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2 3 4 5 Editors Note Contributors Chat Room Inside the Market

By Jeff Ponczak

Advanced Strategies 35 Measuring trend momentum

Its every traders dream to build an indicator that can adjust its behavior with the moods of the market. Heres a look at a dynamic moving average that responds to changes in momentum rather than prices. By Tushar Chande

13 Web Watch
Broker-Trader matchmaker:

38 Trading Systems Lab Face of Trading 40 Keeping it simple

By Allen Sykora

14 Traders Bookshelf
Kiara Ashanti reviews Day Trading on the Edge by Les N. Masonson.

15 New Products Technology for Traders 17 Software Screening

A review of ProphetStation, a real-time analysis and market-tracking platform. By Scott Os

Trading Psychology 42 Mind over money management

How to improve your ability to assume risk and take your trading to the next level. By Dr. Ari Kiev

Risk Control & Money Management 45 Analyzing the cringe curve

Match the risk profile of your strategy with the ability to accept losses. By Daryl Guppy

Trading Strategies 19 One- and two-bar price patterns

Learn about simple price patterns that signal short-term reversals. By Martin Pring

Trading Basics 47 Riding the learning curve

The two most common mistakes among new traders are the inability to take losses and the tendency to trade too many strategies at once. Learn how to avoid these pitfalls. By Stan Kim

23 Holding on to profits
Study a trailing stop technique you can use to capture profits on any time frame. By Dave Baker

49 Indicator Insight
Understanding and using the Advance-Decline line.

26 Catch the third

The subjective character of Elliott Wave makes it too difficult for most traders to use in day-to-day trading. A short-term chart pattern can help you catch the important third wave as its about to take off. By Eric S. Hadik

The Big Picture 51 Acting vs. reacting

Successful traders use trading plans that allow them to act instead of react. Two tools that help you do that are the displaced moving average (DMA) and Fibonacci levels. By Thomas Stridsman

30 MACD divergences
A trader describes how to use the MACD indicator to build a top-down trading approach in the currency market. By Gary Tilkin

Business of Trading 55 Keeping your trading business simple

Do you think you need to incorporate to get the best tax treatment as a trader? Maybemaybe not. By Robert A. Green, CPA

33 The execution solution

Tips and techniques on trade execution, order routing and trading technology. By M. Rogan LaBier

58 After Hours 59 Trade Diary





Striking a BALANCE
hen it comes to trading psychology, there Analyzing the cringe curve (p. 76) looks not so much at are two basic schools of thought. The first the mechanics of placing stop orders but at our ability to honor dismisses the importance of the mental and execute them. Author Daryl Guppy navigates the psychoaspect of trading, claiming research and logical twists and turns we take as a loss increases in size, and strategy render emotion and interpretation how to better match your risk level with your ability to execute moot. Once you have a system, and the trades. discipline to follow it, your feelings about Most discussions of risk control involve the market shouldnt matter. ways of minimizing risk. But for some Anyone who has The second group believes trading is, traders, the inability to assume more risk first and foremost, a mental exercise, and (depending on the circumstances) is almost made the switch from as much of a problem as not being able to that success or failure stems directly from your psychological outlook and approach handle any risk. In Mind over money manto the markets. A trading plan may be paper trading to real agement (p. 72), Dr. Ari Kiev looks at this essential to success, but the discipline to less-discussed aspect of the risk-psychology trade it effectively, and the ability to balproblem trading, or increased from taking one that prevents many traders ance discipline with flexibility, is purely a their careers to the next level. matter of the mind. In Acting vs. reacting (p. 88), senior The truth, as usual, is probably sometheir trading size, editor Thomas Stridsman looks at how where in between. The reason many peoeffective risk control and money manageple are attracted to systematic trading knows the mind games ment is built on the ability to be proactive approaches is the promise to remove emo to operate with a plan instead of a series tion from trading a tacit acknowledgof ad hoc responses to events. He illustrates that accompany ment of the role of psychology in trading. this point by analyzing two approaches of Anyone who has made the switch from trader Joe DiNapoli that allow short-term paper trading to real trading, or increased putting money at risk. traders to establish stop levels and price tartheir trading size, knows the mind games gets in advance. that accompany putting money at risk. In the Trading Basics section, Stan Kim How many traders have been sabodiscusses the ongoing educational process taged by the inability to stick with their approaches during of trading (Riding the learning curve, p. 82), and how rough patches in the market? How many others have given traders can avoid the two most common mistakes and use away money by not honoring their stops because when it came their experience to improve bottom-line results. down to it, they just couldnt stand the thought of a loss? What Our Trading Strategies section features an analysis of chart about the traders who, flush with success, increase their risk patterns by noted analyst Martin Pring (see p. 34). Find out too dramatically? And dont forget traders who have trouble how simple one-and two-bar price patterns can offer clues assuming even the lowest levels of risk. Then again, the best about short-term momentum moves. attitude in the world wont salvage a haphazard trading Very few traders are able to operate completely on autopilot, plan. removing themselves from the stress of the market and disenThis month features several articles that stress the role of gaging from their emotions. One 20-year veteran trader I trade exits, risk control and psychology in a winning trading recently spoke to surprised me by saying, despite years of conapproach. They offer a range of perspectives on one of the sistent profitability, he found trading as stressful as when he more complex areas of trading: the balance between risk and first started. What he had learned to do was accept the risk and psychology how to match your trading personality with the stress that goes with trading managing his emotions rather risk demands of the markets and use techniques that promote than attempting to ignore or overpower them in the frameyour trading goals instead of undercutting them. work of his trading and money management plan. Most strategy articles focus on where to enter a trade. In Holding on to your profits (p. 42), trader David Baker rightMark Etzkorn, Editor-in-chief ly points out that exiting a trade successfully is more than half the trading battle and shows how a simple, price-sensitive trailing stop technique can help accomplish this goal on any time frame. June 2001 ACTIVE TRADER



w Martin J. Pring is editor of a number of monthly publications, including the

Intermarket Review and the Traders Daily Fix. He is author of Technical Analysis Explained and a pioneer in the development of multimedia CD-ROM tutorials on technical. Prings books, CDs and videos are available at Free streaming educational multimedia presentations, articles, charts and online chart books are also provided.

w David Baker is a professional day trader and the president of Strategic Traders (, a nightly education and selection service designed to help short-term traders develop strategies for each day. He has been a featured analyst on BizNewsOne Television (KJLA) and featured as one of 12 traders in The Best: Conversations with Top Traders (M. Gordon Publishing, 2000). He can be reached at davidb@strategic w Tushar Chande is president of LongView Capital Management LLC ( He is author of Beyond Technical Analysis (2001, 2nd Edition) and The New Technical Trader (1994), both published by John Wiley & Sons. A prominent innovator in technical analysis, his indicators such as VIDYA, CMO and AROON are now included in many technical analysis packages.

w M. Rogan LaBier is a former Nasdaq market maker, sales-trader, registered principal

of Terra Nova Trading and head trader at MB Trading. Currently he is CEO of Rocket Trading (, a company catering to high-end hyper-active day traders. He is also author of The Tools of the Trade, the best-selling e-book about trade execution. The Nasdaq Traders Toolkit, published by John Wiley & Sons in December 2000, is the updated hardcover version of this book.

w Stan Kim has been trading full time since 1994 and is a frequent speaker at investment and trading seminars. He also does private consulting and mentoring on a limited basis. His book Never Trade In The Tail of the Snail is scheduled to be published this year. He holds an MBAfrom UCLA. Kim can be contacted via his Web site at w Daryl Guppy is a private equity and derivatives trader. He is the author of Market Trading Tactics, Share Trading and Chart Trading. He speaks regularly on trading in Australia and Asia. He can be contacted via w Ari Kiev, M.D. is a trading coach and management consultant to several trading firms in New York. His latest book is Trading in the Zone: Maximizing Performance with Focus and Discipline. His first book was Trading to Win: The Psychology of Mastering the Markets. w Erik S. Hadik is president of INSIIDE Track Trading ( and editor of INSIIDE Track newsletter and the Weekly Re-Lay fax/e-mail service. He is also author of Eric Hadiks Tech Tip Reference Library a 120-page collection of indicators he has taught since 1989.

w Robert A. Green is a CPA and his firm,, consults traders on tax solutions, reviews or prepares their tax returns and sets up business entities and retirement plans. For more information or help about this and other trader tax matters, visit or Contact Green at w Gary L. Tilkin is president of Global Forex Trading, an online Forex dealer. He can be reached via, or (800) 465-4373.


Learning Tree International (LTRE), daily A BCOG pattern following a strong advance signals a major collapse. Also a NRB. A gap down followed by a major decline ensues. 75 70 65 60 55 50 45 43 18 5,000,000

As a beginner, I really appreciated Oliver Velezs article, The seven deadly signs of danger, in the March issue. I learned a lot from it. I have a question however, regarding Figure 3 on p. 61. If you count 20 candles to the right you come to what appears to be a red NRB (narrow-range bar) or BCOG (bearish changing of the guard). It meets your criteria of a smaller than normal body following a three-bar advance. If one could not see the following sequence there would be no reason for not interpreting it as a bearish signal. Why is this different? Ralph Pauly

Oliver Velez responds:

I am delighted that you found my article helpful and September October informative. The question you raise regarding the red Source: narrow range bar preceding the one detailed in the arti cle shows your thorough analysis of the concept. First, it is imperative to understand that the seven deadly signs signify potential trouble, not definite trouble. Every sign will not necessarily bring about doom. These signs exist to put the trader I have an out-of-date question, but please help me on guard for what is nothing more than increased odds of trouble. because I love something I read in the November 2000 With that being said, the bar you mention is, in fact, a BCOG issue of Active Trader. On p. 52 you ran a story called that should have put a trader who happened to be long on the Trading the bow-tie pattern by Dave Landry. I have defensive. If you go back to Aug. 29, 2000, the day following the access to Web sites where I can analyze moving averages, BCOG, you will also discover that LTRE declined nearly 3 full but I dont have the time to sift through the whole marpoints (slightly more than five percent intraday), before rebound ket to look for a handful of stocks whose moving avering later in the day. So, in essence, this BCOG did give ages are converging. advanced warning of temporary trouble. Please help! I need the name of some software, service, However, theres a very important difference between stock screener, filter, Web site anything that will find this BCOG and the one detailed in the article. The latter BCOG these stocks for me. Any suggestions? came after a climactic run up, while the former came after a milder, Tim Sweet more gradual ascent. The presence of a BCOG immediately follow ing such a dramatic up move greatly increases the likelihood that Dave Landry responds: major trouble will strike, simplybecause traders and investors will be more prone to protect and/or take profits on even the slightest Thanks for your interest in the pattern. I use SuperCharts and hint of weakness. Think of it this way: The higher you climb a TradeStation to scan for the Bow Tie pattern. The same soft mountain, the more fatal a slip up or a misstep can be. I hope this ware I use is sold as an add-on module for my book, Dave helps. Landry On Swing Trading (M. Gordon Publishing, 2001). The add-on software also includes indicators, systems and other patterns that are described in the book. Questions about an article or trading issue? Send them to us at Active Trader reserves the right to edit letters for clarity and length. June 2001 ACTIVE TRADER




The newest feature

Hey, let me tell you about

ith the trading landscape changing virtually every day, direct-access companies are realizing the need to adapt with it. One thing that has changed drastically in the past year or so is how direct-access firms promote themselves. Director of marketing a position not found on every direct-access firms payroll a year ago is now a given, and some companies have even hired outside firms to supplement their own marketing programs. Most direct-access brokers have advertised in various financial publications. However, more firms are finding that while advertising will get people to know they exist, it takes marketing to truly get the message across to traders. Indeed, the ability to stand out is crucial in todays marketplace. Because all direct-access brokers provide essentially the same service (they allow traders to bypass the middleman, often providing instant execution), each company must stress the little things that set it apart. Many firms promote their educational programs. Others claim they have superior customer service, and still others (most companies, actually) are always touting the latest bell or whistle they have added to their platforms. At the recent Online Trading Expo in

New York City, dozens of direct-access firms displayed their wares. While most show attendees were savvy enough to know the difference between directaccess trading and using a standard online broker, the expo provided an opportunity for firms to show thousands of potential customers the little differences that make their companies unique. What you really have to do is educate, says Ross Ditlove, CEO of MB Trading. You have to take a step backwards and teach them how it started, what direct-access really is to the industry today, and then tell them the difference [between you and other firms]. One firm that decided to have some fun in New York was On-Site Trading the company used an Austin Powers look-alike to draw people in. The caricature was well done and it certainly drew attention to On-Site Trading. Its a branding issue as much as anything else, says the companys president Gary Mednick. Were very cognizant of that. We know were probably at the end of a growth cycle, and now were entering the second phase. The first phase was [aimed at getting] customers to know about [our product]. Now they know about it, so as we get through the second growth cycle, branding is going to be very key.

Such concentrated marketing campaigns are a far cry from the industrys once-popular technique of dressing a young, buxom blonde in a tight shirt and a low skirt and placing her in front of a companys booth. I could never imagine stooping to that level and present the company in a way that were not, Ditlove says. We know exactly who we want to be; we know exactly who we want as clients, and hopefully the two meet. Of course, all the marketing in the world wont do any good unless the company has something to back it up. There are a lot of firms popping up, and lately, a lot have been going out of business, says Tradescape CEO Omar Amanet. Its one thing to recreate the technology, but its quite a different thing to recreate the business processes surrounding the technology. For companies that have yet to put a large amount of time and money into marketing, positive word-of-mouth how many companies have thrived over the past few years remains a key part of success. Weve done very little in terms of marketing and advertising, says Kyle Zasky, president of Weve grown organically because people who become our customers are really good about referrals.





Casting another line in the direct-access pond

he sound heard rushing through the trading world in mid-February was direct access moving into the mainstream again. On Feb. 14, online broker Ameritrade bought direct-access firm TradeCast, becoming the latest traditional online broker to enter the world of direct access. Ameritrade purchased Houstonbased TradeCast for 7.5 million shares of Ameritrade stock, plus the possibility for 750,000 more based on TradeCasts success. The move comes in the wake of Dateks announcement that it would offer direct-access trading and an agreement between E-Trade and direct-access firm A.B. Watley, and just before Charles Schwab began offering direct-access trading (see Schwab does it again, opposite page). Schwab purchased direct-access firm CyBerCorp in February 2000. We feel they have one of the top platforms in the industry, says Ameritrade chief information officer Jim Ditmore. They have a very good management team, and were very comfortable with their business-to-business strategy. Those were the three big things. Ameritrade had been interested in entering the direct-access area for quite some time, while Tradecast had been actively pursuing a partner among mainstream online brokers. We talked to a lot of players over the

last year, says TradeCast founder and president Bobby Earthman. We went with Ameritrade mainly because of [its] interest in what we were doing on the business-to-business space. It was a real good fit. I dont think theres a broker on the Street thats going to have the combination of the infrastructure and costs of Ameritrade and the technology of TradeCast, he says. TradeCasts business-tobusiness agenda includes licensing TradeCast to institutions and other trading firms. While there are hundreds of companies interested in using directaccess software, there are only a handful of firms providing the technology. Ameritrade is a good household brand, but its not something people use on Wall Street, Earthman says. You want the whole array of that professional space to be using your product. You want money managers, investment advisors, proprietary trading firms, day trading firms. Were going to keep the high-end active brand called TradeCast. I think strategically thats very important. TradeCast will function as an independent business unit and will be adding clearing services through Advanced Clearing, a division of Ameritrade.

Most of the impetus for the deal was to get new clients in a strategic segment, Ditmore says. We are really looking at becoming a significant force in the pro segment, and we feel that TradeCast is an excellent launching platform for that. But TradeCast and Ameritrade are very different platforms, and [keeping highly active Ameritrade customers] has not been an overwhelming impetus for us. Still, there are an increasing number of active traders at the traditional online firms traders who might be tempted to leave their existing broker for one of the direct-access variety. While Ameritrade is accustomed to battling other online brokers for their share of the investing public, the battle for active traders is beginning to heat up. This was a space that wasnt really looked at by the big players, but now the big players are having to adopt it because its eating their best customers, Earthman says. Theres going to be a big battle among the Schwabs, E-Trades and Ameritrades. There will be some other players, but were going to be the dominant player in that game. Theres no doubt in my mind. June 2001 ACTIVE TRADER



Direct access x2

Schwab does it again

n mid-March, Charles Schwab became the latest online broker to venture into the world of direct access. Yes, that Charles Schwab. The one that paid almost $500 million for directaccess firm CyBerCorp in February 2000. However, Schwab is confident its introduction of Street Smart Pro makes perfect sense. We see Schwab and CyBerCorp coexisting side-by-side, says Beth Stelluto, Schwabs senior vice president of Active Trader Marketing. [Street Smart Pro] is really designed for customers who are trading actively but are looking much more at a portfolio view of what theyre doing and looking for investment returns to enhance their overall portfolio. CyBerCorp is much more on the highly active end of the trading continuum. Its targeting folks who are using trading strategies for equities and options and doing their trading for current income. Currently, Schwab and CyBerCorp exist as different companies. A trader wishing to use both firms must have two accounts. While Schwab has hundreds of customers who do just that, it wanted to create a separate system to make it easier for certain traders to take advantage of direct access without going through the hassle of opening a new account. [Many] people wanted to do their trading with Schwab but wanted to take advantage of some of these advanced tools and technologies that were available at CyBerCorp, says Jim Hawn, vice president of Electronic Brokerage at Schwab. Now, if I placed a trade in Street Smart Pro, I could contact my Schwab account rep and they would see the trade. They cant see CyBerCorp trades. Schwab used CyBerTrader as the basis for Street Smart Pro, using such CyBerCorp technology as Level II, streaming news, interactive charting, and time and sales. Prior to the acquisition of CyBerCorp, we had extensive plans to move into this area of providing streaming quotes and

news and more robust charting, Hawn says. The acquisition allowed us to dramatically reduce our time to market, because we were able to leverage their engineering talent as well as technology that CyBerCorp had pioneered. It would be wrong to say that we just cloned CyBerTrader. [We...] went out to our customers and asked them what they needed. [We...] also went out to customers of mainline competitors and

asked them what their needs were. We took those and put together a product development agenda that we worked on with CyBerCorp. That allowed us to basically customize a product that was targeted to Schwab customers and potential Schwab customers. Customers must make at least 10 trades per month and have a minimum equity level of $50,000 to be eligible to use Street Smart Pro.

Get paid to trade

recent J.P. Morgan study showed that an active trader can accrue yearly commission fees totaling between $75,000 and $100,000. A new plan unveiled by direct-access firm Tradescape may be able to take a bite out of that number. Under the plan, any Tradescape customer who places a limit order and routes it through MarketXT the ECN owned by Tradescape will receive a rebate of one penny per share. Thats $10 per 1,000 shares. A standard Tradescape commission is $7.95. Thats what the next wave of competition is going to be price in the directaccess space, says Tradescape CEO Omar Amanet. An average active trader who uses Tradescape and makes [his or her] trades through MarketXT [and averages 1,000 shares per transaction] will receive $120,000 back. That will bring down the transaction costs, and if you bring that down, incrementally, volume will explode. And volume is what MarketXT needs. While about 300 million shares trade through Tradescape daily, MarketXT averages only 5 million shares per day. Island, the No. 1 volume ECN, routinely

A penny for your shares

trades 200 million shares per day. Because of ECN transaction fees, Tradescape will still be able to make money, even when giving a rebate to customers using MarketXT. ECNs charge brokers a fee when they put an order in the system. MarketXT will charge brokers a half-cent per share, while institutional traders will be charged 1.5 cents. While Tradescape could lose money if a retail order is matched by a broker, Amanet says that happens only in about one percent of all trades. MarketXT is an active ECN, meaning it will search through the other ECNs, SOES and SelectNet to determine the best price for a particular stock, then route the trade to that destination.




w, a chemical industry exchange, has partnered with the Chicago Mercantile Exchange and will be the
first B2B hub to offer online futures trading to individual investors. CheMatch hopes to have the service available by mid-year. Although CheMatch is not licensed by the Commodity Futures Trading Commission, it will route its business through Globex, avoiding the need for CFTC sanctioning. In return, the CME gets CheMatchs product line.



w The Chicago Fed in early March introduced a new monthly economic indicator, the Chicago Fed National Activity

Index. It is a weighted average of 85 existing monthly indicators taken from five categories: output and income; employment, unemployment and hours; personal consumption, housing starts and sales; manufacturing and trade sales; and inventories and orders. The index is designed to provide an indication of current and future economic activity and inflation. It will usually be released during the first week of a new month, and it will be listed in the Active Trader Trading Calendar.

w A federal court ruling handed down in mid-February makes it easier for anonymous Internet message board posters
to express their opinions. A judge ruled that Global Telemedia International could not sue a group of anonymous posters for derogatory comments they made about the company. The judge ruled that the posts were opinions, not facts, and therefore not libelous. David Carter, the presiding judge, wrote, The postings [in question] are full of hyperbole, invective, short-hand phrases and language not generally found in fact-based documents, such as corporate press releases or SEC filings.


w Online brokerage firm Datek has unveiled a new streaming quote service that gives free, real-time information from ECNs. The Streamer ECN, which is available to all traders even if they are not Datek clients, provides streaming data and real-time quotes from ECNs such as Island, REDIBook and Archipelago. More information is available at w A snafu in the trading of Nasdaq stock Axcelis Technologies in late February has a group of day traders up in arms.
After someone accidentally entered the wrong price when making an offer, the price of the stock shot up to $93. It had been trading in the $10 range since October of 1999. Nasdaq couldnt halt trading, so they voided any trades that were made when the stock was trading at more than $22. Five Texas-based day traders who sold short when the stock was going up, then exited their trades at $19, are furious. Since the short sale transaction was voided, they are stuck with shares of Axcelis at $19, almost double its market value.




w Noted Merrill Lynch analyst Henry Blodget made a name for himself during the tech run up of the last few years.

Blodget was extremely bullish on the sector and gained notoriety when he issued a $1,000 price target on Qualcomm in late 1999. However, when the tech bubble burst, so did Blodgets favorite stocks. One investor who got burned in the mess is taking Blodget to arbitration. He bought 4,600 shares of InfoSpace Inc. at around $125 a share and held it in a rapidly declining market because Blodget maintained a buy recommendation on the stock. The stock was trading at about $3.50 in mid-March. The arbitration filing alleges that Blodgets rating was primarily because Merrill Lynch had a connection with InfoSpace and the success of the stock helped Merrills investment banking division.

w The SEC approved a pair of Nasdaq rules on a one-year, pilot basis. Both rules are modifications of old rules caused
by Nasdaqs conversion to decimals. The modified Manning Rules state that any market maker who intends to step ahead of a customer order must improve price by at least a penny. This applies to all stocks, regardless of price (the old rule depended on whether a stock was priced above or below $10). Likewise, the new short sale rule states that short sales must be done on a downtick of at least one cent. The Nasdaq must provide the SEC with a report on trading activity under the new rules when the pilot program ends.




Not so super

Doubting SuperMontage
hile the coming of SuperMontage, Nasdaqs new quotation and execution system, is inevitable (see A Super day for Nasdaq, Active Trader, April 2001, p. 15), there is still some debate over whether the plan will be beneficial to traders. The latest to chime in on the antiSuperMontage side of the discussion is Todd Eyler of research and analysis firm Forrester Research. In a note entitled, Investors need an alternative to SuperMontage, Eyler thinks SuperMontage will cause a greater dependence on Electronic Communication Networks (ECNs). Eyler doesnt think SuperMontage will provide the best price, as it wont prevent internalization where a bro-

ker sends an order to an in-house market maker rather than routing it to another market maker who may have a better price or payment for order flow. Also, writes Eyler, Investor orders will still flow through broker-dealers, who will retain the ability to buy or sell ahead of large investor orders and generate riskfree trading profits at investors expense. Eyler is also concerned about Nasdaqs sloppy track record when it comes to technological reliability. He points out how the exchange delayed decimalization because of technological concerns. With SuperMontage, Nasdaq will become the central point of trade execution and failure for all Nasdaq stock trades, even though its SelectNet order routing system remains unreliable.

Eyler also believes SuperMontage is anti-competitive, saying, Since 1997, when ECNs began to compete against dealers, bid-ask spreads for Nasdaq stocks have fallen by 30 percent. The SuperMontage plan directly threatens the ECNs survival by consolidating all of their order books and centralizing trade execution. Eylers prediction: Traders will adapt and find ways to bypass SuperMontage by using direct-access software to trade through ECNs and avoid Nasdaq entirely, and institutions will take an equity stake in ECNs. To ensure representation of their interests, Eyler says, smart investors will become equity investors in leading ECNs similar to what American Century has done with Archipelago.


Arrgghh! My screen just went dead. Ive got five trades on. Dude, yours? I needed to plug in my new CDplayer.

Better exit em fast. I make Com Ed look like a soup kitchen.

Hey, Igot Britney Spears!

OOOPS! He did it again. Man, you are hopeless!

All my chances were there

Hopeless, hopeless, hopeless, hopeless




Old school, new school

The SEC cracks the whip again

hile the Internet has in many cases replaced the boiler room as the de facto forum for unscrupulous stock manipulators to conduct pump-and-dump schemes, frauds still flourish in both environments. In early March, the SEC cracked down on both old and new, charging 23 companies and individuals with Internet fraud and, a week later, charging 18 individuals in a boiler-room scheme. The Internet charges were part of a periodic sweep by the SEC. This was the fifth such sweep, and it has resulted in more than 200 cases of Internet fraud. The most common scams used by the various firms and individuals were some of the old standbys, including: False IPO claims: One company promoted through e-mail and on its Web site that its IPO was imminent and offered traders a chance to invest. In reality, the company had no office, inventory, product or services. Financial projections without merit: A company issued a press release saying its market share would soon be more than $400 million. The price of the stock went up tenfold within two days, but the SEC discovered the company had $30 total in gross sales in 14 months prior to the press release. Phony track records and personal experience: A former roofer claimed on a

Web site that he had a proprietary trading system, had been trading for 14 years and enjoyed an 85 percent success rate. In fact, he had limited securities experience, and his trading system was available for purchase on the Internet. Misleading analyst coverage: A company posted a link to a supposedly independent analyst who touted the companys stock. The SEC discovered the analyst was given 12,500 shares of company stock, and all he did was merely repeat the boasts and claims of the company which were fraudulent to begin with. Overblown performance claims and fraudulent testimonials: A group of Web sites claimed their team posted significant gains in the market. However, the SEC claims the gains were all hypothetical, and the team in reality is just one individual. [These] cases are a sobering reminder that, on the Internet, there is no clearly defined border between reliable and unreliable information. Therefore, investors must exercise extreme caution when they receive investment pitches online, says SEC director of enforcement Richard H. Walker. In the boiler-room scam, the SEC charged 18 individuals operating a microcap scheme in Long Island, N.Y. The charges coincide with 20 indictments made by the U.S. Attorney for the Eastern

District of New York, the FBI and the New York Attorney General. Those indictments allegedly include two members of the Gambino organized crime family. The SEC alleges that the company in question, First United, underwrote IPOs in National Medical Financial Services and Ashton Technology Group and maintained a significant amount of stock in both companies. Then, using highpressure sales tactics and misrepresentation, the company persuaded people to purchase the stock. First United also told buyers that no First United customer had ever lost money and that any losses incurred in the two stocks would be reimbursed. When a client tried to sell one of the stocks, First United either bullied investors away from selling it or simply refused to execute sell orders. First United also made unauthorized purchases for some clients, including one who was deceased. [These] charges involve a classic boiler-room operation, carried out by individuals who were willing to tell any lie no matter how brazen in order to get their hands on the publics hardearned money, Walker says. The SEC has posted a Survivor Checklist on its Web site. The checklist warns traders about potential fraud on the Web. It is available at investor/pubs/fraudsurvivor.htm.

10 June 2001 ACTIVE TRADER



A whole new ballgame

1997: ECNs open up the playing field

Last month, we looked at the origins of direct-access trading. In part two of a threepart series, well discuss how new Order Handling Rules changed the trading land scape by allowing the creation of Electronic Communications Networks (ECNs) and giving individual traders the chance to trade directly with the exchanges, creating the boom in short-term trading.

n the mid 1990s, SOES Bandits using early direct-access technology in day-trading rooms were enjoying success picking off market makers who were slow to update their quotes on the Nasdaqs Small Order Execution System. However, they were the fortunate ones. For the average individual stock trader, the only option was to call their broker on the phone, who would then route the order to a Nasdaq market maker. However, there was a problem. Traders claimed and the Securities and Exchange Commission (SEC) later agreed that market makers were artificially inflating spreads for their own profit. As a result, the SEC created new rules (the Order Handling Rules) concerning the trading of Nasdaq stocks in the fall of 1996. They went into effect in January 1997. Among other things, the new rules allowed for the creation of Alternative Trading Systems. This led to the origi-

nal ECNs, and trading as most people knew it changed forever. However, there was some confusion and some concern when the rules were first announced. Initially, the SEC presented several rules but did not specify which ones would eventually take affect. And, before it was made clear that ECNs would be allowed, not everybody had an optimistic take on the future. We thought the world of SOES trading was coming to an end with the launch of the order handling rules, says Omar Amanet, founder and CEO of direct-access firm From an early insiders perspective, it was widely viewed as the death of day trading. But what ended up happening is that the order handling rules led to the launch of ECNs, and what we didnt realize back then was that the real benefit we derived out of SOES was automated execution, which up until that point wasnt present anywhere else. Once the SEC clarified things, trading

would never be the same. The rules were pretty clear, says Stuart Townsend, who along with wife MarrGwen founded Townsend Analytics, a pioneering firm in the annals of direct-access trading. However, I dont think anyone understood what the real ramifications were. The ramifications were that, for the first time, traders would be able to use alternate systems to trade stocks, systems that would allow them to avoid the middleman and trade directly with other market participants. Instinet, an ECN formed in the late 1960s, already provided that service to institutions and the SEC hoped the new rules would accentuate Instinets impact. However, there was no similar system for individual traders. That was about to change. Four ECNs were formed in early 1997 including Island and Archipelago, the major players in todays retail ECN arena. ECNs dont function exactly like brokers that is, an individual trader doesnt send an



formed, did not even have its own employees they leased them from a trading firm. But gradually (traders) saw the advantages of trading on Archipelago, Stuart Townsend says. Even more than the SOES traders, some of the larger proprietary groups started to use it because of the execution quality. Once they started using it, there was enough liquidity and enough action and then the day traders started using it more. Barely two years after the creation of ECNs, direct-access trading became a national phenomenon. Goldman Sachs and E-Trade, sensing the changing atmosphere, invested in Archipelago. People quit their jobs to try their hand at trading, and a raging bull market fueled the fire. If you look at [direct-access trading] over a three- or five-year horizon, you couldnt anticipate the growth, Berber says. But on a year-to-year basis, it was absolutely on plan. The trends we anticipated in the marketplace and the growth opportunities were exactly in line with what we had predicted. Still, in 1997, no one could have foreseen what would happen in February 2000. Charles Schwab, a traditional Wall Street firm, purchased CyBerCorp in a deal valued at almost $500 million. [Two years] or so ago, we thought it was inevitable that direct access would be embraced and used by a much broader type of online trader/investor, Berber says. Thats what took us down the path of seeking strategic partners, which led to the acquisition. We were seeking to position CyBerCorp optimally, given the inevitability of the trend. Direct access has since become an even bigger piece of the mainstream trading pie (see Casting another line in the direct-access pond, p. 14 and Schwab does it again, p. 15), and an entire industry Web sites, books, magazines has emerged from it. Its important to remember, though, that direct-access trading is still less than five years old. In the final installment of the series, well look at what the future may bring for the technology and the industry.

The pioneers
ack in January 1997, the market wasnt flooded with direct-access firms. In the early days of online day trading, you could practically count the players on one hand. The earliest direct-access firms were familiar names: Townsend, CyBerCorp and TradeCast provided most of the software and technology to fledgling companies looking to enter the direct-access business. More than four years later, while the number of direct-access brokers has increased exponentially, the number of software providers hasnt. Townsend, through its RealTick product, provides dozens of firms with directaccess software. CyBerCorp and Tradecast are also still big players in the software game, and each have a successful brokerage as well (Townsend is not a broker, although it has long been affiliated with Terra Nova Trading). Tradescape has been successful at both aspects even though it didnt enter the scene until months after its competitors. Tradescape CEO Omar Amanet began his financial software career with CyberCorp founder Philip Berber. Amanet eventually went on his own to form Tradescape in May of 1997, and initially targeted only well-experienced, highnet-worth traders. Eventually, he branched out to include newer traders, and today his company is the No. 1 direct-access broker from a volume standpoint. order directly to an ECN. Rather, certain brokers have access to ECNs, and orders sent through that broker can be routed to an ECN, bypassing the exchange. Archipelago which was created in large part thanks to technology provided by Townsend Analytics and Island work differently. Island is a matching ECN. It executes trades, often instantaneously, in its order book. Archipelago is an active ECN. It uses a proprietary logarithm to search out the best price, whether that be on an ECN or through Nasdaqs SOES or SelectNet. There is some debate over which ECN Archipelago or Island was most crucial to the development of short-term trading, but theres no question that direct-access trading would not be possible without them. When we argued that we should be allowed to do this, the first thing everybody said was, You have no liquidity, MarrGwen Townsend says. And we said, We only need one customer, and well get them the best price. The SEC was persuaded, and I think that was what really revolutionized the stock market. We had a program that automatically searched out the best price. Besides Townsend, CyBerCorp was a major player early in the world of direct

access. Island came to us and a few of the other software developers and asked us to write software that would connect our software to theirs so there would be more liquidity, recalls CyBerCorp executive vice president Butch Jones. It was kind of a two-way street, says CyBerCorp founder Philip Berber. They needed the flow of orders from the types of traders our software was serving. We could see that this was a new world, and you no longer needed to go through Nasdaq to get your Nasdaq orders executed. In the spirit of innovation, we could see that to interface these ECNs was both good for our technology and also good for our customers. Apparently, the trading world agreed. There are currently 10 ECNs, and in 2000 Island matched more than 53 billion shares. Island really set the standard, because they had the fastest matching system, the most liquidity, CyBerCorp COO Greg Farris says. They were the ones that on the ECN front really broke the ground. Still, since the SOES Bandits were enjoying success without the use of ECNs, the technology was a bit slow to catch on. Archipelago, when it was first June 2001 ACTIVE TRADER



Broker-Trader matchmaker:

primary reason Electr onic By filling out an online questionnaire, allows you to solicit Communications Networks offers from brokers who match your trading profile. (ECNs) such as Island and Archipelago have become so popular is the market efficiency they provide. By matching buyers directly with sellers, ECNs reduce the cost of trading and increase profit potential for individual traders. (, a recently launched Web site, hopes to become the ECN of the Internet by matching traders directly with brokerage firms that meet a traders individual needs and are willing to pay the trader for doing business with them. The concept of is simple. After registering, a trader builds an anonymous profile, answering questions such as: What type of securities do you trade? What size is your account? How many trades do you make in a month? How many shares do you trade per day? Once you verify this information via an e-mail sent to you you can sign in and see what offers await you. For example, one firm was willing to pay $1,000 cash to a trader who made approximately 20 trades per day. Of course, there are conditions that come with each offer, but provides links that provide details regarding the offer, as well as information on the broker who made it. The initial list provided is by no means the final offer a trader might receive. You can specify the number of days 30, 60, 90 you wish to have offers sent to your account. to make three profiles. This is a bit of an annoyance, but a necThe main goal of is to create a paradigm essary evil because some brokerage firms may have better shift in the way brokerages advertise for business by allowing incentives for a stock trading account, while other firms may them to transfer a fraction of their heavy campaign costs to provide better offers for options traders. In addition, the comconsumers in the form of a cash reward for opening an pany profiles are only accessible if that firm has made you an account, says co-founder Wayne Connors. offer. This is a pain if you would like information on a firm not There is no cost for the matching services. The site is easy to included on your incentive list. And, there are no offerings for navigate, and the profile questionnaire is direct and simple to areas such as futures or currency trading. follow. The summaries give quick information on the services, Most of the drawbacks, however, are minor. As the site opening balances, margin interest rates, etc., of the firm in becomes more popular and signs agreements with additional question. In short, the site provides all the information you brokerage firms, has the potential to become an need to know about the broker without having to navigate excellent research tool for making decisions about where to through all the extraneous information on the companys Web trade. has hopes of expanding into the realm of site. credit cards, wireless service and long distance. While that may There are some quirks to One small draw- not be anytime soon, HighOffer.coms current service is a good back is that you need to make a separate profile for each type way to cut through the advertising hype and find out how of account you have. For instance, if you have a trading much you are really worth to a broker. account, an IRAaccount and an options account, you will need Kiara Ashanti





Day Trading on the Edge

By Les N. Masonson AMACOM Books, 2001 Hardcover, 367 pages $29.95

nother day-trading guide is hardly something to make your head turn in your local Barnes & Noble. Nonetheless, if you want a book that examines nearly every possible aspect of this business, then Les Masonsons book, Day Trading on the Edge, is for you. The book features material by Masonson as well as chapters written by various industry professionals (including material from Active Trader by Gibbons Burke). Lets be clear on a few things first, however. Day Trading on the


dispelling the belief that this is a young persons game. Section two covers nuts-and-bolts topics such as where to trade, what you need for a home office and how to select a broker. Section three covers money management, trading psychology and taxes. This is where Day Trading on the Edge separates itself from other trading books. Chapter 8, Trading to Make Money by John Piper, and Chapter 10, Money Management by Ryan Jones, are worth the price of the book themselves. Piper discusses what he calls the trading pyramid the psychological base of becoming a successful trader. Jones introduces the fixed-ratio method of money management. Essentially the method requires that the same amount of profits be generated for each increase in units (shares, contracts, etc.,) being traded prior to increasing to an additional unit. For example, if you start trading $10,000 with one unit, you would not increase to two units until your account increases to $20,000. Section three ends with Ted Tesser discussing ways on preventing all the money you plan on making from going to the government. Section four consists of interviews with traders and CEOs of day-trading firms. Masonson essentially asks the same questions of each person, providing different perspectives on subjects such as: if its possible to trade profitably part-time; risk capital minimums; and common mistakes of beginning traders. A different or expanded set of interview questions would have offered a great deal more information than is given here. Day Trading on the Edge ends with an SEC report titled Regulatory Findings on the Day-trading Industry, and a CEO interview that basically rips apart the whole notion of day trading. It is clear the Masonson wanted to write a book that covers everything a person is likely to encounter as a professional day trader, and he does a nearly masterful job. If you can get through the first 68 pages or so, you will find a great deal of useful material to consider before you attempt to trade for a living.

Day trading can be dangerous to your wealth if you are not fully prepared mentally, financially, and educationally.

Edge is not for those with a casual interest in trading. If you want success stories and anyone can do this fluff, look elsewhere. This is a book for people who wish to become professional traders. The book reads more like a textbook than the typical checklist of things to consider before joining the day-trading ranks. Day Trading on the Edge is broken down into five parts. Section one outlines day trading, the history of the industry, basic characteristics of day traders and statistics regarding the demographics of traders and their success rate. This part of the book, which is full of numbers and surveys, is quite dry and will likely disappoint any starry-eyed, wannabe traders who picked the book up because of its enticing title. One interesting discovery according to a survey included in the book is that the majority of active traders are between the ages of 31 and 41,

14 June 2001 ACTIVE TRADER


TraderProfile, from Trader Profile LLC, is a tool that records and maintains a database of all the trades a user makes each day, without manual input. For a review of each trade, the user can call up a daily and intraday stock chart with the entry and exit transactions plotted directly over the chart. TraderProfile performs more than 23 automated analyses of personal trading performance, such as how well the trader does when going long strong vs. weak stocks, or how well overnights have performed vs. day trades. It also includes an end-of-day charting package optimized for day traders. OnSite Trading Inc. ( is the first broker to support TraderProfile. More information is available at

w Tradetrek.coms Money Trek is a technical trading training tool for both beginning and experienced online investors and traders. It lets users practice making trading decisions based on technical indicators and is designed to improve their chart reading and trading skills. Money Trek keeps track of paper trading activities, so the user can gauge his or her moves against the market and others. Tradetrek offers three versions of Money Trek: Interday Trek is available now, free of charge; at press time, Intraday Trek and Portfolio Trek had not yet been released but will be available for Tradetrek.coms paying subscribers. For more information go to

w Appian Graphics, provider of extended desktop technology, recently released Appian Hurricane, part of a new line of graphics cards based on ATIs Radeon graphics accelerator. With 32MB of DDR RAM and ATIs new RADEON VE graphics processor, the Appian Hurricane is capable of dual-screen resolution up to 1600x1200x16bpp at 75Hz. The Appian Hurricane offers one DVI and one analog output and comes with a DVI-to-analog adapter. The card comes with Appians HydraVision desktopmanagement software and the AppianXtras suite. With the PCI-format card (unreleased at press time), users will be able to power up to 16 displays with eight Appian Hurricanes (seven PCI, one AGP). The Appian Hurricane AGP version is available for a suggested retail price of $199. For more information, visit

w Street Falcon Inc. has introduced a software aimed at helping individual investors manage stock portfolios by collecting information from a customers online brokerage accounts, analyzing risk and calculating appropriate diversification. Street Falcon also tracks prices, splits, dividends and dividend reinvestments for each stock from the date of purchase to the most recent quote. Three versions are available: Street Falcon Standard tracks a portfolio from multiple online accounts, minimizes tax exposure, calculates returns, synchronizes transactions and tracks purchases of new lots through dividend reinvestment. Street Falcon Professional builds on the Standard version with: risk-adjusted return calculation, assessment and adjustment of risk levels, portfolio optimization and hidden trading cost detection. Street Falcon Gold has all the features of the Professional version, but also lets the investor check skill factor. To purchase the software or for more information, go to A free demo version is also available.



w (, a free educational
technical analysis web site from Equis International Inc., is now online. Features include: current investment information and articles; the MetaStock Online Java Chart Applet with access to Reuters Data; the Trader Optimization Profile (T.O.P.) by trading coach Mark Douglas; the eCharts HotStocks Report; current commentary from top names in the industry; discussion group forums; tips; events calendar; and a learning library.

w TradeCast has introduced version 4.1 of TradeCast Elite. Upgrades include additional direct-order entries, the ability to place reserve orders, total keyboard customization, enhanced SelectNet preferencing and multiple direct-ECN order delivery. In addition, Elite will allow users to send trades through the Island ECN. And, TradeScout, TradeCasts smart-order routing system, will now automatically send orders to direct-connect or active ECNs. More information is available at w Hold Brothers launched its Graybox
software trading system for active traders. Highlights of the system include: Asuper ECN key that will send orders to all ECNs at a specific price; the ability to send multiple orders to all market makers and ECNs at multiple prices; the ability to place an order at the top of an ECN book with a single keystroke; smart order routing and an integrated ECN order book. More information is available at

w Charles Schwab changed its optionpricing structure and will charge a flat rate based on a traders market activity and the size of the transaction. The new pricing structure will most benefit active traders who take advantage of Schwabs electronic channels. Detailed information is available at w Online broker Web Street has teamed with Xigo Inc. to allow its customers to receive personalized news and events alerts, and technical alerts, courtesy of Xigo. Among the notifications Web Street customers can receive are: analyst recommendations, company news, price, volume and P/E ratio targets, real-time news and end-of-day summaries. More information can be found at and

w Rina Systems recently announced PortfolioStream, a portfolio testing and optimization platform for TradeStation. PortfolioStream tests large baskets of stocks, futures or indices across several trading system input combinations in a completely automated environment. Studies of systems can run across these baskets, generate reports for each system/market combination and each portfolio. Reports can be filtered and sorted for user defined performance criteria to find desirable strategies and portfolios. Users can choose money management strategies to test portfolios with different position size and capitalization. For more information visit

Send your new product information to: Amy Brader, Managing Editor, or Jeff Ponczak, Associate Editor Active Trader Magazine 555 West Madison, Suite 1210 Chicago, IL 60661 Fax: (312) 775-5423 June 2001 ACTIVE TRADER

Technology for TRADERS



FIGURE 1 CHARTING ProphetStation features both historical and intraday charting capabilities.

hen it comes to backup analysis software or even primary software for the budget-conscious trader ProphetStation is a service worth considering. Its a real-time analysis and portfolio program with a good selection of tools for its price range, especially for beginning- to intermediate-level traders. ProphetStation is a bargain. At $34.95 per month, plus exchange fees of $4 per month for Nasdaq, NYSE, AMEX and OPRA, ProphetStation provides much of the functionality of services running $69.95 or even $99.95. You can download a free 30day trial version that uses delayed price data.

Portfolios and watch lists. ProphetStation, which is powered by real-time streaming quotes, allows you to set up multiple portfolios and watch lists. You can customize the layouts by pulling up a menu with column selections and then clicking on the fields (there are about 30 total) you want to display. There is no limit to the number of symbols you can track in real-time in any given portfolio or watch list. Right-clicking on a symbol calls up a menu from which you can access additional information and analytical tools. Charting. ProphetStation offers a range of charting options. If you click on a symbol within a list and then right-click, you Product: ProphetStation, version 2.0 Company: Prophet Financial Systems Mailing address: 115 Everett Ave., Palo Alto, CA 94301 Web address: E-mail address: Phone number: (800) 772-8040 Fax: (650) 322-4184 Price: $34.95 per month plus exchange fees System requirements: PC with Windows 95, 98, or NT; at least 32 MB RAM; Internet connection; Microsoft Internet Explorer (version 4.X or later) Web browser

are presented with a menu, the first choice being create intraday chart. You can set defaults for these intraday charts encompassing frequency (one-minute, three-minute, fiveminute, 10-minute, 15-minute and custom frequency), chart period (last 10 minutes, last 30 minutes, last hour, last two hours, all day and custom), indicators (more on this below) and chart type (line, bar and candlestick). You can only access one day of intraday data. Intraday chart indicators cover 15 of the usual suspects, including moving averages, Bollinger Bands, MACD, stochastics, on balance volume and the relative strength index (RSI). All indicator parameters are fully customizable. The nice thing is that you can set up a default chart profile that includes your favorite indicators for example, Bollinger Bands in the top pane along with the price plot and a MACD in the bottom pane (see Figure 1, above). You can apply a maximum of eight indicators to a chart. You also can create historical charts going back as far as 10 years and apply any of 48 technical indicators. You can draw trendlines on both intraday and historical charts a nice addition on a package at this price. News and research. When you notice a light bulb next to the ticker symbol in the portfolio, it means that company has news. Click on the light bulb and up pops a new window with two panes: The top pane contains the list of news stories associated with that symbol; the bottom pane is a browser window displaying the full text of the story. Fundamental data is available


FIGURE 2 PORTFOLIO TRACKING ProphetStations quote screen allows you to monitor a wide range of data on your favorite stocks, including intraday trend charts (seventh column from the left).

from Yahoo, and a complete set of reports from Zacks Investment Research is available as well. Alerts. The alert capabilities are relatively complete for a product at this price level. They include the ability to pull up a window given certain circumstances (using as a trigger price action, news events or any column value in a portfolio), the ability to highlight the row containing the symbol, audio alerts and, most importantly, e-mail alerts. If you have a pager or cell phone with an e-mail address, you can configure ProphetStation to alert that device when a wide range of conditions are met. Other features. One of the programs coolest features is a column inside the portfolio that displays a miniature version of the chart for each symbol (see Figure 2, above). Obviously, a chart of this size isnt useful for technical analysis, but if you want to see a particular symbols trend over the day, a quick glance is all it takes. ProphetStation also contains a separate ticker along the top of the portfolio pane that displays index data. You may select from a range of indices or specify other markets you want to track. Nasdaq Level II is limited at this point to the Island book. There is a menu item for streaming Archipelago quotes, but the connection didnt work.

ProphetStation is easy to learn and use. It takes up a relatively SOFTWARE SUMMARY Product: ProphetStation What it is: Real-time analysis platform with streaming quotes, charting, alerts and watch lists Who the product is for: Stock, futures, option and mutual fund traders Skill level: Beginner to intermediate Upside: Relatively inexpensive; program uses few system resources; good selection of analysis tools (including a trend chart that is visible within a portfolio) Downside: No Level II quotes (Island book only)

small amount of memory on your system so you can run it and any number of other applications simultaneously without adverse effects. Using the software was easy. Creating multiple-window workspaces is a simple process and changing technical indicators requires a simple point and click. Right-clicks control most of the action. If you right-click on a symbol within a portfolio, you can access charts, alerts and research for that symbol. If you rightclick within a chart, all of the chart variables such as frequency, chart period and indicators are available for modification. The software had a few glitches, as do many streamingquote platforms. When setting up an intraday chart in approximately one-quarter of a 19-inch display, using a one-minute frequency setting and anything greater than a 240-minute chart period, the plot got blurry. It looked like the bars were being plotted too close together to make them out. A solution to this is to set the chart period to a value less than four hours. (An inquiry to ProphetStations technical support e-mail address generated the response that they were aware of and working on the problem and a fix would be released soon.) The new release was not available at press time, but that kind of response from a technical support department is what we would like to see more often from vendors. Also, the separate index ticker bar at the top of the portfolio is only updated once every 60 seconds. This means the index data isnt actually real-time. To work around this just enter the index directly into your portfolio. That way the index will be updated in real-time from the same source as the rest of the symbols. Data. The quote and chart performance are good, and the data appeared to be high quality. (Prophet Financial, the maker of ProphetStation, is known for the quality of its data, which it also sells in a number of end-of-day formats). One of the problems with some streaming-quote applications is the quality of the data. A few bad data points can throw off your analysis and your trading.

Despite its minor drawbacks, ProphetStation is a solid real-time analysis platform for traders who do not need Level II quotes or advanced analysis features. Like other streaming quote programs, it has a few bugs, but for its price, its a winner.

18 June 2001 ACTIVE TRADER

TRADING Strategies


price patterns
For short-term trading, a few one- and two-bar patterns can be among the most useful tools you can use. Find out how to identify reversal points with these simple formations.

t is accepted among technicians that prices in all markets at all times are determined by psychology rather than fundamentals. Garfield Drew, a well-known technician in the 1940s, put it best when he said, Stocks do not sell for what they are worth, but for what people think they are worth. How else could you explain the phenomenal rise of the so-called nifty-fifty growth stocks in the late 1960s? These stocks flew up to incredible valuations by the start of the 1973-74 bear market. Even though most of the companies continued to increase earnings during the 1970s, few exceeded their 1973 highs until the 1980s. Such examples indicate that it is not earnings that drive prices, but the attitude of traders and investors to those earnings. Fortunately for market technicians, specific price patterns and formations often provide vital clues that sentiment is changing. Most people are familiar with patterns such as the head-and-shoulders, triangles, rectangles and so on, which are longer-term chart formations. For short er-term traders, price patterns that form over the course of just one or two bars often identify reversal points. These


used to be called one- and two-day patterns, but with the advent of intraday charts, one- and two-bar is more appropriate.

One factor that influences the significance of a pattern is its size or length. Because one- and two-bar patterns do not take very long to form, they have, by definition, only short-term significance. For example, under normal circumstances a one-day pattern would only be expected to affect price over a five- to 15day period. A two-bar pattern on a 10minute bar chart would influence the trend over the course of the next 50 to 60 minutes or so. However, these kinds of patterns can reliably signal short-term trend reversals. We will concentrate on four shortterm patterns: inside bars, outside bars, key reversal bars and two-bar reversals. To begin, lets establish the key reasons these patterns are useful. First, they generally reflect exhaustion points and are associated with reversals of the prevailing trend. In an uptrend, they develop when buyers have temporarily pushed prices up too far and, in a sense, need a rest; in a downtrend, they form when there is little, if any, supply because sell -

ers have finished liquidating their holdings. Second, for these formations to be effective there must be something to reverse. This means top patterns should be preceded by meaningful rallies and bottom formations should be preceded by sharp sell-offs. It is important to interpret these patterns not so much in black-and-white terms, but in shades of gray. In other words, not all patterns are created equal. Some show all of the typical characteristics of the pattern in a clear-cut manner. Others will reflect only a few characteristics in a mild way. Consequently, what we may call a five-star pattern one that clearly displays the full range of characteristics is more likely to result in a strong reversal than, say, a twostar pattern with mild characteristics. Always use common sense when interpreting these patterns; dont immediately conclude the presence of one of these formations guarantees a quick, profitable price reversal. The first pattern we will look at is the outside bar.

Outside bars are those for which the trading range totally encompasses that


FIGURE 1 OUTSIDE BARS of the previous bar. This pattern will appear after both downThe end of a downtrend is marked by a strong, upward-closing outside bar. trends and uptrends, and is a The increase in volume also is a sign of new buyers coming into the market. strong signal of exhaustion. In 60.00 Figure 1, notice the persistent Merrill Lynch (MER), 10-minute 59.50 downtrend on the afternoon of 59.00 58.50 March 20. At 4:20 p.m., an out58.00 side bar encompassed the previ57.50 ous bar and formed the low 57.00 56.50 point for the move. This outside 56.00 bar was a strong indication of 55.50 Outside bar demand because it opened near 55.00 its low and closed almost at its 7000 high. Note also the high volume that accompanied it. 6000 Although Figure 1 is an excel5000 Volume increase lent example of a outside-bar 4000 reversal pattern, again remem3000 ber that any chart pattern should 2000 be interpreted in shades of gray x100 rather than black and white. 4 p.m. 11 a.m. 12 p.m. 1 p.m. 2 p.m. 3 p.m. 4 p.m. 11 a.m. 12 p.m. Some patterns offer clearer signs 20 21 of exhaustion than others. The Source: MetaStock Professional by Equis International astute technician searches for additional clues to determine the FIGURE 2 INSIDE BARS degree of exhaustion in a particular reversal pattern. Consider a The inside bar indicates the market has reached a balance between the buyers and non-market situation: You could sellers. Any profit-taking can lead to a reversal of the uptrend. simply say the word help, but 1280 Peak bar if you shout help! from the March S&P futures (SPM1), 10-minute rooftop, you will get the mes1275 sage out far more clearly that 1270 you need help. The same princi1265 ple operates in the market. What are the clues, then? The 1260 Inside bar wider the bar, the stronger the 1255 signal. If the outside bar encom1250 passes the trading range of three or four bars it is likely, all 1245 else being equal, to be more sig1240 nificant than if it barely encompasses one bar, and so on. 1235 In Figure 1, the outside bar 1230 represents a five-star signal 1225 because it has all the characteristics of a strong reversal: more 11 a.m. 12 p.m. 1 p.m. 2 p.m. 3 p.m. 4 p.m. 11 a.m.12 p.m. 1 p.m. 2 p.m. 3 p.m. 4 p.m. than one bar was encompassed, Feb. 28 March a significant volume rise accomSource: MetaStock Professional by Equis International panied the outside bar and the trading action immediately after the outside bar occurred and do fail from time to time. Always Outside bars indicate a strong reversal in on low volume, indicating there was no use stop-loss orders to protect yourself. sentiment; inside bars reflect balance new heavy selling pressure. between buyers and sellers. Following a Still, a caveat is necessary: Not all onesharp up or down move, the inside bar and two-bar patterns are followed by Inside bars are the opposite of outside can forewarn of a trend reversal. reversals. As technical traders we are bars: The high and low of the inside bar During the trend preceding the formaalways dealing in probabilities, never fall within the trading range of the pre- tion of the inside bar, buyers or sellers certainties. This means that outside bars, ceding bar. The implication of the inside have everything going their way. The far along with other technical patterns, can bar is the opposite of the outside bar. left hand side of Figure 2 shows the buy20 June 2001 ACTIVE TRADER

ers are in charge. Following the peak bar, the development of the inside bar is significant because it suggests the market has reached a balance between buyers and sellers. This balanced state can be enough to entice longs to lock in profits. If they do this en masse, a shortterm reversal is the result. Three key characteristics give the inside-bar pattern power. First, the pattern should be preceded by a sharp up move or down move. Second, the trading range of the first bar (the bar preceding the inside bar) should be quite wide relative to previous bars. The wide bar indicates the strong, underlying momentum of the prevailing trend has reached a climax. Finally, the trading range of the inside bar should be much smaller than the preceding bar, which indicates buyers and sellers are now much more evenly matched. As a guideline, the sharper the contrast between the two bars, the greater the potential for reversal. The greater the number of aforementioned elements, the higher the probability the pattern is signaling a change in trend.

FIGURE 3 KEY REVERSAL BARS This chart includes a key reversal bar, an inside bar and an outside bar. The decline did not begin to accelerate until some time after the key reversal bar had developed. Because the inside bar formed with virtually no volume, we would expect the resulting rally to be short lived. Similarly, the low volume of the outside bar indicated the downtrend had not yet reached its climax.
Key reversal bar
17.5 17.0 16.5 16.0 15.5 15.0

Barrick Gold (ABX), 30-minute

Inside bar

Outside bar

1000 500 x1000

8 9 12 13 2001 Source: MetaStock Professional by Equis International




FIGURE 4 KEY REVERSAL BARS Two key reversals form, the first in September and the second in February. Key reversals often are followed by a sharp change in trend.
26 25 24

Key reversal

Barrick Gold (ABX), daily

23 Key reversal bars develop after 22 Key reversal prolonged rallies or reactions. 21 Often, the trend will be acceler20 ating at an unsustainable rate 19 before finally forming a key 18 reversal bar. 17 The classic key reversal pat16 tern has the following characteristics: First, the bar opens strongly in the direction of the prevailing trend with a gap 5000 above the previous bars high (or below the previous bars x10 low). Second, the bars trading September October November December January February March range is very wide relative to Source: MetaStock Professional by Equis International the preceding bars. Third, the bar closes near or below the previous close (in an uptrend) or near or though the subsequent decline did not dramatically, an inside bar forms with above the previous close (in a down- begin to accelerate until some time after virtually no volume. What follows is a counter-cyclical rally in a major intraday trend). Fourth, volume should be climac- the key reversal bar had developed. Figure 3 also includes an example of decline. The rally was short lived, which tic on the key-reversal bar. The key reversal shown in Figure 3 shows all of an inside bar and an outside bar. In the is not a surprise because the relatively the characteristics of a key reversal, center of the chart, after price declines low volume of the bar preceding the



FIGURE 5 TWO-BAR REVERSALS An immediate advance followed the two-bar reversal pattern. The inside bar immediately after the two-bar pattern was a sign of consolidation before the advance.
274 273 272 271 270 269 268 267 266 265 264 263 262 261 260 259 258 257 256 255 254

June 2001 gold (GCM1), daily

expanded along with the trading range. However, it is not preceded by much of a rally and would not therefore earn as many stars as the first one.

Two-bar reversal 16 22 29 5 February 12 20 26 5 March

Source: MetaStock Professional by Equis International

FIGURE 6 Both the two-bar reversals in this chart led to short-term trends.
74 73 72 71 70 69 68 67 66 65 64 63 62 61 60 ^16

Alltel (ATPR), daily

3 10 April Source: MetaStock Professional by Equis International





inside bar indicated the downtrend had not yet reached a climactic state. The outside bar in Figure 3 did not have any significant volume increase and, consequently, price consolidated for about four hours before resuming the downtrend, Figure 4 shows two classic key reversals, the first in September 1999 and the second in February 2000. The short-term rallies climaxed with volume explosions

and wide key-reversal bars. Key reversals often are followed by sharp trend changes, as was the case with the first key reversal in this example. Note that price rallied in the fourth and fifth sessions following the key reversal in September, and the termination of this brief advance was signaled by an outside day. The February key reversal example also is a good one because volume

The two-bar reversal is the final example of price patterns that signal exhaustion of the current trend. These patterns develop after a prolonged advance or decline. The first bar of the formation is a wide-range continuation bar in the direction of the current trend. For a five-star signal (in an uptrend), the close of the first bar should be at, or very near, the high. The opening of the next bar should be near the close and high of the 12 previous bar, indicating buyers come in expecting the trend to continue. However (and this is the point of the two-bar reversal), a change in psychology takes place as the second bar closes slightly below the low of the previous bar. Hence, the high expectations of participants at the opening of the bar are totally dashed at the end of the bar, indicating a change in psychology and thereby a change in the trend. To be most effective, this has to be a climactic experience. The two-bar pattern should be preceded by a persistent trend, and both bars should stand out by having exceptionally wide trading ranges. Figure 5 is an example of the two-bar reversal pattern on a daily chart. In many cases, an immediate advance fol1 lows such patterns. In Figure 5, May additional evidence of a reversal was given by the third day, which was an inside bar. Figure 6 shows two examples of two-bar reversals that preceded short-term trends.

These one- and two-bar price patterns generally impact a market for a very short period. They are not suitable for longterm investors. However, for short-term traders looking for clear-cut entry and exit points, they can be of immense value. June 2001 ACTIVE TRADER

TRADING Strategies

Getting in a position is one thing. Getting out of it with a profit is another. This trailing stop technique can help you hold on to profits in trending and choppy markets by adjusting to market volatility.
ity of trading books in circulation today focus on how to open positions; youd have a tough time finding one that focuses on how to exit them. Volatility has increased dramatically over the last few years. Thanks to this shift in dynamics, many classic stop techniques are not working as efficiently as they have in the past. The whipsaws that occur in just one day can stop a trader out of all his or her positions. The trader then often watches, exasperated, as the market completely rebounds within moments. With this in mind, it is necessary to find a trailing stop technique that is able to accelerate quickly and smoothly while allowing for the present market volatility. When you have a profit in a position, it is necessary to move beyond the initial stop and use a trailing stop to protect your gains. The Baker Five-and-Dime (F&D) allows you to do that. This approach is unique in that it does not use a fixed percentage or number of points to determine an exit level. Rather, it adjusts itself automatically based on the volatility and speed of the stock. The F&D requires three technical indicators: a five-period moving average, a 10-period moving average and volume. While the method works on any time frame, three- and five-minute charts work best for intraday trading. Limiting the number of technical studies helps prevent confusion resulting from conflicting signals. Although it is not specifically required for the pattern, volume provides additional confirmation for a move. Price shifts backed by volume tend to be more significant. When trying to determine how significant a move is, compare the volume of the current price bar to that of the last 20 bars. This will help show how many traders are participating in the move and can help to indicate the end of a move, such as a pullback.


or many people, trading success is exclusively a matter of the bottom line. However, a traders skill is based not on how much money he or she makes but on the consistency of returns. Good traders profit over time by consistently cutting losses quickly and letting winners run. Of course, talking about this and actually doing it are two different things. To accomplish this goal you need to design a strategy that fits your personality and risk profile. Contrary to popular belief, professional traders do not speculate; they look for trades with the highest probability of success. This approach is required not only for opening positions, but also for closing them a frequently overlooked aspect of trading. Unfortunately, the vast major-

There are two variations of the F&D, one for trending markets and one for nontrending (choppy) markets. A trending market can be defined several ways. The first kind of trending market is simply a bigger-picture bull market, in which stocks are in a longer-term uptrend and tend to rally out of pullbacks. The second type of trending market is one with a consistent intraday pattern (regardless of whats happening on a bigger-picture basis) that can be determined by simply looking at a five- or 10minute chart. Which way is the market moving in general: up, down or sideways? In a bigger-picture bull market it is not necessary to determine each day if the market is trending or not, although it helps to have an idea of the days direction. However, in a bigger-picture bear or choppy market, it is important to determine if the market is trending on a given day. Most importantly, the key is to have a feel for the overall situation. For example, from 1995 through early


FIGURE 1 VERSION 1.0 Version 1.0 of the five-and-dime (F&D) trailing stop approach is designed for trending markets. It uses penetration of a five-period moving average to signal the potential end of a move, while penetration of a 10-period moving average triggers the exit.
Applied Micro Circuits (AMCC), three-minute 10-period moving average Five-period moving average 32 30.313 29.842 29 58 28

The five-period MAmust be above the 10-period MA. 3. Signal: A close below the five-period MA indicates the move may be over. Prepare to exit the position. 4. Trigger: If the 10-period MA is broken by a quarter-point within five price bars, close the position. Figure 1, a three-minute chart of Applied Micro Circuits (AMCC) from March 1, 2001, shows this technique in action. AMCC was halted intraday after quickly selling off because of news released during regular trading hours. It reopened roughly one hour later and the Level II screen showed a flurry of buyers rushing both to cover shorts and perhaps profit on the long side. Once it was reasonably clear the stock was going to continue higher, there was a somewhat jagged move to the upside. The stock opened near 23 12, and after three price bars, the five-period MA crossed above the 10-period MA. Lets assume a long position was established near 26 14. At this point, the second rule had been met, and the stock had closed above the two MAs for three consecutive bars. Not long after the entry, AMCC made a short-term top near 28 916 and quickly retraced to 27 716, making its first move below the five-period MA, without closing below it. In the next 30 minutes the stock traded as high as 31 12 and it looked as if momentum might drive price higher. At this point another retracement occurred, out of which there would not be another rally something no one could know until after the fact. The signal was hit when the stock broke and closed below the five-period MA at 30 12. Roughly five minutes later the price penetrated the 10-period MA near 30 14 (the trigger) and the position was closed. Ultimately, AMCC fell as low as 29 716. The 8-point move from low to high was 35 percent of AMCCs re-opening price. Based on the aforementioned entry and exit points, a trader would have been able to keep four of the five points of the move in which he participated. Letting a winner run is hard enough, but with the type of activity occurring in this move and an erratic Level II quote screen, it was particularly difficult to hold on. The F&D is designed to keep a trader in for the meat of a move. The rules for the F&D v2.0 are as fol-

26 AMCC was halted because of news released during the regular trading session. Volume

24 Log 2,000,000 1,000,000 390,500









2000 the market was in a general uptrend. During these years, there were several short-lived bear markets, when downtrends were in effect, but the longer-term uptrend remained intact. In a strong bull market, the corrections are smoother, in the sense that a downward move will be more consistent. When we finally entered a real bear market, where many longer-term trends were broken, the choppiness began. The second variation (v2.0) of the F&D is for less-consistent, choppy markets, such as the environment that has persisted since October 2000. In this type of market, the technique is adjusted because many breakouts and breakdowns fail and are followed by quick retracements. There is often very little continuation and momentum is scarce. This type of market makes it very hard to hold a stock when it finally starts to move. A bear market is a perfect example. Although people often associate bull and bear markets with up and down movement, respectively, bear phases tend not to trend; they are more choppy. Although the overall direction may be down, this kind of market is plagued by choppy price and volume action. Sideways movement also is common. The easiest way to confirm if a market

calls for the second variation is when traders are being shaken out of clearly trending stocks because of whipsaws.

The key when entering or exiting a trade is to always watch for a continuation move, to avoid entering on a false breakout or getting shaken out by whipsaws. Initial moves are often traps. The continuation move refers to the price bar (in any time frame) after the initial move. The first move is known as the signal, which indicates the expected move is occurring. When the signal is hit, it is time to seriously monitor the price movement. The second part of the process is the trigger, which is the confirmation of the expected move. At this point, action is taken, and the position is closed. The F&D v1.0 rules for a long trade are as follows (reverse for short trades): 1. Add volume, a five-period and 10period moving average (MA) to the price chart. 2. When a stock begins to break out or run to the upside, it must trade and close above the five-period and 10-period MAs for at least three price bars. June 2001 ACTIVE TRADER

FIGURE 2 VERSION 2.0 Version 2.0 of the F&D is intended for choppier, non-trending markets. Similar to v1.0, a close below (in the case of long trades) the five-period MA signals the potential end of a move; however, the exit trigger is a move a quarter-point below the low of the bar that closed below the five-period MA.
Broadcom (BRCM), three-minute Sell at the close. 133 78 132.988 132 An entry is taken after the breakout. 128 The signal is given, but the trigger is not hit. Continue to hold. 136

124 Log 400,000 200,000 176,800 0 1/24 Wed.


11 Source:





lows (reverse for short trades): 1. Add volume and a five-period moving average (MA) to the price charts. 2. When a stock begins to break out or run to the upside, it must trade and close above the five-period MA for at least three price bars. 3. Signal: A close below the five-period MA indicates the move may be over. Prepare to exit the position. 4. Trigger: Exit the position when price moves a quarter-point below the low of the bar that closed below the MA. The two notable differences between versions 1.0 and 2.0 is that the latter uses only a five-period MA and waits for the continuation move on the second price bar (trigger). The goal is to avoid being shaken out by a false violation of support. An example will help illustrate this variation. On Jan. 23, Broadcom (BRCM) entered a consolidation with a slight downtrend (see Figure 2). After spending some time in this range, it finally broke out to the upside on a volume-backed move. Just before 2 p.m. EST, there was a pause in the move, providing an opportunity to enter this breakout on the continuation (near 125). After surging up to 130,

BRCM entered another consolidation, where it dipped below the five-period MAon several occasions. The signal was hit, alerting the trader to potentially close the position. However, the stock never hit the trigger, keeping the trader long BRCM during the congestion pattern. After taking a breather, BRCM made two more powerful moves until it topped out just over 134. Again, while the signal was hit several times, the trigger was never hit, keeping the trader long for almost a 9-point gain. Just before the close, there was a quick selloff, giving another sell signal. But as often happens, the sell-off was followed by a snap-back, taking BRCM back to its highs. A true day-trader could then sell his position at the close near 133 78. The trader remained long despite the whipsaw, maximizing profits on the trade.

driven move; sometimes a stock will be halted while you are in a position. Often, it is the things that we cannot control that cost us the most. As a result, it is crucial to take profits along the way to lock in gains. One technique that helps is to close a portion of a position with each one-point move from the entry point. In the case of an unexpected move, gains will already be realized. Selling into rallies and buying into sell-offs will ensure profits and help maintain focus. It is much easier on the psyche to sell because you want to not because you have to. Always use logic when trading. If youre using the F&D v1.0, pay attention to the difference between the five-period and 10-period MAs. If the two are separated by more than 2 points, it might be more efficient to sell out early (or buy back shorts) to avoid giving back too much of your profits. As a benchmark, never allow a trade to retrace more than 2 points, or 50 percent, of a move. The same logic applies to v2.0. If a trader is long and the five-period MA is violated by 2 points, or 50 percent of the move from high to low, the position should be closed without waiting for the trigger. Never let a trade profitable by at least 1 point become a loss. Finally, there is a shortcut for determining which variation of the trailing stop to use. If there is no trend clearly visible with the human eye in the stock you are trading, look to see if you can determine a trend in the broader market, and confirm the strength of the trend by looking at the volume. If a market index such as the Nasdaq Composite or Nasdaq 100 has not moved at least two percent from the opening price, then default to v2.0. This lack of movement tends to indicate choppy trading and a lack of momentum.

As most traders know, it is rare that textbook-style trades develop in real trading. It is not uncommon to have a certain amount of slippage in each trade and to experience several chart anomalies during the trading day. Sometimes there will be a quick sell-off or reversal on a news-

Good trading is at least 75 percent proper money management, which is a product of discipline. Before taking any trade, have strategies in place for both entry and exit. Once you have established the rules of the trade, stick to them. The recent activity in the market has shown us that sometimes there simply is no bottom and no forgiveness for undisciplined traders. Discipline means trading based on a plan, not a feeling. Strategize, dont speculate.


TRADING Strategies

Many Elliott Wave traders recommend you only trade the third, most dynamic wave of the Elliott Wave sequence. Heres a way to use a basic short-term chart pattern to recognize when the third wave is imminent.

Timing the THIRD WAVE

ome people contend that Elliott Wave theory (and related Fibonacci analysis) is too subjective and ambiguous for day-to-day trading. In some respects, that might be true. But the same thing could be said about any indicator, market fundamental or timing approach if a trader attempts to use it at all times and in all circumstances with little regard for what other analysis techniques are saying about the market. The best way to use any indicator is to find its strengths and focus on them. There is no need to waste unnecessary time on weaknesses once theyve been identified (other than to avoid them). If there are times when an indicators credibility is strained, do not use it. For example, if an indicator works great

in congestion markets but not in trending ones, only use it when other filters signal a consolidation period is taking hold. Elliott Wave analysis can be made more practical by combining it with short-term patterns that let you know where you are in a wave count and when to enter trades when the odds of a sizable move are high.

FIGURE 1 TEXTBOOK ELLIOTT WAVE A perfect Elliott Wave sequence consists of eight waves, labeled 1 through 5 and A through C. Wave 3 is usually the strongest wave in the direction of the underlying trend. The A-B-C correction should not fall below wave 4.
(Impulse subwave) 5 (Impulse subwave) 3 Major impulse wave A C (Impulse subwave) 1 4 (Corrective subwave) Major corrective wave

Elliott Wave organizes market movement into a series of impulse and corrective waves. Impulse waves move in the direction of the underlying trend and are numbered 1, 3 and 5. Corrective waves move against the underlying trend and are numbered 2 and 4. Each wave also holds a sequence of waves of lesser degree or magnitude. Impulse waves hold waves 1 through 5, while corrective waves hold a series of three waves, labeled A, B and C. Usually, wave 3, or wave C in a corrective move, is the

In many instances, this pattern will signal the onset of a third wave before traditional Elliott methods can verify it.
most dynamic wave within a sequence of waves and typically accounts for the sharpest moves made in the shortest amount of time. (Because the C wave is itself a third wave, it possesses most of the characteristics of a wave 3.) It also is the wave that immediately follows the first advance and pullback from an important low (or decline and rebound from a critical high). This allows a trader to clearly define a stop-loss level near the beginning of wave 1, which is usually not too June 2001 ACTIVE TRADER

2 (Corrective subwave)


FIGURE 2 ALTERNATE COUNTS far from the bottom of wave 2. For these reasons and to concentrate your Because wave 3 can never be the shortest wave in an impulse move (A), capital, time and energy on the most producthere must be an alternative wave count. In this case, what first seemed tive, highest probability and best risk-defined to be a wave 3, is actually a smaller wave 1 within a developing wave 3. opportunity, its recommended you only trade wave 3 of an impulse move or wave C iii 5 A B in a corrective move. This means that 75 percent of the waves in a normal wave sequence (six out of eight; the 1, 2, 4, 5, A & B waves) should be viewed as setups as opposed to signals. To find these waves it is important to understand the basics of the Elliott Wave principle. In a textbook Elliott Wave sequence, a mari 3 1 ket will complete five waves (1, 2, 3, 4 and 5) in 1 its impulse stage and then retrace in three waves (A, B and C) during its correction (see Figure 1, opposite page). There are some 4 important rules regarding the structure and ii relationship of these eight waves that must be 2 2 understood to effectively isolate the important third wave in an impulse move, or the C wave in a corrective move. These are: 1. Of the three advances in an impulse wave (waves 1, 3 and 5), wave 3 can never be the smallest, as rective sequence that follows a five-wave impulse advance often terminates at or above the low is the case in Figure 2a (above). If it of the preceding wave 4 (see Figure appears to be, there must be an FIGURE 3 A PERFECT WAVE 3 1). alternative count unfolding, as sugOf waves 1, 3 and 5, wave 3 usually covers the 6. The magnitude of waves 1 and gested by Figure 2b. most ground in the least amount of time. 5 are often similar, particularly 2. Of the three advances in an Consequently, it has the most profit potential when wave 3 has been confirmed as impulse wave (waves 1, 3 and 5), and should be the focus of traders trying to the dynamic wave by advancing at wave 3 is typically the largest and capitalize on Elliott Wave patterns. least 1.618 times as far as wave 1. most dynamic (Figure 3), often coin7. Wave 2 often retraces much or ciding with the revelation of funda5 all of wave 1. mental news or other technical 3 analysis tools signaling a shift in the The following set of additional trend. guidelines not found in Elliotts 3. The low of wave 4 should not writings can further help identidrop below the high of wave 1, as it 4 fy waves: does in Figure 4a, except in a diago1. Wave 4 often is similar in magnal triangle (a topping pattern, nitude to wave 1. known to most technical analysts as 2. Wave 5 often is similar in magan ascending wedge or bear nitude to wave 2 (there is a logical wedge). To filter out some noise it is 1 reason for these two points that is advisable to compare the tops and discussed separately). bottoms of waves using closing 3. The magnitude of wave 5 often prices only. 2 is related to the magnitude of wave 4. The low of wave 4 often termi1 by the 2nd degree golden ratio nates near the low of wave 4 of a of 0.786 or its inverse of 1.272. (The smaller degree (iv), as illustrated in 2nd degree golden ratio is the Figure 4b. square root of the golden ratio, 5. The low of the entire A-B-C corACTIVE TRADER June 2001 27

FIGURE 4 STAYING ABOVE WAVE 1 Wave 4 can never penetrate the top of wave 1 (example A). It often makes its low near the bottom of a wave 4 of a lesser degree, iv (example B). (below) the close two bars ago. Figure 5 shows an example. The 2CR pattern can complete in one day or extend over a couple of days. In other words, once a key reversal occurs, the important price is the close two days before the completion of the reversal; this price remains the confirmation point until the market closes below it. This might happen on the same day as the key reversal or it might take an additional day or two. (For a more in-depth discussion of the 2CR, see Patterns to improve your timing, Active Trader, December 2000, p. 46.) A 2SR takes the 2CR pattern a step further. To identify a bottom, as in Figure 6 (opposite page), it requires a 2CR up (the third bar), followed by a down bar, followed by another 2CR higher (the fifth bar). The main distinction is that the intervening down bar (the fourth bar) is not a key reversal and therefore cannot be a 2CR in the opposite direction. In many cases, the support for the second 2CR (formed on the fifth bar) is the same as the close two days before the fourth bars decline (the close of the second bar in the five-bar diagram in Figure 6). As long as the following bars remain within the price range of the first 2CR higher, this pattern can stretch out a few days. In other words, the textbook example involves five days from set-up to execution: three days to complete the first 2CR, a down bar on the fourth bar, and a second 2CR higher on the fifth bar. In reality there can be several days between the two 2CR signals as long as price remains within the range of the initial 2CR signal. The 2SR pattern is, in effect, a wave 1 advance (bar three in the five-bar sequence), wave 2 decline (bar four in the sequence) and the start of a wave 3 advance (bar five in the sequence) on a small scale (relative to the size of the bars being used). As a result, price often accelerates higher immediately after the completion of this signal, which is made stronger because of the double reinforcement of successive 2CR buy signals.


4 1 1 ii 4 2 2 i iv

0.618, which is the approximate value obtained from dividing one value with the next larger value on the Fibonacci series. The Fibonacci series is the sequence of numbers that, beginning with 1 and 2, results from adding the two previous numbers, as follows: 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144and so on.) 4. The end of wave 5 is often projected by adding the distance between the beginning of wave 1 and the end of wave 4 to the low of wave 4.

ect intraday trends. The 2SR pattern is a combination of successive two-close reversal (2CR) patterns that occur within a limited amount of time, in the same direction and without an intervening 2CR in the opposite direction. The 2CR is a key reversal pattern, but as opposed to a regular key reversal, the 2CR pattern also requires a close above FIGURE 5 THE TWO-CLOSE REVERSAL (2CR) PATTERN The 2CR pattern is a key reversal that also closes above (below) the close of the bar two days before. A key reversal pattern that does not immediately cross above (below) the close two days before can do so a few bars later to complete the pattern.

Although these rules identify all waves after the fact, they still help you position yourself correctly and prepare for the next sequence of waves. However, a practical trading strategy requires more precision. Once you know the market has completed an eight-wave sequence and is in the process of completing waves 1 and 2 in the next sequence, you need a way to identify the bottom of wave 2 and the start of the wave 3. One of the most effective patterns for identifying the beginning of wave 3 is the two-step reversal (2SR). This pattern can signal the onset of a third wave long before traditional Elliott methods. It can be applied on a daily chart to identify a two- to four-week trend, on a 60-minute chart to identify a two- to four-day trend or on an even shorter-term basis to proj28 June 2001 ACTIVE TRADER

FIGURE 6 THE TWO-STEP REVERSAL (2SR) PATTERN The 2SR consists of consecutive 2CR patterns with one or several bars between. In its most compact form, shown here, five bars are needed for its completion.

FIGURE 7 DOW JONES INDUSTRIAL AVERAGE TOP The second 2CR completed on Feb. 9 when the DJIA closed below the close of the first 2CR, which completed on Feb. 2. The key reversal bar on Feb. 6 indicated that a second 2CR was in the works. Note there are no other key reversal or 2CR patterns in any direction between Feb. 2 and Feb. 9.
Dow Jones Industrial, daily 11000

Key reversal First 2CR Second 2CR completed





Figure 7 shows that the Dow Jones Industrial Average first signaled a 2CR lower on Feb. 2, then rebounded into Feb. 6, before forming a subsequent extended 2CR sell signal on Feb. 9. The second 2CR stretched out over a few days from the key reversal day on Feb. 6 to the close of Feb. 9, below the close of Feb. 2. Figure 8 shows another example that took place in the dollar index futures. The market gave a 2CR buy signal on Jan. 3, pulled back on Jan. 4 and 5 and then gave a second 2CR buy signal on Jan. 8. In this case, the key reversal pattern of the second 2CR took two days to form, with the first bar closing near its low and the second bar closer to its high and above the close two days prior. The 2SR is an infrequent but reliable trading pattern. It is not the only way to identify a third Elliott Wave early on, but it is one of the more consistent. This offers two benefits. First, it filters out a great deal of false reversal signals. Second, it identifies the onset of the third wave, which is associated with the sharpest moves in the shortest amount of time. Whether this is used as a standalone pattern, a means of confirming other signals or a trigger to take a more aggressive position is up to the individual trader.










Source: TradeStation by TradeStation Group Inc.

FIGURE 8 DOLLAR BOTTOM The first 2CR, in the form of a key reversal with a close above the close two bars prior, formed in the dollar index. Three days later, on Jan. 8, a second 2CR developed, signaling a new up move. The second 2CR consisted of a twoday reversal with the close of the second day above the close two days prior.
Dollar index, daily First 2CR 111


Second 2CR completed with a 2-day reversal















Source: TradeStation by TradeStation Group Inc.



TRADING Strategies

MACD divergences
short-term trades.
level was confirmed by the MACD, as indicated by the upward-sloping line 1. However, the second test of the same level in August 1992 corresponded with a negative divergence between the price and the MACD, indicated by the downward-sloping line 2. (A divergence occurs when price moves in one direction and the indicator moves in the opposite direction.) Longer-term divergences such as this can alert the trader to potential weakness in the market. Had you reacted to this sign, you would have

No matter what market you trade, taking a top-down approach can save you from bad

decisions. Heres how to use the MACD indicator to identify longer-term turning points that set up

been ready when the free fall started.

lthough many stock traders believe short-term trading is a new phenomenon, its been going on for years in the foreign exchange (Forex) market. Unfortunately, many shortterm Forex traders (like stock FIGURE 1 BIG PICTURE traders) do not pay enough attention to the longer-term picture provided by monthly and weekly data. One reason monthly and weekly analysis is important is common technical studies such as the moving average convergence-divergence (MACD) tend to give stronger signals when longer-term data is used. Well show how to use the MACD indicator to establish a top-down (long-term to shortterm) analysis approach. Figure 1 (right), a monthly chart of the British pound with the MACD histogram (see Moving average convergencedivergence, opposite page), shows how starting with a long-term view will keep you on the correct side of the market. In early 1991, the first rally in the British pound to the 2.000


As with most technical indicators, the most reliable MACD signals occur when the monthly, weekly and daily analyses are all in agreement. However, this is not always the case; a lack of agreement between the time periods may cause some traders to miss significant opportunities or trade the wrong side of the market. To get a better feel for how to use the MACD, lets first set a few guidelines

The MACD divergence identified by line 2 on this monthly chart warned that the British pound was ripe for a downturn. British pound, monthly
2.0500 1.9800 1.9100 1.8400 1.7700 1.6300 1.5600 1.4900 1.4200 1.3500 0.0537

0.0337 0.0137 -0.0063 -0.0263

3/31/87 10/31/88









Source: Strategem Software and Bridge Data June 2001 ACTIVE TRADER

FIGURE 2 MONTHLY DIVERGENCES and then follow a sequence of events in the Japanese yen. The trending character of the currency markets lends itself to a top-down approach where the shorter-term trades are confirmed by the longer-term trend. Divergences in the monthly MACD signal the major trend has changed. Divergences in the weekly MACD histogram signal corrections within the major trend. Divergences in the daily MACD histogram also signal corrections within the major trend. However, trades against the long-term trend should be treated carefully. The longer-term divergences on the monthly Japanese yen chart provided advance notice of the major switch from downtrend to uptrend in 1995. U.S. dollar/Japanese yen, monthly
162.0000 153.0000 144.0000 135.0000 126.0000 117.0000 108.0000 99.0000 90.0000 81.0000 72.0000 3.1187

2.1187 1.1187 0.1187

2 1

-0.8813 -1.8813 -2.8813

3/31/87 10/31/88 5/31/90 12/31/91 7/30/93 2/28/95 9/30/96 4/30/98 11/30/99 Figure 2 (right) shows a longSource: Strategem Software and Bridge Data term chart of the Japanese yen together with a monthly MACD histogram. From April 1990 to April 1995, strong signs a major turning point is at dollar, was warranted. The ensuing decline that ended in the latter part of the value of the yen rose 50 percent, when hand. The dollar then rallied from 80 yen in 2000 took the dollar back to the 100 area. the exchange rate dropped from 160 to 80 Consequently, during the early 1995 yen per dollar. (For anyone not familiar early 1995 to 145 yen in June 1998. with exchange rates, a simple way of During this rally, the MACD formed an to mid-1998 period, the monthly MACD looking at this is that in April 1990 it took initial divergence in 1997, and a much told you to emphasize the long side and, 160 yen to buy one dollar; a few years stronger one in 1998, as indicated by line more often than not, buy dollars and sell 3. At this point, even the shortest-term yen. Between mid-1998 and late 2000, later, it took only 80 yen.) Today you can trade the Forex market Forex trader should have been warned the monthly MACD favored the short in $100,000 lot sizes, with leverage as high that a shift in the overall bias, from being side, which would have meant selling as 100 to 1, which means you can partici- bullish the dollar to being bearish the dollars and buying yen pate in the market with only a $1,000 margin requirement. (This increases both the profit potential and risk of trading in this market.) When the yen doubled in value to the dollar, it equaled a change in the exchange rate of 80 yen (160-80) or 8,000 pips, which is the Forex term for the he moving average convergence-divergence (MACD) indicator, smallest possible price increment. To caldesigned by Gerald Appel, is created by taking the difference culate how much a one-pip move is worth between two exponential moving averages (default values of 12 and in dollars, divide $1,000 with the current 26 days). An additional nine-day EMA is typically applied to the resulting number of yen to the dollar. At the beginoscillator to provide a signal line. Accordingly, the standard indicator is ning of the above move each one-pip sometimes referred to as the 12-26-9 MACD. change was worth $6.25 (1,000/160); at The MACD has a number of uses, including crossovers of the MACD and the the end of the move it was worth $12.5 signal line. Essentially, a buy (sell) is issued when the signal line crosses (1,000/80); and on average over the entire above (below) the MACD line. period it was worth $8.3 (1,000/120). The difference between the MACD line and the signal line is sometimes During this appreciation of the yen, the plotted as a histogram below the actual MACD. This is simply an alternate MACD formed its first divergence in way of representing MACD-signal line crossovers: When the histogram cross1993, shown by the upward sloping line 1. es above the median line, it represents the signal line crossing above the This divergence continued to grow into MACD line (a buy signal); the opposite is true when the histogram crosses 1995 (line 2). Double divergences, espebelow the median line. Also, divergences between the MACD and price can cially those formed over a two-year perisignal trend exhaustion (see Figures 1-4). od when viewed using monthly data, are

Moving average convergence-divergence



FIGURE 3 WEEKLY DIVERGENCES Weekly divergences help identify corrections within the major trend. The trick is to always put the weekly chart in the context of the longer-term, monthly chart.
154.0000 U.S. dollar/Japanese yen, weekly 147.0000 Line 1 in Figure 3 (above) shows 140.0000 there was no divergence formed 133.0000 by the weekly MACD his126.0000 togram during the yens initial 119.0000 appreciation in the early 1990s. 112.0000 However, the MACD is often 105.0000 misleading in strongly trending 98.0000 markets. To its credit, it did 91.0000 show a strong burst of upside 84.0000 momentum on the dollars first 72.0000 rally in 1995. 2.1789 During the subsequent 1.2789 2 3 appreciation of the dollar, the 0.3789 weekly MACD never reached 0.5211 the initial high levels of 1995. -1.4211 1 However, it did make marginal-2.3211 ly higher highs until August -3.2211 8/6/93 5/6/94 2/3/95 11/3/95 8/2/96 5/2//97 2/6/98 11/6/98 8/6/99 1998, when the histogram formed an eight-week negative Source: Strategem Software and Bridge Data divergence (line 3). Looking back to Figure 2, you can see FIGURE 4 DAILY DIVERGENCES that the monthly MACD histogram formed a second major Daily divergences must always be considered in light of what the weekly and monthly divergence at the same time. In charts say. Look for opportunities where the signals on all three time frames are in sync. keeping with the MACD guidelines, there was strong evidence U.S. dollar/Japanese yen, daily 148.0000 of a significant turning point 146.0000 with both the weekly and 144.0000 monthly MACD signals work142.0000 ing in tandem. 140.0000 Now, lets look at the daily 138.0000 data in Figure 4 (bottom left). 136.0000 Note that by early August 1998 134.0000 the daily MACD histogram was 132.0000 forming a long-term divergence 130.0000 to the downside, as indicated 128.0000 by line 1. This divergence later 0.5872 1 was confirmed by a shorter2 0.1872 term divergence (line 2), which -0.2128 was given further weight when the MACD histogram dropped 3 -0.6128 below the previous lows a -1.0128 sign of greater downside -1.4128 momentum. 6/1/98 7/1/98 8/3/98 9/1/98 This is where those traders Source: Strategem Software and Bridge Data who focus solely on the daily and intraday data most often interpret the MACD incorrectly.A trader lived. They can be traded by scalpers, itself especially well to catch currency who has missed a major rally often looks but it is often better to set up new entries trends, both with and against the longerat the first daily divergence in the in the direction of the weekly and term underlying trend. To make the most of this indicator, MACD histogram as a reason to trade monthly trend. however, its important that you work the short side. But if the daily diverwith a top-down approach, always makgences are not accompanied by weekly divergences, as they were in this case Because the MACD indicator works like ing sure you know what type of trending (see Figure 3), the corrections indicated an oscillator based on a trend-following move you can expect within the context by the daily MACD are generally short- indicator (the moving average) it lends of the larger trend.

32 June 2001 ACTIVE TRADER

TRADING Strategies


In our new Q&A on trade execution, routing and technology, we look at NYSE automatic trade execution, waiting in line for your order to be filled and the realities of online Forex trading.
Q. I entered a limit sell order (an order to sell a position once price hits a particular limit) with my online bro ker. Thousands of shares traded at my price, so I assumed I was filled. But at the end of the day, the stock was still in my account! I called the broker and he told me (after about an hour on hold) that stock traded ahead and thats why I didnt get filled. My question: What happened and would I get better results with a direct-access broker? Michael P. FIGURE 1 THE LEVEL II SCREEN The primary advantage of the Level II quote screen is that it shows all the bids and offers in a stock, not just the best bid and offer. This can help you decide at what level you should price a trade at a given time. A. There probably were other orders entered before yours. Because your order was part of a first-come, first-served process, the other orders got executed, but yours (and orders placed after yours) did not, because there were no more buy orders at that price level. This is truly an unhappy situation, and one that many traders are well acquainted with. Seeing all those shares trade, it is easy to assume your order will get done. But you can never take this for granted, because you really dont know all the parameters (or you didnt at the time you placed your order). This is one example of when a Nasdaq Level II screen can really help. If you had Level II access (and could see all the bids and offers at different levels, not just the best bid and offer), you may have seen there were many thousands of shares offered at your price. This information may have influenced where you priced your order. For example, you might have determined that an execution at that price was not likely and thus altered your order to best fit the circumstances. There often are numerous limit and stop orders placed around the figure that is, a round number ($47, $52). Sometimes when you place your order it is like waiting in line for a movie ticket: Being in line is important, but the closer you are to the head of the line the better, especially if the show is popular and might sell out. So, while you were waiting in line with your online broker (if you were not using direct-access software) your broker passed your order on to a market maker. When your market maker started selling, you were in line in his order queue as well. Orders placed with him at an earlier time than yours may have received time priority. So, your choice of price may have affected your order you may have chosen a very popular price, where other orders were waiting ahead of yours. Q. Ive heard the NYSE has a new elec tronic routing platform that bypasses the specialist. How can I get this? Thomas H. A. You probably already have it. Its called NYSE Direct and heres what it does: For marketable orders up to 1,099 shares, the Direct feature will provide instant execution against available stock



in price-time priority (i.e., first-come, first-served) without passing through the hands of the specialist. Member firms of the NYSE have integrated the feature, called NYSE Direct, into their software platforms. When you place an order to the NYSE, it will be sent to an NYSE member firm your brokerage has an agreement with; that member firm will in turn send the order to the floor of the exchange. If an immediate electronic execution is possible, the member firm will automatically designate the order Direct. If your order cannot be executed in its entirety (in the case of a limit order where the total number of shares you want to buy or sell are not available), the remaining orders go into the specialists book. As a retail user, you do not need to do anything different to take advantage of NYSE Direct. The new feature is an addon to the SuperDot system and was quietly rolled out in December 2000. Has this new feature significantly speeded up orders? Results arent available yet, but take note next time you trade a small amount of an NYSE stock, your order may have gone direct. Q. My browser crashes all the time; it seems to happen especially when I go to place an order (to my online bro ker). What can I do? Wendy Z. A. First of all, make sure that you clear your Temporary Internet Files (also called browser cache) on a regular basis (Temporary Internet Files is a directory within the Windows directory). These files are all the pages, pictures, etc., you have looked at online. Your browser stores these files on an ongoing basis and if you do a lot of Web surfing, you will rapidly build up a huge collection. When you try to access a particular Web page, it will first check the Temporary Internet Files folder to see if that page is already stored. But this checking process can grind to a halt as the number of files in this folder becomes unwieldy. As a result, your browser ceases to function. For easy, step-by-step directions on how to clear the files, go to For a related discussion go to www.orderX

FIGURE 2 TEMPORARY INTERNET FILES On a PC, the C:/Windows/Temporary Internet Files folder contains all the Web pages and images youve downloaded to your computer when surfing the Web. When this folder becomes too congested, it can slow down your browser (or cause crashes). Emptying it from time to time can improve performance.

Source: Microsoft

ket compare to direct-access trading of stock? Richard P. A. In the last couple of years, as directaccess equity trading systems have matured, Forex trading platforms have come online. However, execution in the Forex market is different from Nasdaq trading in many respects. Without getting into the particulars of currency trading, Ill concentrate on the execution question. In the Forex market, retail traders do not trade directly in the interbank market (the network of banks and institutions among which the trades are actually executed). Rather, the members of the interbank market create a market around the bids and offers. These bids and offers are the prices available to the retail trader. Often, there are no formal commission charges in Forex trading; the currency trading firms profit from the spreads they set. Better firms make very tight markets. However, since retail traders dont have access to the actual interbank quotes, it is difficult to Q. Ive heard about day trading the monitor just how tight the firm is keeping Forex currency market. How does the its market. There are essentially two types of speed of execution in the Forex mar 34

firms. Both maintain two-sided markets and display those quotes in their software. However, some firms guarantee to honor those quotes, while others do not. In the former case, the quotes presented in the software are firm, and you may execute against them at any time. In the latter case, you must request a quote for the trade you would like to execute. A quote will be provided immediately, against which you may execute. So, execution in the online Forex markets can be very fast, but the process is significantly different from execution in the equity markets. As time goes on, innovations will certainly occur in online Forex trading, making the market more accessible to retail traders. After all, the Forex market is a true 24-hour market. It moves from region to region across the globe, linked up continuously at the interbank level. The global foreign exchange market is huge on a dollar volume, around 140 times bigger than the NYSE on a daily basis. Forex trading is ubiquitous in Europe, and is rapidly gaining popularity in the United States. June 2001 ACTIVE TRADER

ADVANCED Strategies

MEASURING trend momentum

Most technical analysis indicators monitor either price direction or price momentum. Heres an indicator that does both, changing its behavior with the dynamics of the market.

f all the price-based technical indicators, few are as popular as simple moving averages. A simple moving average (SMA) is the average of a specific price point, usually the close, over a prescribed time period. The primary function of moving aver ages is to smooth prices, thus identifying the underlying trend. Countless systems have been built using moving averages and many billions of dollars traded based on their signals. As a tool, they are robust, simple to construct and easy to understand. As with all technical indicators, SMAs have their limitations. Since they smooth past data, they lag the actual price movement (i.e., any decline in the price of a stock will not be detected by the SMA until several time periods later). Many attempts have been made to make moving averages more sensitive to recent data. The weighted moving average (WMA), for example,

gives greater weight to recent data. Similarly, the exponential moving average (XMA) also gives the greatest weight to the most recent data, but unlike the WMA, the XMA takes all available data into account. In these instances, fixed weights are assigned to the data in calculating the moving average.

The variable-index dynamic moving average (VIDYA), originally developed in 1992, uses market information such as volatility to make the weighting scheme used to compute the moving average more responsive to market

action. Since its inception, it has been added to many commercial software packages and inspired many other traders to build their own dynamic moving averages. One of the features of VIDYA that makes it particularly attractive is that it flattens when the market consolidates. (To learn more about this indicator see The New Technical Trader, Chande and Kroll, John Wiley & Sons, 1994, and Beyond Technical Analysis, second edition, John Wiley & Sons, 2001.) However, a new variable moving average one that is, like VIDYA, responsive to market consolidations but is more


FIGURE 1 CONFIRMING THE TREND Notice how the Chande Directional Moving Average (solid line) has a more stable appearance than a regular exponential moving average. This characteristic can help you filter out whipsaw trades that are common during market consolidations. Nasdaq 100 Index (NDX), daily

ADXW REF 22.35 20.00




January 2000


Source: TradeStation by TradeStation Group Inc.

directly tied to the trend can be constructed. It is formed by combining the ideas behind the following three common indicators: the average directional index (ADX), the stochastic oscillator and exponential moving averages (XMA). The resulting indicator is called the Chande Directional Moving Average (CDMA).

A complete discussion of the ADX, stochastic oscillator and XMAis beyond the scope of this article, but a brief summary will provide the necessary background for our new indicator. The ADX has a rather complex calculation; it can be approximated by taking the simple moving average of a simple moving average of closing prices (double smoothing). While the ADX responds unevenly to price action, it is generally considered an excellent indicator of trend strength. The stochastic oscillator is comprised of two lines: %K and %D, the latter of which is a moving average of %K. To cal36

culate %K, subtract the lowest price of the most recent n bars from the most recent close, and divide that total by the range (high-low) of the most recent n bars. Stochastics range from 0 to 100. A reading over 80 is considered overbought and a reading below 20 is considered oversold. An exponential moving average is constructed by adding a fixed percentage, x, of the latest closing price to (1-x) of the previous value of the moving average. For example, an XMA could add 20 percent of the latest close to 80 percent of yesterdays XMA to find todays XMA. An XMA is designed to give recent prices greater weight. The plan behind the new CDMA is to apply the stochastic oscillator to the values of the ADX. When the ADX is rising, there will be a trend, and a stochastic applied to the ADX will be near the top of its range. Conversely, when the ADX is falling, which implies a lack of trend, a stochastic of the ADX will be near the

bottom of its range. The stochastic reading (translated into a value 4600.0 between 0 to 1, instead 4400.0 of 0 and 100) will then be used to weigh the 4200.0 XMA for the current 4000.0 bar. 3800.0 If the stochastic oscillator applied to 3600.0 the ADX indicator is 0, 3400.0 the assumption is that 3200.0 there is no trend and the new value of the 3000.0 XMA will be equal to 2800.0 the old value of the 2600.0 XMA. Hence, the 2400.0 CDMA will flatten out. 40.00 When the CDMA con35.00 firms the XMA action, 30.00 the trend has strong 25.00 momentum; when they 20.00 diverge, caution may 15.00 be warranted. Figure 1 shows the March CDMA (solid line) and the equivalent 20-day XMA(small crosses) on a continuous chart of the Nasdaq 100 futures. The lower half of Figure 1 shows a plot of the 20-day ADX. The market is trending when the ADX is above the reference level of 20 and rising. The values chosen for the length of the ADX and the reference level are arbitrary.

In October 1999, the ADX was at a low level, indicating a lack of trend, and the CDMA and the XMA had separated. As the market broke out of a trading range, the ADX quickly rose above 20 and the CDMA and XMA values converged rapidly, confirming the rally. During the consolidation in January, the ADX declined but stayed above 20, showing a weakening trend. Hence, CDMAand XMA separated, with the CDMAflattening out. When the Nasdaq rally resumed in February, the CDMA followed the XMA reluctantly, as the ADX had flattened out, even though it was above the 20 level. This is typical of rallies after brief consolidations within prolonged bull June 2001 ACTIVE TRADER

FIGURE 2 WORKING IN TANDEM During May and June 1999, the CDMA stayed flat, indicating the market was in a consolidation and that the crossover signals between price and the XMA should be ignored. However, when the market broke down in September, both MAs were moving in tandem, signaling a valid trading opportunity. Dow Jones Industrial Average Index (DJIA), daily
11800 11600 11400 11200 11000 10800 10600 10400 10200 10000 9800 ADXW REF 33.40 20.00 40.00 30.00 20.00 May June July Aug. Sept. Oct. Nov. Dec. 2000 Feb. Mar.

trends. The difference in behavior between the CDMAand XMAis explained by the fact that the CDMA responds to changes in momentum rather than prices. Figure 2 shows a continuous chart of Dow Jones futures. Note how the CDMA (solid line) flattened out during consolidations, and how the CDMA and the 20-day XMA (crosses) came together during declines, confirming the bearish tone of the market.

Source: TradeStation by TradeStation Group Inc.

Programming code
{Tushar Chande 2001: VIDYA/CDMA}
Input: Len(10); Vars: Diff(0), MyConst(0), MyAdx(0), Varma(0), EmaIndex(0); { Index of EMA } If Len > 0 then EmaIndex = (2 / (1 + Len)) else EmaIndex = 0.20; { Stochastic oscillator using ADX } MyAdx = ADX(20); Diff = Highest(MyAdx, 20) - Lowest(MyAdx, 20); If Diff > 0 then MyConst = (MyAdx - Lowest(MyAdx, 20))/Diff else MyConst = EmaIndex; { Clamp length to that implied by input value of Len } If MyConst > EmaIndex then MyConst = EmaIndex; { Create the variable MA } If CurrentBar < 50 then Varma = Close else Varma = (1 - MyConst) * Varma[1] + MyConst * Close; Plot1(Varma, VarMA) ; Plot2(XAverage(Close, Len), XAvg) This code can be copied from

The CDMA is a valuable variation on traditional moving averages but, like any other indicator, it has limitations. For example, price could continue to rise or fall slowly after an initial strong move. In this case, the ADX will be declining and the CDMA will flatten out, showing a lack of trend. However, the price action in this instance would be worth trading, as in the most recent period in Figure 1. Even so, you can use the CDMA to confirm that market momentum supports the move indicated by the equivalent XMA. You can also use it for any time frame, ranging from intraday to monthly data, and it gives you the ability to combine multiple time frames, as well as momentum data, into a single indicator.


The TRADING Systems Lab


Old faithful
Markets: Stocks, stock index futures, index tracking stocks (SPYs, DIAs, QQQs), futures and currencies

250 225 200 175 150

System logic: 125 This system is a combination of two techniques tested in previous issues of Active Trader. The 100 moving average slope (MAS) trend filter (Building a better trend indicator, May 2001, 75 p. 80) and the Meander short-term entry tech50 nique (Moving beyond the closing price, 1/23/95 7/24/95 October 2000, p.100, and the January/February 2001 Trading System Lab, p. 108). The following test uses six foreign currencies. We also decided to test only the robustness of the entry technique; the exit strategy is to close each position after two days, rain or shine. The MAS indicator is the difference between todays 80-day moving average value and its value 11 days ago. When todays moving average value is higher than it was 11 days ago, the trend is considered to be up, and the system will look for long entry signals only. Reverse the reasoning for short trades. The logic behind the Meander is a bit more complex. Its a combination between Bollinger Bands and momentum that uses all available price information from each bar, so that all open, high, low and closing prices are treated equally in the indicators construction. Together with the MAS trend filter it allows you to identify short-term overbought and oversold market conditions suitable for placing orders in the direction of the underlying trend. SAMPLE TRADES
Japanese yen, daily






1/18/99 7/19/99




Rules: 1. Go long if the MAS indicator signals an uptrend and the price crosses below the one standard deviation boundary of the Meander indicator (an oversold signal). 2. Go short if the MAS indicator signals a downtrend and the price crosses above the one standard deviation boundary of the Meander indicator (an overbought signal). 3. Exit all trades on the close after two days, counting the day for the entry as the first day in the trade, no matter how late in the day the entry took place. Test period: January 1995 to March 2001 Test data: Daily currency spot prices against the dollar for the Japanese yen, Swiss franc, British pound, Canadian dollar, Australian dollar and Euro (the German mark was used up until December 1998). No money was deducted for slippage and commissions.
115 LX 114 113 112 Buy 111 110

LX LX Sell LX LX LX LX Sell Sell Buy Buy SX Buy SX September SX October November Buy Buy Buy SX Sell LX LX Sell SX





109 108 107 106 105


Source: TradeStation by TradeStation Group Inc.

System analysis: First, there are a few numbers missing in the strategy summary report because we have calculated all values as percentages instead of dollars, which also means the equity chart shows the cumulative equity growth as a percentage rather than a dollar value. However, the results are perfectly valid for evaluating the systems robustness. (The filter and entry techniques also are taken as is from the stock market and therefore completely un-optimized for the currency markets.) When evaluating this system a few things need to be addressed. The average trade is very small in percentage terms, but because the profits are continuously compounded and immediately put to use in all

38 June 2001 ACTIVE TRADER

1/23/95 7/24/95 0.00% 1/22/96 7/22/96 1/20/97 7/21/97 7/20/98 1/18/99 7/19/99 1/17/00 7/17/00 1/15/01





(33.3 months). If you would like to optimize this system, we recommend you focus on shortening this period to less than 18 months. This too could be remedied by adding a few stop and exit techniques, which also should help lower the drawdown. Remember, however, that both the drawdown and the length of the flat period are highly dependent on how all the markets within the portfolio interact. In this case, most markets went heavily against us during the Asian economic crisis in late 1997 through late 1998.



Cumulative 12 months 24 months 36 months 48 months 60 months

future trades, even an average profit as small as this one will add up over time, provided the system is robust. A few welldesigned exit techniques should improve performance. One major disadvantage of the system is that the flat period (time between two equity highs) is much too long for comfort STRATEGY SUMMARY
End. equity ($): Total return (%): Profit factor: Avg. tied cap ($): Win. months (%): N/A 132 N/A N/A 63.5

Most recent: Average: Best: Worst: St. dev.: Annualized Most recent: Average: Best: Worst: St. dev:

22.25% 14.53% 59.01% -16.09% 17.35%

12 months

28.81% 26.42% 92.05% -10.09% 30.15%

24 months

33.62% 30.96% 94.54% -3.90% 26.15%

26.49% 50.08% 95.66% 22.07% 21.54%

69.53% 81.05% 98.32% 57.28% 12.20%

60 months

36 48 months months

Trade statistics
No. trades: Avg. trade (%): Avg. DIT: Avg. win/loss (%): Lrg. win/loss (%): Win. trades(%): 1,653 0.05 2.0 0.60 (0.62) 4.45 (6.12) 55.0

22.25% 14.53% 59.01% -16.09% 17.35%

13.49% 10.14% 6.05% 11.14% 12.44% 9.41% 10.68% 12.61% 38.58% 24.84% 18.27% 14.68% -5.18% -1.32% 5.11% 9.48% 14.08% 8.05% 5.00% 2.33%

Avg. annual ret. (%): 15.0

Max DD (%): Longest flat (m): 21.6 33.3

TIM (%):
Tr./Mark./Year: Tr./Month:

45.9 23.0

LEGEND: Cumulative returns Most recent: most recent return from start to end of the respective periods Average: the average of all cumulative returns from start to end of the respective periods Best: the best of all cumulative returns from start to end of the respective periods Worst: the worst of all cumulative returns from start to end of the respective periods St. dev: the standard deviation of all cumulative returns from start to end of the respective periods Annualized returns The ending equity as a result of the cumulative returns, raised by 1/n, where n is the respective period in number of years

LEGEND: End. equity ($) equity at the end of test period Total return (%) total percentage return over test period Avg. annual ret. (%) average continuously compounded annual return Profit factor gross profit/gross loss Avg. tied cap (%) average percent of total available cap ital tied up in open positions Win. months (%) percentage profitable months over test period Max DD (%) maximum drop in equity Longest flat longest period, in months, spent between two equity highs No. trades number of trades Avg. trade ($) amount won or lost by the average trade Avg. DIT average days in trade Avg. win/loss ($) average wining and losing trade, respectively Lrg. win/loss ($) largest wining and losing trade, respectively Win. trades (%) percent winning trades TIM (%) amount of time there is at least one open posi tion for entire portfolio, and each market, respectively Tr./Mark./Year trades per market per year Tr./Month trades per month for all markets

If you have a trading system or idea youd like to see tested, send it to us at the Trading System Lab. Well test it on a portfolio of stocks or futures (for now, max 30 markets, using daily data starting Jan. 1, 1990), using true portfolio analysis/optimization. Most system testing software only allows you to test one market at a time. Our system testing technique lets all markets share the same account and is based on the interaction within the portfolio as a whole. Start by e-mailing system logic (in TradeStations EasyLanguage or in an Excel spreadsheet) and a short description to, and well get back to you. Note: Each system must have a clearly defined stop loss level and a suggested optimal amount to risk per trade.

Send Active Trader your systems

Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee future results; historical testing may not reflect a systems behavior in real-time trading.



The Face of TRADING

fter retiring from IBM in 1992, Bob Frassanito became an enthusiastic student of technical analysis. But he gradually learned that when it comes to trading, less can be more. Being an engineer, technical analysis appealed to me, Frassanito says. I was able to look at charts and see whether something was in an uptrend or downtrend. I think I went through the normal evolution in technical analysis. I began by using standard indicators and then began writing my own formulas. As I progressed, my analysis became more

Keeping it simple
complicated. I kept adding custom indicators. But I began to realize that my analysis technique was becoming too cumbersome. A conversation with a neighbor changed that. It helped that Frassanitos neighbor happened to be Richard Arms, the market analyst and creator of the widely watched Arms Index, or TRIN (see Indicator Insight, Active Trader, December 2000, p. 88). Arms suggested Frassanito stick to one or two indicators, but learn them well. He said, You know Bob, if I had a watch, I could tell you what time it was. But if I had two watches, I wouldnt know what time it was. That kind of sunk in, Frassanito says. I started throwing away all of the esoteric custom formulas and got very simple. Frassanito now relies upon stochastics (see Indicator Insight, Active Trader, August 2000, p. 82), entering trades when an overbought or oversold read40

As I progressed, my analysis became more and more

ing or a divergence is complemented by a trendline violation. This combination helps him identify situations in which a stocks price is down but its momentum has turned back up or vice versa. Frassanito estimates 50 percent of his trades are winners, but he is profitable because his profit-to-loss ratio is approximately 2 to 1. On the day he was interviewed, he got in and out of eight positions, although he says that is about twice his daily average. He prefers to swing trade, holding positions for two to three days. But if the market does not seem to be closing the way I think it should, Id rather not carry a position overnight, Frassanito says. Im exiting at the end of the day more frequently because the aftermarket is so unstable and you dont know where it will open the next day. Id rather be flat and start fresh in the morning. As an example of his approach, Frassanito pointed to a trade he made on

complicated. I began to realize that my technique was becoming too cumbersome.

Feb. 6 in the Nasdaq 100 tracking stock (QQQ). He tends to use a seven-period stochastic with a four-period smoothing (on a five-minute candlestick chart). The QQQs fell to 60.5 around 1 p.m. (EST), which coincided with an oversold stochastic reading of 10. A divergence June 2001 ACTIVE TRADER

If a pattern fails,
occurred at 1:30 p.m. when price made a new low (at 60.12) but the stochastic made a slightly higher low at 13. That suggested the stock was making a new low on decreased downward momentum a bullish sign. Frassanito drew a down trendline from a mid-morning high of 61.6 to the early afternoon low of 60.12. He bought at 60.5, when the stock moved back above the trendline. He uses discretion to exit most of his trades, often scaling out of positions. What I have started doing lately is rather than putting a protective trailing stop under the position, I try to take the profits on the way up, he says. I miss out on some opportunities, but I dont give back nearly as much. Although Frassanito does not necessarily use a trailing stop, he does put on an initial stop when he first enters a trade. He places it at the bottom of the most recent swing move, which in this case was at the 60.12 low. He adds that if his stop is hit, he will often turn around and take a position in the opposite direction. In the case of the QQQ trade, if he had been stopped out of his long position at 60.12, he would have gone short. Failed patterns can be lucrative, he says. If a pattern fails, something with

something with power is moving against it, which means there are many sellers in what was originally a buy pattern. So there is usually a good move the other way.
some power is moving against it, which means there are many sellers in what was originally a buy pattern. So there is usually a good move the other way.

Trading set-up
Hardware: 600 Mhz Pentium III Dell laptop with docking station connecting
a 19-inch monitor; tape drive for backup. The same machine is used at home or when traveling.

Internet connection: Satellite connection to AOL (approximately 500k reception speed,

24k sending). Backup ISP is AT&T (56k modem, 24k maximum speed).

Brokerage: CyberCorp (direct access) Analysis Software: Equis MetaStock Pro version 7.03

Frassanito also monitors the indices and volume. If the broader market is down for the day, he may be reluctant to buy a stock even if his signals tell him to. Likewise, he wants to know volume is moving in his favor. That gives me a feel for momentum and whether there is a lot of push behind the direction Im trying to trade in, he says. Frassanito tends to confine his trading to around 25 stocks he is most familiar with, many of them in the tech sector. As the head of a local users group for MetaStock (a trading analysis software program), Frassanito is often asked for advice by newcomers. Fundamental analysis lends itself to long-term investing, he says. If you want to trade short-term, you must use technical analysis. Study indicators and develop a feel for how they work. Once you get a few you feel comfortable with, back-test and see if you have a technique that has some advantage. Then paper trade, and paper trade a lot. When somebody does start trading with real money, Frassanito advises to start small no more than 100 shares at a time. Youre trying to prove the technique youre using, he says. Once you feel comfortable, you can increase your size. Also, you really have to protect your assets put stops in and get out when you feel a trade is going against you. You will lose from time to time, but you want to live to fight another day. Not doing this, he concedes, is one of the mistakes he sometimes makes. Suppose I go long because I get an entry signal, but then the trade starts going against me, and I pull the stop because I think the trade will come back, he says. In another scenario, I may have to leave and do not put in a stop. Both situations are deadly. Thats the worst thing you can do. I need someone to kick me in the shins every time I do that.


TRADING Psychology


The risk door swings both ways: Taking too much risk or not taking enough can sabotage your trading. Learn how to improve your understanding of risk and trade according to the prevailing market conditions.

isk unavoidably involves uncertainty, in trading as in all areas of life. One trader defines risk this way: Risk is how much you are willing to lose on any single bet, he says. This has to do with your tolerance your tolerance for uncertainty. Anything other than cash is risk. The most commonly emphasized aspect of risk control is the need to curtail losses quickly. The flipside is discussed less frequently: Some traders suffer from an inability to assume the necessary risk to realize a profit. No trader should incur risk unnecessarily, but a trader who tries to keep losses too small will simply put himself out of business incrementally. All traders must understand the environment in which they trade, learning to balance the risks of the market with the need to accept enough risk to profit. For the last 10 years, I have participated in the development of a short-term, catalyst-driven stock-trading approach built around the discipline of setting daily or weekly targets. The objective is to minimize risk and maximize profitability by taking profits at the high point of the
42 June 2001 ACTIVE TRADER

intraday volatility over the period of one to three days (for example, selling a stock at the high point of the intraday volatility and buying it back on pullbacks at cheaper prices). By focusing on achievable results, the trader is able to control risk in a proactive way by trading in and out of a stock in response to shorter-term market movements. By using both long

key to risk management. Often, traders are reluctant to use sufficient capital to reach their objective or are so driven to meet a goal they do so in a foolhardy way. While the risk manager is concerned with measuring performance in terms such as volatility, standard deviation and rate of return, personality features and

need to be improved to increase the chance of profitability. The problem is that markets are not static. You have to adapt your style to changes in the marketplace. If you are a trend follower who plays small, incremental changes into a breakout and takes the first bit of profit, you may want to hold longer and profit from the

The best traders are humble, open, resilient and willing to keep working on themselves so they can remain objective. If they are rigid and fearful, they wont learn additional skills for handling risk.
and short positions, a trader can eliminate systemic market risk. The power of this short-term model was brought home to me recently when I spoke to a value-oriented portfolio manager who was beginning to adopt the approach to his trading. Find the ideas that are hot for the day, he says. Make a decision as to how you are going to trade them [that] day or the next several days. The goal is to find a good entry point, feel it out and play it out dont chase the stock. What is new is to have this as an everyday requirement and to cut through the hyperbole to the essence of a story and the essence of a short-term trade. According to this trader, the daily goal-oriented approach is different from analytically oriented, longer-term trades. Most people dont think in short-term, goal-oriented terms. Longer-term fundamentalists are trading stories over an extended time line of three months to a year, which results in a lot of wasted time and productivity. It is more productive to look at the curve of volatility in stocks on a daily basis, which provides trading action daily. attitudes are the ultimate limiting variables in how individuals handle risk. It is not uncommon to see traders trade a smaller number of shares of more expensive stocks even though they are most likely to make the most money with these stocks. They may be trapped by their risk aversion and will need to address this issue to be able to expand their ability to assume risk and enhance their chances for greater profitability. 2. Make a traders report card. Important questions I constantly ask traders: Do you think you trade a particular part of the swing in a stock? What part of the chart do you like? If you charted your trades, where in the cycle of the chart are you most likely to be buying it or selling it? Are there any regularities or patterns to your trade selections? One of the most useful insights into a traders performance is to examine a typical trade and then ask critical questions about the psychological factors that may have influenced the trade, such as: What prompted you to get out of the trade so fast? Was there a reason you didnt add to the position when it was working in your favor? These kinds of questions are useful in illuminating a traders willingness to take on more risk after uncovering information that may increase the chance of profitability. These questions are also useful in discovering trading patterns. When these patterns are identified, you can begin to focus on elements of your trading that increased volatility and heightened range of trades. If you are a contrarian trader, you want to be more cautious in the volatile markets so you dont exhaust your resources waiting for the stock to turn at the inflection point as it goes higher. 3. Be confident in your confidence. The psychology of proper risk taking requires a willingness to go to the cutting edge, learn new skills and follow your discipline in the face of difficulties. It requires a willingness to be coached, accept support from others, ask questions, get beyond the need to appear to be in control. The best traders are humble, open, resilient and willing to keep working on themselves so they can remain objective. If they are rigid and fearful, they wont learn additional skills for handling risk. In addition, successful risk management requires that a trader not be easily distracted, too argumentative or too opinionated. A trader must be willing to measure risk by assessing the upside and downside of a trade and stepping out of the comfort zone to take on new behavior patterns. He or she must develop the ability to reduce positions in the face of drawdowns and cut losses appropriately. A trader must have the ability to add resources to his or her approach to increase knowledge, skill and capacity to execute. I asked a successful trader how these criteria related to his own risk manage43

The study of risk involves examining a traders style favorite kinds of trades, information used and the attitudes and habits that comprise a traders assumption of risk. Here are the keys to understanding risk: 1. Set a target and reach it. This is the


ment approach. His answer: I am trading with $10 million. If I can grow, I believe I can do five times as much with $50 million as with $10 million. Some traders conversely may think of how much they can lose with the larger amount of money. That is why they are not using all of their capital when they are trading. They are dominated by a need not to lose.

Do you know other traders who would have traded it differently? The value of this kind of consideration is that it begins to clarify the ways people approach opportunities for taking risk. Next consider: What are some of the alternatives you might have taken, or what steps do you need to take to expand your trading style and your assumption of risk? What are the barriers or obstacles to doing this? What might you have experienced in the past in relationship to similar trades that is a sticking point for you something you have trouble doing because it creates too much anxiety or uncertainty?

To understand what it will take to improve your risk profile, it is useful to consider where you fall in the spectrum of trading styles and approaches. Specifically, think of a recent trade you

If you ride out enough downturns, you get to a level where doing so will be easier.
Do you have difficulty increasing the size of your positions, even when you know the fundamentals and the stock is moving in your direction? By considering these kinds of questions you come face to face with steps needed to become a better, more skilled and more flexible trader. In effect, a trader who has trouble accepting risk must be able to understand how to get bigger, how to hold longer, what to overcome in his personality that is interfering with his capacity to handle more risk.

made and look at the chart of that stock over a period of time say, the six months prior to the trade. Answer the following questions in relation to that trade: Where did you get into the trade? Where did you add to the position? Where did you get out, if you got out? Was there anything about your trading style that was reflected in the way you traded that stock? Did you buy it at the bottom and scale into the position as it moved upwards? Or did you buy it at the bottom and get out fast as it was going up? Conversely, did you see it as an opportunity to start shorting the stock prior to an anticipated inflection point, and did you get out after the inflection point as the stock was going down? What does your approach to the trade tell you about your general style of trading and risk tolerance? Looking at the same chart, can you see how others might have traded the stock?

In order to profit it is necessary to risk something. If you risk too much and dont have a good reason for putting on a trade, you put yourself in jeopardy. To put on a trade in as risk-free a way as possible requires considerable practice and, most of all, understanding your own psychological contribution to the process which ultimately is the key to the whole game. Learning to tolerate the uncertainty in order to succeed or to reach a greater

level of success is essential. Sometimes, tolerating the uncertainty means riding out a drawdown. If you ride out enough downturns, you get to a level where doing so will be easier. Believe it or not, when you take enough pain, you will eventually be able to relax and enjoy it more. You can learn to sell positions when you are down instead of holding on to them. You will be able to admit a losing trade and get out of it sooner. You will learn to trade in the zone not some magical place, but a mindset of total action, focusing on the present moment, without concern for your emotions or past mistakes. Being in the zone allows you to take appropriate risk, to balance your risk, to size your risk and to tolerate the uncertainty of risk. Being in the zone means you can tolerate the pain better. Risk-taking requires a certain amount of guts. Some traders gain confidence after successes and take on more risk. On the other hand, others remain so consumed by fear of failing they are unable to get any bigger. On a micro basis, there is no recipe in learning how to trade. Risk-taking, though, is best done by focusing on the processes and tasks ahead. Risk-taking means a willingness to create a new vision for your trading and breaking the shackles of limiting life principles and past perspectives. It means acting outside the vicious circle that fear creates. Risk-taking means being willing to make your trades based on a goal that you have previously set, following an action that you have already outlined. To manage your risk is to engage in your trading in a spontaneous and naturally open and honest way. It means being willing to make decisions to act before all the facts are in and before you have checked everything out with the experts. According to a successful bond trader, The psychology of risk is the psychology of confidence. Trader confidence means knowing what to do in all situations. Good markets make geniuses. The confidence that people have the traders edge is the confidence that they are going to do it so that they might as well do it bigger. That is the key. Step one is to develop a methodology that makes some money. If you can get people to make money steadily, then you only have to turn up the gas a little bit and play bigger. June 2001 ACTIVE TRADER

RISK Control and MONEY Management

Analyzing the CRINGE CURVE

Knowing how much to risk isnt the same as being able to handle risk. Heres a technique you can use to analyze your risk tolerance and make sure your stop-losses are placed at levels where you can execute them.

here are two parts to risk control: Having a risk management plan in place and being able to implement it. Unfortunately, when it comes time to act, many traders cringe they cant execute because they are frozen by the prospect of taking losses. By using records of past trades it is possible to plot a cringe curve that identifies the risk levels we are able and unable to handle. From there we can better match our risk tolerance level with our ability to execute. First, we need to understand just why it is we cringe and how we can measure it. The primary control risk method is the stop-loss order. However, although it is a well-known technique, only a few traders apply it consistently. Stop-loss strategies require discipline and willingness to act. It is astounding how many times we fail to act when our stop-losses are hit. This is not a problem with the stop-loss mechanism, but with our ability to use it. We seem to find convenient excuses to abandon our stops, ranging from the old standbys (my stop is too close, the price looks like its getting better) to the more imaginative (the mouse stopped working, the telephone rang and tied up the Internet line just before the close of trading, visitors arrived and so on). These are similar to the excuses we often make when we have a dental appointment. It is often only severe discomfort that encourages us to go. A toothache is not enough to outweigh the potential for more pain at the dentist. Regardless of the excuse, we freeze just when action is required. The

prospect of financial loss is not enough to outweigh the pain of executing a stoploss order. We shy away from making a decision. The value of this freezing point is measured in the potential dollars lost and it varies from trader to trader. If we can develop a better understanding of the way our fear develops and where the freeze point is located, we can improve the chances of acting on stoploss orders. By researching our past trades we can develop a cringe curve to help us plot our position in real terms. loss incurred. These curves fall into four sections with quite different shapes. Figure 1 (below) shows an example. Section 1 is the type of curve we expect, with a steady rise from our ability to act quickly and efficiently to the area where action becomes more difficult. As the level of loss increases in dollar terms, the ability to act on a stop-loss decision is diminished. A $500 loss is easy to take. (Your starting figure may be different, but the shape of the curve remains the same.) By the time the loss grows to $1,500 it takes a little more thought before we click the mouse to send the sell order. As the level of financial pain increases, we find our good intentions get weaker. In this example, by the time it sneaks to over $2,000 our ability to act is frozen. In trading, this shows up as an indecision zone created by our inability to take action. We intend to honor the stop-loss, but we actively seek reasons not to execute it. This is section 2 of the curve. It is the freeze point the danger zone responsible for more trading deaths than any other factor. It is directly related to the size of the potential loss. We have shown this zone stretching from $2,000 to $3,000. Sometimes we can screw up our courage and take a larger-than-normal loss, but once a loss grows to this size it is very difficult to act on a stop order. The larger a loss grows the greater the probability that we will fail to act. The shape of the curve changes in section 2 to create this freeze point. There is no gradual move from action to inaction. As the size of the loss grows we move rapidly through this zone of indecision

Start the process by identifying the size of the losses in your past trades. Two important aspects of trading behavior typically emerge. We are good at selling when a loss is quite small. For example, if the loss is $500 we sell the position without difficulty. Stop losses at this level are easy to execute. We also are good at selling when a loss is very large. Well use a loss larger than $4,500 in this example. These are trades that have gone seriously wrong when the evidence of failure is too large to be ignored. It often takes a long time to make the sell decision, and it is rarely related to a formal stop loss level. Once the decision is made we tend to sell at whatever price is available. These sell decisions are like cleaning out the spare room. Its distasteful, but once done it is a bit of a relief. Between the two extremes of a small loss and a very large loss, a series of curves compare our willingness to take action on our stop-losses with the size of the dollar


FIGURE 1 CRINGE CURVE The cringe curve plots the typical traders ability or inability to accept a loss as it increases in size. Most traders can handle a small loss, but many freeze when the loss moves out of their comfort zone.
Unable to act Section 1 Section 2 Section 3 Section 4

Action indecision

stantial, almost catastrophic losses. They are too large to ignore, and it takes a great deal of courage to sell. The shape of this curve is a function of time and the dollar loss. For some perverse reason, after a long period in a losing trade it becomes easier to sell a stock with a very large loss. Our ability to act returns quickly and the large loss is locked in with grim resolution. You may have one or two of these trades in your trading records. (Hopefully they date back to your days as a novice.)

Dollar indecision Able to act 500

The freeze point danger zone

1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 Level of dollar loss

to a stage where fatalism takes over. You can verify the exact parameters of this danger zone from your trading records. Most traders beginning or experienced have an idea of how much loss they can comfortably take. Keeping detailed records of your trades (i.e., a trade diary) helps provide a precise figure. Pinpoint the price at the time of this indecision and calculate the loss in dollar terms. This loss cluster defines the danger zone. These are trades that you know you should have closed, but did not. When there is a gap between where this danger zone is on the scale of dollar loss and where you think it is, you have a problem. You may believe you can take a $2,000 loss but your trading records will prove if this is the case. Your cringe level may be lower than you think it is. In this example, the successful trader knows he can take a loss up to $2,000 without too much worry. As a result, his stop-loss level is at the edge of zone 1 and he has a high probability of acting on his stops. By contrast, a novice trader tends to consistently overestimate his cringe level. He thinks he can take a loss up to $2,500. But in reality this puts his stop loss in the middle of the danger zone on the cringe curve in Figure 1. When it comes time to act he is paralyzed. Instead of looking for the best exit he looks for reasons to stay in the trade or distracts himself from the trade. Once the loss breaks into section 3, the cringe curve changes shape again. As the

loss grows, in this case beyond $3,000, we quickly decide that it is so large that we cannot afford to take it. This is more than paralysis or freezing. We disown the trade, turn our backs on it and walk away. (This exit from the danger zone often has a well-defined trigger level and can be plotted within just a few hundred dollars.) Resolving not to take action to disown or forget the trade comes with a rush of relief, as shown by the way the curve quickly climbs to the unable level and stays there. In effect, we jump at the opportunity to avoid pain. Now, the larger the loss grows in dollar terms the less likely we are to close the trade. Traders come up with some remarkable excuses for this inaction, including: This company has real value but it has been unfairly lumped with all the other dot-coms; this is a long-term investment; if I dont sell then I really havent suffered a loss; its only speculative money, so you have to expect a major loss every now and then. Take a good look at your account. How many of your trades are in section 3 of the curve? More importantly, how did they get there? Identify the period, defined by the dollar value of the loss, where they slipped into and then out of the danger zone. This is the starting point for plotting your personal section 3 of the cringe curve. Use your trading records to define how large the loss grew before you closed the trade. Section 4 is the last significant threshold. Figure 1 shows it as a loss greater than $4,500. This level represents sub-

Heres a solution to the inability to act on stop-loss orders. If you move the size of your dollar stop-loss so that it falls in Section 1 of the curve, you instantly improve the odds of actually executing a stop-loss order. As mentioned, this value will differ from trader to trader and can be established by analyzing your trading records. The shape of the cringe curve matches our ability to act with the size of the dollar loss. Take the time to plot your own cringe curve and adjust the figures to match your trading experience and records. If youre a beginner, plot the curve using figures you think are correct and then track your trading performance against the curve. Adjust the level of dollar stop-loss until you identify your personal danger zone. As your experience grows and discipline develops, the danger zone moves to the right. It becomes easier to take a larger loss and stop-losses placed in this area will be executed. No matter how experienced or skilled we become, the shape of the three sections in the cringe curve remains the same. Successful trading is possible while we make sure our intended stop-loss remains in Section 1 of the curve. When it is, we give ourselves a better chance to trade effectively because our stop-loss level is in sync with our ability to act.

Additional reading:
Market Trading Tactics by Daryl Guppy, John Wiley (2000). Trading to Win by Ari Kiev, John Wiley (1998). Trade Your Way to Financial Freedom by Van K. Tharp, McGraw-Hill (1999). June 2001 ACTIVE TRADER


Riding the
Becoming a successful trader is about finding a good trading strategy template. Heres how to avoid the two most common bumps on the road to trading proficiency.



ew traders commonly believe in the myth of the market guru that there are successful traders who are blessed with a sixth sense that allows them to anticipate every move in the market. With this gift, these gurus only need to place their orders at the correct time, take a short nap and awaken in time to close their positions with a gratifying profit. Not surprisingly, there is a different thought among successful traders. They know learning to trade is a long, hard road filled with financial and emotional potholes. They understand there are no secret gifts or psychic abilities that make them successful; experience and emotional and technical discipline allow them to excel. There is no secret formula to making money in the stock market. In fact, it can even be argued there is no such thing as a market expert or guru. The truth is, no one can predict better than anyone

It can be argued there is no such thing as a market expert or guru. The truth is, no one can predict better than anyone else what the market will do next.

else what the market will do next. In other words, trading is not a gift, but a skill that can be learned and practiced. Any skill whether it be playing golf, learning the piano or trading has a learning curve. Unfortunately, beginning traders often ignore the concept of trading as a skill and the reality of a learning curve because the lure of riches motivates them to try to make money before they know what they are doing. The fascinating thing is that a traders learning curve is independent of the system he or she chooses. It makes no difference whether youre a day trader, position trader or investor. If you study top traders in books or listen to them speak at conferences, you will find they all trade different systems; hardly any of them trade alike. However, their learning curves and experiences are usually similar.


There is nothing more important or valuable than experience. By understanding the learning curve of trading, you can learn to set goals by it, eliminate common mistakes and accentuate important trading skills, regardless of your system or time frame.

When asked what they want to accomplish in the markets, most traders probably would respond, Make money. However, a beginning or struggling traders first goal should be consistency. Whether a trader initially makes money is not as significant to a long-term trading career as forming a template for correct trading, which can be rebuilt and improved over time. The creation of this template should be the first and foremost goal. However, the most common trading learning curve is distinguished by two major pitfalls. These mistakes are prime suspects in the poor performance or failure of most traders, and the pain and frustration they cause can haunt a trader throughout his or her career. Mistake No. 1: Not cutting losses. Many traders know the financial and emotional pain of having just one or two big losers wipe out an extended run of profitable trades. It is common to hear, I made $10,000 last month, but I had two bad trades that lost double that. Or, If I just had gotten rid of XYZ, I would have been up 50 percent last year. The reasons for not cutting losses vary, but the most common is that traders dont want to admit they are wrong about positions they put on. While it is true that a couple of big winners can make your month, it is more likely that a couple of big losers will destroy your month and the month before that as well. If you recognize intuitively or empirically that large losses are crushing your portfolio, then you have faced the learning curves first major challenge. One exercise that has turned many traders performances around is practicing taking losses, with the goal that the losses will not be huge. Many traders who undertake this exercise and resign themselves to the fact that they will lose, report (remarkably) their first monthly profit. Practicing taking losses requires a completely different mindset from dreaming about big profits. You are not focused on how much you will make or how good you will feel. You are simply

focused on the process of mechanically accepting losses, proving to yourself that you can honor your stops. You focus on execution without keeping score of profits or losses. Good traders do not make up the rules of probability; they live by them. And one truth about probability in trading is that inevitably you will pick a loser that will devastate your portfolio unless you stop it first. One effective technique that can be used on any time frame is to move your stop up to breakeven at the first chance, then trail a 50-percent stop as the stock moves in your direction. In other words, as soon as your position becomes profitable, move your stop to your entry point. This protects you from losing money on the position and essentially turns it into a free trade. As the position moves in your direction, move your stop up so 50 percent of your profit is protected. If a stock moves forward a certain amount, and then retraces more than half that amount, exit your trade. While many different techniques can be used, the key is to always have some kind of stop-loss system. A stop-loss is like insurance. While it is true that the price of this insurance is high, there is a reason: The cost of failure in trading could be everything you have. Mistake No. 2: Too many trading ideas. With todays heavy marketing of trading products, and the plethora of market information available, it is only natural to assume that each bit of information can help you get one step closer to your ultimate goal. It does not. Not only does attempting to use too many trading systems and ideas at one time not work in a practical sense, it also contributes significantly to your stress level. Traders often get caught up in trying to find the solutions to detailed trading problems instead of focusing on the big picture. Before some traders understand trading different time frames, they are concerned about interpreting Level II. Before they understand chart patterns, they wonder whether wireless trading will give them an advantage. Before they understand valid breakouts, they wonder if exotic options strategies will put them on the cover of Forbes. In other words, many traders try to maximize their returns before they have any returns. The template is not formed. There is no basis

from which to move forward. An example is a trader mulling over the money he might lose if he does not possess a direct-access trading platform. A gross fallacy in the market is that faster is better. However, speed doesnt make you better or worse trader; it simply accentuates what you are already doing. If you trade a system that has not been successful and dont have a consistent template from which to work, faster tools and brighter lights wont help you become more successful; they will simply help you lose at a faster pace. Another common mistake among beginning traders is changing time frames when a trade goes against them. Your intraday trade is down $500, and in a wave of inspiration (read: desperation), you decide it becomes a long-term investment. Or, the opposite may occur: You set up a trade with a two-week horizon, then get nervous and sell when you are two points up. A solution to maintaining discipline in your time frame is to keep long-term investments separate from your short-term trades. Use different brokers whose tools are appropriate for each of your trading and investment time frames.

The key is to focus on a single system, strategy or approach, one that can be repeated over and over. This is your template. The very best traders in the world are not known for their skill at trading numerous systems. They look for a pattern they are comfortable with and trade it repeatedly. For new traders, the best approach is to understand basic trading systems and pick the one that best fits their time frame and emotional disposition. Further, this is an ongoing process, not a weekend project. Recognizing the learning curve of trading, and acting upon it, allows you to objectively assess performance patterns rather than subjectively reacting to the ups and downs of daily trading. The first and most difficult goal in trading is to consistently make money. It does not matter if it is $1 per month, as long as you havent lost money. You can grow as you progress along the learning curve. A trader who learns to cut his losses and focuses on a single trading approach has accomplished the most difficult task in becoming a successful trader: building and following a template of consistency. June 2001 ACTIVE TRADER


Indicator insight:

Advance-Decline (A-D) line

Advancing issues Prev. A-D value Day 1 Day 2 Day 3 1,500 1,200 900 Declining issues 500 600 1,400 Difference +1,000 +600 -500 A-D line value 10,000 11,000 11,600 11,100

he Advance-Decline (A-D) line is a breadth indicator that measures aspects of supply and demand not always reflected directly in price. The indicator is a day-to-day running total of the number of stocks that have closed higher on the day (advancing) minus the number of stocks that have closed lower on the day (declining). A version using the week-to-week figures can also be used as a longer-term indicator. The most commonly referenced A-D line is the one calculated on New York Stock Exchange (NYSE) stocks, but the indicator can be calculated on any index or exchange.

The A-D line is most commonly used to gauge the strength or weakness of a trend in an index. An A-D line that moves in the same direction as the trend of the market supports the strength Calculation of that trend; the opposite is true when the A-D line moves counter to the trend. A-D line = [AS (today) DS (today)] + AD (prev) For example, when an index embarks on a sustained uptrend but the A-D line declines (which means more stocks where are losing ground from day to day), it means a minority of stocks are propelling the index higher. Because a strong trend AS(today) = the number of advancing stocks (those that is typified by broad participation among the stocks in the index closed higher than the previous days close) (rather than a select few), the behavior of such an A-D line DS(today) = the number of declining stocks (those that reveals potential weakness in the market. (The key word here closed lower than the previous days close) is potential, as will be discussed in the next section.) Similarly, AD(prev) = previous days A-D line value shorter-term divergences between the index and the A-D line are sometimes used as indications of an imminent reversal or That is, add the difference between the number of advancing correction (see Figure 2, opposite page). stocks and declining stocks today to yesterdays A-D number, Because the A-D line reflects the roughly 3,500 stocks traded on which is the running total of all previous days. A nominal the NYSE, it can provide a broader (and more in-depth) perspecvalue is often used to begin the A-D calculation. The following tive of overall market strength or weakness than an individual table shows an example. index, such as the Dow Jones Industrial Average or S&P 500, which consist of only 30 FIGURE 1 THE ADVANCE-DECLINE (A-D) LINE and 500 stocks, respectively. The A-D line reflects how many stocks are rising vs. falling. Here, the declining A-D line revealed that more stocks were falling from day to day even though the NYSE index continued to rise. NYSE Index, daily
700 675 650 625 600 575 A-D line 550 525 500 475 A M J J A S O N D 99 F M A M J J A S O N D 00 F M A M J J A S O N D 01 F Source: ACTIVE TRADER June 2001 450

The level of the A-D line is unimportant, since the beginning value is nominal. The direction of the A-D line, especially in relation to its underlying index, is whats crucial. However, the A-D line can diverge from price for extended periods, as shown in Figure 1, making the indicator a less-than-reliable timing tool. When more stocks are participating

FIGURE 2 DIVERGENCE: PLUSES AND MINUSES in a trend, the stronger it is; howevTwo divergences are highlighted on a longer-term (weekly) A-D line. The first came in late 1997 when er, a minority of the NYSE index traded sideways to slightly higher and the A-D line diverged by making a series of exceptionally strong lower highs. The market subsequently shot to the upside. In 1998, however, a divergence between stocks can prop up the index and the A-D line was followed by a sharp sell-off. an index for quite a NYSE Index, weekly while. The A-D line 700 may be able to tell you that the trend in 650 an index is weak, but it cannot tell you 600 when that trend will 550 end. A-D line The A-D line does 500 not measure the de450 gree to which stocks are rising or falling 400 day after day, only whether more stocks 350 are rising than falling 300 or vice versa. As a 1997 1998 1999 2000 2001 result, the indicator Source: can be misleading. For example, if the Because of these issues, Paul Desmond, president of analysis number of declining stocks was consistently higher than the number of advancing stocks, but only marginally so, the result- firm Lowrys Reports Inc., says the standard A-D line has lim ing falling A-D line could be perceived as a reflection of weakness ited timing value (his firm uses a proprietary version of the in the market. However, the advancing issues may be rising indicator that excludes many of the interest-rate-sensitive much more dramatically than the declining issues are falling, stocks). He says when the A-D line shows the market is broadening, portfolios can be more widely diversified. When the Awhich, on balance, would be bullish. Also, temporary (and common) pullbacks in the market can D line shows the market is narrowing, investors and traders result in retracements in the A-D line which may trigger diver - should progressively eliminate the lagging issues in their portgence signals, which can appear repeatedly in strongly trending folios and concentrate on the remaining strong stocks. markets. It is difficult, if not impossible, to gauge which signals have a high likelihood of forecasting a true reversal. The Advancing-Declining Issues indicator is simply each days individual advance-decline number (i.e., the ones in the Many traders believe it is necessary to include unchanged Difference column in the table), not the cumulative figure stocks in the A-D calculation. Others point out the indicator that makes up the A-D line. (Traders typically smooth this indican be unduly influenced by interest rates because of the num- cator with a moving average because it is erratic.) The Advance-Decline Ratio is the same indicator except that ber of preferred stocks and other interest-rate-sensitive stocks it encompasses and, as a result, only common stocks should be it divides the number of advancing issues by the number of used in its calculation. However, obtaining a common-stock- declining issues, rather than taking the difference between them. These indicators are generally used to highlight overonly version of the indicator can be difficult. bought and oversold levels. The McClellan oscillator is the difference between two exponential moving averages (see Indicator Insight, Active Trader, June 2000, p. 78) of the A-D line. It also is used to identify overbought and oversold levels.


A comparison of advancing stocks vs. declining stocks (the internal strength or weakness of the market), rather than a direct analysis of price movement.

When an indicator and a market (or two markets, or two indicators) move in opposite directions, such as when an index rises (or makes a higher high) and its A-D line falls (or makes a lower high).

The A-D line is a longer-term indicator that measures the underlying (internal) strength or weakness of a trend in a stock index. It shows if more stocks are advancing than declining, but it does not measure the degree to which those stocks are rising or falling. It can provide additional insight into the strength or weakness of a trend, but it should not be relied upon exclusively because it can diverge from price for long periods of time. June 2001 ACTIVE TRADER



Successful risk control is about knowing what to do when a certain event occurs before it occurs. But the only way to know what to do is to use trading techniques that let you act instead of react.

instead of react. Acting means having a specific, predetermined plan, no matter what the market is doing. Reacting means waiting for something to happen and then responding, addressing each situaFIGURE 1 COMPARING AVERAGES tion on a case-by-case basis. Shifting a moving average forward in time gives you room to prepare and act. Note how the The importance of 3x3 DMA (red line) tracks the regular nine-bar MA (blue line) closely while the market trends. being proactive in But, because its shorter, it approaches the price faster when the market starts to consolidate. money management is stressed in the Trading Japanese yen, daily 120 Systems Lab in each issue of Active Trader, where all systems 118 require both an exact stop-loss level and an exact amount to risk. 116 Being proactive means not doing anything before any of those lev114 els are hit, even if the market is behaving in a way that may cause 112 you to doubt the trade. Unfortunately, with the exception of pure 110 price-pattern analysis, most technical indicators encourage a reac108 tive trading approach. Even a 20-day breakout system can leave December January 2001 February March you with very little Source: TradeStation by TradeStation Group Inc. and Unfair Advantage time for planning
ACTIVE TRADER June 2001 51

he hallmarks of good trading and money management plans are that they require traders to act

FIGURE 2 SEVERAL AVERAGES, SEVERAL TRENDS ahead. There are, however, two techniques taught by trader Joe DiNapoli that lend themselves very well to planning ahead, and consequently to risk control and money management: The displaced moving average (DMA) and DiNapoli levels (which are based on Fibonacci analysis). Depending on the type of trader you are, one of these two approaches offers a good starting point for research on proactive trading. If youre a systematic trader, you should learn more about the DMA. If you have a more discretionary approach, look into DiNapoli levels. Using several DMAs provides multiple price levels for which you can plan appropriate action. The disadvantage is that not all the averages will be suitable for your trading horizon. Nasdaq 100 (NDX), daily 4200 4000 3800 3600 3400 3200 3000 2800 2600 2400 2200 2000








Jan. 01 Feb.


Source: TradeStation by TradeStation Group Inc. and Unfair Advantage

The blue line in Figure 1 (opposite page) is a regular nine-bar moving average (MA) applied to the Japanese yen. With a

regular MA, a buy (sell) is triggered when price crosses above (below) the average, or when the MA changes direction. However, because there is no way of knowing where and when the

he Fibonacci series is a number progression in which each successive number is the sum of the two immediately preceding it: 1, 2, 3, 5, 8, 13, 21 and so on. As the series progresses, the ratio of a number divided by the immediately preceding number approaches 1.618, the golden mean found in the dimensions of the Parthenon, the Great Pyramid and many natural phenomena. Some traders use 1.618, its inverse .618 (.62) and other ratios (such as .38 and .50) to calculate price targets and retracement points. For example, if a stock rallied from 25 to 55, potential retracement levels could be calculated by multiplying the distance of the move (30 points) by Fibonacci ratios say, .38, .50 and .62 and then subtracting these results from the high of the price move. In this case, levels of 43.6 (55-[30*.38]), 40 (55-[30*.50]) and 36.4 (55-[30 *.62]) would result.

The Fibonacci series

crossover will take place, this is a reactive approach. Depending on the last move in the market, the where and when of a trade will change continuously. Contrast that to the red line in Figure 1 that shows a second, shorter MA. Instead of charting its last reading together with the last price bar, it is displaced a few bars into the future. In this case, it is a three-bar moving average shifted forward three days in time (3x3). Shifting a moving average forward is a way of projecting a technical price level ahead of time, which makes it easier to set up specific guidelines for what to do in the event of different market situations. Combined with other analysis techniques, the DMA gives you a better feel for where and when certain scenarios are likely to occur. As already mentioned, one major advantage of the DMA is that it allows you to use proper money management and risk assessment methods. The prob- June 2001 ACTIVE TRADER

TABLE 1 SYSTEM COMPARISON The system using non-displaced averages has a lower drawdown and higher net profit than its DMA counterpart. However, the DMA system has a higher profit factor and average profit per trade. Performance summary: All trades Total net profit($) Gross profit($) Total Number of trades Number of winning trades Largest winning trade($) Average winning trade($) Ratio avg. win/avg. loss Max. consecutive winners Avg. number bars in winners 186,826.00 330,736.50 236 86 44,064.00 3,845.77 4.01 4 14 Open position P/L($) Gross loss($) Percentage profitable(%) Number of losing trades 0.00 (143,910.50) 36.44 150

Largest losing trade($) (35,457.50) Average losing trade($) (959.40) Avg. trade (win and loss)($) 791.64 Max. consecutive losers Avg. number bars in losers Max. number contracts held Return on account(%) 13 2 1 371.89

depends on how aggressively you want to trade the system using a fixed-fractional money management strategy. What matters more at this stage of the evaluation process is the profit factor (how many dollars the system makes for every dollar it loses) and the average trade, which in both instances are higher for the DMA system. Unfortunately, the largest loser also skyrockets for the DMA system, which, of course, is not a sign of more efficient risk control. This disastrous trade coincided with the end of the bull market in late March 2000.

Max. intraday drawdown($) (50,237.50) Profit factor 2.30 Account size required($) 50,237.50

Performance summary: All trades Total net profit($) Gross profit($) Total Number of trades Number of winning trades Largest winning trade($) Average winning trade($) Ratio avg. win/avg. loss Max. consecutive winners Avg. number bars in winners 254,074.50 480,636.00 469 170 58,095.50 2,827.27 3.73 6 7 Open position P/L($) Gross loss($) Percentage profitable(%) Number of losing trades 0.00 (226,561.50) 36.25 299

Largest losing trade($) (11,140.00) Average losing trade($) (757.73) Avg. trade (win and loss)($) 541.74 Max. consecutive losers Avg. number bars in losers Max. number contracts held Return on account(%) 14 1 1 696.20

Max. intraday drawdown($)(36,494.50) Profit factor 2.12 Account size required($) 36,494.50

Source: TradeStation by TradeStation Group Inc. and Unfair Advantage

lem with just using one DMA, however, is that you only have one level to work with. One way to work around this is simply to use several averages. Figure 2 (p. 89) shows the Nasdaq 100 index with the three DMAs. The red line is the same 3x3 average shown in Figure 1; the blue line is a seven-bar average displaced five days forward (7x5); and the green line is a 25-bar average displaced five days forward (25x5). In this case, one systematic trading

strategy could be to buy only when the 3x3 DMA is above the 7x5 DMA, and price is above the 25x5 DMAand crosses above the 3x3 DMA. A stop loss could be placed at the 7x5 DMA. Table 1 (left) shows the result from such a system (top), compared to the same system using regular (non-displaced) MAs (bottom). The regular MA system has a higher net profit and a lower drawdown. However, the end result ultimately

One way to avoid such trades is to scout for potential overbought or oversold regions using DiNapoli levels. This also can help address one of the major disadvantages of using too many averages at once: Theyre all trying to capture trends of different magnitudes. Therefore, instead of using several averages, use the one that best fits your trading horizon and combine it with DiNapoli levels. This is the way to go if you prefer to trade with more discretion, as opposed to being 100 percent systematic. DiNapoli levels can be very hard to quantify and implement in a systematic strategy. Briefly put, DiNapoli levels are the most commonly used Fibonacci retracement and expansion levels, such as the 61.8 percent retracement of the latest bull or bear run, or the 161.8 percent extension of the latest trend in relation to the previous one in the same direction (see The Fibonacci series, p. 90). Our disaster trade could have been avoided (or at least traded with lower risk) had we known that the DiNapoli levels indicated major resistance in the 4,850 to 4,860 area, suggesting the upside of the trade was limited to approximately 160 points. Because the stop-loss, as indicated by the moving averages, was approximately 350 points below the entry point, knowing the upside potential beforehand would have alerted us to a bad trade.


Figure 3 (below) shows the entire bull run that led up to this bad trade. The arrow signifies March 28, 2000, two days after the market topped at 4,816. To find the forecasted Fibonacci/DiNapoli resistance level, calculate 61.8 percent of the length of the preceding bull run (marked as trend A in Figure 3): (4,660 3,349) * 0.618 = 810. Add that to the subsequent retracement bottom (marked as B in Figure 3) prior to the bull run leading up to the trade: 4,050 + 810 = 4,860.

framework for possible market action and gives you plenty of time to plan your course of action. All successful traders use techniques that help them trade proactively instead of reactively. Without such techniques, there is no way to apply proper money management and risk control. To learn more about DMAs and DiNapoli lev els, see Trading with DiNapoli Levels, Coast Investment & Joe DiNapoli, 1998.

All successful traders use techniques that help them trade proactively instead of reactively.

Keep in mind that just because the market is approaching an important DiNapoli level, or some other Fibonaccirelated support or resistance level, a change of direction wont occur automatically. It simply means these points are likely levels for buyers and sellers to enter the market, making it possible for support and resistance levels to emerge. Knowing this beforehand enables you to be proactive instead of blindly reactive. Similarly, there is no guarantee something dramatic will happen just because price crosses a DMA (or any other type of average, for that matter). However, this kind of analysis provides a

FIGURE 3 CALCULATING RESISTANCE The one trade that ruined the performance summary for the DMA system could have been avoided by combining it with some basic Fibonacci retracement/expansion analysis. This type of analysis is, however, very hard to program into a mechanical trading system. Nasdaq 100 (NDX), daily Forecasted resistance 4800 4600 4400 4200 B Trade A 4000 3800 3600

24 31 (F) 7 14 28 (M) 6 13 20 27 (A) 10

Source: TradeStation by TradeStation Group Inc. and Unfair Advantage

54 June 2001 ACTIVE TRADER

The Business of TRADING

Keeping your trading business

When evaluating business and tax structures for trading in an entity, traders need to consider substance over form. An unincorporated trading business is the best choice for most traders.


n trading, an edge can come in many forms: a particular pattern, superior execution capabilities, better money management and so on. Another edge is properly structuring your trading business for tax purposes. Traders are often enticed by the potential benefits of various business entities (corporations, LLCs, etc.) and are eager to establish them. However, these benefits are not always what they appear to be at first glance. One-man shows who trade for their own accounts are interested in separate legal entities for their trading businesses because they think trading in an entity will lower their tax liabilities. However, for the majority of traders this is not true. Unincorporated traders are able to take advantage of all of the trader tax benefits without having a separate legal entity. There is one exception: The reason a stock trader should consider a separate legal entity is to create earned income to fund a retirement account. While many proposals from proprietary trading firms and tax professionals are attractive in form, traders need to look closer at the substance, or reality of a tax and business structure, as well as its underlying legal agreements.
ACTIVE TRADER June 2001 55

In many cases, traders are being sold form, which is materially different from the underlying substance. Because certain business proposals may lead to trouble, sometimes traders should just say no. The bottom line: The Internal Revenue Service (IRS), many state tax authorities, and the Securities and Exchange Commission (SEC) value substance over form. Next, well explain how unincorporated traders can take full advantage of all trader tax laws and benefits by qualifying as being in the business of trading.

Some traders who dont qualify as being in the business of trading believe that conducting their trading activity in a separate legal entity will help them qualify for trader tax benefits. This is not true.
reported on Schedule C are connected to trading gains and losses reported on either Schedule D or Form 4797. Unincorporated traders with trading business expenses are able to deduct their entire trading business expenses (and trading losses if they have filed for mark-to-market accounting treatment) against all other types of income on their individual income tax return (see Get the tax refund you deserve, Active Trader, March 2001, p. 128). A trader who establishes a C-corporation and has a trading loss in his or her

To unlock trader tax benefits (business deductions and ordinary trading loss treatment vs. capital loss limitations), a trader first must qualify as being in the business of trading. Traders are considered by the IRS to be in the business of trading when they trade frequently, continuously and actively regardless if this activity takes place through a business entity or not. These qualifications are subjective rather than objective. Some traders who dont qualify as being in the business of trading believe that conducting their trading activity in a separate legal entity will help them qualify for trader tax benefits. This is not true. An entity may appear to be a trading business in form, but the IRS will look at the underlying activity the substance in making its decision. If the business activity is really just investing and does not rise to the level of a trading business, the IRS will consider the entity to be an investment company and not a trading business. In that case, the trader is not able to take advantage of any trader tax benefits (no business expenses and no ordinary loss treatment).

first year will not get immediate tax relief from trading business expenses and trading losses. The C-corporation is a separately taxed entity, so the losses cannot be utilized on the traders individual tax return. However, the C-corporation tax losses can be carried forward to a future corporate tax year. Unincorporated traders are able to deduct their home office expenses (see Home-office tax deductions for traders, Active Trader, April 2001, p. 102). Incorporated traders do not have a home-office tax form, making it difficult for them to get tax benefits from a home office. Unincorporated traders are allowed the same business expense treatment as incorporated traders, including but not limited to: no limitations on business expenses and the ability to depreciate computers, equipment and furniture.

In terms of trading business expenses, incorporated and unincorporated traders receive similar tax treatment. Traders deduct their trading business expenses from gross income. To report trading business expense deductions, an unincorporated trader uses Schedule C and an incorporated trader uses the regular deduction lines of an entity tax return. Unincorporated traders should file a footnote with their individual tax returns explaining the trading business expenses

In terms of trading gains and losses and mark-to-market (MTM) accounting treatment, incorporated and unincorporated traders also receive similar tax treatment. Both groups are permitted to elect markto-market (MTM) accounting treatment. MTM converts capital gains and losses to ordinary gains and losses. Without MTM, unincorporated and incorporated traders are subject to capital-loss limitation rules, wash sales and are allowed to carry over excess capital losses. The only areas in which incorporated and unincorporated traders differ without MTM is that unincorporated traders are allowed a net capital-loss deduction of $3,000 per tax year; a C-corporation is not. In electing MTM, the only differences between incorporated and unincorporated traders are unincorporated traders must elect MTM by April 15 of the current tax year (three-and-a-half months from the beginning of the calendar year) and incorporated traders must elect MTM within two-and-a-half months of the beginning of their fiscal or calendar year. Tax strategy: An unincorporated trader who missed the April 15, 2001, deadline for electing MTM for calendar year 2001 may be interested in incorporating a new entity that can elect MTM within 75 days of its inception. For example, say a trader June 2001 ACTIVE TRADER

misses the April 15, 2001, MTM deadline and later decides he wants MTM for 2001. The trader can stop trading as an individual (or wait until he is at breakeven for the 2001 calendar year) and then incorporate a new entity to conduct his trading for the balance of the year. The trader elects MTM for this new entity and remains without MTM as an individual.

In terms of earned income and selfemployment tax laws, incorporated and unincorporated traders receive similar tax treatment. Earned income refers to income a taxpayer earns from servicerelated work, as opposed to non-earned income from sources like investing. Trading in securities is not earned income, so trading gains are exempt from self-employment taxation. The difference between incorporated and unincorporated traders here is that incorporated traders can pay themselves salaries, thereby creating earned income. This salary is then subject to social security and Medicare taxes (the equivalent of self-employment taxes) and a retirement plan can be set up and funded in

connection with this salary. Trading in commodities is earned income, so trading gains are subject to self-employment taxation. Incorporated and unincorporated commodity traders receive similar tax treatment. Tax strategy: Traders in securities interested in setting up a tax-deductible retirement plan should consider incorporating. Traders in commodities interested in setting up a tax-deductible retirement plan dont need to incorporate. Commodity traders are paying selfemployment taxes on their trading gains, so they might as well consider the tax advantages of a retirement plan deduction. Traders in securities have the luxury of not paying self-employment taxes unless they want a retirement plan. The tax deduction from the retirement plan contribution usually offsets the cost of self-employment taxes.

nership, all of which are taxed differently. One decision traders need to make is whether to incorporate in their home state or out-of-state. Many traders are interested in out-of-state entities in Nevada or Delaware because these states have no state income taxes. However, many high-tax states (including California) consider this a sham form over substance. Some states will ignore a traders out-of-state incorporation and will tax the traders out-of-state entity in the traders home state. One choice a trader should consider is a flow-through entity in his or her home state. A flow-through entitys taxable activity is reported on the traders individual tax return. (Tax losses or taxable gains flow through to the traders individual tax return.) The trader receives immediate tax relief for losses and does not pay double taxation for gains (i.e., on the entity level and then again on the individual level).

Stock traders who want retirement plans need to be incorporated. Entity choices are a C-corporation, an S-corporation, a Limited Liability Company (LLC), or Part-

After Hours crossword solution

Traders should consider a separate legal entity only if they trade stocks (rather than commodities) and if they want to fund a tax-deductible retirement plan in connection with their trading business income. For most other traders a business entity is unnecessary. You dont have to inform the IRS or your state that you are an unincorporated trading business, and there is no deadline for claiming this part of trader tax status. A trader on extension for 2000 after April 15, 2001, can still file as an unincorporated trading business using Schedule C for tax year 2000. Traders can also amend tax returns from prior tax years to report trading expenses on Schedule C. The second part of trader tax status, MTM, cannot be used after the fact. It can only be used if you filed your MTM election on time, as previously described. Dont be fooled by the form of a trading business entity. All the substance of trader tax benefits can be reaped as an unincorporated trader. Unincorporated traders actually have more flexibility and options than incorporated traders. After you have had success for several years, then you can consider an entity to set up and fund a retirement plan, which every trader does need.



2 3 8 4



12 13

14 15 20 22 23 26 24 27 28 29 31 32 37 39 42 43 44 46 47 50 51 52 53 45 48 49 40 30 33 34 35 38 41 36 25 16 17 18 19 21

34 36 37 39 40 41 42 44 46 47 48 51 52 53

Another answer for 1 across You might use a stop for this ____stick charts Symbol for Dow Jones tracking stock Symbol for Market or limit Before 51 across Nickname for S&Ptracking stock Profit ___ should be greater than 1:1 Symbol for Nortel Networks After 51 across, commissions, etc. They go to the IRS Reversals friend On a Level II screen, it might be green or red

2 3 4 6 7 8 9 12 13 15 17 18 19 22 25 30 32 33 35 38 39 42 43 45 49 50

Price Be careful when using this Symbol for Canadian chip maker A measure of dividend Highly erratic Fundamentals This often occurs after a failed breakout Yours should be at least 17 inches (pl.) Traders hope this kind of cut only occurs at the barber Market _____ (not a specialist) Not resistance Yours may be at home Nasdaq software company ____ hours start at 4 p.m. (EST) The second C in CCI Another term for money If youre reading this magazine, youre probably one In the market, the opposite of bulls Archipelago, Island, Instinet, e.g. There are 6 12 in every market day. Subtract, as in commission Microsoft chairman Bill One of the three major indices (3 wds.) See 43 down (abbr.) You shouldnt trade based on this Symbol for the parent company of CNBC 2001, Active Trader Magazine

Constructed using Crossword Weaver

1 5 7 9 10 11 14


Greenspans group (abbr.) Direct-access firm ___Corp Volatility index A ratio many investors look at Some think these are too wide All stocks trade in these Active Traders Trading Systems ___, or where a scientist works 16 A highly traded Nasdaq stock

20 Traders are always looking for ____outs 21 CNBC anchor Mathisen 23 How you load your software, 24 26 27 28 29 31
or a no-risk place to put your money Small, mid or large Sell an options contract Opposite of puts John Bollingers indicator What every trader aims for Symbol for Intel


I had to do some research. I'm studying some bar charts.

You left the office early. Where are you?

58 June 2001 ACTIVE TRADER



An ongoing look at a trading journal and the analysis of individual trades. In this trade, a market oscillating in a trading range set up a short-term buy. Find out what happened.

Date: Feb. 23 Entry: Long Geron (GERN) at 14 1516 Type of trade: Swing trade Reason for trade: The stock showed strength on a very weak day in the overall market and most importantly was bouncing after slightly penetrating a nearly one-year-old support level. The stock had also rebounded the previous day after establishing its lowest low in more than a month. The stock had been oscillating fairly consistently for many months, giving the oversold signal (the indicator had bottomed and turned up) on the eight-day RSI some credibility (which it would lack in a trending market). The stock had rallied (at least slightly) at such points throughout the course of this trading range. A short-term bounce seemed possible. Stop: 13 38, one-eighth below the most recent swing low that occurred on Jan. 10. Will trail stop one-eighth below lowest low of the past three days. Target: Will look for an up move to challenge the most recent swing high of 20 34 established on Jan. 31. Will lock in profits on half the position around 18, the approximate midpoint of the last swing move. Pluses: Downside risk is easily defined and fairly limited, given the nearby support. After buying the offer, the stock immediately went in the direction of the trade (see Update, below). Initial reward-risk ratio is favorable. Minuses: Stock has been moving sideways to lower for nearly a year. In essence, this trade (at worst) is fighting the trend or (at best) trading when there is no trend. Update (Feb. 23, 4:30 p.m. EST): The Nasdaq reversed dramatically to close up on the day. GERN rallied nearly a point from the entry level to close (at 15 58) near its high.
Geron Corporation (GERN), daily Exit 1

Update (Feb. 26, 2:25 p.m. EST): Took partial profits (one-quarter of position) at 16 14. Will tighten stop to trail one-eighth under the low of the past two days, effective today. Update (Feb. 27, 2:25 p.m. EST): Took partial profits (one-quarter of position) at 1 6 18, because of weakness in broader market after the opening. Half the position remains open. Result

Date 2/23

Stock Entry Initial Target Intial stop rewardrisk 15 3 GERN 14 16 13 8 20 3.24

Exit 16 14 16 18 1514

Date 2/26 2/27 2/28

Total P/L
3 4 (rounded)

Initial stop level

Long-term support




1 8 15 January 2001



5 12 February



Exit: First quarter of position, 16 14; second quarter of position, 16 18; remaining half of position, 15 14 (on Feb. 28 open). Reason for exit: Trailing stop was triggered (15 38, filled at 15 14). Profit/loss: Three-quarters of a point (total). Lesson(s): As of 12:45 p.m. EST on Feb. 28 (with the stock still trading around 15 14), the jury was still out regarding the wisdom of this trade. Tightening the trailing stop was a conservative move, which is generally a good thing, but doing so was also a deviation from the original trade plan. If the stock continues to drop, it will (in retrospect) seem like a shrewd, riskconscious decision; but if the stock takes off to the upside, it will seem like a case of tinkering with the trade plan (out of fear) and giving up profits as a result. However, this trade netted a small profit and leaves open the possibility of re-entering a long position on renewed upside momentum, or going short if the market Exit heads down. (Update: By March 7, the stock had only 2 21.00 20.00 poked its head above 16 once, and only briefly.) Exit 19.00 Negative: Given the down bias of the market, it may 3 18.00 have been better to wait for a selling opportunity. The 17.00 larger market environment (i.e., downtrend) was conve16.00 niently ignored; in retrospect, there were probably better 15.00 candidates for a long trade at the time (and even better 14.00 choices for a short trade). Enter 70.00 Positive: Stops were honored; risk was limited; profits long 60.00 were taken when available. Good execution and risk 50.00 control helped turn a shaky trade idea into a marginally 40.00 profitable trade. 30.00
5 March