t just go down to your knees, or your waist, or evenyour neck. No, thanks to your shiny new skates and soaking wetclothing, you sink, way, way over your head, right down to thecold, muddy lake bottom. Something very similar happens atPoint 30. You should sell short at the break in support, which werefer to as the Break Low—Sell Signal 2.Sell Signal 3 is just after Point 33, the Rally After BreakLow. In this case, Point 31 to Point 33 is more of a consolidation32
Roth_0471394211_c02.qxd
11/2/00
8:42 AM
Page 33
the Kinematic Model
than a rally, but the drop in price after Point 33 confirms thedowntrend. Remember, Sell Signal 1 was at the resistancepoint. Sell Signal 2 was at the break in support. Let me repeat:It is far easier to locate these points on a weekly or daily chart,than on a five-minute chart where they are even more valuable. Among other things, it’s a case of not being able to seethe forest for the trees.There is another important phenomenon to keep in mind.Remember the Shakeout-Fake-Out-Before-the-Breakout at theend of the accumulation phase? As indicated in Figure 2.5a,something very similar sometimes occurs at the end of thedistribution phase. Because of its importance, we shall give itanother indelible name—the Shake-Up-Fake-Out-Before-theBreakdown.If you see the break in resistance and wide price spreadindicative of the Shake-Up-Fake-Out-Before-the-Breakdown,immediately, and I do mean immediately, check stock volume.
figure 2.5 price markup and markdown phases
33
Roth_0471394211_c02.qxd
11/2/00
8:42 AM
Page 34
technical trading online
Very low volume would tend to confirm a Shake-Up-Fake-Out.It could have been caused by short covering, hitting buy stoporders, or both. As with the Shakeout-Fake-Out-Before-theBreakout, you may want to follow the stock price, this timewith automatic sell short stop orders.Another thing to keep in mind is that in a markdownphase, you usually have less time to locate the mentionedpoints and their associated sell signals compared to the buysignals on a markup phase. Markdown phases tend to bestrikingly more precipitous than markup phases. One of thereasons for this is that greed helps fuel uptrends and fearhelps fuel downtrends. Greed can be tempered by an extremely common deficiency, that of guts. Fear is reinforcedand accelerated by this very same deficiency. Thus, fear is byfar the stronger emotion. Another reason markdown phasesare more precipitous than markup phases is the confusion inherent in both of these phases. Confusion during a markupphase tends to decelerate it. Conversely, confusion during amarkdown phase tends to accelerate it.The high-rising markup phases and fast-falling markdownphases that connect trading ranges can also be thought of astrends. If you are going to think about them, you might as wellknow how to draw them. Figure 2.5b is an uptrend. Figure 2.5cillustrates how to mark the bottom of the first two troughs( Points 1 and 5), connect these two points, and extrapolatethem forward to draw a support line. Now draw a line parallelto the support line and through the highest point of the rallybetween the two troughs ( Point 3). This is the resistance line.We will frequently refer to it as an overbought line because aprice rise caused by “overbuying” is likely to lead to profit taking. You will see this pattern very often, even on five-minutecharts. In an uptrend like this, you want to buy, not sell short.
34
Roth_0471394211_c02.qxd
11/2/00
8:42 AM
Page 35
the Kinematic Model
And you want to buy immediately after a pullback, that is, immediately after the last point of support.Let’s assume you take a position just after Point 5 in Figure2.5c. Sure enough, share price rises to Point 6. Then, it moves almost laterally but drops slightly to Point 7. Smart trader thatyou are, you originally set a stop below Point 5. If you wouldhave moved it up to just below Point 6 to follow the rising price,the almost lateral movement between Points 6 and 7 might haveactivated and closed you out before that mouth-watering risebetween Points 7 and 10. This would not have happened if youhad moved the stop parallel to and just below the extrapolatedsupport line.Before we say au revoir to Figure 2.5c, notice that ourstock enters a trading range at Point 12. Unfortunately, thisrange is too narrow to offer a worthwhile profit. Unless youhave a very good idea where share price is going when itbreaks out of this trading range, I would advise you not to getentranced by its tiny ups and downs. Check back periodicallyto see if this stock breaks its range, but in the meantime, takeyour profits and find a more interesting, less mesmerizingstock to concentrate on.Figure 2.6a is a downtrend. Not only does it look like theopposite of an uptrend, for our purposes we treat it as such.In Figure 2.6b, we have connected the first two rally peaks tomake a resistance line. We then draw a line parallel to it,through the lowest point in the trough between them. Again,though this is commonly called a support line, we will frequently refer to it as an oversold line. The precipitous pricedrop is attributed to overselling, and will likely generateshort covering and bargain hunting, thus an accompanyingprice recovery. During a downtrend, you want to sell short,and do so on the last point of supply.
35
Roth_0471394211_c02.qxd
11/2/00
8:42 AM
Page 36
technical trading onlinefigure 2.6 downtrends
Let’s take a closer look at an uptrend such as that in Figure 2.5c. Day traders will often see mini-buying climaxes suchas at Point 10 on five-minute charts. Now from Point 1 to Point7, you had a normal, balanced interaction between supply anddemand. The sudden parabolic rise to Point 10 indicates thatthe relationship between supply and demand has swung to anextreme, or in more technical terms, gone kaplooey. So as notto depress you, let’s assume that you had the foresight to buylong around Point 1 at $60. And let’s assume the break in resistance leading to Point 10 was caused by a burst of coveringshorts, a likely assumption.Unless you like losing money, you had your exit strategyplanned even before you entered the market. The simpleststrategy involves a stop order, either actual or mental. Youroriginal stop order should have been set tight, at 59 3⁄4, or at the36
Roth_0471394211_c02.qxd
11/2/00
8:42 AM
Page 37
the Kinematic Model
lowest, 591⁄ 2 . When the stock price rises to $70 at Point 3, shouldyou raise your stop? There are two trains of thought on thissubject. People of minimum intelligence and above would sayyes. Idiots would say no.Allow me to digress a moment on this point. Let’s say youmake $100,000 trading stocks and, like all intelligent investors,decide to take this loot down to your bank and put it into a certificate of deposit. And let’s say you made another $100,000working nights as a ditch digger, putting this money into another certificate of deposit. Now tragedy strikes. For the thirdtime this year, you lose your prepaid bus pass. To complicatematters, you never learned how to ride a bike. Just when youfigure you are ripe for a change of luck, sure enough yourUncle Earl dies. Aunt Myrtle, who can’t drive, wants to sell youEarl’s 1980 Olds Cutlass. It is in mint condition with less than40,000 below the speed limit miles on it. In fact, they stillhaven’t ripped the protective plastic off the rear seat. On topof that, you are sure you can knock something off Aunt Myrtle’s $1,000 asking price.Of course, this is all too good to believe. You know therehas to be a catch somewhere. Sure enough, there is, and in theusual place, your friendly bank. The certificate of deposit containing the money you earned breaking your back diggingditches came due today, but the certificate containing the easyloot you made trading stocks doesn’t come due for anothermonth. To complicate matters, the place you buy your buspasses closes in 10 minutes. What should you do?As far as I’m concerned, you have two options, and notthe ones you think you have. In fact, they are both far moredistasteful. You can either see a psychiatrist or, worse yet,take an economics course. The common object of both ofthese options would be to get it through your thick skull thatthere is no damn difference in value between a dollar earned37
Roth_0471394211_c02.qxd
11/2/00
8:42 AM
Page 38
technical trading online
digging ditches and a dollar earned trading stocks—a dollarearned strip mining and one earned stripping—a dollar lostand a dollar found.Now you are probably wondering what this all has to dowith stock trading, that is, if you still remember that stocktrading was the supposed subject of this book. Well it all goesback to four paragraphs ago when you bought long at $60 witha stop order at 593⁄4. The question then, when the stock pricewent up to $70, was if you should move up your stop order.The answer is, “Damn right, you should!” The logic behind thisanswer is that there is absolutely no difference in value between a $10 profit not yet taken and a $10 bill in your wallet.You protect one to the same degree you protect the other. Ifyou can’t get this principle through your skull, trading stocksis not for you.Your next stop order does not, and likely should not, haveto be set at 1⁄4 below market value. You don’t want to getknocked off the back of a hot stock because some little old ladyin Iowa gets conned into selling her stocks to pay for a new roofshe does not need in the first place. Feel free to set your newstop order around $69. At Point 6, where share price has goneup to $80, and you have made a 331⁄ 3 percent paper profit of $20,you can be even more reckless and reset it at $78. Just remember that a dollar paper profit has the exact same value to you asa dollar in your pocket. And be thankful that Uncle Sam cannotsay the same thing.Before we leave Figure 2.5, a word of caution. When ridinga stock through a euphoric rise like that between Points 7 and10, you shouldn’t be thinking about what you are going to dowith your profits, I don’t care how mint Uncle Earl’s Cutlassmay be. You should be updating your exit strategy, thinkingabout when and where to take those profits. Keep in mind thatthings are happening quicker than they were a few points38
Roth_0471394211_c02.qxd
11/2/00
8:42 AM
Page 39
the Kinematic Model
down that chart. If you aren’t moving up your stop order a lotfaster now, then you’re not moving it fast enough.Remember, Figure 2.5, like our model previously, is merelya tool to teach you about price behavior. Price behavior is basically an interaction between supply and demand. A chart is avisual representation of this interaction. Though supply and demand seem to strive to stay in balance, they don’t always succeed. As a stock trader, it will certainly pay you to know aheadof time when a market will go out of balance. Even more important, it will often cost you when you don’t. Learning how toknow is not an event such as turning on a light. It is a continuous learning process that builds on current knowledge.
39
Roth_0471394211_c02.qxd
11/2/00
8:42 AM
Page 40
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 41
chapter 3
indicatorshow to stalk a trend
41
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 42
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 43
The Kinematic Model discussed in Chapter 2 is a far from perfect indicator of a stock’s future. I would not recommend anyone bet the family farm on it, if the family farm still exists bythe time this book is published. However, this model is notmerely a learning tool, it is an applicable tool designed to beapplied with other tools by people who have acquired theknowledge and refined the discipline necessary to effectivelyuse such tools.The Kinematic Model cannot guarantee the future behavior of a particular stock. No indicator or combination of indicators can. Still, if you discover parallels between this model andthe behavior of a stock, and these parallels encompass buy orsell signals, this should raise your interest in taking a positionin the stock. However, before you do, you must first look at thestock again through the filters of every other relevant indicator. These indicators can reflect the market as a whole or specific segments of it. Some enable you to determine the trendand trade with it. Other indicators are predictors derived fromand to be applied to a particular stock. Over the years I’vecome across enough indicators to threaten my own sanity, notto mention questioning the sanity of their authors and the people who waste their time using them. If you want a theoreticalexplanation on how the phases of the moon affect stock prices,you bought the wrong book. This chapter covers only those indicators I judge most worthwhile, giving a brief description ofthem and their proper use.There are three types of indicators: sentiment, flowof-funds, and market structure indicators. The day trader is
43
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 44
technical trading online
primarily concerned with market structure indicators, but hemust also be cognizant of sentiment and flow-of-fundsindicators.Sentiment indicators deal with psychology. They monitorgroups of people—some usually right about the market andsome usually wrong—and draw conclusions based on the behavior of these groups. The put/call ratio is a sentiment indicator. When there is a high ratio of puts to calls, masssentiment is predicting that the market is heading down. However, mass sentiment is usually wrong. Therefore, a highput/call ratio is actually indicating an imminent rise in themarket. By the way, the put/call ratio should not be applied onan individual basis. Even if you consider yourself snake-bit,mass sentiment incarnate, don’t bother doing exactly the opposite of what you think you should be doing. Been tried.Don’t work. Besides, it will make you dizzy just trying to figureout what is the opposite and who is you. Technical Trading Online is written for technical traders prepared to get slightlymore technical than this.Odd lot short sales—sales of less than one hundredshares—are another sentiment indicator. Such sales are theprovince of the small player—the least professional, the leastinformed, the least successful trader. So here is another casewhere the informed trader bets against the amateur.Conversely, floor specialist short sales are a signal to getonboard. Floor specialists tend to be right. If you can figureout what they are doing, you would be wise to follow suit.Mutual funds are a driving force in the market. However,when they are fully invested, they have to cut down on theirdriving. These rest stops often help cause and/or coincidewith the topping out of the market. This is not the time for thestock trader to jump in long.
44
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 45
indicators
Flow of funds indicators include mutual funds cash, hedgefunds cash, insurance company cash, bank customer’s cash,and brokerage customer’s free balances. Is this cash availableor is it fully invested and margined out? Is there fuel to feedthe fire of a rising market? Also, be aware that a rise in interestrates can divert available funds from stocks to bonds.Market structure indicators involve, among other things,price trends, cycles, volume, and their interrelationships. Thefollowing are the market structure indicators and techniques Ifind most valuable.
S&P cash to futures relationshipTo make this relationship easier to understand, we will focuson gold for a moment. If you could buy gold in the cash marketfor $300 and you could sell it three months from now for $400,would you be willing to do so? I certainly hope so. I myselfwould be more than willing. What if the market price of goldwent up to $310 and the futures price went down to $390,would you still be willing to take this position? I certainlywould. If you have a better way to make money, I should bereading your book. In fact, I wouldn’t be too proud to jump ata substantially smaller profit. Neither would your average goldtrader. Let’s take a look at how they would react.If the price of gold in the cash market is $300 and the futures price is $400, you can buy the gold immediately and contract to sell it in three months for $400. This is a $100 or 33percent profit in just three months. Forgive me for showing offmy math skills, but that results in an annual profit of 132 percent, ignoring lost interest and other costs. Traders will certainly increase buying pressure in the cash market. Thisincrease in demand will raise the current price. Remember,
45
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 46
technical trading online
buying stems not from any intention to hoard the gold, butrather to contract to sell it in the future. Therefore, an increase in current demand entails an increase in future supply.This increase in supply will decrease the price of gold futures.In case your mouth is watering at the thought of the next $100gap between gold cash to futures, I should warn you not towait around for it. This example has been a more than slightexaggeration. The same market pressures that would narrowsuch an end-of-the-rainbow gap would also prevent one in thefirst place.Now let’s get back to the stock market. The Standard &Poor’s 500 Index represents 500 specific stocks taken as awhole. You can buy and sell futures contracts based on it. Hypothetically, let us say that the S&P 500 is at 1000. You maythink of this 1000 as meaning the basket of stocks this index isbased on is selling for $1000. Again hypothetically, let us say thefutures contract on this basket is selling at $1100. Obviously,there is optimism about the future prospects of the stock market, and it has driven up the futures price. The result is alocked-in profit—an arbitrage—if someone buys the stocks encompassed by the S&P 500 and also sells a futures contract onthem. These conditions will entice traders, some of them verybig players, into doing just that.The buying pressure means increased demand that willincrease the cash price of these stocks. The increased supplyand selling pressure means a decrease in the futures price. Asin the previous gold example, the gap between the two priceswill narrow. Therefore, in general, when cash price is lowerthan futures price by a significant margin over the interestthat could have been earned and other costs, conditions arefavorable for buying stock. In part as a self-fulfilling prophecy,buying pressure by itself will help raise the stock price, whichwas the expectation that made conditions for buying favorable46
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 47
indicators
in the first place. The relationship between the cash marketand the futures market is extremely important in determiningthe trend of the market.Of course determining the trend means determiningwhether people are going to buy stock and sell futures causing an uptrend, or do the opposite causing a downtrend. Sohow do we calculate exactly which is a better buy—stock orfutures? We don’t. This is already calculated for us and is areadily available statistic called Fair Value.Fair Value takes into account the fact that $100 in yourpossession today is worth more than a guaranteed $100 threemonths from now. To understand this, you have to ignore,however comforting it may be, the fact that in three monthsyou will have a guaranteed credit of $100. Admittedly, notevery stock trader can feel so secure. On the other hand, youmay starve to death in the meantime. Also, if you had the $100today, you could probably live off all the interest and a fewfriends, and still have the $100 principal in three months.Whether you would still have the friends is another question.Of course, if you would get serious about finishing this book,you could trade stocks with the $100 and turn it into a fortune.I assure you, nothing facilitates new friendships better than alarge fortune.It is also important that you understand how the termsbullish and bearish are applied to the cash-to-futures relationship. Let us assume the S&P Cash Market (SPX) closes strong at1280, and the S&P Futures Market (SP/mg) closes at 1289. Thenext morning you come in and CNBC is saying that S&P Futuresare up 1.0 and really bullish. You sit there wondering how up 1.0can be really bullish. Well CNBC is taking into account that theSP/mg was already 9.0 over cash, now it is 10.0 over.The Fair Value we are interested in refers to a standardthree-month contract, one of four that run consecutively47
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 48
technical trading online
throughout the year. Specifically, it refers to the current one,that which is closest to coming due. It is important to keep thisin mind because as the term of the contract expires, the timeof payment draws closer, and therefore the Fair Value of thecontract should move toward the sum of the actual payment tobe made.Remember, Fair Value is not a figure you have to compute.One of the easier ways to find it is by tuning in to CNBC. Theirtalking heads cannot go more than a few minutes without mentioning it. Market pressures tend to push market values in thedirection of Fair Value. Any substantial difference between thetwo that is caused by market inefficiencies will bring on astampede of arbitragers to scarf up the locked-in profits thusmade available. However, the effect of all the individual arbitragers is dwarfed by that of automatic computer programs.When these pachyderms stampede, all you itty bitty traderswant to be running in the right direction—and running fast.For example, let us assume CNBC says, “Fair Value is 4.76over.” This means that the price of the current S&P Futurescontract should be 4.76 more than the current S&P 500 Index(4.76 over cash). If it is close, relationships are rational andshould be fairly stable. Now CNBC also provides us with twofigures that make the Fair Value figure even more valuable toyou. In this case, CNBC tells us that the computer buy programs will kick in at 7.24 over cash and the sell programs at2.48 over cash. Both of these figures are positive, and theybracket the Fair Value of 4.76. If you see cash approachingeither of these brackets, you better find yourself an elephantto ride or get the hell out of the jungle. Take advantage of myvast experience in the bush when I say that it is considerablyeasier to jump up on an elephant before it starts to stampede.If you insist on waiting, you better at least be running in thesame direction.48
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 49
indicators
advances versus declinesThe relationship between all 3000 advancing and declining issues on the New York Stock Exchange is a statistic readilyavailable throughout the day. If there is a better indicator ofthe trend of the market as a whole, I haven’t found it. The chartbelow represents this relationship, though the swings described have been exaggerated for purposes of illustration:
10:00 A.M.12:00 P.M.2:00 P.M.3:55 P.M.
Advancing Issues
Declining
Unchanged
50090020001250
200015005001250
500600500500
What is the trend at 10:00 A.M.? Obviously, it is down, andyou can bet that at least a few of those declining issues wouldand should be advancing except for the mood of the market as awhole. So what about Organic Junk Foods, Inc., that stock youhave been watching for weeks? You almost bought it yesterday.This morning you heard some additional favorable informationabout it. An upturn is looking even more likely. Something tellsyou the hell with the trend, “Buy now!” Well that something sureisn’t our Rule 3. So what should you do? Plain and simple, youshould wait for a reversal of trend in the market as a whole. Ifyou are a day trader, you should also start looking for a stock tosell short. The best place to look is in a group of stocks (banks,oil and gas, and so on) that is even weaker than the market as awhole. The best stock to sell short in that group should be oneof the weakest. Weak stocks are more likely to move with thedowntrend, getting even weaker.What is the trend at 2:00 P.M.? Before we get into that,let’s hope that by now our day trader has covered that stock49
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 50
technical trading online
he or she sold short at 10:00 A.M. And if Organic Junk Food,Inc. was still looking strong a few hours ago, let’s hope he orshe went ahead and bought it. Back to 2:00 P.M.. What’s thetrend? I’ll give you a hint. The 12:00 P.M. figures were a goodindication that the 10:00 A.M. downtrend was reversing. Thetrend at 2:00 P.M. is up. You day traders should get busy andfind a stock to go long. Again, the best place to look is in astock group even stronger than the market as a whole.Strong stocks are more likely to move with the uptrend, getting even stronger. And the best stock should be one of thestrongest in the group.Now let’s check out 3:55 P.M.. Again the question is, “Whatis the trend?” The answer is, “What trend?” If you really insiston buying something now, I would suggest a cold beer on yourway home. By the way, if you think the preceding chart meansthat you should go in every day and sell short at 10:00 A.M. andbuy long at 2:00 P.M., then perhaps in your case this book is notthe ideal tool with which to make your fortune. You might trya shovel or a broom instead.
the trader’s indexThe Trader’s Index, also called the Arms Index, is named afterits inventor, Richard Arms:Advancing issues / Declining issues=NAdvancing volume / Declining volumeIf N is >1, for example 1.90, the market is bearish. If N is < 1, forexample 0.48, the market is bullish. The value of N is of interest, but of greater interest are the changes in N.Let’s say N was 0.50, and you went long. N moves to 0.55and then to 0.60. N is becoming less bullish, moving closer to
50
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 51
indicators
1.0. If and when it crosses 1.0, the market trend will have reversed, switching from bullish to bearish. The Trader’s Indexis telling you to sell or be ready to sell.Or let’s say N was 1.50 and you sold short. N rises to 1.60,then 1.90. The Trader’s Index is moving away from 1.0, indicating a strengthening downtrend, getting more bearish. It istelling you to hold your short position.Remember, any time the Trader’s Index moves significantlytoward 1.0, the market trend is reversing. If your position isbased on the existing trend, especially you day traders, you better think hard and fast about abandoning it.
comparative relative strengthComparative relative strength refers to a stock’s performancerelative to a market indicator. The question it should answer iswhether a stock is weaker or stronger than the market as awhole. There are numerous indexes you can use to measurethe market’s strength such as the S&P 500 Index, S&P FuturesIndex, the Dow Jones Index, and so on. If, for instance, the S&P500 Index is rising as in Figure 3.1a, and a stock price is moving
figure 3.1 relative strength
51
Roth_0471394211_c03.qxd
11/2/00
8:42 AM
Page 52
technical trading online
sideways as in Figure 3.1b, what signal should you watch for?First of all, we can see that the stock is weak relative to themarket. At the first sign of a downturn in the S&P 500 Index,you should seriously consider selling the stock short unlessthere is a compelling reason why the mood of the overall market will not effect this stock’s price negatively. Likewise, ifthe S&P 500 is declining as in Figure 3.1c, and the stock’sprice, as in Figure 3.1d, is rising steadily despite this, youshould seriously consider buying long at the first signs of anupturn. Comparative relative strength is one of the most reliable stock market tools. It is of great value to all traders,from day to swing to position.
oscillatorsTo make money trading stocks, and I’m of course talking aboutuntold millions, all you really have to know are two things:when to buy and when to sell. I apologize for not letting the catout of the bag sooner, but at least I didn’t wait until the lastsentence of the last chapter to give this secret away. Anotherthing I can now give away is the unfortunate fact that this bookcan’t tell you when to buy or when to sell. It can only teach youhow to figure this out for yourself.Amazingly, an oscillator, a mere two-dimensional chart,can predict trend reversals, thereby telling you when to buyand sell. Not so amaz