I
n my youth I lived in Ohio on the shores of Lake Erie, one of the Great Lakes. Boating—on the open water or on ice—was king. Everyone and his brother had some sort of sail or power craft. One would imagine sailing on a lake to be a safe sport, but I learned differently.More ships and boats have sunkin Lake Erie than have gone down in the famous, or infamous, Bermuda Triangle. The reason is simple. The lake is very shallow compared with the size of the surface area. When a squall blows up, you can be caught in waves that are 6 feet and higher in a matter of minutes. I was once caught in such a predicament as a teenager. Three classmates and I had taken a 12-foot Chris Craft run- about to Cedar Point to enjoy the beach and the mermaids. We were
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heading home about dusk. As we entered Sandusky Bay, the winds picked up and it began to rain. Minutes later we were engulfed in waves ranging in height from 3 to 6 feet. The 25-horsepower Johnson outboard motor could barely make headway. Our small boat was tossed around like a bobber at the end of a fishing line. Eventually this very shaken quartet reached shore. We could have just as easily become one of the members of the Lost Souls Club of Lake Erie.
Years later, I was again on the water. This time it was on a man-of- war in the North Atlantic. A very similar storm blew up out of nowhere, but no one tooknotice. The difference was that the size and depth of the ocean allowed it to absorb the storm’s energy, and the ship’s tonnage gave it stability in heavy weather.
The moral of this tale is that you must pay as much attention to where you are trading as you do to where you are sailing. If you are trading a blue-chip security, let’s say IBM whose daily volume is in the millions of shares, you are in an ocean. If you decide to trade a stocklike MROI (MRO Software) with daily volumes of less than a half million shares or a thinly traded futures contract, let’s say O (oats), you are in a lake or just a pond. And shallow-water markets can become extremely volatile faster than most new traders can react, making them very dangerous.
The challenge of trading in lakes is volatility and liquidity. One or two large orders can become a white squall that has enough energy to capsize your account. For example, you can watch a sparsely traded se- curity for a weekor two. You notice a pattern that you thinkyou can take advantage of. You jump in and make a few successful trades. This is not unlike how my gang got into trouble on Lake Erie. We had suc- cessfully run over to Cedar Point on many occasions without mishap. We thought nothing of it. Then out of nowhere we were surrounded by white- caps, with our lives on the line.
Thinly traded securities must be entered with care. The odd thing about them is that you can almost always get into these markets, but you cannot always get out. There are always sellers, but there are not always buyers—at least not at the price you want to, or have to, exit to keep from drowning in red ink. Someone is always willing to sell you the entity, but your offer may go begging for hours. Between high volatility and low liquidity, the thinly traded markets should be avoided until you become trained and have developed substantial experience as a trader.
To our parents’ credit, they insisted that all of us take a course in the handling and safety of powerboats (education). Additionally, we were not permitted to take the boat out alone until we had spent many hours in it
under close supervision of an experienced boat handler (mentor). Life- jackets were a must (stop-loss order). The training and precautions saved our lives. When I first began trading futures, I had that same feeling of helplessness when I plunged recklessly into a thinly traded lumber con- tract. Luckily, my mentor was there to bail me out before I took on too much water or ran aground on shallow liquidity.
When you begin trading, particularly if you are on a public trading floor, you will see the floor “leaders” popping in and out of very thinly traded stocks. I strongly caution new traders against this. Many a novice has been blown out of the market attempting to mimic the style of these more experienced traders during the first weeks of trading. Instead, work at your own speed. In the Marines, Sergeant Ross used to say, “Never grab a hold of anything you can’t let go of!” This is particularly true in trading, because there are stocks and futures contracts you can’t always sell easily. Some mentors will want you to begin trading New YorkStock Exchange issues or the major grains on the futures markets. The reason for the NYSE, of course, is the size of the float of these stocks and the specialist system. The grains, particularly corn and soybeans, tend to have sufficient trading volume, and so entering and exiting trades is normally not a problem and the size of the contracts is not prohibitive. Neverthe- less, you will have to deal with volatility with any futures contract and the possibility of limit-up/-down trading sessions. You might consider beginning when the grains are seasonally not so volatile.
GET A SHTICK
Another consideration regarding market perspective is your “shtick.” You know what a shtick is. It’s a comedian’s or actor’s unique style or routine.
For example, George Burns always played the straight man to Gracie Allen. Lucy constantly got herself into trouble. Jackie Gleason was “The Great One.” Rodney Dangerfield never got any respect. Tom Cruise plays the troubled hero. No one gets more out of pomposity than Frasier, and we all wait up late for Dave Letterman’s Top Ten List. How will you approach the market? What will your shtick be?
A few years back, I was representing some commodity trading ad- visers (CTAs). Before I tookanyone on, I spent a considerable amount of time conducting an in-depth evaluation—due diligence—of the per- son’s trading style and organization. I did not want to recommend any CTA to my clients that I did not believe in and whose trading style I did
not totally understand. (In the process, I collected enough information for a book, Winning with Managed Futures: How to Select Top Performing Commodity Trading Advisors.)
One thing became clear to me as I studied these successful CTAs.
They each had a unique approach to the market that they relied on. And they did not vary from it. For example, one CTA I represented had been a computer programmer for NASA before entering the futures market.
He wrote programs that predicted when and which asteroids might hit the earth. His programs had to take hundreds of random variables into con- sideration and predict the most logical outcome. He put this experience into predicting the futures market. Another had been a classical musician and composer before entering the trading arena. His mind grasped the ever-changing, yet repetitious, nature of the futures price activity. When I read Jack Schwager’s three books on market wizards, I noticed that the people he chose to interview for his books also had a unique approach to the markets they traded. Two of Schwager’s books are primarily on commodity traders, and the third is on stockpickers. You would do well to read them as you develop your own style.
The first step in your development, in my opinion, is to become a specialist—an expert in one aspect of trading—or at least plan to learn one aspect at a time. In this chapter, I am going to discuss one specific trading strategy or approach to the markets that utilizes moving averages.
There are many, many more—thousands. I dare say there are as many as there are successful traders. New traders usually borrow a strategy from a veteran trader and in time develop their own as they become more experienced and competent. Or you can begin with an area, a stocksector for example, you currently have expertise in and expand on it
For example, one student I came to know at the Market Wise Trading School had traded a group of 10 to 15 blue-chip stocks. The person had watched and traded the same stocks for years, make that decades. Upon retirement, he wanted to become a more active trader. Thus he attended our trading school. Once he graduated, he began day- and swing-trading the stocks he had been investing in and holding for months and years previously. At the time, it worked very well for him since these stocks were trading nicely in a 5- to 10-point channel. He bought when they bounced off the bottom trendline and sold as they approached the upper one. The beauty of this approach is that it gave him time to become technically competent and experiment with other strategies and software trading platforms until he was ready to sail into uncharted waters. I think
it is critical to begin with a single strategy, perfect it, and then move on to others. Never be in a hurry to get rich trading and always remember . . .
A BUS LEAVES EVERY 15MINUTES
If you miss a trading opportunity at 8:15, another will be coming down the pike by 8:30. If you want to learn to scalp or swing-trade, or milk stocksplits, earnings plays, IPOs, futures unbalances, option spreads, or whatever, write down those strategies in your trading plan. Put them in order of priority. Which is most important to you? Which is easiest to learn? Which is most in tune with the complexion of the current market?
Which will get you making money the fastest? Then go after them one at a time. Focus on developing a whole bag of profitable plays.
Thinkfor a second how the professional golfer differs from the happy hacker at the driving range. The pro takes multiple buckets of practice balls and one club to his practice session. The pro hits bucket after bucket until he becomes expert in a single club. The distance the pro can hit with that club must be uniform to within a meter each time. The pro must be able to curve the ball to the left and right at various degrees. He must be able to hit it well with a low and high arc, off uphill and downhill lies, out of traps and roughs, etc.
The weekend duffer picks up multiple clubs, usually the whole bag, and one bucket of balls for his practice session. He hits a few five irons.
Then he hits a few drives, followed by a slew of short irons. He perfects none of his shots. The amateur never leaves the flat, well-manicured range area. Is it any wonder the pro shoots scratch or better and the amateur has an 18 handicap?
Hackers in the professional trading world are known as losers. Losers of respect. Losers of confidence. Losers of money. The saddest part of this analogy is that there is just a very thin line between the winners and the losers in golf or trading. JackNicklaus, in one of his best years, had an average score for tour events only four strokes better than the average pro making the cut that year. When he lost a tournament, he was often at the backof the pack. When he won, he set records. Remember the little girl with the curl down the middle of her forehead? When she was good, she was very, very good. When she was bad, she was horrid! You will find the same pattern with trading. When a trader makes money, he or she usually makes BIG money. I call it a wide spot in the road to
success. The key to trading is surviving between tournament wins—in other words, not blowing out when your “A” game does not show up.
This is another big reason to develop patience and discipline if they are not part of your nature.
All it takes for the trader to be a big winner is a little more education.
A little more passion. A little more mentoring. A little more discipline.
A little more money management. And a lot more patience and planning.
In other words, a lot. Trading professionally for a living is almost as tough as making and staying on the PGA tour. But a lot of people become scratch golfers, and a lot of traders do pretty well without turning pro.
Let’s get backto what it means to specialize. You can become an expert in a particular stockor stocksector or in a particular commodity or commodity complex, or you can master a trading technique or even a single chart pattern. For example, Linda Bradford Raschke, who was writ- ten up by JackSchwager in Market Wizards and is coauthor of Street Smarts, has said in some of the public appearances she has made that if a trader only can master bull flags, he or she can made a good living trading. Linda has been a successful S&P futures trader for over 20 years.
She knows of what she speaks.
I know another trader that does well just trading a single stock, AMAT (Applied Materials). He usually only trades the first hour or two after the open and knows how that issue responds to the premarket trend of the Nasdaq futures before the open, the trend of the Nasdaq itself once the market opens, and the behavior of the stock after the first 15 minutes of trading. His day and profit objectives are often met by 9:00 or 10:00 a.m. How’s that for a life?
What some specialists lookfor is called a setup. This can be a set of circumstances or a technical signal that indicates with a high degree of reliability what a stockor commodity may do next. The key phrase is
“with a high degree of reliability.” It is at this point that money manage- ment protects the trader’s equity. When I mention money management in this context, I thinkspecifically of protective stops (real or mental), risk versus reward, size of positions, and time in the market. Remember, the only aspects of the markets you have absolute control over are on which side of the market you enter a trade (long or short), what the size of your position is, when you enter the market, and how long you stay in the trade. Everything else is totally out of your control. Therefore, all your focus must be on those elements.
The best way to explain the concepts of control and specialization is to review a few examples. I’ll cover a simple strategy that has worked
for those new to active trading. To even touch on all the possibilities is impossible. As I am sure you recall from Chapter 3, literally hundreds of technical studies can be used to trade successfully. A trader developed each, and it became his or her shtick. At some point the trader or an associate wanted some publicity and published a bookor started giving seminars. In other words, you have access to plenty of possible trading signals generating strategies to adapt as your own. Plus hundreds of web sites offer ideas. My advice is to start simply until you have mastered the software you will be using and you are absolutely sure how orders are routed electronically. I don’t get into order routing in this bookbecause order routing is changing so quickly. By the time you would read about it here, it would be different. Get it off the WWW or at a trading school.
From our previous discussion of technical analysis, you know it deals with history, even if the chart you are looking at is only a moment old.
Additionally, to accept technical analysis you must be prepared to live by two other axioms. First is an old law of physics you learn in high school.
A body remains in motion until another force influences that motion. In other words, a trend—be it up, down, or sideways—continues trending in the direction it is going until something, often news, causes it to change direction. The reason for this is simple. I call it the lemming reflex in humans. When dealing with the unknown, humans tend to herd together.
In the markets, the great unknown is what will the price of a certain security be 5 minutes, 5 hours, 5 days, 5 months, or 5 years from now?
Therefore, if a stockor commodity is trending up, the majority of the crowd of traders interested in it will continue to buy. The greater fool theory prevails as each buyer looks for a greater fool to sell to at a profit.
King Greed rules the pits.
At some point, more news seeps into the market that scares some traders. It is time for fear to move to center stage. This news may not be known to the entire trading community. Or the entity being traded just gets too expensive, or the influential advisers convince the crowd it is too expensive. It could be stocks with no earnings trading at $200 or $300 a share. Did you hold Enron at its highs? A lot of folks did. Or pork bellies when they soared to $1 per pound? Sugar over 45¢ per pound, or when crude oil was over $25 per barrel? Looking back at these prices, we are dumbfounded to thinkwe would not have seen a bubble was about to burst.
Trading is all in the timing. Who wanted to be left out of a very good thing and stop buying Amazon at just $100 per share? Almost no one!
When greed dominates the market, we are all too human. Of course, greed
is usually followed by fear. That trader who uncovers some negative news regarding the stockmaking new highs begins selling. At first, it is called profit taking. Pretty soon we all know the bubble has burst, and it looks like pandemonium in the pits.
It is these abnormal swings that technical analysis is supposed to alert you to and protect you from. And in my opinion, it can—if you stay rational. Nothing can help you if you give in to greed and fear. When a high is peaking, the trading volume can be your guide. It will give you a sign to exit. But it does not mean volume will not pickup again after a top and the entity will go to even higher highs. That happens, but it can just as easily crash. As noted earlier, you can get rich selling too soon. But you can’t by selling too late. Let technical analysis rule your normal instincts of greed and fear. Remember, human beings create the price patterns you see on the charts.
Now I would like to give you a brief description of a professional trader’s shtick. First I must apologize to Brian Shannon, a professional trader and instructor of technical analysis at the Market Wise Trading School for oversimplifying his approach to the market. As with any trad- ing approach, many subtle aspects go by virtually unnoticed. My objective is to offer a simple overview of one of the ways Brian trades to illustrate how it can be done simply and efficiently. Keep in mind, it is only an overview of one of the many strategies Brian has learned and used over years of trading. Brian’s approach to the market changes as the market does. As you become more experienced, you will see many of the strat- egies you initially learned become obsolete. The market is like the ocean, always changing while always being the same. Your “old” setups are replaced by new ones as you and the markets evolve.
TRADING IS A LONG, ARDUOUS JOURNEY
Here is a concrete example of how fast a trading strategy can vanish from the trading floors. When I first became involved in day-trading stocks about 5 years ago, one of the most popular and reliable strategies was called “following the ax”—the ax being the dominant market maker for a specific Nasdaq stock. It might have been Bear Stearns or Merrill Lynch manhandling Cisco, for example. When you saw the ax on the bid, you joined the bid and let the ax run the stockup a quarter point, a half point, or more. Traders would often join the ax by SOESing it for 1000 shares.
SOES is basically Nasdaq’s ECN and stands for Small Order Execution