Market Skill-Builder Financial Markets & Financial Software The Skill-Builder for Financial Trading - Financial Training Software.

The Learning Zone. Financial Markets - the forces behind the Moves. This discussion was described in the "Investor's Chronicle" as "The most lucid explanation of how the financial markets work that I have seen: a worthwhile read for investors at all levels of expertise". Technical Analysis and Trading- The Essentials. Technical Analysis is, in essence, the observation of the market itself with a view to deducing its probable next move from its past and current behaviour - as opposed to Fundamental Analysis, which is the study of the external factors likely to push the market higher or lower. Disciplined, straighforward analysis & trading techniques work the best, as explained in these pages.

Trading and Investing, Strategic Considerations. Trading and Investing based on Technical Analysis - Introduction. The Market Variables: Direction, Momentum, Volatility, Liquidity Market Trends, Highs and Lows Impulsive vs Drifting Price-Action Volatility Expansion Tests of Major Support / Resistance (1) Tests of Major Support / Resistance (2) Summary Is That All !?

Market Skill-Builder Financial Markets & Financial Software The Skill-Builder for Financial Trading - Financial Training Software.

Financial Markets : The Forces Behind The Moves. This general discussion of how the dynamics of the financial markets - how they really work - is an expansion of an article originally published in the Belgian business magazine "Trends et Tendances" of April 14, 1994. The Markets: Unpredictable but beatable... Centuries ago it was thought that inspection of the entrails of dead animals provided the data necessary for the prediction of future events. Astrological techniques were an improvement - at least in terms of hygiene. The British, a nation with many curious habits, took to interpreting the patterns of dead leaves left in the bottom of their tea-cups. This was, of course, before the invention of the tea-bag. More recently, with the aid of telecommunications and computers, more sophisticated methods of arriving at future projections have been applied, particularly to the financial markets:

Economists build complex econometric models and study the correlations between money supply, inflation, interest-rates, industrial capacity utilisation, wage settlements, taxation policy and many other variables. Forecasts are made based on the results of these studies.

Financial Analysts study balance-sheets, income statements, product markets, quality of management, manufacturing costs and many other variables in order to determine whether the shares of a particular company or sector "ought" to go up or down.

Technical Analysts study charts and complex indicators based on historical price movements, apply a variety of theories, and attempt to develop fool-proof forecasting techniques and trading systems.

So, based on the results of the application of all of this awesome intellectual and electronic power, where will the yen, or the London stock market, or shares in Siemens, or US treasury bonds be next week - or next month - or next year ?

Nobody knows . . . .
Not only does nobody know by how much any of these instruments will go up or down: it is impossible to predict the direction of the next move in any market in any time-frame. The only exceptions to this rule are: 1. Insider trading ahead of the publication of important news, this is illegal in most jurisdictions (which does not seem to act as much of a deterrent). In order to get away with it you need (a) to have access to inside information in the first place, (b) to distance yourself from the execution of the transactions (not that easy), and - possibly - (c) have a very good and expensive lawyer and/or be highly placed politically. I advise against insider-trading. 2. Speculation against irrational market manipulators, usually governments or cartels. The spectacle of governments vainly attempting to maintain indefensible exchange-rates is always pathetic, and would be laughable were it not so expensive. The fact that, after they have failed, subsequent events usually demonstrate that they were wrong even to have made the attempt adds irony to these sad events (witness the improved performance of the British economy following the most recent EMS debacle, and the relative absence of the expected surge in inflation). The academic consensus used to be that it was impossible to "beat" freely fluctuating markets on a regular basis because they were inherently unpredictable. Two theories were advanced in support of this proposition: The "efficient market theory" postulated that everything now known which is relevant to a particular market has already been taken into account by market participants in determining the current price. It followed that only unknown future events could influence the price up or down. This argument:

failed to explain the wide fluctuations which occur in the absence of any significant news, and did not take into account the fact that different people and organisations react at different speeds and in different ways to the same information - even if they learn of it simultaneously.

pre-supposes that there is a "correct" price for anything whereas, at any given time, there is only a price at which two or more people are prepared to make an exchange. One or both of them may be making a serious error.

Mr. Soros' Quantum fund is reputed to have made a billion dollar profit speculating against Sterling during the most recent EMS crisis. The Malaysian national bank, whose then governor is now otherwise occupied, lost more than that betting the other way (ironically, Mr. Soros himself admitted to losing $600 Mn. in speculation, notably in the Yen, early in 1994). The "random walk theory" is a development of the same line of thought, postulating that "Price action is random, and therefore unpredictable, since the markets are continually reacting to a random stream of positive and negative news of randomly varying intensity". Prices do not, however, behave randomly (or at least not entirely randomly). The really significant difference between random and real price-series is that in real markets the variations in volatility are much wider: markets go through long periods of relative calm punctuated by dramatic moves with much wider period-to-period variations. The bar-chart shown below (with "RSI" underneath it) was generated using Excel's random-number generator. The program used to generate is available for free down-load here. Every time the worksheet is recalculated a new chart will be generated.

The above randomly-generated "time-series" shows surprisingly persistent "trends", interrupted by "corrections", as will the others you generate if you run the program. The methods used to generate the charts are detailed on the spread-sheet.

The following two charts compare the "Frequency Distributions" of a randomly generated series with 5-minute moves in the Standard & Poors stock-index futures over three months, excluding the first and last half-hours of each day to ensure that the results are not skewed by the influence of the overnight gap:

The chart on the left shows a typical bell-shaped random distribution. On the right the "real-market" distribution is taller and thinner, with broad, relatively flat extremities. It confirms what experienced market observers already know:

Most of the time the market is constrained in tight ranges, moving less than observers and participants are expecting.

Every now and then a major (and unexpected) move occurs, of a size to knock the unwary flat.

Note that while the "body" of the S&P chart is shifted to the right (more positive than negative moves in an up-trend) the largest move is on the left (a vicious correction). In the simplest possible terms, the reason that neither of the above theories holds true is that while, over the long term, market prices will always adjust to changes in the underlying fundamentals, it is also true that the underlying fundamentals are continually influenced by changes in market prices. A simple example: if share prices are under-valued in relation to net company assets (as they are in the depths of a bear-market), alert financiers can make large profits by buying companies and selling-off their assets. This has a number of effects including the triggering of a general rise in equity prices, which has the effect of increasing

everyone's wealth, and in particular the collateral value of shares against which money can be raised to carry out additional leveraged deals, which then accelerate the process. At the same time "real-world" activity is stimulated. Increasing asset-valuations encourage investment. The economy and consumption expand. These processes become self-feeding and continue until levels of excess are reached, deals start to fail, and the process reverses. These observations are not original, of course. This was the story of the 1980's and the processes are well understood. The key points are:

The process is "self-feeding" - until it auto-destructs through excess. "Self-feeding" market moves are the result of the "mode-locked" inter-action of real-world events and market-price evolution (not of technical traders following trends, or of market conspirators acting in concert to de-stabilise virtuous policies, as ignorant by-standers and politicians frequently suppose. Mr. Harold Wilson, a British prime minister in the 1960s famously blamed one of the Pound Sterlings numerous devaluations on the "Gnomes of Zurich").

Once one of these processes is under-way, it is easy to see (and predict) that a reversal will eventually occur. It is impossible, however to predict when and from what level. This point is worthy of emphasis : it is absolutely and utterly impossible to predict major (or minor) turning points in any freely-traded market. Ever. This does not, of course, stop people from trying. Market and economic cycles are accompanied by GuruCycles. The process here is that someone makes a few good market turning-point calls, gathers a following, becomes a celebrity, makes a spectacularly inaccurate prediction at the height of his or her fame, and retires to obscurity.

Since even powerful trends are interrupted by corrections (counter-trend moves), it is not necessarily evident at any given time whether a reversal has occurred. Distinguishing between corrections and major reversals as they are occurring is the main problem faced by all market analysts. In simplistic terms: if a market is running up strongly, potential supply is withdrawn (sellers abstain). At some point profit-taking starts, sellers appear, holders perceive their profits to be eroding and accentuate the counter-trend move. Market commentators are split as to whether a correction or reversal is occurring, and erratic trading ensues as bargain-hunters buy dips and profit-takers sell rallies. All of this can occur without any significant change to the fundamental dynamics governing the longer-term move. The main trend then resumes once all the "weak holders" have been shaken-out.

Whether or not these processes are "Chaotic" in the mathematical sense is open to debate. Chaos theory postulates that dynamical systems, where the future values of the variables involved (such as market prices, the weather, population sizes or gross national product) depend both on each other and on their own previous values, evolve in series of persistent cyclical trends. The cycles are never however identical, and are extremely sensitive to tiny changes in the initial conditions. In other words, even if the markets are governed by deterministic forces (which would imply that they can be predicted by accurate modeling of the current situation and the forces which apply to each variable including the price), it would paradoxically still be impossible to predict them because tiny and unavoidable errors in the definition of the initial conditions would cause major errors to appear in the results after a very few iterations. Of course if they are not deterministic, then any attempt to build forecasting models is futile. Either way, forecasters and econometric modelers are doomed to failure. Dynamical systems can remain in a trend much longer than expected (as when stocks remain in a bull market long after most commentators consider them to be over-valued). At other times they break down unexpectedly, the 1994 collapse in bond prices world-wide being a case in point. When this happens scapegoats are quickly identified. In 1987 it was "program trading", in 1994 it was "hedge funds".

Notwithstanding all of the above, there are numerous different strategies, both "fundamental" and "technical" which can be successfully deployed to obtain above-average returns from the markets. All of them involve the disciplined assumption of risk, and the willingness to get out as soon as it becomes apparent either that the initial analysis was wrong or that conditions have changed. My own preferred approach is technical because everything which is relevant to a particular market is reflected in the evolution of its price. Alert interpretation of the manner in which a price is acting, as revealed by price-charts, gives clues as to its future movement which are at least as likely to be correct as the attempted analysis of all of the many outside factors which are thought likely to influence it: and it is much easier to do. Equally importantly, the market tells me directly (and brutally) when I am wrong, and I can act accordingly. Next, Technical Analysis and Trading - the Essentials. Market Skill-Builder Financial Markets & Financial Software The Skill-Builder for Financial Trading - Financial Training Software.

Trading / Investing : Strategic Considerations The type of trading advocated here is designed to permit rapid capital expansion while guarding against the risk of ruin. To be successful in the markets over the long-term a trader must have a winning strategy, and apply it consistently. A winning strategy :

Must be clearly defined : The simpler the better. Remember, you can't forecast the market's next move, and neither can anyone else. Simple trading rules make for clear-cut and effective decisions (while most other participants are still trying to compute and weigh the implications of dozens of factors and indicators - and generally wallowing in a state of catatonic confusion, particularly if the market is not going their way - you will have acted, and will be calmly observing and waiting for a new signal).

Must include :

definition of the conditions which will trigger the opening and closing of positions (both to take profits and to cut losses).

rules governing the size of position to be taken.

That much seems obvious (at least to me), but a very large proportion of traders and investors fail to make these definitions. They buy things they think (or are advised) are likely to go up; watch them start to go down; then think "Oh #@#?! (supply your own preferred expression of disgust) - what shall I do now ?". This is not the way to succeed. I recall a converstaion with a very well known and respected market commentator: he was very taken aback by my observation that trading should be extremely boring. "How can that be!? - all of life's rich tapestry is reflected in market action etc. etc.". Very true, but if you want to make money in the markets all you do is look for a few simple repetitive patterns and act on them when they appear. Very tedious, but then excited traders do not win over the long term (any more than excited poker players do). Trading Vs "Portfolio Management"

The classic response to dealing with market uncertainty is, of course, to diversify. An un-leveraged diversified portfolio will never disappear altogether (unless either the financial intermediary with whom it is placed disappears or the entire financial system collapses). It is, however very unlikely to expand faster than (or even as fast as) the underlying market averages. If the objective is capital expansion (as well as conservation), it seems to me that rather than diversifying, it is more rational to place the bulk of capital in ultra-safe relatively short-term government paper, thus guaranteeing capital conservation, and using the balance to finance a small number of "at risk" positions with a view to capital expansion. A portfolio containing 90% zero-risk and 10% high-risk components is safer than one containing 100% diversified medium-risk investments if only because all one's attention can then be concentrated on managing the 10% high-risk element. "Exposure Management" A brief word about corporate market exposures: Most corporations with currency and commodity market exposures have policies regarding the resulting market activity which are designed to limit the attendant risk of loss. Many do not (or do but fail to police them adequately) - which is why spectacular, sometimes crippling, losses are announced and widely reported by one company or another at approximately 6-monthly intervals. In general terms, selective hedging is usually thought to be "OK", trading for profit is frequently forbidden. A more rational approach is to:

a) Hedge all exposures 100% : This is not as simple as it sounds since while the balance-sheet exposures relating to completed but unsettled transactions are easily identified, quantification of the exposures relating to forward business can depend on numerous factors including terms of contracts, pricing flexibility, matching of purchases and inventory to sales commitments etc. etc. Although it can be complex, the problem is essentially accounting / budgeting / administrative in nature.

b) Undertake (or not) "Trading for profit" as a completely separate profit-centre activity operating under clearly defined constraints. Provided that all trading counter-parties are instructed to send transaction confirmations to a separate department this activity can be controlled and monitored without the risk of catastrophic loss.

The advantages of separating these activities are obvious. "Selective hedging" is ridiculous (a) because it is trading with one hand tied behind the trader's back (selective hedgers play only one side of the market) and (b) because it tends to generate internal conflict and unclear reporting (a hedge which cost money was someone else's stupid mistake, one which made money a master-stroke for which everyone seeks to take the credit). Trading / Investing based on Technical Analysis: Introduction "I don't know where to start". said Alice "Start at the beginning. Go on to the end, then stop," said the Red Queen. So let's start by stating the obvious: The objective of the technical trader is "To accumulate capital by maximising profits gained from favourable market moves while minimising losses suffered on unfavourable moves and transaction costs". In other words, profits must more than equal the sum of losses plus costs.

The above may seem blindingly obvious, but it is at this simplest-possible level that most participants in the game fail, because they expend too great a proportion of their efforts on attempting to perfect forecasting techniques with a view to maximising the probability of profit, and pay insufficient attention to the strategies required to minimise losses. The first point to note is that the analytical technique(s) used by the trader must "Give him an edge" on the market, in other words produce better than random results: "Monte-Carlo" systems, where stakes are doubled on even bets until a win is gained require enormous initial capital to avoid the risk of ruin. Suppose you bet $1000 on the toss of a coin, doubling the bet each time you lose, and reverting to $1000 when a win in gained. How much will you have won after 2500 throws, and what will your maximum bet have been ? This can be easily simulated using any spreadsheet program with a random function. I ran this simulation 25 times while writing this. Profits varied between $1,164,000 and 1,293,000, On two occasions consecutive runs of 15 occurred. Bets of $16,384,000 would then have been required to keep the sequence going (with no guarantee of success on the next try). No amount of mathematical tinkering can change the basic brutality of these numbers: You gotta have an edge. A note on transaction costs: The shorter the time-frame traded, the more important aggressive control of transaction costs becomes. An intra-day trader may be capturing 50-point moves, while a position-trader who holds positions for days / weeks might be looking for 500 points. a few extra points of slippage (bid/offer spread) or dollars of commission may not matter too much to the latter, but intra-day trading performance can be seriously hurt by inefficient order execution and excessive commissions. Additionally, the intra-day trader must have on-line nondelayed quotes and charts (which cost money) whereas the position-trader can update charts manually. Basically, all technical traders should use discount brokers, negotiate commissions aggressively (on the basis of trading volume), and challenge execution prices which are out-of-line. In developing a "reliable edge", two ratios need to be optimised:

Frequency of profits / frequency of losses. Average profit / average loss.

These two ratios tend to be negatively correlated: for example, the trader who consistently aims to take 100-point profits while cutting losses as soon as they reach 10 points will obviously tend to be "stopped-out" frequently (causing a low profit to loss frequency ratio) but his average profit to average loss ratio will be high. Conversely, the trader who maximises P/L frequency by placing 200 point stops and 100 point targets will suffer fewer losses each of which will hurt more. Either or both of them may make or lose money over time depending on the quality of their underlying analysis and the consistency and discipline with which they apply their respective strategies. As a general "Rule of Thumb" : The trader should aim for three profits for every two losses, and a 3 to 1 average profit to average loss ratio. These targets leave room for considerable under-performance before the trading becomes unprofitable overall. (anyone who can achieve both objectives consistently will become very rich indeed). Note that a free program down-load to model trading results resulting from random sequences of profits / losses with defined probabilities will be posted to this site in June 1998. Before considering how to determine the size of positions to be taken, let's take a look at the basics of the technical analysis of market action necessary to determine whether to buy, sell or stand aside; and when to take action. Market Skill-Builder Financial Markets & Financial Software The Skill-Builder for Financial Trading - Financial Training Software.

Market Variables : Direction, Momentum, Volatility, Liquidity Direction During any given time-frame a market can do one of three things : go up, go down, move sideways. Persistent moves in the same direction are generally referred-to as "Trends". Momentum Up and down-moves can be fast ("impulsive") or slow ("corrective" or "drifting") in nature (or in between). Note: The most important aspect of "Momentum" is not any absolute measurement of its value, but whether it is constant or changing. the key questions (to be answered from direct observation of the price-charts) are:

Is the current price-move speeding up (in which case you want to stay with / get into it) or slowing down (in which case, consider taking a position against it)

Is the current price-move faster or slower than the immediately preceding move in the opposite direction (expect the on-going trend to be in the direction of the faster of the two).

Volatility Can be low, with almost no price-swings away from and back to the underlying trend; high, with wide and erratic price-swings in both directions, or anywhere in between. Changes in volatility often signal changes in trend, often either in the form of either:

Liquidity

A sharp move against the direction of the current trend, or a reduction in activity and size of short-term price-swings.

Can be high, with thousands of transactions being carried out on a continuous basis; or low, with only intermittent price-quote updates and transactions. In general terms technical-trading is best suited to highly liquid markets because effective transaction-costs (bid-offer spreads and commissions) are lower, and large orders can be placed without adversely affecting the market. All of these variables are directly dependant on the actions taken (or not taken) by the participants in the market : Technical Analysis is simply the observation of those actions, as shown on price-charts. As stated above, technical trading is predicated on the proposition that the action of the market, which is the reflection of the sum of the actions of all participants, provides clues as to the most likely future evolution of prices. The clues are, however, frequently misleading (or mis-interpreted). This leads to the necessity for any successful trading strategy to provide in advance for the "avoiding action" to be taken to minimise the damage caused by bad positions. Technical traders/investors take important decisions (risk their own and other people's capital) on the basis of very flimsy evidence: the direction prices are moving and the type of price-action. Successful trading is based on the following basic observations:

The current trend (up, down or flat) is more likely to persist than reverse.

The trend will be interrupted by corrections (counter-trend price-moves). An accelerating price-move is likely to continue, a decelerating move is likely to reverse. The direction of the next significant price-swing will probably be in the same direction as the stronger of the last two.

But:

Minor supports / resistances to the current trend are more likely to break than hold.

Major supports / resistances are more likely to turn the market back than break. Trend reversals are usually signalled by a clearly observable change in volatility (either a sharp break against the trend or its continuation at reduced momentum).

Notes:

Long-Term charts are reviewed only in order to observe major support and resistance levels. Medium-term charts are reviewed in order to determine both the trend and intermediate support / resistancelevels.

Short-term charts are reviewed in order to evaluate current (and observe changes in) volatility and momentum.

Before amplifying the above statements and defining the terms used in detail, the following key points must be emphasised:

An "Investor" attempts to profit from major market swings which last many weeks / months (or even years). In monitoring his investments, and the general population of other investments into which he might switch, he should review monthly ("long-term"), weekly ("medium-term") and daily ("short-term") charts.

A "Position-Trader" attempts to profit from major market swings which last several days or weeks. In monitoring their trades, they also generally review monthly ("long-term"), weeky ("medium-term") and daily ("short-term") charts every day and with greater emphasis on the daily charts.

An "Intra-day Trader" attempts to profit from major market swings which last from minutes to hours, and always closes his positions overnight (or hands them on to a colleague in the next time-zone). In monitoring his trades, he should review hourly ("long-term"), 5-minute ("medium-term") and 1-minute ("short-term") charts.

That said, since price-charts are fractal in nature (ie self-similar irrespective of the time-frame being observed), there is absolutely no difference in the methods of analysis and decision-making to be applied. It is absolutely critical to success that which of these activities is being pursued is clearly understood and the appropriate actions consistently taken. Disaster frequently overtakes those who fail to take this simple but critical decision. The cynical definition of a "Long-Term Investment" is "A trade gone sour" ! (as when a trader buys a stock at 100, watches it go to 80, and then says "That's OK, it's a .........") Next, Trends, Highs & Lows.

Trends, Highs & Lows Now let's try to clarify the above statements by defining the terms:

The Trend is:

Notes:

Up if successive Lows are higher than their predecessors. Down if successive Highs are lower than their predecessors. Flat if successive highs / lows are approximately level.

The trend shown on this bar chart is down (the strength of the current bounce indicates that it might be turning up, but in the absence of a higher low, and as no major resistances have been broken, the trend is down). Highs and lows are defined below. The trend is judged by reviewing the medium-term chart (the objective being to "catch" medium-term price-swings).

Highs / Lows:

A "High" occurs when the top of a price-bar is higher than the tops of the two preceding and two following price-bars (or three or more equal price-bar tops are higher than the two on either side)

A "low" occurs when the bottom of a price-bar is lower than the bottoms of the two preceding and two following price-bars (or three or more equal price-bar bottoms are lower than the two on either side)

Isolated highs and lows are referred to as "Minor resistance" (above the market) and " Minor support" (below the market). As noted above, minor resistance to an up-trend and minor support below the price in a down-trend are expected to break In the above example it can be seen that the trend is up (because successive lows are higher) and the second correction held at the support provided by the first high. So far so easy: the market moves in trends interspersed with counter-trend moves called corrections (which are often referred to as "Rallies" where the trend is down and the counter-trend move up). Minor support and resistance-levels are formed at the extremities of the sub-moves within the trend. Minor supports and resistances are expected to hold and break respectively in an up-trend, and vice-versa in a down-trend.

Now we arrive at the critical question: how do we identify the conditions which indicate that the trend is likely to change (or is in the process of changing) ? In other words, how do we distinguish trend reversals from corrections ? Market Skill-Builder Financial Markets & Financial Software The Skill-Builder for Financial Trading - Financial Training Software.

Distinguishing Reversals from Corrections (1) Impulse Vs. Drift The answer is that we watch for and act upon two separate types of event: : 1) We watch the action of the market (concentrating on the short-term price-chart) for signs of significant changes in momentum and volatility. 1a) as evidenced by the alternation between "Impulsive" and "drifting" price-action:

Trading rule: always trade in line with the impulsive move and against the direction of the drift.. In the example on the left, the second up-move is what is expected when the first is interrupted by the brief period of down-drift. This is because down-drift indicates that, on balance, the pressure is on the sell-side (probably due to profit-taking by short-term traders who were in the move early and now consider the market to be "overbought"). There is, however no real pressure or conviction in the selling (or the price would be falling faster). This process "frees-up" future buying-power as it means that there is a declining total of long positions in the market, some of which will be re-established by trend-following operators when and if the market accelerates up. Note that this type of pattern often occurs half-way through the larger move.

In the example on the right, the trend has remained the same, but momentum and volatility have declined significantly. This is a warning that the trend is likely to change at any time. This is because while, on balance, the market is still buying and few profit-takers are supplying the demand, "buying energy" is clearly less strong than it was. This indicates that most participants who want to be long already are, and very few of them have already taken their profits. There is therefore a lot of potential supply and few potential new buyers available to support the price when the balance turns. The down-move, when it develops, is likely to be sharp as everyone heads simultaneously for the exit. This is therefore an excellent opportunity to reverse from long to short close to the "top of the drift" (which is likely to be the extremity of the move, thus maximising profit on the both long position being closed and the new short position as well as minimising the size of the loss to be taken if the up-trend re-asserts itself rather than reversing as expected). Note that "Drifting" action can take more complex forms, as on the left where two brief periods of down-drift are separated by a sharp up-period. The principle remains the same and this pattern is bullish. (In market parlance "Bullish" = likely to go up, "Bearish" = likely to go down) Positions taken "against the drift" (in either direction) should be protected by stops at a level above or below

the market which would represent a re-acceleration of the market in the same direction as the drift, two examples:

Market Skill-Builder Financial Markets & Financial Software The Skill-Builder for Financial Trading - Financial Training Software.

Distinguishing Reversals from Corrections (2) Volatility Expansion 1b - 1) as evidenced by a sudden volatility expansion, against the trend: A sharp break against the trend with greatly expanded single-period range. This type of action may (but will not neccessarily) follow-through with a succession of similar periods. Often caused by unexpected news which is perceived as being significant by the market. This type of action is "tough-to-trade" because it can be followed by further volatile periods in either direction. Trading Rules:

market".

If carrying a large long position : cut back to more reasonable levels immediately "at

Place a limit order to exit the balance of any long position and establish a relatively small short position 2/3 of the way back to the top. Place a "stop" order to exit the balance of any long position (without entering a new short position) if the immediate down-move extends by a further 1/3.

Note: The odds that the limit price will be reached before the stop is hit are probably worse than even, but the potential recovered-profit to potential additional-loss ratio is two-to-one. This makes it the rational decision to take provided that the additional loss would not be excessive: hence the necessity to cut back immediately if the position being carried is unusually large (the basic rules on the determination of position-sizing are discussed below). 1b - 2) as evidenced by a sudden volatility expansion, with the trend: A sudden acceleration of the existing trend with greatly expanded single-period range. This type of action may also (but will not neccessarily) follow-through with a succession of similar periods. This is usually the final bull-market buying-panic during the course of which the "last fool" finally gets into the market. This type of move can provide spectacular profits to those who stay with it but frequently reverses as brutally as it proceeds. Generally referred to as a "blow-off or "spike" top (or bottom if the chart is reversed). Trading rules:

If carrying a position against the trend: Get out immediately. It is very occasionally

appropriate to panic. this is one of those times. For survival it is very important to be amongst the first (not last) so to do.

carrying a position in line with the trend:

place an "exit-stop" just below the start of the acceleration (above if the move is down), and follow the move up with a trailing stop (see below). You may be stopped-out well before the final top: but that is much better than watching a massive profit wiped-out by staying with the move to the top, and then staying with the following collapse. There is absolutely no way to judge in advance where a "mass hysteria" move will end. When people start confidently to predict that a price which has already tripled is going to re-double might be a good time to sell.

If not already carrying a position: Stand-aside (watch and weep). Market Skill-Builder

Financial Markets & Financial Software The Skill-Builder for Financial Trading - Financial Training Software.

Distinguishing Reversals from Corrections (3) Tests of Major Support and Resistance 2) The second type of event to be watched for / acted upon is a test of Major Support or Major Resistance. If long or aside: reverse to / sell short on a test of Major resistance. If short or aside: reverse to / buy long on a test of Major support. Obviously "Major" needs to be defined, see below. Incidentally you are "Long" something (a stock, currency or whatever) if you have either bought and paid for it (entirely or partially) or have promised to buy it at a future date at a specified price. You are "short" something which you have promised to deliver at a specified future date in exchange for a specified price. If you buy a house and take out a mortgage you are long property and short cash. (This is usually but not necessarily a good position to be in). "Major" supports and resistances are previous market turning-points separated from the current price-action by at least two intervening reversals.

Sell short a test of major resistance of the type shown above, with a "re-reverse stop" just over a "normal" period's range above the old high. (if the chart were inverted it would be support to be bought, naturally). Not infrequently, the market will go straight through the resistance, and you will be "Stopped-out" within a very few time periods. This is extremely irritating and expensive. On the other hand, it is astonishing how often markets will test and reverse from "Major" levels of this type, in which case you are positioned to profit from the entire ensuing down-move. The really critical point, however, is this: If you do not sell the test of the resistance but stay long and "wait to see" whether the market goes through the resistance where do you place your stop ? (to get out of your current long position if any and to join the move on the short side). Casual inspection of the chart shows that, since a new downtrend will not have been "confirmed" until either at least one level of support has been taken out or a new (lower) high has been formed, at least one-third, more likely a half, of the previous up-move will have been re-traced before you enter your short position. At this point a significant proportion (possibly all) the unrealised profit on the up-move will have been eroded, and a significant proportion of the new down-move missed and the logical place for the protective stop on the new short position will be a long way from the entry-price. Selling the above market short can be a gut-wrenching thing to do: particularly if you are watching the news and all the commentators are explaining why the market is going through the roof (which they invariably are at extremities). It becomes even more difficult if you have done the same thing before and been stopped-out for a significant loss almost before putting down the 'phone. It is nevertheless the right thing to do because buying and selling at probable extremities maximises the ratio of average profit to average loss. It is noticeable that most analysts concentrate their attention on attempting to identify the direction of the next move correctly (intending to maximise the frequency of profits compared to the frequency of losses). It is, however, at least as important to maximise the ratio of average profit to average loss. If that means taking occasional additional (relatively small) losses (and possibly feeling like a fool in the process), then so be it. To repeat the definition of what constitutes "Major" support and resistance: "Major supports and resistances are previous market turning-points separated from the current price-action by at least two intervening reversals." The example given above was obvious in that there were numerous minor reversals between the major resistance and its current re-test. It is less obvious, however, when there are only two:

Answer: The three-wave move down from the top (ie two down-moves with one intervening upward correction) may simply be a now-complete correction of the preceding up-move, in which case the market is destined to reverse up from here and go straight through to new highs. This type of three-wave correction is extremely common.

But: it is at least as likely that it is either the start of a more extended and complex (and tradeable) form of correction or the start of a new down-move which is destined to continue without a significant rally for some time. Next, Trading Strategy - tests of major support and resistance. Market Skill-Builder Financial Markets & Financial Software The Skill-Builder for Financial Trading - Financial Training Software.

Trading Strategy on tests of Resistance (Same logic inverted applies to tests of Support). The correct trading strategy therefore includes alternatives based on what happens next:

First, place a sell-stop below the next low which, if hit, will exit any existing long position and enter a small short position (small because the initial stop on the new position would be above the recent high - ie a significant distance away from the entry price). This initial stop protects against serious loss in the event that the market continues straight down, and turns a profit if it goes far enough.

Then watch which of the following occurs and act accordingly:

If the market takes-out your stop, you will have a (small) short position. Place an initial stop above the recent high and await developments: If the market turns back up towards the high (a) you will be glad that the short position is only small and (b) you will watch the market action carefully in accordance with the notes below the next horizontal line to determine whether to add to the short position as the market approaches the high. On the other hand . . . .

. . . .If the market the market carries-on down (making you money on your new short position (a) lower the buy-stop to just above the second minor-resistance level (the two levels of resistance are indicated here by jagged horizontal lines) and (b) optionally - plan to increase the short position on any rally towards the first resistance.

If not stopped-out as described above:

If the market moves straight back up "impulsively" to re-test the high without forming a clearly identifiable intermediate high: stay long and raise the sell-stop to just below the most recent low.

If the market moves back up towards the high, but in a "drifting pattern": reverse to short and place a buy-stop to cancel the new short position and reverse to long above the high.

Similarly, if the move back towards the top is interrupted by a correction as shown here, reverse to short and place a buy-stop to cancel the new short position and reverse to long above the high.

NB: all of the above applies in reverse to tests of Support.

Market Skill-Builder Financial Markets & Financial Software The Skill-Builder for Financial Trading - Financial Training Software.

Trading / Investing based on Technical Analysis To summarise:

Look at the Long-Term Charts to identify major support and resistance-levels. Look at the Medium-Term Chart to determine the current trend, trade in line with it so long as a reversal is not indicated by the pattern of highs and lows, and / or direction of "drift", and / or changes in momentum / volatility.

Look at the Short-Term Chart for additional clues relating to the way the market is acting (volatility, momentum and drift in particular).

Always sell tests of Major Resistance / buy tests of Major support. Expect the current trend to continue unless a counter-trend move is stronger than the previous "with-trend" move (in which case, place orders to reverse on a re-test of support / resistance with a stop beyond the next level of resistance to the presumed new trend)

All positions should be protected by stops: placed in the market if you are a small / medium-sized player. Maybe some points will occasionally be scalped from you on the fills, but that is much better than getting out of a fast market ten minutes late.

The closer the market is to the support / resistance beyond which the stop is to be placed, the larger the position which can be taken.

Position-Sizing: Medium / large accounts. I recommend that no more than 1% of capital be risked on an individual trade (entry-price to initial stop). This relatively conservative policy ensures survival in the face of either a sudden massive adverse move or an extended series of "Nickel & Dime" losses. This limit can be increased (say to 2.5%) if only one position is carried at a time. Aggressive traders (many of whom fail to survive) risk much more: remember that if a draw-down of 50% is suffered the trader then has to gain 100% on his remaining capital to get back to where he started. Minimising losses is much more important than maximising profits. The position-size to take (assuming a policy which precludes adding to positions) is therefore: 1% - 2.5% of capital / $ per single-contract point / no of points to stop. Position-Sizing: Small accounts. With commission and slippage realistically costing +/- $50 / trade, how can someone with a limited starting capital of say $5,000 enter this game since $100 - $250 stops are not realistic ? Stop trading (fire your money-manager) if somewhere between 33 and 50% (decide in advance) of your risk capital is lost - you/he are incompetent ! The answer is to approach the problem slightly differently, but still in a disciplined and business-like fashion, as follows:

Don't start trading until you have saved a minimum of $10,000. Yes, I know that an account can be opened with $5,000 and that people have gone from less than that to millions in the past - but don't count on it (many are called but few are chosen) . . . so step 1 - Save $10,000.

Plan to add to the account every month from additional savings: preferably $1,000 ($500 minimum). If you can't do that, you will almost certainly not trade successfully (too much pressure).

Trade one position at a time with $500 - $1,000 stops.

Stop trading any time the equity of the account falls below $5,000. Re-start only when it has been replenished to $10,000.

Continue the regular investment until the equity in the account reaches at least $25,000. Plan to start withdrawing (say) 10% of net new equity every month after the account has reached $100,000.

A person who implements this type of strategy may spend a long time with capital fluctuating between $5,000 and $15,000, but has an excellent chance of long-term success because:

They will not be wiped-out (remember, the average life of a retail futures account is six months). They will benefit from the enforced trading-pauses (if any) to re-gain their mental equilibrium and refine their techniques.

The discipline of regarding the enterprise as a business into which a regular investment is being made until it is successful enough to start paying dividends is conducive to development of the type of systematic approach which is vital to success.

Obviously the above numbers are not "cast in stone", but the general idea is sound. As in many other areas of life, one starts by paying for education and experience, and then one profits from it. The more structured and disciplined the approach, the quicker the pay-back is likely to be.

Market Skill-Builder Financial Markets & Financial Software The Skill-Builder for Financial Trading - Financial Training Software.

Trading / Investing based on Technical Analysis Is that all ! ? Am I seriously proposing that the financial markets can really be beaten by the application of this simplistic analysis ? In a word : Yes ! But what about Moving averages, Kalman filters, RSI, Stochastics, Cycles (Astro & other), Dow Theory, Elliott waves, Fibbonnacci, Fuzzy logic, Artificial intelligence, Chaos Theory, Delta theory, Trend-lines etc., etc. ? The use of some of the above tools and techniques / application of the theories may marginally increase the proportion of profits to losses, but this will almost certainly be at the cost of a deterioration of the ratio of average profit to average loss. Note, however, that discussion of many of these indicators and techniques will be added progressively to this site - let me know if you would like to be kept informed of developments Remember, the essential point about the trading-style advocated above is that transactions only take place in proximity to support and resistance levels beyond which stops can be placed - so that losses, when experienced, are

small. If you rely on one or several indicators or other techniques separate from the direct observation of the price and its behaviour to tell you when to trade, this will inevitably be less true. In real-estate it is said that there are three important elements : location, location, and LOCATION. In trading and investing there are also three important elements : price, price, and PRICE. Final Note: Nobody has to take my word for any of the above. The whole point of the "Market Skill-Builder" package is that the program gives the user the opportunity to learn, practice, acquire effective realistic experience risk-free. Ready to order ? - click here Your comments on, questions about and criticisms of the above material will be very much appreciated. Please click and send us a message!