysettle at a new level of equilibrium.(c) The marginal barrel of crude oil is controlled by OPEC; therefore, they are very influential in controlling price. OPEC sets atarget price at, for example, $22 per barrel. That represents anartificial “equilibrium” in the same way as foreign exchange hasan equilibrium level. When prices move either higher or lower,volatility increases. If OPEC changes the target level by a smallamount, then prices take that level as equilibrium. If they changethe target upward by a large amount, then the market fights withtheir decision and volatility increases until the issue is resolved.
Answers to Chapter Questions
305
(d) Treasury notes have a normal volatility relationship except thatvolatility is in direct proportion to the interest rate yield, not theTreasury note prices. Volatility increases as rates go from 5 percent to 6 percent, while Treasury prices go down from about 108to 100. If you’re using prices because you trade futures, thenyou’ll need to change to yield to apply any long-term relativevolatility measurement.5. To find the “true range” of the day, you need to find the largest of what
three values (using high, low, and closing prices)?(a) Today’s high minus today’s low.(b) Today’s high minus yesterday’s close.(c) Yesterday’s close minus today’s low.6. As a short-term trader using profit targets and stop-loss
orders, which would be closer, the profit target or thestop-loss order?The profit target.7. What does low volatility imply with regard to price movement?
Lack of direction.8. If you are trading three stocks, A, B, and C, with corresponding daily
volatilities of $1, $2, and $3, what percentage of your total capital wouldyou place in each one to minimize risk?54 percent in A, 27 percent in B, and 18 percent in C.9. You are trading two stocks, A and B, and gold futures. Stock A has a
daily price range of $3, stock B has a daily range of $4, and gold hasa daily range of $3/ounce. The gold contract is 100 troy ounces. Howmany shares of A and B do you need to trade so that each stock hasthe same risk as gold?Gold has a daily volatility of $3 × 100 = $300; therefore, you need totrade 100 shares of A and 75 shares of B.
Chapter 18
Dow Theory
1. In Dow Theory, what are the three waves of stock market movement
called?The primary, the secondary, and daily price fluctuations.
306
ANSWERS TO CHAPTER QUESTIONS
2. Why did Dow use averages?
Because low liquidity in individual stocks allowed for price manipulation. These were seen as “unusual” price moves that could be minimized using averages.3. Why did Dow want confirmation of more than one index?
To be certain that the price move was based on broad economicfactors and not limited to a specific industry.4. What is the price pattern that gives you a bull market signal?
Prices go above previous resistance, where that resistance is about20 percent above the major lows of the previous price move. A bullmarket signal is similar to a price breakout.5. In Dow Theory, what are the terms describing the first phases
of a bull or bear market?Accumulation for a bull market and distribution for a bear market.6. In Dow Theory, how do you tell the difference between a secondary
reaction in a bull market and a downturn signalinga bear market?A secondary reaction lasts from three weeks to three months, thesize of the downturn is less than 20 percent, and volume declinesduring the price drop.7. In Dow Theory, what happens to volume in a bull market? In a bear
market?Volume goes with the trend. It increases in a bull market andincreases in a bear market.
ReviewAnswers
1. The analysis or forecasting of price movement using only price and
volume; the study of price patterns.2. Pros:
(a) Allows, discipline, ability to assess expectations and, backtesting.(b) Creates an objective, not arbitrary, assessment of market direction.(c) Applies discipline to trading (to know when to take a loss) andrisk control.Cons:(a) Lack of flexibility.(b) Inability to override with fundamentals.(c) Inability to analyze the market correctly.3. The weekly chart is smoother. The trend is clearer on the weekly chart.
The daily chart has more noise.4. Higher prices have higher volatility; lower prices have low volatility and
often lack direction. credit 1⁄2 point for answering, “Volume is different.”5. An unpredictable, very large, volatile price move.6. You cannot predict a price shock; therefore, you can’t plan to profit.
Credit 1⁄2 point for answering, “Have profit-taking orders placed in themarket.”7. The small, erratic, unpredictable price moves that occur frequently.
307
308
REVIEW ANSWERS
8. (a) The change in price over N days.
(b) The highest high to lowest low over N days.(c) The sum of the absolute price changes over N days.(d) The average true range over N days.9. The S&P gives the direction of the overall market. When the S&P has a
strong trend, it is best to consider that trend, and its correlation to themarketplace, when trading individual stocks. Don’t fight the big trend.Credit 1 point for answering, “In order to hedge.”10.SpikeExhaustiongap
Runaway gapsRunaway gaps
Spike
Reversalday
Outside day2 inside days
2 insidedays
Breakway gaps
Breakway gaps
FIGURE R3.1
11. See Figure R3.2 on facing page.12. See Figure R3.3 on facing page.13. Monthly, because it smoothes price movement.14. The N-day calculation, through day t, is plotted below day t rather than
at the average point of the calculation period, t − N / 2. Also, the effectsof smoothing cause lag.15. (c) Many small losses and a few large profits.16. All of them would be expected to produce similar results, but with a
different pattern. It’s the risk and trading frequency that differ.
309
Review Answers
Figure showing answer for Question 11.Pennant
DescendingtriangleSymmetric triangle
Rounded top
Flag
Symmetrictriangle
Descendingwedge
Fly
FIGURE R3.2
Figure showing answer for Question 12.
204060
FIGURE R3.3
Descendingtriangle
REVIEW ANSWERS
17.
Perfect “sell”
Downtrend
Confirmationof topPerfect “buy”
Uptrend
310
FIGURE R3.4
18.
Minor support
Minor support
Major support and 38% retracement50% retracementMajor support
100%retracement
FIGURE R3.5
Review Answers
311
19. (c) You cannot apply profit-taking.20. The long-term MA takes advantage of fundamental factors, primarily
Fed interest rate policy, which can dominate the market for sixmonths to two years. Short-term trends fight with market noise; therefore, they have many false signals. Credit 1 point for answering, “Thereis more data,” and 1 point for answering, “There is less noise.”21. (b) In a noisy market.22. An upward channel is drawn parallel to an uptrend line across the tops
of the price movement. Also, draw a regression line through the centerof prices, and then two parallel lines across the corresponding topsand bottoms.23. Buy when prices near the bottom of an upward-sloping channel and
sell when prices near the top of the channel. Credit 1 point for answering, “The breakout target is the width of the channel,” and 1 point foranswering, “Buy an upward breakout and sell a downward breakout.”24. Bollinger bands are 2-standard-deviation bands around a moving aver-
age. The calculation period is the same as the moving average.25. As a countertrend trader you would sell when prices penetrated the
top band and buy when prices penetrated the bottom band.26. A bar chart advances to the right each day, the point-and-figure chart
has no time component. Also, a bar chart is time-driven; a point-andfigure chart is event-driven.27. When a box is entered that is higher than the box in the previous col-
umn of boxes.28. To control your risk or losses.29. Just above or below the resistance level that is outside normal volatil-
ity range. Credit 1 point for answering, “Two times the volatility belowthe entry.”30. Raise it after new support levels are formed, always keeping it away
from the current daily volatility range. Also, raise it to the next secondary buy signal.31. (b) Descending.32. Below the neckline by the same distance as from the neckline to the
top of the head.
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REVIEW ANSWERS
33. 100 percent, 50 percent, and 61.8 percent.34. 1, 1, 2, 3, 5, 8, 13.35. (c) Neither 1 or 2.36. Decline in volume, decline in volatility, nearby resistance—horizontal
or downtrend trendline, overbought indicator, bearish divergence, testing a long-term moving average line, cross-market confirmation, highvolatility top, rounded top, head-and-shoulders top, island reversal,reversal day, volume spike, gap down, MACD signal crossing.37.PriceVolume
Increasing
Unchanged
Decreasing
Increasing
Strong up
None
Strong down
Unchanged
Up
None
Down
Decreasing
Weak up
None
Weak down
38. Change in price over a time interval; speed.39. (a) Smoother.40. $10.41. (c) Removing the trend.42. (c) Bullish and bearish divergence.43. Prices make lower lows and the oscillator makes higher lows.44. (a) The MACD line.45. The MACD crosses the signal line heading downward.46. (c) It remains at high levels for an uncertain period of time.47. $.75.48. None.49. The position of the closing price in the recent 10-day high-low range.
Credit 1 point for answering, “Speed and relative price,” and 1 point foranswering, “Whether the price is overbought or oversold.”50. Slow K is a three-day average of K, slow D is a three-day average of
slow K. Credit 1 point for answering, “Smooth.”51. (c) About 20 percent of the time.
313
Review Answers
52. (c) An overbought and oversold indicator.53. (c) Upward and downward price changes.54. False. A small number of days causes the stochastic to be erratic and
bounce from extreme highs to extreme lows based on market noise.Signals are undependable.55. True.56. (a) High minus low.
(b) High minus previous close.(c) Previous close minus low.57. (a) Scaling down because you have the largest position when you lose and
the smallest when the market moves quickly in a profitable direction.58.
Double topAscending wedgeDescendingtriangle
Target
Bearish divergence
FIGURE R3.6
314
REVIEW ANSWERS
Explanation for either higher or lower answer:Lower because of double top, bearish divergence, ascending wedge,descending triangle, lower volatility.Higher because of medium-term uptrend, not overbought, higher volume on upward moves.59. (a) Having a trading system that is correctly positioned for a price shock.60.
Stock AStock BStock CStock D
Price
Volatility
No. of Shares
$10.00$50.00$50.00$100.00
$0.50$1.00$1.50$5.00
162815416
61.
S&PT-notes
Price
Volatility
ConversionFactor
Margin
No. ofContracts
1100.00102/00
20.00/24
2501000
20,0003,000
12.583.0
62. (b) Scale out at multiple levels looking for an average price.63. All are true.64. (a) Bull and bear market, major trend, policy.
(b) Secondary trends or reactions, secular trends.(c) Minor trends or noise.65. To be sure it was a broad-based economic movement, not limited to
one industry.66. Accumulation.67. (b) Assuming that the trend persists.68. (c) Short-term trading, because it has the largest amount of noise and
the trend does not persist.69. (a) Periodic news releases.70. Long DELL because of a bullish divergence, rising prices near a hori-
zontal breakout, and a potential descending wedge bottom formation.Credit 5 points if you can justify another decision.
315
Review Answers
Descending wedge
Bullish divergence
FIGURE R3.7
71. (c) Decline if earnings are lower than anticipated.72. Because “big money thinks the same,” pensions and institutions buy
and sell across the board without distinguishing the specific attributesof a stock. They are setting or removing long-term long positions.73. “When you need it most,” during a price shock.74. (b) A larger number of losing trades.75. (a) When the MACD value reaches historic lows.76. True.77. True.78. The open, $52.00.79. (b) Greater than your average losses.80. Positive: Strong correlation between the two gives signal confirmation.
Negative: It doesn’t always work, analyzing the stock itself is “pure,”and the actions of management or company earnings do not necessarily relate to the underlying price of the physical market.81. Leverage; you can buy $25,000 worth of crude oil for $3,000 margin.
316
REVIEW ANSWERS
82. A failed signal can be a strong indicator of direction, you were proved
wrong in your choice of direction by virtue of a loss, or simply, “thetrend changed.”83. (c) Trading quickly, because profits are smaller; therefore, you need to
act faster.84. (b) Midday, because it is less liquid.85. (d) It is indirectly related to the amount of diversification.86. (a) Close out the trade as soon as possible.87. (b) Always get out of a windfall profit due to a price shock.88. Profits tend to make you complacent. Losses teach you lessons in how
to control risk and trade during difficult times.89. You don’t know their biases, what tools they’ve used, whether they
have analyzed the market correctly, or potential conflicts of interest orhidden agendas.90. $14.25.91. $56.90.92. 1106.50.93. You are not filled.94. A resistance line.
Index
Accumulation phase, in bear market, 267Acquisitions, 46Active trading, 166Acts of God, market response to, 264Advance-decline (AD) index, 193Aggressive investors, 28–29, 46Amazon.com, 13–15, 32–33, 114, 118–119,123–125, 133, 153, 181, 206American Airlines (AMR), 13–14AMR, 94–95, 97–98, 100Analyst reports, 215AOL, 36, 38, 183–184, 200–203, 210, 218, 221,224, 248Arbitrage, 144Arbitrageurs, 259Arm’s Index-TRIN, 194Ascending triangles, 145–147Asset allocation, volatility and, 254–256Average price method, 235–237Averages, in Dow Theory, 263–264Average true range, in volatility measurement,244–245, 250–251Balanced portfolios:benefits of, 252–253trading equal dollar amounts, 253–254trading equal number of shares, 253volatility, influences on, 254–256Bands:benefits of, 104–105Bollinger, 98–103percentage, 97–98, 103regression, 102–103Bearish divergence, 206–209, 224–225Bearish signals, 228
317
Bear market:confirmation, 269formation, 264–265, 268implications of, generally, 10, 147, 154phases, 265–266signals, 265–266, 271transition from bull market, 270–271volume, 269Bias, importance of, 116, 173, 215BigCharts.com, 80Big Money, 259Bloomberg.com, 80Bollinger bands, 98–103Bolton-Tremblay (BT) Index, 194–195Bond market, 75, 86, 258Bottoms:characteristics of, 30–32double, 155, 157–158head-and-shoulders, 164island, 137profit target after, 159–160rounded, 161–162triple, 158“V,” 154–156wedge, 163Breakaway gap:characteristics of, 131–132defined, 131example of, 132–133trading, 133Breakouts:anticipation of, 47defined, 36–37false, 36, 39–40, 62, 94, 122implications of, 37, 39
318
INDEX
Breakouts (continued)multiple, 38profits per trade, 67reliability of, 116risk management, 41, 121, 126rolling, 41–46sell orders, 39–40sideways, 36–38, 43–46stochastic signals, 219support and resistance lines, 37–39, 43,45–47trading frequency, 67trading rules for, 39, 47–48, 61–63trendlines compared with, 46Bullish Consensus (Hadady), 214Bullish divergence, 207, 209, 224, 226, 228Bullish signals, 225Bull market:confirmation, 269formation, 264–265corrections, 267implications of, 2, 5, 12, 17, 27, 34, 147, 154phases, 265, 267signals, 264–266transition to bear market, 270–271volume, 269Buy high, sell low, 116Buy orders:breakaway gaps, 133placement of, 81, 126–127, 211Buy signals:breakouts, 39, 41–42, 47, 61–62channels and, 92high volatility, 250moving average convergence-divergence(MACD), 205moving averages, 53–54, 125one-day patterns, 143point-and-figure, 114–115risk management and, 119smoothing and, 231using stochastics, 222stop-loss orders, 121–122swing trading, 111using trendlines, 28Buy-and-hold approach, 3Buy-and-hold portfolio, 258Buy-sell principles, 15Cancel (CANCEL) order , 83Cancel replace (CR) order, 83Cardinal square, 177Chaiken, Mark, 186Channels:benefits of, 104–105charting, 91–92
development of, 95–96profit-taking, 93–94redrawing, 94–95trading rules for, 92–93Charting:benefits of, 6channels, 91–97daily prices, 26Enron, 26–28manual, 45starting point, 24stochastic, 218–219stop-loss orders, 119trendlines, 24–25volatility, 246–247Charts, see Chartingdaily, 23, 26–27, 34, 55, 59–60intraday, 23, 29, 127monthly, 23patterns, implications of, 15persistent trends, 20–21, 29–30short trends, 21–22time frame, 18–20trend followers, 20trend identification, 22–23weekly, 23, 30, 33Chicago Board of Trade, 80Chicago Mercantile Exchange, 80Cinergy, 6–7, 254Cisco, 12, 24–25, 35, 38–39, 157, 160, 237Clearinghouse, 81Closed-out trades, 86Closing price, 29, 46, 62–63, 70, 122–123, 242,269Commissions, 16, 29, 81Commodities, 168–169Common gap, 131Computer software programs, 6, 31–32Confidence level, significance of, 10, 147,198Confirmation, in bear/bull market, 269Confirming the top, 159Conservation of capital, 30, 50, 55–56, 68Conservative investors, 28–29, 46Consumer confidence, 10, 19Consumer Price Index (CPI), 6Continuation patterns:ascending triangles, 145–147characteristics of, 150–151defined, 145descending triangles, 145–147, 149flags, 147–149pennants, 148–149symmetric triangles, 145, 147, 149trading tips, 151–152wedges, 149–150
319
Index
Contrarian investors, 214Contrary opinion, 214Corrections, 267Correlations:cross-correlations, 258–259negative, 259–260portfolio adjustments for, 260portfolio diversification, 251–252price substitution, 258Crises, market response to, 4, 13, 95–96,107–108, 189–191, 251–252, 259Cross-correlations, 258–259Crowd psychology, 156, 184, 267Currencies, influential factors, 19, 21%D, 216–217, 222Daily charts, 23, 26–27, 34, 55, 59–60Daily prices, 269DAX index, 160Day trading, 16, 127, 195, 211Declining prices, 24Declining wedge, 165Descending triangles, 145–147, 149Detrended price series, 202–203Disciplined trading, 78Distribution phase, in bear market, 267Divergence, MACD:Amazon.com example, 207–208anticipation of, 208–209exit strategy and, 209implications of, 206–207stochastic signals, 223–226Diversification, significance of, 8, 251–252Double bottom formation, 155, 157–158Double-smoothing, 229–232Double top formations, 155–157, 159Dow, Charles, 130, 262, 269Dow Jones Industrial Average, 262, 269Dow Jones Transportation (DJT) Index, 262,269Dow Jones Utilities (DJU), 262, 269Dow Theory:basic tenets of, 263–269market interpretation using, 270–271overview, 262Downgrades, 143Downswings, 269Downtrends, implications of, 22–24, 27–28, 47,113, 205, 220, 222. See also DownwardtrendsDownward channel, 91Downward gap, 131Downward reversal day, 137Downward trendlines, 26, 32–33, 47Downward trends, 19–20, 24–26, 38, 148
Drawdowns, 67, 69%D-Slow, 216, 219, 222, 228Earnings expectations, 46Economic conditions, impact of, 49Economic policy, 27280-day moving average, 53–56, 58, 12480-week moving average, 52, 54Electronic exchanges, 16Electronic orders, 16Elliott, R.N., 175–176Elliott Wave Theory, 175Emotional trading, 49Employment report, 235Enron (ENE), 9–11, 26–28, 40, 42, 52–54Entry points:adding positions on profit, 238–239average price method, 235–237averaging into a trade, 238common trading sense, 239magic number for, 236mistakes, recovery from, 241one position at a time, 237pyramiding, 238–239scaling down technique, 237–238secondary signals, 239size of position, 238time of day, 241volatility and, 252Entry rules, 28Equally weighted trends, 58Equity orders